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The Late Great Market

Irwin M. Stelzer

The American system of market-based capitalism is in trouble. And the reasons are not the ones commonly cited. The trouble is not that the financial system came close to collapse in the fall of 2008: We have experienced panics before, and the ability of the political and regulatory authorities to cope proves that the financial system is resilient and capable of being coaxed back from the brink of disaster.

Nor is it the long, deep recession that proved resistant to a variety of stimulative policies: We have experienced recessions before and recovered, as we seem to be doing from this most recent cyclical decline.

Nor is it the increasingly unequal distribution of incomes (a trend that might be on the verge of reversing). Again, we have survived periods of wild spending by the increasingly wealthy and simultaneous pressure on the living standard of others, with faith in our capitalist system intact, despite the fleeting popularity of alternative models, ranging from fascism to National Socialism to communism and, more recently, China’s despotic central direction of the economy mixed with market incentives.

Nor is it the fact that the political system underlying our economic system is underperforming: We have seen that several times in the past, one of those periods resulting in a civil war, another in runaway inflation, and market capitalism as the system best suited to Americans’ needs has endured.

All of the problems sketched above proved to be less of a threat to market capitalism than they were sometimes feared to be. The current threat might in the end prove similarly overstated. Let us hope so. For what we are living with now is an economic system that has come loose from its moorings. We have lost what Adam Smith called interest in the happiness of others, though we derive “nothing from it except the pleasure of seeing it.”

Yes, we remain a generous, philanthropic society, with the very rich funding efforts to combat many of the nation’s and the world’s problems. Yes, we have woven a safety net to prevent those who cannot trade their labor for a decent wage from going hungry and homeless—a net that many consider too porous, but a net nevertheless. Yes, we have developed a progressive system of taxation that in effect takes from the rich to give to the poor.

And yet, and yet. We cannot dismiss the charge that in some sense our economic system is stacked against the less powerful. An increasingly concentrated banking system evicts people from their homes based on faulty paperwork and after peddling securities that were touted as reducing risk by bundling very risky mortgages into one very risky package, which the rating agencies then rated highly pursuant to a remuneration system that rewarded the agencies only if they gave wondrous AAA ratings. Unions successfully lobby to make summer internships largely unavailable to college students, reducing their chances to gain experience that would enhance their career opportunities. Monetary policy aims at enriching owners of homes and stocks at the expense of small savers and pensioners, for whom zero or near-zero interest rates are a curse, whatever their effect on boosting economic activity. Fiscal policy conjures a tax system that places a lesser burden on the incomes of billionaire hedge fund operators than on their secretaries, as a distinctly unsocialist professional deal-maker repeatedly points out. Powerful lenders manipulate the legal system so as to deny troubled borrowers, unable to match the massive resources lenders have available, the relief to which they are entitled. Pharmaceutical companies fight to retain pricing systems that make their wonderful products, on which they are surely entitled to a generous return, less affordable to those who might benefit from them. Automobile manufacturers conceal easily fixable but lethal faults in their products on the assumption that individuals injured by these defects cannot cope with the well-staffed and funded legal departments of the manufacturers. Corporate boards approve compensation systems for executives that are often only remotely connected to performance. When a bank CEO messes up so badly that his institution fails some of the Federal Reserve’s stress tests, his board reduces his compensation—from $14.5 million to $13 million.

There is more, but you get the idea. Either these and other instances are isolated blemishes that stand out so starkly because the overall system is otherwise without sin, or they reflect a corrosive weakening in our market capitalism. It is true, of course, that the system has always been home to scoundrels, what Bagehot called “ingenious mendacity .  .  . monstrous frauds .  .  . which generate a sort of tone, tolerant of successful fraud, if not admiring it,” or as Ian Klaus puts it in his recent Forging Capitalism, a system more accurately described by Dickens and Trollope than by Smith and Hume, one in which vice has always been endemic, and “the thieves were often difficult to distinguish from the legitimate.”

But somehow the honorable triumphed over the dishonorable. Republican Teddy Roosevelt broke up the trusts that were creating barriers to competitive entry and prices; Democrat Woodrow Wilson created the Federal Trade Commission to protect consumers from fraudulent business practices; Franklin Roosevelt created the Securities and Exchange Commission to attempt to level the playing field between insiders and small investors; both parties backed extensive reforms in the financial system after the recent collapse. Never mind whether these steps tamed cowboy capitalism or merely created what Bagehot called “trust in unreal help.” They sent a signal that the American system could and would respond to public demands for a fairer shake, that there was some limit to what the powerful could inflict on the less powerful, the rich on the poor, the immoral on the public at large.

In part these reforms worked as well as they did because the legal penalties they created were buttressed by an equally or even more important enforcement mechanism—constraints on behavior created by a desire for the approbation of others. It is the absence of such a constraint, or rather the redefinition of the “others” whose approbation is sought, that is creating a real danger to capitalism. Smith pointed out that the authority of “a distinguished member of a great society .  .  . depend[s] very much on the respect which this society bears to him. He .  .  . is obliged to a very strict observation of that species of morals, whether liberal or austere, which the general consent of this society prescribes to persons of his rank and fortune.” Capitalism’s current problem is that the “general consent” major participants in our market economy seek is the approbation of peers whose moral compasses are unreliable, and who measure each other by the size of their bonuses. These businessmen, wrote Irving Kristol, “because of their indifference to culture, their placid philistinism .  .  . [defend] capitalism .  .  . in purely amoral terms .  .  . and find the bourgeois ethos embarrassingly old fashioned.”

A banker repossessing a car from a veteran who is unavailable to defend his claim to it cares little what the veteran thinks; it is his peers’ opinion of him as a hardheaded businessman that matters. A doctor prescribing a drug in which he has a financial interest, and for which his patient has no need, is seeking the approbation of the profit-maximizing institutions with which he works, and perhaps an approving chuckle from a colleague. A lobbyist who slips a clause into a bill that was intended to protect the public but with that clause included does not, seeks the admiring applause and approbation of his professional colleagues and client. Any need such people might have for approbation from a broader audience can be had by achievements outside of the market system, or by generous charitable or political donations that produce dinners in their honor at ballrooms filled with ticket-purchasers in one way or another beholden to the honoree.

“Now vee may perhaps to begin. Yes?” was the way Alex Portnoy’s analyst put it to him after listening to his long list of complaints. That question, and the further, less eloquent, and shorter one—“So what?”—are perhaps appropriate here.

So let’s start with the fact that many of the practices that are assaulting the integrity of market capitalism are also resulting in massive misallocations of capital. Bankers more interested in selling bundles of risky mortgages than in studying the business plans of prospective borrowers are directing capital to the construction of houses that cannot be afforded by their new owners, and will end up derelict or being snatched from them, with considerable social cost that is of no consequence to the banker. Meanwhile, small businesses are being denied job- and growth-creating capital, even from small, local banks that find the cost of the capital they must raise higher than that of banks investors know are too big to fail and the cost of unnecessary regulation difficult to shed because big banks want them to remain regulated and less able to compete.

In the labor market, Americans find themselves competing with workers in countries that pay as little as a dollar per day because international corporations with outsize influence in Washington have successfully lobbied for trade agreements that enhance their access to foreign markets, or so they believe, while making it more difficult for American workers to earn a decent living. It is of course true that globalization—the dramatic lowering of transport and communication costs—has created competitors for jobs once reserved to American workers, and that some of those jobs carried above-market wages extracted by trade unions with little regard for consumers. But nowhere in the system is there a balancing of the social costs and benefits of freer trade, and an attempt to share some of the gains of consumers with the workers adversely affected by an inflow of low-priced imports, workers who are in a sense the collateral damage of free trade.

And nowhere in the system is there a force that would suggest to Silicon Valley billionaires that there is something wrong with conspiring to hold down the wages of American workers with “no poaching” agreements while at the same time lobbying the government to increase the number of visas for foreign workers and their spouses. The self-congratulatory emails of the executives as they entered into such deals tell us something about the lack of constraint on their behavior, the feeling of camaraderie as they knowingly violated the law, the absence of shame—as does the Justice Department’s decision to settle for a slap on the wrist for a price-fixing offense that has landed less politically well-connected businessmen in jail.

There is more, and perhaps worse. Broad acceptance of capitalism depends in part on the belief that reward follows performance, that people are “paid what they are worth,” and that investment in training and sheer hard work are rewarded. Not perfectly, and not instantly, but at least as a long-run general tendency. I hold no brief for those who profess to know when someone’s compensation is simply too high. But when the process that produces that compensation is seriously flawed, skewed in favor of executives selected by a board they influence and often chair, a board that spends a great deal of effort to make certain that the shareholders who own the company have little to say about who represents their interests, justification of executive compensation becomes more than a little difficult. Directors set the compensation of a CEO who has an important say over whether they retain their posts, fees, and perks. Objectors, or “activists,” are fended off for as long as possible, and then at times bought off with a board appointment or two and a share buyback that rewards them handsomely and, at times, appropriately for their intervention. That all of this results in compensation that cannot be based on performance—executives who perform badly often ride off into the sunset with handsome golden goodbyes—is clear. That such a flawed compensation system, along with blindingly insensitive ostentation that would make a Putin-protected Russian oligarch envious, has the subtle effect of sapping faith in the capitalist system, especially when it plays out as bonuses for bankers who almost brought the system down, only to be bailed out by taxpayers, is less obvious but just as real.

Bankers, easy to demonize, are not the only ones putting pressure on capitalism as we know it. We tolerate a system of licensing, affecting over 100 low- and moderate-income occupations, barring millions of people from jobs they are well able to handle, requiring months of unnecessary training and hundreds of dollars in fees. In many states licenses are required of prospective hairdressers, manicurists, barbers, yoga teachers, locksmiths, bartenders, interior designers, florists—all de facto conspiracies between government bureaucrats and incumbents to prevent competition from workers who are right to believe the system is stacked against them. Lawyers admitted to practice in one state must be retested to practice in another, in a cartel-like arrangement that drives up costs and makes it more difficult for the average person to obtain cost-effective representation he needs to pursue a legitimate claim against businesses with amply staffed legal departments. This creates an imperfect form of competition, a system in which the best lawyered rather than the producer of the best product has an advantage, further adding to the misallocation of resources, and to a feeling that dark forces are operating to make the system unfair.

In prior crises, the answer was “reform.” Teddy and Franklin Roosevelt, Woodrow Wilson, and others did eliminate the grossest abuses of the market system, or at least provided the appearance of a willingness and ability to do so. A similar expansion of the regulatory state is now underway, and it might, only might, eliminate some of the current abuses, although the growth of the lobbying industry will make that difficult; witness the ability of the banking industry to slip a provision easing regulation into a bill passed early in the reign of the newly installed Republican Congress.

But government action cannot make up for the collapse of self-regulation based on modesty and restraint, an understanding that enough is enough, a recognition that productive efficiency and fabulous rewards alone do not make for what Kristol called “a good life in a good society.” When a leading banker tells Congress that he “does God’s work,” he is suggesting that the sky is the limit on his compensation. We have always had our ostentatious rich, men and women who, to use modern jargon, “lived large.” J. P. Morgan, William Randolph Hearst, and others were not consumed with a desire to keep their extravagance invisible to the less well off. But that was then and this is now. The hopeless poor have been replaced by an aspirational middle class, politicians subservient to malefactors of great wealth by those subservient to the mass of voters, in primaries and general elections. Unless convinced that the capitalist system as practiced here and now is fair—not that everyone can become a Bill Gates or Warren Buffett, but that the avenues of advancement are not closed because of imperfections in capital and labor markets—support for our system will deteriorate. Unless convinced that those at the top of the income pyramid are not as insensitive to the needs of the less well off as were royalists of old in other countries, voters will demand more and more regulations, with politicians rather than markets allocating housing, and then health care, then energy resources, then incomes. Or are we there already?

If so, that would be a pity, and for the very people the regulators and bureaucrats claim to benefit. Capitalism, properly but not heavily regulated, has produced greater material well-being than any system, anywhere. Karl Marx grudgingly recognized that in his day, Joseph Schumpeter in his, John Maynard Keynes in his, although Marx and Schumpeter forecast Communist and socialist futures for capitalism, while Keynes worried about its ability to respond to depressions.

But none doubted capitalism’s ability to produce the goods. As NYU and Princeton professor William Baumol concluded after a long study of the free market, “The capitalist economy can usefully be viewed as a machine whose primary product is economic growth. Indeed its effectiveness in this role is unparalleled. .  .  . [The free market has produced] a rate of growth in living standards far beyond anything that any other type has ever been able to achieve for any protracted period.” Capitalism, dependent for its success on the rule of law, has also been associated with individual freedom, a factor not unrelated to its fabulous innovative capability and the fact that people, when free to vote with their feet, come to America to participate in its opportunity-based economy. There is very little exodus from Beverly Hills to Beijing, or Palm Beach to Paris. Those facts are self-evident.

And it may well be that some of the gloom isn’t as gloomy as the gloom-mongers originally believed. Larry Summers, the thinking man’s Keynesian, has backed off his assertion that America is entering a period of secular stagnation. Thomas Piketty, the French economist and author of the publishing sensation Capital in the Twenty-First Century, is beating a similar retreat from his now-famous conclusion that under circumstances likely to prevail in this century “capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based.” The middle class might be having some difficulties, but the Pew Center has found that 84 percent of Americans have higher real incomes than their parents did at their age when we adjust for family size. Conservatives such as Peter Wehner and Yuval Levin add, encouragingly, that there are policies, if adopted, that might reverse those that are contributing to the seemingly relentless rise of a permanent underclass in America that so troubles observers such as Charles Murray (Coming Apart) and Robert Putnam (Our Kids: The American Dream in Crisis). Despite the grumbling, paving stones are not being hurled at politicians, tanks are not patrolling the streets, and the Occupy Wall Street crowd has dispersed.

So far, so not-too-bad. But capitalism unmoored from the codes of behavior assumed by Adam Smith and others cannot survive in its present form, especially when dominated by parochial pressure groups that create what Mancur Olson called a choking undergrowth that saps a country’s economic vitality. A rising tide of regulations designed to control the worst behavior of our current self-styled but too-often-amoral masters of the universe, and of taxation to offset the perceived flaws in the way income is distributed, may very well consign markets to a much reduced role in our economic system. As a result, we could end up with a system unable to produce the material well-being that has made American market capitalism a source of worldwide envy and wonder. I suppose we should fear the worst and hope for the best. But as we have learned recently, to our pain, hope does not necessarily produce change for the better.

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