How Capitalism Will Save Us (15 page)

Advances that are today considered progress were seen as destructive by the nobles and aristocrats of that era. We see creation. They saw destruction.

Industrialization brought similarly disruptive changes in the nineteenth century: the rise of mechanical looms boosted textile production, but they rendered traditional hand weavers obsolete. The result: riots in England. Craftsmen smashed the machines they saw as job killers. One riot was led by Ned Ludd. His opposition was so virulent that his name became synonymous with resistance to all technology. Hence the term
Luddite
.

The spread of railroads throughout America and Europe enabled people to travel and transport freight faster. Yet railways also replaced the canals that had been used for commercial transport. Many canal operators went broke, stiffing bondholders. People who made their living from canals had to find new lines of work. Contractors had to switch from digging canal trenches to laying rails and building railroad cars.

Joseph Schumpeter, the great twentieth-century Austrian economist, recognized the disruptive power of innovation. He understood that advances wrought by entrepreneurs and others are not only beneficial. They also shatter the old order. Schumpeter called this process “creative destruction” and explained that it is essential to a healthy economy.

Creative destruction can provoke a yearning for a simpler way of life. Industrialization in the nineteenth century raised living standards and made life easier. But it also disrupted the agrarian rhythms of the countryside with smoke-belching factories. People like the writer William Blake called the large textile plants “satanic mills.”

Like Blake, many people today are upset by the process of change—especially politicians. Ohio congressman Dennis Kucinich calls for protections against foreign competition. New York senator Charles Schumer wants China to revalue its currency to slow exports to the United States. Unfortunately, the instinct of such free-market opponents is to condemn what is changing and attempt to preserve the old order. They don’t see the process of creation simultaneously taking place in the economy.

Think of where we’d be today if, to preserve jobs, we had to continue using old-fashioned typewriters instead of word processors. Or if we had to use human operators instead of electronic routers to direct our telephone and cell-phone calls. Or if we still had to ship goods via canals—instead of by trucks, rails, and air. Or if we continued using those mammoth old mainframe computers instead of today’s PCs and handhelds. Or, finally, if we still used the telegraph instead of communicating by fax, phone, or e-mail. Some jobs would have been saved. But many more never would have been created. And our general standard of living would have been far lower.

People who complain about the “brutality” of free markets fail to appreciate that over time, democratic capitalism has resulted in more job creation than destruction. The U.S economy is constantly creating and destroying jobs. Each week in normal times 540,000 jobs are lost while some 580,000 new ones are created.

Between 1980 and 2007, despite fluctuations, the United States overall gained jobs. Employment rose to 130 million from 91 million, a net gain of nearly 40 million jobs, far more than the rest of the developed world put together. Productivity, measured by output per worker, increased more than 56 percent, despite three recessions during this period.
¹
Thus, even though there are serious job losses as of this writing in 2009, history shows that the United States will remain a vigorous job-creating machine because we don’t have the job-killing regulations and taxes of Western Europe—at least not yet.

Many of these new jobs barely existed just a short time ago. For example, no one had ever heard of a “webmaster” in 1990. But in 2002 there were 280,000 of them, in addition to programmers, network operators, and the millions of other jobs created by the Internet in the last two decades.

Sometimes labor-saving devices end up creating more jobs than they destroy. Take ATMs, which were meant to replace most bank tellers. There are now more bank tellers than there were when ATMs were introduced thirty years ago. Why? The machines handle routine banking transactions, allowing branch personnel to focus on providing customers with specialized services.

For decades, until the current recession, U.S. unemployment has been significantly lower than in most nations of Europe, where hiring
and firing and new business formation and closings are heavily regulated by government in the name of creating a kinder, gentler capitalism.

Competition can be rough in a free market. But it also compels people to do things better. Individuals hone their skills; companies improve quality and cut costs. The result tends to be better, cheaper products. Society as a whole benefits. A study by the McKinsey Global Institute, for example, suggested that competition was at least as important as technology in improving a business’s productivity and innovation—its effectiveness in serving its customers.
²

Thanks to growth created in part by the “brutality” of democratic capitalism, a middle-class American commands a greater variety of goods and services and better health care than any monarch in the nineteenth and early twentieth centuries. No doubt individuals as well as organizations can experience failure in a free market. And for some, those failures are acutely painful. Yet thanks to the flexibility of our economy, those who suffer setbacks have a greater chance of recovering and eventually succeeding.

W
hen the economy goes through a major downturn, políticos and pundits inevitably blame capitalism. The last few years have been no exception. The collapse of the subprime-mortgage market and the credit crisis that followed have been widely blamed on “unfettered markets.” Congressman Barney Frank, chairman of the House Financial Services Committee, declared the crisis the fault of “the private sector”
³
and “predatory lenders.”
⁴
“Wall Street greed” was blamed not only by Democrats but Republican candidates in the 2008 presidential campaign.
John McCain attributed the crisis in part on “a casino on Wall Street of greedy, corrupt excess—corruption and excess that has damaged them and their futures.”
⁵

Finger-pointing like this, however, obscures a Real World economic truth: what is often blamed on free enterprise is in fact the result of price or supply distortions created by government.

We’re not saying that all downturns are government created. There’s a distinction to be made between catastrophes like the 2008 credit crisis and ordinary business cycles produced by the forces of marketplace creative destruction. Normal downturns can be caused by—to give an example—too many companies entering a market. In the early 1980s numerous players jumped into the personal-computer business. Most failed. This kind of turbulence, while painful, is part of the economy’s process of change, whereby new technologies and ways of doing things supplant the old, creating more jobs and higher levels of prosperity.

Recessions produced by such normal cycles, though, are usually not long lasting. But the very biggest traumas, such as the 2008 meltdown of the credit and housing markets, are not made by free markets. They result from government intervention that didn’t allow markets to work.

Few people fully appreciate the extent to which the behavior of markets is influenced by government, with its mammoth powers of regulation and taxation and ability to direct, indeed to print, trillions of dollars. This immense power was a key determinant in both the subprime collapse and the credit crisis.

We began to outline government’s role in the crisis in
chapter 1
. The financial crisis in fact was the by-product of not one but three government-created disasters. The first was in monetary policy. The housing bubble would not have reached its immense size without the Federal Reserve’s low-interest-rate, “easy money” policy of the early 2000s. In 2003–2004, the Federal Reserve made a fateful miscalculation, believing that the U.S. economy was much weaker than it was. The Fed therefore pumped out excessive liquidity, printing dollars and keeping interest rates artificially low. That affected not only housing, but also the entire economy.

When too much money is printed, the first area to feel it is commodities. (They’re traded globally on a daily basis in dollars and are therefore more sensitive to changes in the money supply than, say, a fixed asset like a home that is sold every few years or months.) Thus the Fed begat a
global commodities boom as the price of oil, copper, steel—even mud—shot up. The price of gold roared above its average of the previous twelve years. For nearly four years the dollar sank like a rock in water against the euro, yen, and pound.

The already booming housing market exploded. Housing was experiencing above-average price rises because of a favorable change in the tax law in 1998 that virtually eliminated capital-gains taxes on the sale of most primary residences. Now with money easy, a bubble mentality took hold. The reasoning was that housing prices always go up; therefore, lending standards could be safely lowered.

We described in
chapter 1
how people were swept up in this manic optimism: so what if a dodgy borrower defaulted? It didn’t matter—the value of the house would always be higher.

No doubt some lenders became aggressively reckless. One homeless man reportedly got to buy a $700,000 house. Mortgage underwriters in institutions like Washington Mutual were under severe pressure to process mortgages, quality be damned. So-called teaser rates proliferated. A borrower would be given a very low rate at the beginning of the mortgage, which would be jacked up after a given period. Such a higher rate might be beyond the borrower’s ability to pay. But not to worry. Many of these borrowers were assured that they could refinance with a new teaser rate.

The housing debacle could never have happened on such a catastrophic scale without the government’s easy-money policy. Yet the Fed’s error was studiously ignored by most policy makers as well as the mainstream media.

Disaster number two: government-created mortgage giants Freddie and Fannie helped inflate the balloon still further. As we mentioned in
chapter 1
, Fannie and Freddie dominated the subprime market. With $1 trillion in assets and more than $53 billion in revenues, Fannie Mae was in 2004 the nation’s twentieth-largest corporation and the second-largest financial institution in the country, right behind Citigroup. Freddie Mac, meanwhile, held some $800 billion in assets in 2007.

By 2008, Freddie and Fannie bought, packaged, and guaranteed more than $1
trillion
worth of less-than-prime mortgages, selling them as securities to investors. These securities—remarkably—were rated “triple A” by rating agencies, in an extraordinary bout of hallucination.

The third government disaster bringing on the financial meltdown was a succession of regulatory failures. The worst by far was the refusal by regulators to back off “mark-to-market” or “fair value” accounting rules, which gratuitously destroyed banks and insurance companies. A concept floating around since the 1990s, mark-to-market accounting got a push from the corporate scandals that engulfed Enron and others. The intent was to compel public corporations to increase accounting transparency.

Mark-to-market required financial companies to adjust the value of their regulatory capital—to mark it down or up—to what they would command on the open market. These changes would “have to flow through” the companies’ profit-and-loss statements. In other words, if the value of a bank’s securities went down, it would have to show a charge. The rule meant that the bank had to raise capital in order to restore its balance sheet.