Case for new era is overdone

There follows my Fund Strategy review of Anatole Kaletsky’s Capitalism 4.0 (Bloomsbury)

It is hard to resist the inclination to exaggerate the importance of contemporary or recent events. Dramatic changes from the immediate past will often overshadow all but the biggest historical developments.

Who nowadays, apart from hard core experts, discusses the Asian financial crisis of 1997-98? Or the Latin American debt crisis of the 1980s? Yet both were once seen as posing existential threats to the global financial system and endangering the world economy.

This tendency to exaggerate the historic importance of the present helps explain why so many experts are eager to declare that the world has entered a new era. There is the “new normal” (Mohamed El-Erian and Bill Gross of Pimco), the “new paradigm” (George Soros) and the “new capitalism” (the BBC’s Robert Peston).

Anatole Kaletsky’s Capitalism 4.0 is different from most in that his new era embodies a positive vision. Most others foresee a period of low growth as well as high political and financial instability. In contrast, Kaletsky, the principal economics editor of the Times (London), sees the recent global crisis as an aberration. As long as policymakers are willing to be pragmatic the future, he argues, should be bright

The name of Kaletsky’s book relates to three eras of capitalism he identifies. Capitalism 1 ran from 1776 (the American Declaration of Independence and the publication of Adam Smith’s The Wealth of Nations) to 1931. Its philosophy was laissez-faire, which held that economics and politics should be kept as distinct as possible. Capitalism 2, the Keynesian era, ran from 1931-80. Most recent, running until 2008, was the Capitalism 3 of free market economics and the Thatcher-Reagan political revolution.

Probably the most interesting part of the book is Kaletsky’s rebuttal to the orthodoxy that America suffered a massive housing bubble. He contends that the increase in house prices between 2000 and their peak in 2006 was modest in historical terms. It was more a recovery from an earlier 20-year slump than a true bubble.

To the extent global property prices were rising it was a rational response to benign trends. In particular the period of the Great Moderation – the unprecedented stability in the economy and labour market – made it easier for ordinary people to borrow. They had to worry less about losing their jobs than in the past and could expect rising prosperity.

Two other megatrends helped to bolster the long-term prognosis of the world economy. The addition of three billion people to the global economy – including China, India and the former Soviet Union – was a huge boon. In addition, globalisation meant that the principles of market competition, private enterprise and free trade were almost universally accepted.

Since these themes were central to Kaletsky’s optimistic outlook before 2008 he should not be accused of inconsistency. However, it could be argued he is trying to justify his previous optimistic stance in the light of the subsequent crisis.

Kaletsky is less convincing in his explanation of the crisis. He attributes much of the blame to Hank Paulson, the former US treasury secretary and head of Goldman Sachs. Kaletsky portrays him as the epitome of what he calls: “the total failure of leadership and judgement in the United States”.

For Kaletsky the backdrop to Paulson’s colossal blunders was his attachment to “market fundamentalism” – “a quasi-religious faith that markets are always right”. This narrow intellectual viewpoint led to the disastrous adoption of mark-to-market accounting and risk-weighted capital requirements. The first of these meant that banks’ accounts assumed the true value of its loans was that determined by the market. As a result the regulator’s discretion was minimised. Together with risk-based capital regulation this had the effect of exaggerating the booms and busts in finance.

The second big blunder, also reflecting a market fundamentalist mentality, was the refusal by the American administration to intervene to stem surging oil and food prices. Although the spike was, in Kaletsky’s view, the result of speculation the authorities refused to intervene.

Most serious of all was the administration’s refusal to intervene in the financial system when the credit crunch began. Britain had shown what could be achieved by providing an open-ended guarantee to all domestic financial institutions to cushion the impact of Northern Rock’s collapse in 2007. Yet America had failed to take similar action following the collapse of Lehman Brothers.

The main problem with Kaletsky’s work is that he exaggerates the influence of market fundamentalism. Outside of American economics faculties relatively few Americans were hard core free marketeers. And even if they did believe in free market economics in principle the practice was completely different.

Milton Friedman’s Free to Choose, the 1979 work that Kaletsky describes as the “intellectual bible” of market fundamentalism, advocates a far more limited role for the state than existed in America in 2008. For Friedman the role of government should include the three duties outlined by Adam Smith in 1776: protecting society from violence and invasion; administration of justice; erecting and maintaining key public works. In addition, Friedman added a fourth duty of protecting members of society who cannot be regarded as “responsible” such as children.

Whatever one thinks of this prescription it bears no relationship to America on the verge of crisis. State spending accounted for about 37% of GDP and federal regulators such as the Federal Reserve and Securities and Exchange Commission played an extensive role. The American authorities made mistakes but they were far more pragmatic than Kaletsky’s account allows. To the extent they exacerbated the crisis it was more to do with a reluctance to face their responsibilities than a doctrinaire allegiance to the free market.

Kaletsky’s distinction between a fundamentalist Capitalism 3 and a pragmatic Capitalism 4 is overdrawn. He comes nowhere near making a convincing case that the world has entered a new economic era.