<b>Jagdish Bhagwati:</b> Capitalism: Myths and fallacies - II

Madoff is not a product of financial markets; he was depraved to begin with

It is not financial markets that produce crooks like Madoff, says Jagdish Bhagwati

Myth #4: Markets undermine morality
Inevitably, the crisis on Wall Street has revived the notion that markets undermine morality. Oliver Stone, ever restless to recapture the days of former glory, is, we’re told, contemplating a sequel to the 1987 movie Wall Street which immortalised Gordon Gekko as the symbol of markets and greed. These critics believe that working with and within markets fuels our pursuit of self-interest, greed, avarice, self-love in ascending orders of moral turpitude.

But this assertion is surely at variance with what we know about ourselves.

Yes, markets will influence values. But, far more important, the values which we develop in several ways will affect how we behave in the marketplace. Consider just the fact that different cultures exhibit different forms of capitalism. The Dutch burghers Simon Schama wrote about in The Embarrassment of Riches used their wealth to address the embarrassment of poverty. They and the Jains of Gujarat from whom Mahatma Gandhi surely drew inspiration, and the followers of John Calvin, were all exhibiting values that came from religion and culture to bring morality to the market.

Again, the economist Andre Sapir of Brussels, in particular, has pointed out the diverse forms of capitalism that flourish in the world, denying the claim that markets wholly determine what we value. Thus, the Scandinavians have an egalitarian approach to their capitalism which differs from what we find in the United States where equality of access, rather than of success, is the norm.

How does one react then to the Madoffs? Do they not represent the corrosion of moral values in the marketplace? Not quite. The payoffs from cutting corners, indeed outright theft, have been so huge in the financial sector that those who are crooked are naturally drawn to this sector. It is not the financial markets that have produced Madoff’s crookedness; Madoff was almost certainly depraved to begin with.

Myth # 5: The financial collapse reflected ideology
Yet another myth, at least in the financial sector where the collapse began, is that the crisis had been driven predominantly by the ideology of markets and deregulation, rather than by factors such as lobbying by Wall Street to make profit. 

 

 

Unwarranted extrapolation: Of course, the notion that a freer play for financial markets, and indeed increased reliance on self-regulation, would produce the greater good, played a role. The postwar period had shown the power of liberal economic policies on trade and direct foreign investment. But to carry over the legitimate approbation of freer trade in particular to the altogether more volatile financial sector, which represents the soft underbelly of capitalism, was surely unwarranted.

The East Asian crisis in 1998 had been a result of this unwarranted extrapolation from free trade, resulting in freed international capital flows. But a simple analogy illustrates the asymmetry well. If I exchange some toothbrushes for some of your toothpaste, and we both remember to brush our teeth, our teeth will be whiter and the chance of our teeth being knocked out in the process is negligible. But with capital flows, the proper analogy is to fire. It enables Tarzan to roast his kill in the jungle but it can also burn down Lord Greystoke’s manor in England. 

Wall Street-Treasury Complex: But we must ask why some of the world’s best economists such as Larry Summers went along with this illegitimate extension of the indisputable advantages of markets in trade to the financial sector, when in fact they could not but have been aware of the asymmetry I had written about. For this, my explanation was what I called in my 1998 Foreign Affairs article, and in several writings subsequently, the Wall Street-Treasury Complex. With the constant to-and-fro movement of people like Robert Rubin and lesser but still influential figures between Wall Street and Treasury, the euphoria about how markets, which would serve the interests of Wall Street, would function as well in the financial sector as in trade was shared by people wearing the same Brooks Brothers suits and belonging to the same clubs and circuits. It therefore led to a suspension of guard by these gifted economists in the Treasury, and by their high-level counterparts in the International Monetary Fund which also joined in the chorus for freeing up capital flows. 
 

Lobbying: One of the dramatic moves that played a role in the crisis was when the heads of the big five investment banks, among them Treasury Secretary Hank Paulson who was then CEO of Goldman Sachs, “persuaded” SEC to impose no reserve requirements on their lending, resulting in reckless over-leveraging that accentuated the crisis when the housing bubble burst and securitised mortgages became toxic assets. But this had to do with lobbying for profit, not with ideology. Hank Paulson was a graduate of Dartmouth, a famously liberal arts college; and he was known to be an ardent environmentalist. He was no ideologue on markets. 
 

Government failures: But why did the SEC agree to this demand? This had to do with governmental failure, for sure. Senator Schumer who represents New York and therefore has Wall Street PAC contributors, is known for having indulged in Japan-bashing, then India-bashing, and now China-bashing: all because he was playing for his constituents. This time around, he bought into their argument that Wall Street would lose to London if the demands of the investment banks were not conceded. So, he played a crucial role in the “race to the bottom” that was central to the crisis.

In addition, governmental role in the crisis was evident in the way in which Congressmen of both parties bought into the argument that everyone, regardless of their circumstance, must own a home, thus encouraging profligate spread of sub-prime mortgages that fed the housing bubble with what would become toxic assets. The US, instead of becoming a house-owning democracy, bought into a certain crash that would imperil the economy. 

“Destructive Creation” in financial innovation versus “Creative Destruction” in non-financial innovation: The packaging of these sub-prime mortgages into collateralised debt obligations (mortgage-backed securities, MBS) was married into the invention of credit default swaps (CDS) by J P Morgan bankers who got third parties like AIG to assume the risk of default on these securities in exchange for regular payments resembling an insurance premium. The MBS was expanded massively because it was assumed that the risk of default in the underlying mortgages was less because everyone would not default together, not allowing for the tsunami that hit when the housing bubble burst and the sub-prime mortgages collapsed together. The associated massive exposure by those issuing CDS, which had been done without setting aside adequate reserves to guard against such a tsunami, meant that the collapse of the financial sector was guaranteed.

In short, few on Wall Street, caught up in the euphoria over these financial innovations, had allowed for the fact that financial innovation had potential downsides which were huge and had to be carefully thought through and guarded against. We were confronted by the fact that, while non-financial innovation such as the invention of the PC would require what Schumpeter called “creative destruction” so that Olivetti and IBM which produced now-obsolete typewriters would be eased out, in the case of financial innovation, the invention of new instruments had a wholly different downside possibility which could make it into what I, and journalists such as Gillian Tett and Thomas Friedman since then, have called “destructive creation”.

Innovation in the financial sector therefore has to be dealt with differently from other innovation. I have therefore argued that we need an independent set of experts, who are familiar with Wall Street but are not part of it and the Wall Street-Treasury Complex, to evaluate the downside of new instruments and to make that informed analysis available to regulators. Regulators, after all, cannot regulate what they cannot understand. True, no one can foresee everything. As Keynes remarked characteristically in a letter to Kingsley Martin, the editor of The New Statesman, “The inevitable never happens; it is always the unexpected.” But the Committee which I have proposed, and which is in different versions part of the new financial regulatory architecture now being discussed, should be able to narrow the range of the unexpected.

Clearly, the crisis demonstrates that the financial sector which provides the life blood of capitalism — without the blood flow, the best muscles in the world will not survive — needs carefully designed, not knee-jerk, correctives, as indeed is widely recognised. Nor does it condemn capitalism to the dustbins of history as the critics would hope for.

This is the second and final part of a two-part series on capitalism. 
Read the first part at https://www.business-standard.com/370098/