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YOU DECIDE: Is capitalism up for grabs?

June 24, 2010

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu


Dr. Mike Walden
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More so than at any time in the last 70 years, our fundamental economic system -- capitalism -- is being questioned. Capitalism is a system of private ownership of resources and private decisions about how those resources are used. While we certainly don't have a pure form of capitalism -- public decisions (government) do play a major role in our economy -- business decisions about what to produce and what prices to set and household decisions about where to work and what to buy are largely left in private hands.

But some are now saying the capitalist system has failed us. The basis for this statement is the recession. While recessions occur with some degree of regularity, the severity of the recession which began in late 2007 has shocked most people. It has revived ideas that capitalism is inherently unstable and requires more government control.

What is the intellectual basis for this claim? There are two fundamental roots to the argument. One comes from the English economist Keynes who believed capitalist economies go through periods of optimism and pessimism. During the optimistic times, consumer spending is high and investment returns are significant. Then, something sparks a mood change to pessimism. Investors sell, returns fall and consumers retreat by curtailing spending and increasing saving. These economic conditions prompt a recession.

Several factors could cause the change in attitude ("animal spirits" in Keynes' language). Bad weather could cause crop failures or floods. International political tensions could increase the chance of war. Or technological advances may cause investors initially to over-estimate the resulting investment returns. Then, when reality sets in, there's an investment pullback (a bust) and subsequent decline in the broader economy.

In the 1970s the economist Hyman Minsky offered a somewhat different, although related, cause for capitalism's instability. Minsky focused on the banking system and the instability caused by fractional reserve banking. Fractional reserve banking results in depositors' total claims on banks' reserves exceeding those reserves. For example, a bank may have $10 million in loans but only $2 million in reserves. The system works fine when the banks' loans succeed. But if a substantial number of the loans fail, the result can be a run on the bank by depositors and collapse of the financial system.

Some observers say a "Minsky moment" occurred in the 2007-09 recession, when a drop in housing values effectively prompted a run on the "shadow" banking system (hedge funds, investment banks) and brought the nation -- and world -- close to a financial calamity.

Believers in either of these two bases for capitalism's instability see a need for greater regulation of our economic system, including restrictions on how financial managers are compensated, what products financial firms can offer and additional public funds to be used for the rescue of large (too big to fail) companies. Some of these ideas are embodied in legislation currently being considered by Congress.

But there is an alternative view, which says that rather than private decision-makers making capitalism inherently unstable, it is the actions of public decision-makers that are the source of the problem. The Federal Reserve can create economic instability by alternatively increasing and then decreasing the availability and cost of credit. This realization led the economist Milton Friedman to propose replacing the Federal Reserve Board with a computer programmed to increase the credit supply at a constant rate. Public decision-makers can also create instability by changing tax rules and government spending programs.

Indeed, a strong argument can be made that the housing market crash and 2007-2009 recession resulted from easy and ample credit provided by the Federal Reserve in the early 2000s, a change in the tax law in the late 1990s increasing the tax value of homeownership and the aggressive promotion of homeownership by the quasi-governmental agencies Freddie Mac and Fannie Mae.

Many economic historians have argued that capitalism has brought more prosperity to more people than any other economic system developed. But the economic events of the last two years have called the system into question. Each person will have to decide the degree to which capitalism is at fault. My own advice, as a professional economist, is to carefully consider any changes.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

For more news from the College of Agriculture and Life Sciences, please visit http://www.ncsu.edu/project/calscommblogs/news/

Posted by Dave at June 24, 2010 04:34 PM