Donnerstag, 26. März 2009

Capitalism: A Systemic Crisis?

Warning: This post is somewhat philosophical (Krugman would label it "wonkish").

I've been reading FAZ-columnist/blogger Thomas Strobl aka Weissgarnix. He has his own economic theory to explain the current crisis. It is based on a lose assortment of non-mainstream theorists (Marx, Minsky, and a couple of contemporary German academics). While I don't agree with the overall theory (assuming I understand him correctly), I find it useful to dissect unusual approaches, because it can help to get the real issues back into focus.

So what is he saying?

In essence, the train of thought seems to be:

1. The capitalist system cannot exist without growth ("ein nicht wachsender Kapitalismus ist nicht möglich! Und ein nicht wachsender Wohlfahrtsstaat auf Basis eines monetär-marktwirtschaftlichen Systems schon gar nicht.")

2. Growth can only be funded via credit expansion, i.e. no growth without more and more indebtedness ("ohne Nettoneuverschuldung ist der Kapitalismus schneller erledigt, als Sie den Ausdruck 'deflationäre Depression' aussprechen können")

3. If/when indebtedness becomes too much and further debt can no longer be sustained, a crisis ensues

So let's see:

ad 1: Capitalism requires growth

I don't quite understand his reasoning why the capitalist system "needs growth".

At one point, he argues that companies need to grow in order to repay their debt and interest. That is not convincing, because a company producing a profitable product can simply repay its creditors from the revenue it generates by selling the product. Over time, it can grow, stagnate or even cease to operate. Many entrepreneurs like to grow their businesses. Others grow because of scale effects (i.e. they cannot compete if they don't grow). But that's on the company level. It has nothing to do with overall economic growth.

On another level, he argues that the economy needs to grow because otherwise there will be increasing conflict over how to distribute the stagnating pie. According to him, "capital" automatically demands a bigger and bigger piece of the pie, so if/when the pie no longer grows, the "labor" element of the economy will start getting really upset about getting less and less.

But there is no "natural law" that an ever-increasing portion of GDP is distributed as capital income:

- First of all, it is not necessarily the case that more and more capital has to accumulate. Capital accumulates if an economy saves more than the existing capital stock depreciates. If people choose not to save, or if the government uses the savings to redistribute them for consumptive purposes, then there is no net saving, and the capital stock declines.

- Secondly, it is not necessarily the case that the interest/profit earned on the capital increases or even stays constant. If investors can't find attractive investment opportunities, interest and profit go down. The share of the pie allocated to "capital" goes down.

World GDP has been growing because productivity is going up and capital is accumulating. That's the way it has turned out. But it is not a necessary condition for capitalism to exist. If/when productivity growth slows, resource constraints hit and people prefer consumption over productive investments, growth will slow down, or even become negative. But that won't kill the "capitalist system" as such. Why should it?

ad 2: Growth requires credit expansion

Of course world growth over the last decade was to a large extent fueled by credit expansion in the US, UK and some other countries. That's a fact.

But Strobl argues that this was inevitable, that the capitalist system can only work via credit expansion. Maybe the Americans overdid it a bit, but in any case a growing debt mountain would have been necessary to stave off stagnation followed by a systemic collapse.

I'm unable to follow: He argues that capital accumulation can only be financed via debt. But that simply isn't true. Expansion can be equity-financed as well. And equity can come both from outside investors and from retained profits. Neither case requires debt. In fact, all companies in the world could (in theory) operate without any debt and still grow, as long as investors are willing to provide capital in the form of equity participations and/or refrain from full profit distribution. (Strobl counters this argument by saying that equity is a form of debt as well. He lost me there.)

Debt comes into existence becomes some people and/or companies want to consume/invest more than they earn. Others want to consume/invest less than they earn. Credit makes it possible that the first group can borrow today and repay tomorrow, whereas the second group can have funds today and repay tomorrow. It is of course somewhat fragile in the sense that repayment is never assured. But only in the case of straightforward debt obligation (-> repayment with interest) is repayment actually required. Equity participations do not require fixed repayment, they pass on upside and downside instead. Equity and debt have very different characteristics, and Strobl's argument breaks down when the possibility of more equity-financing is introduced.

During the last 5-10 years, leveraging was en vogue. Private equity, hedge funds, off-balance-sheet SPVs - the more leveraging to increase your upside, the better. Too bad that there was also more downside. You can say all you like about the (lack of) relevance of finance theory: Anybody who understands Modigliani-Miller, CAPM and the like knows that leveraging per se doesn't create value. You can slice it anyway you like. And you can certainly structure it with little or no debt.

Admittedly, the concept of equity participation (as opposed to debt) only works for companies, not for private households: A household cannot sell stocks in his personal net worth. If he wants to borrow money to build a house, go to college, etc., he needs debt. But again, there is no need for this debt to keep expanding at an unsustainable pace: If households don't overextend themselves, they can keep their debt exposure low. If their debt doesn't grow faster than their income, the situation is sustainable.

ad 3: Overleveraging leads to crisis

I certainly agree with this point: There is way too much debt in certain countries right now, and things have become unsustainable. I also agree that laissez-faire capitalism frequently exhibits unstable tendencies, if/when governments and regulators allow it.

So to summarize:

In my humble opinion, Strobl's theory doesn't hold water.

I think things are less convoluted, and can be summarized as follows (Keynes and Krugman would probably agree):

- There was significant overinvestment in certain sectors, most notably residential and/or commercial construction in the US, UK, Spain and China

- This overinvestment was facilitated by naive behavior everywhere: hands-off regulators, a banking sector that seemed to think risk can always be passed to someone else, and deluded private households and investors. None of that was inevitable

- Once the bubble burst, there was sudden lack of demand in important sectors of the world economy

- This shortfall of demand by itself would have been enough to set off a recessionary spiral, as demand for capital goods automatically goes down when overall demand cools off

- The collapse of the financial industry exacerbated the problem by suddenly choking off credit, and creating overall panic based on the flood of "end of the world" news

- In the end, everybody's mindset was in "catastrophic crisis"-mode, which meant nobody (neither firms nor private households) wanted to make any investment decision anymore

- And presto: We have a depressionary spiral that can only be solved by government intervention

So what is the role of excess leverage in all that?

Simple: The housing bubble wouldn't have occurred without buildup of excess leverage.

Necessary follow-up question: How would the world have fared if the bubble had never happened in the first place?

According to some (including Martin Wolf), that wouldn't have been good either: In their view, the world faces a "savings glut". The "glut" is particularly acute now that Americans are no longer consuming and building even more houses, but it already existed in the past. If Americans hadn't gone on a spending binge, the excess savings of Asia and Germany wouldn't have been used by anybody, and the world would have entered a recession much earlier. So for a while, America (and the UK) saved everybody's day by putting all those excess savings to use.

In essence, this is similar to the good old-fashioned liquidity trap aka "depression economics": If the world saves too much, there can be no market clearance, because nominal interest rates can't fall below zero. So unless somebody - usually the governments - steps in to use the excess savings, a recession/depression ensues. To put it a bit provocatively: In Martin Wolf's worldview, heroic American consumers did their part to keep the world out of a world recession/liquidity trap. Now they can't continue, and other countries have to do their duty of investing to keep things going. And things have to keep going, growth has to continue.

If it is true - and I tend to agree - that the world saves too much (in the aggregate, savers want to save more than investors are willing and/or able to borrow), and there aren't enough useful investment opportunities to deploy all that money, then governments clearly have to step in and do something. However, the current piling up of government debt mountains is not the only way. It can be a short-term stop-gap solution, but the risk is that people will become mistrustful of the long-term consequences of so much debt. While there is a demand shortfall, there is no "automatic" inflationary pressure. But that only holds true if people do not lose faith in the monetary system. Once there is a credibility crisis, anything can happen, as people no longer want to hold cash and bonds.

However, there is an obvious alternative to escalating government debt: If people insist on saving too much, governments can tax away the excess savings. Of course that's not popular, in particular in the US. And of course there's a danger of setting wrong incentives by going too far: Are people still motivated to work if their earnings are taxed away and generous government transfers are promised to everybody anyway? But if the "savings glut" hypothesis is indeed true, then that's where things will have to go: Higher taxes, more redistribution. It doesn't destroy the "capitalist system". It only readjusts the rules a bit.

And if I'm not mistaken, Strobl wouldn't really disagree with my conclusion, even though he has a somewhat different view of the workings of the "capitalist system"...

(Has anybody continued reading until here? Yes? Wow! I'm impressed by your perseverance!)

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