The Credit Crisis, Socialism and Democracy

Dec 2008, William Hooper, Article

Reading Martin Wolf and the other commentators over at the Financial Times one can not but be impressed by scale of ideological revaluation now taking place with regards to the efficiency of the market economy. For example, in Keynes offers us the best way to think about the financial crisis Wolf writes that we have learned three critical lessons:

(1) The first lesson, which was taken forward by Minsky, is that we should not take the pretensions of financiers seriously. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” Not for him, then, was the notion of “efficient markets”.

(2) The second lesson is that the economy cannot be analysed in the same way as an individual business. For an individual company it now makes sense to cut costs, but if the world does so simultaneously it will merely shrink demand. [What is optimal for the individual is not optimal for the world at large]

(3) The third and most important lesson is that one should not treat the economy as a morality tale. In the 1930s, two opposing ideological visions were on offer: the Austrian; and the socialist. The Austrians – Ludwig von Mises and Friedrich von Hayek – argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order; the latter in the idea that the identical motivation could lead only to exploitation, instability and crisis.

Thus we may be learning that our long cherished 'laissez-faire' or 'invisible hand' economic model is much weaker that we had imagined. The invisible hand is a metaphor coined by the economist Adam Smith. Smith argued that, in a free market, an individual pursuing his own self-interest tends to also promote the good of his community as a whole through a principle that he called “the invisible hand”. He argued that each individual maximizing revenue for himself maximizes the total revenue of society as a whole, as this is identical with the sum total of individual revenues.

Of course our economic model has never been not 100% laissez-faire. For example, we know efficient markets require regulation. If manufacturers are to compete efficiently in the widget market we need to regulate what each participant can call a widget. Likewise heath and safety inspectors ensure restaurants don't cut corners in the kitchen. Without government investment in infrastructure people could not turn up to work and companies could not move goods. In order to contain inflation Central Banks use monetary policy to manipulate the cost of capital. All these are vital modifications to the laissez-faire model. Although it is possible that much stricter banking regulation would have prevented the credit crisis alone, many believe this crisis is nevertheless teaching us that our invisible hand model is much more deeply flawed that we had previously believed.

The two opposing ideological visions which have dominated political debate are Socialism & Capitalism. The socialist model removed individual freedoms in order to enforce equality. We now know that competition and incentive are vital drivers of economic growth and human happiness, and removing them in order to ensure equality proved disastrous. The capitalist model protected individual freedoms which consequently allowed inequality and encouraged competition. Economists cite Smith's invisible hand argument as one justification, democrats cite the moral principle of free will as another.

The pure socialist model was so un-successful that only authoritarian governments prepared to brutally suppress dissent were able to sustain it. Socialist democracies mixed private enterprise with strong welfare benefits financed by high taxes and interventionist government. The problem with socialist democracies is that high welfare benefits sap incentive, the middle classes and the rich often resent the high tax rates, and the government policy is too often focused on preserving jobs even at the expense of productivity. Although the Anglo Saxon nations have delivered higher rates of growth the  Scandinavian Model has remained popular with those who feel there needs to be a trade off between growth promoting inequality and humanitarian values.

Now a third model is emerging, especially from the ashes of socialism, and today it is popular in China, Singapore, Dubai etc. The third model allows individual freedom and inequality where it encourages competition (as capitalism), but also removes individual freedoms wherever it is perceived to benefit the greater good (as socialism). Although the government is interventionist, the third models differs from classic democratic socialism because the driving force of the interventionist policy is the promotion of economic growth, not the soft humanitarian aims of socialism. The Three Georges Dam, in which 1.24 million people were forcibly relocated in order to generate 22.5MW of cheap CO2 free electric is a classic example third way policy. The One Child Policy, designed to dramatically slow population growth, is another. Fans of the third model believe Smith's invisible hand argument is far too simplistic and government intervention is often required to achieve the optimal outcome. Third model proponents are pragmatists and utilitarians, dubious notions of free will (after all there is no pure free will in a society anyway) are sacrificed for the general good.

The Credit Crisis is discrediting capitalism, but it is not reviving socialism. Rather it is championing the third way of utilitarian government. In the 1970 angry socialists clashed with capitalists. The socialists denounced the capitalists as inhumane, but the capitalists proved that socialist equality is inefficient. Now the utilitarians are proving that the individual liberties of capitalism are inefficient. The capitalists are defending their position with increasing rancour as the case against them builds. At it's most extreme we have the "goldbugs" who claim the crisis not a failure of capitalism so much as government control of the money supply, and all we need to do is abolish the FED and adopt the gold standard. Once the capitalists were denounced as inhumane, now they denounce the utilitarians as inhumane, and Churches increasingly take up the cause.

The triumph of the third way is clearly a powerful challenge to democracy. China, Singapore, Dubai, Russia are third way proponents and undemocratic. Democracy and individual liberty are too closely entwined. Democracy is connected with the politics of personal gain, utilitarianism is personal sacrifice for the greater good.

In 2009 all the major developed nations are expected to be in recession and all world growth will be produced in the emerging world, especially China. I believe what we are seeing is the beginning of the end of democracy. The pendulum has swung- we are replaying the seminal moments of history summed up by the 430BC Pelopensian War fought between the rich but self centred democracy of Athens, and the brave self sacrificing autocracy of Sparta. At the end of that war Athens was utterly subjugated and democracy extinguished.

I believe we have reached the end of an era, the next belongs to China and authoritarianism, and in years to come when we look back and compare the economic achievements of the two the contrast will be as extraordinary as it was between the Romans and the Greeks. In Ancient Greece politics divided not into socialism-capitalism but rather authoritarianism-democracy. In years to come I believe we will see this re-emerge, and, just as in Ancient Greece, the intellectuals will generally be on the side of authoritarianism.