WANTED - Platonic Guardians for a New Era of Capitalism

Capitalism v3.0 - the crisis-ridden era ushered in by Britain's Margaret Thatcher and the USA's Ronald Reagan - was declared dead and buried in the wake of Lehman Bank's collapse. Which means the search is on for a blueprint for Capitalism v4.0, and economist Anatole Kaletsky has joined the ranks of those looking for signs of what this brave new era might look like.

In the following review of Kaletsky's new book, Michael Prowse explores his ideas and, amongst other matters, suggests that Kaletsky ducks on possibly the most important issue: the role of progressive taxation in redressing the unacceptable inequalities created by monopolistic market structures.

Here is Prowse's fascinating review of Kaletsky's book:

According to Anatole Kaletsky most pundits have got the global financial crisis of 2007-09 dead wrong. They have confused cyclical and structural forces.

In Capitalism 4.0: The Birth of a New Economy in the Aftermath of Crisis (PublicAffairs, 2010), he argues that the recent recession was just a typical financial bust exacerbated by gross policy errors. The main factors propelling global growth before the downturn – one billion extra Asian consumers and producers, globalisation, financial innovation and sensible macroeconomic policies – will soon reassert themselves, and the global economy will enjoy a fairly robust recovery. It is nonsense, he claims, to believe that we have entered a new era of permanently subdued growth, as suggested by commentators such as Mohamed El-Erian of Pimco.

Financial bubbles reflect excessive investor optimism, Mr Kaletsky readily concedes. But we should also remember that sometimes the underlying prospects really are pretty impressive. The South Sea Bubble did not presage British economic collapse but was rather a mere hiccup in its march to global financial dominance. The same was true of capitalism’s first bubble: following Tulipmania (when bulbs not yet germinated sold for the price of Amsterdam townhouses) 17th century Holland enjoyed a century of economic pre-eminence.

But Capitalism 4.0, as its intriguing title indicates, is much more than a contrarian analysis of the recent financial crisis and a withering critique of Henry Paulson’s policy errors. Mr Kaletsky also offers an “evolutionary” interpretation of capitalism, a powerful critique of the “new classical” economic paradigm that prevailed before the crisis, and a sketch of capitalism’s future, which he calls “Capitalism 4.0” because he regards it as the fourth major phase in capitalism’s development. (The decimal point reflects his view that each phase has various sub-divisions.)

Mr Kaletsky brings much relevant experience to this ambitious agenda. He has been an economics correspondent and columnist for more than 30 years and is currently The Times of London’s principal economic commentator. He is an active participant in financial markets through his stake in a Hong-Kong based hedge fund. And along with George Soros, he was instrumental in setting up the New-York based Institute for New Economic Thinking (INET), a nonprofit created to promote and finance new research programmes in economics – and especially those that avoid the methodological flaws of new classical economics.

Capitalism 4.0 is not without flaws. I would have liked to see his ferocious condemnation of public policy balanced by some criticism of the behaviour and values of leading figures in the banking industry. They could have acted more responsibly even if the regulatory system was poorly designed. But Mr Kaletsky doubtless believes, as does his colleague, Mr Soros, that it is pointless to criticise people for exploiting available opportunities.

His solution to financial market excesses is simply tighter regulation in the public interest. He argues that because governments must always stand behind banks, the taxpayer should be understood as a “silent shareholder”. It is thus politically legitimate to regulate bankers’ salaries to prevent the misappropriation of what are, in effect, quasi public assets. And he argues that this should apply as much to a private firm such as Goldman Sachs as to a partly nationalised bank such as Royal Bank of Scotland.

But setting aside his reluctance to criticise bankers, the virtues of the book vastly exceed its flaws. At its best, Mr Kaletsky’s polemical writing is very fine indeed: his argumentative style and love of paradox make the book an enjoyable as well as an enlightening read.

In what follows, I will briefly review four of Mr Kaletsky’s main themes: his doctrine of capitalism as an evolving adaptive system; his analysis of the causes of financial crisis of 2007-09; his critique of orthodox economic theory; and his sketch of capitalism’s future, which involves a new approach to both economic theory and public policy.

It is wrong, Mr Kaletsky argues, to regard capitalism as something static and unchanging. He identifies three main phases in capitalism’s development. Capitalism 1 ran from 1815 to 1930. The sacred text was Adam Smith’s Wealth of Nations and the dominant view was that economics and politics are distinct spheres: meddling with the iron laws of the market was generally frowned upon.

The Great Depression ushered in the next phase of capitalism – Capitalism 2 – which lasted until the stagflation of the late 1970s. The sacred text became Keynes’s General Theory and the dominant view was that government interventions are highly desirable and can nearly always improve on crude market outcomes.

Capitalism 3 – which persisted until 2007 – was the child of the Reagan-Thatcher conservative revolution of the early 1980s. The sacred text was Milton Friedman’s Capitalism and Freedom and the dominant view was that markets produce optimal outcomes and that governments should intervene as little as possible. Hence the stress on privatisation and tax-cutting, as well as the refusal to place any meaningful restraints on financial markets.

Conservative economists try to pretend there is only one valid form of capitalism – the unregulated markets of the early 19th century. Mr Kaletsky insists that capitalism is constantly evolving. His biological analogy has rhetorical rather than scientific force: there is no environment in which one version of capitalism competes against others for survival. So no form of natural selection can operate.

I would restate Mr Kaletsky’s doctrine as follows. Private property and contract are necessary conditions for any form of capitalism. But democracies can choose to add a wide variety of other rules that modify the operation of markets. They can also restrict the domain of markets to a greater or lesser degree, by funding activities through taxation. These choices – and hence the form that capitalism takes – change over time in response to a wide range of social, cultural and political forces.

Mr Kaletsky regards the severity of the recent global downturn as largely due to unforced policy errors, particularly in the US. He condemns Mr Paulson, the former US Treasury Secretary, for bailing out Fannie Mae and Freddy Mac on unexpectedly harsh terms that expropriated shareholders – and sovereign wealth funds in particular. Thereafter Lehman Brothers was at the mercy of short-selling speculators and had no prospect of finding a private saviour. Yet, blinded by his market fundamentalist ideology, Mr Paulson refused either to guarantee Lehman’s deposits and liabilities or to provide fresh capital at taxpayers’ expense.

He thereby set in motion a “doomsday machine”. Depositors’ and investors’ losses following Lehman’s inevitable bankruptcy destroyed trust in the viability of every major financial institution across the globe. It was the ensuing month of financial paralysis that sent the world economy into a quite unnecessary freefall. But had Mr Paulson recognised that governments have a responsibility to quell banking panics, akin to their responsibility for civil order, the mayhem could have been avoided – just as it was in the Latin American banking crisis of the 1980s when the major western banks were technically even more insolvent than in 2008.

What was wrong with the pre-crisis economic orthodoxy? Just about everything, in Mr Kaletsky’s view. He takes the quasi Marxist view that academia tends to produce the kind of theories that endorse the ideology of ruling elites. So it was no surprise that the conservative political revolution spawned “new classical economics” - a doctrine that held that markets are always efficient and always close to equilibrium, and that individuals and firms are always rational maximisers of utility or profit. Politicians didn’t want to intervene so economists obligingly told them it would be counter-productive to do so. In the different political climate of Capitalism 2, equally obliging economists reached opposite conclusions.

But what made the school based on rational expectations and efficient markets unique was its attempt to look sophisticated (and thereby impress policymakers and investors) by relying on complex mathematics. Real mathematicians, such as Benoit Mandelbrot, a pioneer in chaos theory and complex systems, repeatedly exposed the pretensions of the new classical school. Even before the 2007 crisis, three “statistically impossible” events had rocked Wall Street and other markets: the abrupt 1987 crash, for instance, was clearly not the product of a random walk. During the dark days of 2008 statistically impossible events were happening every other week.

With hindsight it appears that a sports field of Nobel laureates in economics had failed to understand the obvious (even though Keynes pointed it out 70 years ago): the economic future is as radically unpredictable as any other kind of future. One cannot assign probabilities to the unknowable; one cannot banish uncertainty by assuming Normal distributions. Given this basic reality, markets are inevitably fallible. “Efficiency” in the economists’ sense is a property of their models, not of reality.

So what kind of theories, and what kind of policies, are likely to characterise Capitalism 4, the new capitalism that Mr Kaletsky hopes and believes is rising from the ashes of market fundamentalism?

So far as pure theory is concerned, Mr Kaletsky is disappointingly vague – but then he can hardly be expected to create a new theoretical paradigm from scratch. This is the task that has been delegated to the Institute for New Economic Thinking that his friend George Soros is financing. INET will help young academics challenge orthodox ideas by sponsoring research in promising areas, such as imperfect knowledge economics and complex systems. As Max Planck remarked of physics, new ideas gain traction “one funeral at a time”.

In the public policy domain, the watchwords for Capitalism 4 will be pragmatism, experimentation and trial and error. As described by Mr Kaletsky, the new capitalism appears to be a Hegelian synthesis of Capitalisms 2 and 3, with a pinch of Darwin for seasoning. He reckons the knowledge that markets are not infallible will be empowering: henceforth policy makers will have the courage to intervene whenever markets appear to be generating outcomes that are unreasonable in the light of broader public goals. They will jettison the dogma of Capitalism 3, which held that no intervention is justified unless a specific market imperfection can be identified.

Mr Kaletsky anticipates an “adaptive mixed economy”, in which the public and private sectors recognise their mutual inter-dependence. There will be no return to either the “government knows best of Capitalism 2” or the “market knows best of Capitalism 3”. Instead, governments will assess markets on a pragmatic case-by-case basis, recognising that some need much heavier regulation than others. In place of Capitalism 3’s obsession with price stability, governments and central banks will recognise the need for multiple objectives in the economic domain (just as they do in foreign policy and criminal justice). They will openly promote employment and economic growth and cooperate more vigorously with their international partners to ensure that currencies are reasonably valued.

Mr Kaletsky is an unashamed optimist. Amid gloomy talk of double-dip recessions, Capitalism 4.0 makes uplifting reading. If there is a flaw in his vision of democratic capitalism’s future, it lies in his unbounded confidence in bureaucratic discretion. Like many very intelligent people, he thinks it is always possible to improve on any rule, precisely because no rule can anticipate every eventuality. But in the realm of practical politics, will a “partnership” between the public and private sectors work as well as he expects? Will civil servants exercise their discretionary powers to promote economic outcomes as wisely as he hopes? Will they be able to distinguish reasonable from unreasonable outcomes?

If Capitalism 4.0 is to succeed, many of the brightest and best of the next generation will have to devote themselves to public service (just as occurred after the Keynesian revolution of the 1930s). The world will need more Platonic Guardians and fewer Masters of the Universe. But given human nature, I fear this would require something that Mr Kaletsky does not support: far more progressive taxation. I think it would also require a revival of ethical values, a belief in public service for its own sake. Yet nowhere in this book does Mr Kaletsky even hint at how we might encourage the altruistic values on which his vision of capitalism implicitly depends.