September 4, 2011

Capitalism is constantly criticised in the media, in literature, and very ostentatiously in anti-globalisation protests. These protestors offer few credible alternatives or solutions but give voice to a feeling that somehow the system is failing.  At present, the system is especially open to criticism as we are dogged with high unemployment, crippled banks, a possible break-up of the euro, dysfunctional economic management, a sense of directionlessness from the political leadership, riots such as those of a few years ago in the banlieue of Paris and more recently in London and Philadelphia.

At Kennox, we agree – capitalism is flawed.  It is the worst system of economic management ever invented. Except, that is (borrowing from Winston Churchill), for all the other ones that have been tried from time to time. Capitalism can be improved but to do so we must understand its strengths and weaknesses. Then we must reinforce the good and try to limit the bad.

One of the most beneficial aspects of capitalism is the market economy.  For all the anti-globalisation protests and for the troubles and pain that the market causes, we have to be very thankful for the market economy.

Capitalism has given an unprecedented standard of living to an enormous number of people.  Time and again, It has produced advancements that have revolutionised the way we live.  It is an imperfect but efficient allocator of resources in the long term.  It also creates an environment where individuals and organisations are incentivised to come up with new and transformative ideas.

The market economy is the key for this.  It is the calculating machine with billions of moving parts that tests new ideas unrelentingly and consistently, rewarding those that have the most merit, i.e. those ideas that can be sold profitably to others.  In other words, it is the market that makes a robust and innovative economy.

On the negative side, one of the biggest problems is that people believe that we can defeat the economic cycle.

It is very difficult to tell the difference between an increase in productivity and an excessive bubble, without the benefit of hindsight.  The 1920’s were a great example –the widespread adoption of such improvements as electric appliances, cars, radios, and telephones in the first half of the 1920’s lead to a bull market.  Then, by the end of 1928 and into 1929, a bubble had developed.  To pinpoint when it went from rational to irrational, from sustainable to unsustainable, was impossible at the time.

With any time of change, no one can know with certainty whether innovations are having a positive and permanent impact on productivity, or are simply hype.

On top of that, humans are influenced by others around them.   We have a tendency to do what others do. Acceptance of an idea by the wider audience means that it is safe for more individuals to do the same.  Following the leader is natural, and it is especially alluring when it is driven by an intellectually robust idea.

Put these two together – it is difficult to tell the difference between progress and hype, and that humans often tend to herd – and cycles will always be part of the economic landscape.  Cycles are as natural as seasons.

It was very beneficial to have a big upswing in the 1990’s and 2000’s.  Many industries progressed enormously over that time, from mobile devices, to the internet, to pharmaceuticals, and there were many constructive investments in infrastructure.

In an ideal world, we would be able to tell when the cycle went from being a genuine increase in productivity to a state of over-optimism.  Whilst some people may have called it right, in practice it is impossible to get a consensus that something has to be done to reverse the trend.

Accepting that the ability to dampen the upswing only exists in the fictional “ideal world”, all that remains is to improve the way we deal with the aftermath.  Our mistake is often to think that we can avoid the natural downswing afterwards.  As James Grant points out “capitalism is not just about success – that’s the easy part.  It’s also about failure, recognizing it, dealing with it, liquidating it, properly pricing it.”*   You have to let the market clear.

When the economy went soft in 2000, we didn’t take our medicine.  We cut interest rates and tried to keep the party going.  In 2008, we thought that we could do the same again.  We tried to protect an upswing that was too big, that went too far.  We were trying to defend stretched borders that were too distant from Rome.  For example, the system tried to protect the Irish banking system as it was, in its entirety.  We tried to maintain property prices at levels that weren’t sustainable.   We tried to believe that the finances in Greece were viable.  We can’t defend every border.  When things have run too far, it is inevitable that something has to give.

In the past, fire fighters used to try to stop all forest fires.  They have come to see that a small forest fire clears out the small brush.  If there are no forest fires, the brush builds up too high and, when the next fire starts, even the biggest trees will burn.  The entire forest is destroyed.  Small forest fires are necessary to the long term health of a forest.  In a similar manner, small scale recessions are an important mechanism of avoiding a major crisis.  The difficulty is in getting governments who are concentrated on their short term re-election to accept this.

It is quite easy to see what has gone wrong with capitalism.  We ignore many longer term problems.  We destroy and squander resources.  We consume beyond previous generation’s wildest dreams, often wastefully.  That capitalism is mistake-ridden should not be a surprise to anyone – operated by man, it is imperfect.  The capitalist system got carried away in the 1990s and 2000’s.  For that, we will have to retrace and rebuild and it will be difficult.

But let’s not throw out the baby with the bathwater.  Capitalism is as flawed as the humans who propagate it, but heaven help us if we think we’re better off without it.  And let’s be aware of the power and benefits of the cycle, and do better next time.

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