The Heartbeat of Capitalism
In mid-2008, when a whirlwind of credit crises hit the global economies, massive State intervention was needed to prop up the pillars of modern finance. Even as their institutions were kept afloat by taxpayers’ money, financial executives were found to have relentlessly lined their pockets. All this has thrown into doubt the efficiency of the capitalist system. Some commentators have been prepared to dump all the benefits of modern finance and take the extreme view that capitalism, as we know it, is and a completely new system is needed.

Robert J Barbera’s thesis is that capitalism has several flaws but is the best of all possible systems for creating wealth. However, the benefits of capitalism have a cost attached; this cost is a periodic boom and bust led by the financial sector. The same financial systems that create innovative instruments, help reduce risks and create wealth, lead us into financial collapse through excessive risk-taking.

When the collapse takes place, other institutions of society must step forward and deal with this characteristic of financial capitalism, especially when it threatens to spiral into ‘deflationary destruction’. In this, Mr Barbera is a camp-follower of the economist Hyman Minsky who interpreted the work of John Maynard Keynes in the area of financial boom and bust and prescribed what the government needs to do during a financial wreck. Keynes, it may be recalled, argued that the government must step in and intervene with demand-boosting measures when the normal forces of free-markets fail. But Keynes had not taken into account that “the transmission mechanism for monetary policy is through the financial markets” and that banking and financial markets, the cornerstone of modern capitalism, can undergo wild swings leading to booms and busts in the real economy. This is where Minsky’s contribution comes in.

Minsky proposed theories linking the inherent fragility of the financial market to business cycles and to speculative investment bubbles. Minsky argued that in prosperous times, when corporate cash flow is excessive, a speculative euphoria of borrowing and investing develops. After this, the business cycle turns, debts exceed what borrowers can pay from their incoming revenues which, in turn, leads to a financial crisis. Banks and lenders tighten credit, even to companies that can afford loans, leading to a credit crunch and economic contraction.

At that stage, it is critical for the government to step in and keep the financial system going. Mr Barbera states that “there is simply no place for free market ideologues in a banking crisis… The lesson is unambiguous. Banks are not like other businesses.” Mr Barbera recounts the history of the late 20th century, when he was the chief economist for several investment banks, a staff economist for a senator and an economist for the Congressional Budget Office. He gives us a ringside view of business cycles and also of the financial instability that Minsky described, caused by risk-taking of businessmen, bankers, investors and, of course, policymakers such as Alan Greenspan and Ben Bernanke – the creators of the stock bubble in the 1990s and the credit and housing bubble of the 2000s.

One of the popular reactions to a financial bust is to demand more regulation. But the author argues that “regulations are costly. They will only take us so far. And they will be effective for only a while.” The State must find a way to get people on to the path of innovation and creative destruction. For that, the banking system must be kept functioning. This is a small cost for the benefits that come over the long run from free markets and advanced financial systems in normal times. This book clarifies a lot of the currently debated issues by bringing in a fresh perspective. – Debashis Basu

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