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Posts from September 2011

The death of capitalism, apparently

Tuesday 27th September 2011

You would imagine that when a column in a newspaper begins with “I might be an economic dunce, but…”, it would serve as a pretty damn good signal to basically ignore much of what follows. Alas, no.

If you’re on Twitter then you may have seen this article by Charlie Brooker being retweeted today, as seems to happen most Mondays. Brooker’s articles are generally fairly popular amongst the Twitterati, and so they should be as they’re usually quite amusing. But with the latest one, I really couldn’t get past the pretty fundamental error.

The title of the article is “If capitalism has failed, how the hell do we pay for our Shreddies?“. And so we can see the issue. It’s a pretty basic error, but sadly it’s one which is commonly repeated in the present climate: the current economic crisis isn’t really a failure of capitalism – in many respects, quite the opposite. So it’s perhaps a little foolish to be pondering its death.

Fundamentally, the credit crunch which precipitated the present economic mess, happened for a number of reasons. Banks lent money to people to buy houses, which caused house prices to rise. Sadly, lots of money was lent to people who couldn’t afford really afford the loan (and it’s very easy to blame greedy bankers for this; no-one seems willing to blame the greedy consumers who took on debt they couldn’t afford. I suppose it’s politically more convenient to blame bankers though). So when those debts went bad, the banks repossessed the property and put them up for sale, to try to recoup their money. This influx of property into the market drove house prices down. Mortgages are loans secured against the value of a property, and so we reached the situation where there were lots of loans which were secured against property which was worth less than the value of the loan (i.e. if the bank sold the house, they wouldn’t get back all of the money they lent in the first place). Calamity ensued*.

Reading the preceding paragraph there are two blatantly obvious questions: why did the banks feel able to lend the money in the first place, and why did lots of people suddenly become unable to afford their debts? The answer is that central banks and governments set interest rates according to whatever agenda they have at the time. In the early 2000s interest rates were set low in an attempt to soften the effects of the dot-com crash and the terrorist attacks in America in 2001. This had the effect of reducing the cost of lending money, which meant that loans became affordable to more people. Because of the low interest rates, banks could now give mortgages to people who previously couldn’t afford them. And correspondingly, consumers presumably felt encouraged to take on this debt because they assumed that they’d always be able to find affordable finance, even if their initial loan became too expensive. After all, house prices were always going up…

Of course, the low interest rates weren’t sustainable, and when they rose in the latter part of the 2000s, the cost of debt rose accordingly. And then the people who could barely afford their loans when the rates were low, suddenly couldn’t afford the debt at a higher interest rate, and had no way to refinance their debt. And so they defaulted.

We can see then that one of the key weaknesses was nothing at all to do with capitalism, or the free-market liberalism which is often assumed to go with it. It was a housing bubble fuelled by low interest rates. A colossal failure of interventionist policy, and a reminder that centrally managing a fundamental part of the economy is not necessarily a wise thing to do. And this lesson is something that those people who are generally in favour of capitalism go to great pains to point out.

Which isn’t to say that there weren’t market failures as well; the existence of banks that were too big to fail, for instance. But without the interventionist policy – the setting of interest rates – it’s highly questionable whether the conditions would’ve existed for the rest of the crisis to follow, or for it to be as profound as it was/is. Far from the death of capitalism, this – along with the troubles we’re now seeing caused by excesses of sovereign debt – should really signal the end (or at least a reduction) of the interventionist state. Probably won’t be though, and we’re all the poorer for it.

Literally.

* I’m afraid I’m simplifying a little here; there are other factors, such as the way that risk was dispersed throughout the financial system, and the rationale behind subprime lending. That’s somewhat beyond the scope of the point I’m trying to make though.

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