How Capitalism Will Save Us (63 page)

I
n May of 2009, the
New York Times Magazine
featured an interview with President Barack Obama. The magazine’s cover line was “His Economy.” The president discussed with reporter David Leonhardt how the United States would emerge “on the other side of the so-called Great Recession.” He asserted that, in the reporter’s words, “the country needed to break its bubble-and-bust cycle.”
¹

Obama told Leonhardt, “Wall Street will remain a big, important part of our economy, just as it was in the ’70s and the ’80s. It just won’t be
half of our economy.” He strongly implied that the government would be playing a greater role in its direction, with less influence from the private sector: “And that means that more talent, more resources will be going to other sectors of the economy.”
²

Condemning the “massive risk-taking that had become so common,” the president said, “What I think will change, what I think was an aberration, was a situation where corporate profits in the financial sector were such a heavy part of our overall profitability over the last decade.”
³

Obama’s words raised eyebrows among many, especially supporters of democratic capitalism. Not only was the president implying that the government would be stepping up its role in directing economic activity, but he did not seem to appreciate the processes—including normal business cycles and risk taking—that make possible economic progress.

What role should the government play in a democratic capitalist economy? The fight over this fundamental question helped give birth to this nation. Righteous anger over Britain’s trampling of what North American colonists perceived as the traditional rights of Englishmen—especially “no taxation without representation”—sparked the American Revolution. In contrast to many of today’s politicians, the Founding Fathers and framers of the Constitution saw the greatest threat to liberty as coming from an overly powerful government.

For the first hundred years of America’s history, government for the most part had little role in the economic lives of Americans. The one exception during that time was the Civil War. This began to change in the late 1800s. Industrialization was transforming a previously agrarian society, bringing with it growing fear of big corporations, or “trusts.” The Progressive movement sought to impose order on the threatening, seemingly chaotic forces of change. Progressives’ efforts resulted in passage of the Sherman Antitrust Act and the creation of government agencies like the Interstate Commerce Commission and, later, the Food and Drug Administration and the Federal Trade Commission. In 1913, the Federal Reserve System was established. In the words of Florida State University economist and author Randall Holcombe,

Until the 1930s, most economists believed that the economy would remain stable and self-correcting if the government largely stayed out of the way. But this view began to change amid the turmoil of the Great Depression. In 1936, economist John Maynard Keynes published
The General Theory of Employment, Interest and Money
. He advanced the idea, which must have been comforting to many at the time, that the nation’s economic woes could be cured by an activist government. Keynes believed that the way to economic vitality was through heavy government spending during slumps. This spending, he asserted, had a “multiplier effect,” creating more output than the dollars originally spent, increasing “aggregate demand” for products and services that would stimulate the economy and lead to “full employment.”
⁵
No matter if the government had to pay for it by printing more money. Keynes famously called gold “a barbarous relic.”
⁶

Far from a believer in the efficacy of markets, Keynes believed that a group of wise economists could dispassionately direct the economy, independent of normal political pressures. Columbia University economist Edmund Phelps has written that Keynes, while not a socialist, was a “corporatist” and “an exponent of top-down growth.”

Keynesian beliefs became the economic mantra of FDR, and a major influence on the policies of presidents Kennedy, Johnson, Nixon, and Obama. The Keynesian mantle has long conveyed an air of seriousness and legitimacy in policy circles. President Nixon famously proclaimed, “We are all Keynesians now.”
⁸
But when this mystique is put aside and Keynesian policies are viewed from the perspective of history, Keynes the high priest ends up looking more like the Wizard of Oz. Pull back the curtain and he’s less than he’s cracked up to be.

Over decades, Keynesian ideas have rarely worked and have done
serious damage. A growing number of economists and historians—including Amity Shlaes, senior fellow at the Council on Foreign Relations and
Forbes
columnist, economic historian Burton Folsom, and University of Chicago professor John Cochrane—believe that Franklin Roosevelt’s Keynesian interventionism, along with his spending, did not end but rather prolonged the Great Depression of the 1930s.
⁹

Decades later, Richard Nixon, the Keynesian convert who was ostensibly a conservative Republican, created an economic nightmare through Keynesian mismanagement. He severed the dollar’s tie to gold so that he could print more money to boost the economy, along with the equally wrong-headed wage and price controls. All this did, however, was trigger a brief spike in demand, an artificial boom in 1972 that was instantly followed by more inflation and then a severe recession one year later. Price controls on energy suppressed oil and gas exploration and production, strangling supply. Everyday Americans suffered the consequences of these distorting policies. Drivers found themselves idling in gas lines that stretched for blocks. The economy stalled. We ended up with the “stagflation” of the 1970s—economic stagnation
and
rising prices.

Keynes’s most famous critic, Friedrich von Hayek, explained why Keynesian economic policies, with their emphasis on government solutions, were destined to fail. They were not that different from centralized planning. They distorted an economy and undermined growth because they subverted the natural processes of resource allocation and wealth creation that normally take place in a free market.

Hayek explained that prices in an open market function as “a mechanism for communicating information” or “a system of telecommunications” that tells both producers and consumers, buyers and sellers, how they should conduct their activities.

Without the mechanism of pricing, producers can’t signal to the market how rare or available their product is, and consumers aren’t given the knowledge they need to adjust their activities accordingly. With each side not knowing the needs of the other, the mutual benefit of a free-market transaction is not achieved, and you end up with distortions and imbalances—to cite some Real World examples, people waiting on those 1970s gas lines, or waiting even longer in a state-run health-care system for a doctor’s visit.

Building on the work of his mentor, the eminent Austrian economist and philosopher Ludwig von Mises, Hayek argued that Keynes’s analysis of boom-and-bust cycles neglected the degree to which government with its powerful central bank can adversely influence economic activity. Decades before Fannie and Freddie, he explained that a central bank, by lowering interest rates and printing money, produces economic bubbles. Overly abundant, loose money creates a heady, artificial environment where marginal business ventures that would not otherwise have existed spring up and even prosper. That is, until they inevitably collapse. Sound familiar?

In his book
The Road to Serfdom
, Hayek warned that government management of the economy is ultimately driven by the whims of politicians and not the needs of people.
¹⁰
He thought Keynes was fundamentally misguided in his belief that a knowledgeable few could successfully shepherd the economy; Hayek believed it opened up society to the political overreaching that threatens individual liberty.

Keynes himself acknowledged that his economic nostrums “can be much easier adapted to the conditions of a totalitarian state.”
¹¹
Hayek and Keynes debated each other in journals during the 1930s. Their famous exchange foreshadowed today’s debate over the direction of the economy. Just as Keynes overlooked the role of government in producing the Great Depression of the 1930s, his current adherents, as we’ve previously noted, underemphasize the role of the Federal Reserve, Fannie Mae and Freddie Mac, and the SEC in producing the financial crisis and recession.

But what activist Keynesians miss altogether is that real growth comes not from theoretical assessments of a market that originate in an ivory tower, but from unmanaged activities where people are figuring out how to meet one another’s needs and desires in the Real World. Government can command resources; it can redistribute them. But it cannot, long-term,
expand
an economy. That’s because the kind of jobs and businesses that drive wealth creation and growth can emerge only from the trial-and-error process of innovation that takes place in the private sector.

How does capitalism’s dynamism and innovation generate growth? By giving millions of people the latitude to come up with and try totally new ideas—from the iPod to selling groceries over the Internet. Government cannot do this, because it simply does not have the bandwidth—the
expertise, imagination, and resources—of the millions of people who make up a free market. Its decisions are based on political influences. Government programs that don’t perform can continue for decades—welfare, begun in the mid-1930s, wasn’t reformed until 1996. But a company that fails promptly goes out of business.

As we explain later in this chapter, the core capability of government is mainly providing (1) services that maintain order through promoting the rule of law, (2) a sound defense, (3) protection of, as the Constitution puts it, “domestic tranquility,” and (4) assuring basic education for its citizens. That is one reason why policy makers so often assail “unfettered” capitalism and attempt to score political points by promising to end routine business cycles. Capitalism, with its dynamic, ever-changing markets, can be chaotic. But it’s this very disorder—the process of experimentations, success and failure, carried out among millions of people—that produces the new technologies and ways of doing business that lead to genuine growth in an economy.

Take the Home Depot. Founded about thirty years ago, the hardware chain pioneered a new approach to selling home-improvement products, offering a vast array of low-cost products out of enormous warehouses. The chain provided the convenience of one-stop shopping, allowing customers to save time and money. Its huge success created jobs for employees and business for its vendors. But that is not the only way it ends up creating wealth. The Home Depot’s founders invested their personal wealth in unrelated sectors of the economy. Cofounder Bernard Marcus, moreover, donated a portion of his personal wealth to nanotechnology research at Georgia Tech that may eventually yield more growth-creating technologies.

Stanford Graduate School of Business economist Paul Romer has pointed out that wealth and growth are generated not only by the big breakthrough advances that everyone hears about, but also by minor improvements in the way people do things.

This free-market “dynamism” is why Hayek wrote that no government could contain the “know how” that existed throughout a free-market society. Government spending, with its increased taxation, drains businesses and people of the capital needed for this kind of innovation. Thus, it eventually ends up slowing an economy.

This is the very reason why massive federal government spending during the Great Depression failed to restore sustained growth. Yet when the federal government shrank its presence in the economy during the 1980s and ’90s, the nation enjoyed its greatest expansion to date. The United States got closest to the Keynesian goal of “full employment” through cutting taxes and regulations.

The government does indeed have a critical role in democratic capitalism, not as a growth creator but as a facilitator—performing critical functions such as maintaining public order and enforcing commercial contracts. However, when it strays beyond this role, it usually destroys wealth.

The stock market, the foremost barometer of the future health of the nation’s economy, seems to grasp this. (After all, what are markets but people?) A little-known but immensely revealing factoid is that the stock market tends to slump when Congress simply convenes. New York portfolio manager Eric Singer has tracked what he calls “the congressional effect.” Between 1965 and 2008, he found that the S&P on average showed more than a 16 percent gain when Congress was out of session—in contrast to just 0.31 percent when it was at work. Singer founded the Congressional Effect Fund, a mutual fund that takes advantage of these gains for investors. Singer invests client money in stocks when Congress is on vacation, such as in the month of August or at the end of October. But he gets out of the market or reduces his positions when Congress is in session. Singer says that the congressional effect is remarkably consistent—but several years have been exceptions. One of them was 1997, when the market realized annualized average price gains of almost
60 percent when Congress was in session. What happened? Congress cut taxes, including on capital gains.