Financial turmoil: Capitalism is not dead

he past month's turmoil in U.S. and global financial markets has spawned several articles tolling a death knell for capitalism. Some said that the crisis is proof that capitalism never worked, others opined that the solutions to the problems will end capitalism.

To paraphrase Mark Twain, reports of capitalism's death are greatly exaggerated. Although Washington is using non-market solutions in an attempt to unfreeze the credit markets, they have not succeeded, and are unlikely to be permanent. The next administration, Republican or Democratic, might take over more of the economy. But if one country in our global economy proceeds down an unsuccessful socialist road, others will demonstrate the effectiveness of capitalist measures—just as America led the way with tax cuts in the 1980s.

The present crisis started not because capitalism was allowed to run its selfish course, but because the government interfered with the operation of private businesses and allowed excessive growth of money and credit.

Take housing, where the crisis began. The government interfered with private decision-making by requiring banks to make loans to people who could not afford them, through the 1977 Community Reinvestment Act. It forced banks to improve lending and service to borrowers in poorer neighborhoods, including people with poor credit histories. Some of these borrowers only qualified only for subprime mortgages, which had introductory low rates that eventually rose.

In another example of government interference, Fannie Mae and Freddie Mac were given implicit government guarantees, letting them borrow at favorable rates. The rationale given by both mortgage companies was that this was the way that less-affluent Americans could get homes of their own—housing that they could not afford under otherwise. While the government was pressuring financial institutions to increase lending, the Federal Reserve was lowering interest rates to try to avoid a recession after the terrorist attacks of September 11. This vast expansion of money and credit had to go somewhere—and it went into an inflation of housing prices of horrendous proportions, the real estate bubble that eventually burst.

The mission of the central bank is to keep a sound currency. The Fed failed.

The cause of the problems was not capitalism, so it cannot be said that capitalism was unsuccessful. The remedial actions that the government is taking are not capitalism either. The collapse of the bubble and the effects on subprime mortgages and the economy led to additional government intervention of another type. Some institutions, such as Bear Stearns and AIG, were propped up; others, notably Lehman Brothers, were allowed to fail. The Federal Reserve opened its discount window to investment banks, an unprecedented step, and now stands ready to buy commercial paper. The Treasury's recent insistence that nine major banks accept an infusion of official capital—government money—is extraordinarily dangerous. It's one matter to have credit available if private institutions choose to draw on it, and yet another to require them to make the government part-owners, even if temporarily.

If the recent government actions had solved the problem, and the Treasury planned to continue as the owner of preferred bank stock, then capitalism could perhaps be said to be dead. But neither of these is true. Global markets have signaled over the past two days, despite today's 400 point rise in the Dow, that confidence has not been restored. And President Bush has emphasized that the Treasury measures are temporary. Professor Allan Meltzer of Carnegie Mellon University has proposed a capitalist solution—just let the defunct firms fail, and the healthy ones purchase the assets, along the model of the Wells Fargo takeover of Wachovia (despite Uncle Sam's attempted Citibank deal). This would be capitalism. Perhaps it's time to give it a try.

By Diana Furchtgott-Roth

Diana Furchtgott-Roth, former chief economist at the U.S. Department of Labor, is a senior fellow at the Hudson Institute.

Source: EconomicTimes