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March 19, 2009
Exclusive: Capitalism: Trust but Verify
In his 1959 book Bankers and Pashas: International Finance and Economic Imperialism in Egypt the eminent historian David S. Landes presents an overview of the development of modern finance in his first chapter in order to ground the reader for the detailed study of British and French activities, in particular the building of the Suez Canal, that follows. Given the current partisan debate over the causes and cures of America’s deepening recession, it is useful to look for insights from more objective sources far removed from today’s spin doctors.
What makes today’s economic crisis different from the normal business cycle is the collapse of the financial system. It was the collapse of the banks that caused the Great Depression, so it is small wonder that comparisons with the 1930s are prominent in ways they have not been during other post-World War II downturns. In the political arena, the debate has raged over whether government policy caused banks, mortgage companies, equity firms, and insurance companies to behave foolishly, or whether there is an inherent danger in the financial sector that government agencies failed to realize and which now requires increased regulation and oversight.
Using the long view of history, Landes leans towards the second interpretation. “The compleat and orthodox banker was guided by one fundamental principle: commercial credit must be based on commercial transactions.” he writes. In other words, finance had to be tied to the real economy. When it became detached from reality, building finance only upon finance in an empty house of cards, the results were disastrous. As Landes argues, “Even among the most respected firms, there are always some who abuse their positions. And when pillars of commercial integrity lent themselves to such machinations, they could do so on a scale that lesser houses could hardly hope to match: false credits piled on false credits, accommodation paper covered by accommodation paper, forgeries, straw men, all the apparatus that ingenuity could devise to present to the world a legitimate front to obtain money on transactions that never were.” Though it was written 50 years ago and looking back even further, Landes could be describing today’s events.
Financiers often described as “the smartest guys in the room” were tempted by greed to abandon orthodoxy and embrace ingenuity. American International Group (AIG) has come under withering bipartisan fire for its lavish parties and bonuses, even as it has received the largest amount of government bailout money (over $170 billion) to stay afloat. Its extreme behavior took it far away from the real economy. Its downfall came from insuring the derivatives that other “innovative” financiers were creating out of thin air.
Insurance firms are usually very conservative, both from temperament and by regulation. Like casinos, they know the odds from long experience and calculate premiums and payouts to always favor the house. But there was no way to calculate the risk of new financial products, but they tried to cover the bets anyway. Instead of behaving like the house, they adopted the guise of an amateur system player – and casinos love system players! They are guaranteed to lose big.
Political conservatives have become system players as well, betting everything on an uncritical view of capitalism. They have borrowed this notion from the libertarians without considering the larger philosophical content. The libertarian theorist Ludwig von Mises entitled his magnum opus Human Action and extolled the ideal of the free individual. But conservatives should have a better understanding of the human nature that guides human action. They know the character of mankind is “fallen” and that there is a dark side to the world which is evident every day. Freedom without responsibility, and rights without duties, leads to license and wrong-doing. Milton Friedman in his classic Capitalism and Freedom noted that “there is only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game….It is the responsibility of the rest of us to establish a framework of law.” In the real world of flawed people and considerable temptations, Ronald Reagan’s principle of “trust, but verify” has a much wider applicability than arms control agreements.
Treasury Secretary Tim Geithner told the G-20 Finance Ministers meeting last weekend, “All institutions that are important to the stability of the financial system should come within a much stronger framework of oversight, with clearer rules of the game that are enforced more evenly and consistently across countries.” Such regulatory reform, however, needed after decades of laissez-faire, is not enough. The focus of policy must return to the real economy. If finance is seen as pumping money as the blood of the economy, then its purpose is to keep the body alive and functioning. The muscles are represented by the nation’s manufacturing industries and agriculture. Infrastructure and services provide the skeleton and internal organs. Everything must work together, which is the duty of business and governments leaders (left and right sides of the brain) to facilitate.
Landes entitled his opening chapter “The Gentle Calling of High Finance.” Decades later, historians P. J. Cain and A. G. Hopkins would make the gentleman financier a major theme of their study British Imperialism, 1688-2000. They argue, “In an order dominated by gentlemanly norms, production was held in low repute. Working directly for money, as opposed to making it from a distance, was associated with dependence and cultural inferiority.” The social image of bankers seduced political leaders who aspired to the same lifestyle. Cain and Hopkins believe “gentlemanly capitalism…exercised a disproportionate influence on British economic life and economic policy” often at the expense of the real economy. National policy makers and business leaders need to be on guard against temptation and remember, as Cain and Hopkins do, that “the perfect gentleman adhered to a code of conduct which placed duty before self-advancement.” Wall Street’s abandonment of these noble principles has left it in ruins. Honor and duty must be restored if confidence is to be rebuilt with a return to the orthodoxy of sound finance.
FamilySecurityMatters.org William Hawkins is a consultant specializing in international economic and national security issues.
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