From extremely violent cyclical crashes in the stock market to stagnating wages and economic growth, it’s easy to lambast the free market and question the efficacy of voluntary exchange. Many socialists claim we are in the midst of late-stage capitalism, and that the current struggles we face are merely the harbingers of a radical leap from capitalism to socialism. This is a quixotic fairy tail of course, as many thought the 1930’s were also proof capitalism was a fatally flawed paradigm centered around waste and human greed. On the contrary, claims today from presidents and central bankers lead the public to believe that the economy is thriving, and that we have assuredly escaped the depths of the Great Financial Crisis. Glancing at the data impugns that narrative. The evidence many leftists point to regarding the decay of capitalism shouldn’t be brushed off lightly, merely examined from a different point of view.
The graph (from an excellent article) below maps RGDP per capita from various economic downturns throughout their respective recoveries. It is clear to see that our ostensibly booming economy of the 2010s rivals the illustrious periods like the 1930’s and the late 1800’s.
Despite experiencing the longest bull market in history over the last decade or so, growth was slow and underwhelming. Yet is this the withering of the free market? Has she croaked at last? Or is what we call our economy today something entirely different than capitalism?
If quick and painful liquidations of bad businesses and loans are the modus operandi of the free market, where does the moribund, slow stagnation of an economy stem from? Certainly not from the mistress market, scythe in hand, doing her rounds to better allocate resources. Taking a look at total bankruptcies in the United States it would be impossible to detect the devastating recession that locked the entire country in their homes and brought unemployment to 15%. Surprisingly, (or not) bankruptcies went down during the recession. Clearly, this phenomena is not of the free market’s design.
It doesn’t take much perspicacity to realize that calling what we have today a free market is just as much as a pipe dream as late-stage capitalism. The last bastion of the free market was broken quite some time ago as it certainty went gentle into that good night.
While there is a rich and exciting history of the pernicious decay of capitalism in this nation, in this article I wish to focus on the post-GFC environment. I aim to take steps to elucidate the frowsy growth and disinflationary undertow that drags the global economy that has been overwhelmed with pernicious central bank profligacy and financialization.
Eurodollars (offshore US dollars) serve as the global reserve currency, emerging in the 1950s and 60s to solve Triffin’s Dilemma, and ever since the last line of defense was broken in 1971 by Nixon, the financialization of the economy has deformed and bloodied the waters of the free market. One of the worst deformations was the Greenspan Put. In a foolish attempt to keep the economy healthy through wealth effects, interest rates were kept low and the Federal Reserve would backstop a stock market crash by any means necessary, including bail-outs. While Open Market Operations such as QE & the Fed Funds Target are arguably inefficient in lowering interest rates, the Fed’s Open Mouth Operations were more than enough to persuade gamblers to go wild in the casinos of Wall Street. While the Fed is not central by any stretch of the imagination, by acting like they are, through expectations policy, they can manipulate the economy. The ensuing low-interest rates hurt the middle class and traditional savers, forcing them to play in the casinos of Wall Street with their life savings in an attempt to retire happily.
One of the essential hallmarks of capitalism is private property, that one may reap his own profit while equally be held responsible for any losses he occurs. Prices contain valuable information and are signals for investors and consumers alike. By privatizing profits and socializing losses, the playing field has been heavily skewed towards gamblers and against the followers of fundamentals. Much more risk can be taken, leading to procyclical trends. Furthermore, investment projects and businesses can survive with a lower level of marginal efficiency, as cheap credit and lower interest rates allow for the suboptimal endeavors to stay afloat. Research from Japan has shown that these low-interest rates create zombie businesses, dependent on the cheap credit to keep their suboptimal business and investments afloat. Additionally, productivity falls in lieu of a lack of incentives, especially if businesses anticipate the cheapening of credit. Even in America, zombie businesses are in full swing as productivity and real investment in fixed capital have fallen.
This has gone hand in hand with the concentration of businesses via M&A takeovers since the 1970s due to various developments including artificially cheap credit. The rise of big businesses and debt zombies have stunted marginal wages, productivity, and economic growth. Much of these takeovers were found not to be economically beneficial as they destroyed shareholder value, and most were only possible through the prevailing cheap credit and speculative crazed stock market leading up to 2008.
Further distortion of lending occurs through the Federal Reserve’s direct actions. In order to make banks’ balance sheets more liquid, central banks will buy illiquid collateral off of banks for relatively cheap. This in turn hampers market discipline. Additionally, as Kjell Nyborg elucidates, by accepting only certain kinds of collateral, central banks incentivize the use of certain collateral, and the underlying production of those real assets the collateral is tied to. As he puts it, if the central bank only accepts igloo-backed securities, more igloos will be built.
We can also apply Gresham’s Law in this regard, as pristine collateral is hoarded and only used in bilateral repos, while the lowest quality collateral is used with central banks. The increased use of suboptimal collateral incentivizes the real creation of these suboptimal loans, distorting the investment decisions of banks. Meaning that precious balance sheet space will be increasingly used on bad loans. This also plays in tandem with spread compression, forcing banks into suboptimal, risky investments. Both of the factors distort real economic activity towards risky investments, projects that can pragmatically only stay alive because of cheap credit. It is these suboptimal investments that help spawn the creation of the aforementioned debt zombies.
Another pertinent deformation brought about by state intervention and incompetent central banks is the financialization of the economy. Ironically, much of this financialization occurred under the guise of market liberalization during the 80s and 90s. However, the free market at that point had long been abandoned as sound money was a thing of the past. In the graph below the rampant growth and inflation of the financial sector is quite clear when compared to the real economy.
The authors of that paper claim that this dire discrepancy between the financial and real economy induces capital misallocation, as savings are funneled towards financial assets instead of productive and beneficial investment. This slows economic growth, putting CEOs’ bonuses ahead of higher living standards and cheaper prices.
They further elaborate that both naïve deregulation and regulation itself played a role in the financialization of the economy. For example, the Basel Capital Accords skewed bank lending away from smaller firms and in favor of residential real estate through regulatory risk weights.
The fate of small businesses are directly tied to the fate of the middle class, as roughly half of Americans are employed by small businesses. They serve as the lifeblood of the American economy and the middle class. However, Small and Medium Enterprise (SME) lending has largely fallen off since the GFC. Owing to the beforementioned regulation, spread compression, and balance sheet constraints regarding inherent fragility, SME lending has declined dramatically when compared to big business lending.
Furthermore, lending as a whole has not recovered from the GFC, illuminating balance sheet constraints, risk, and excessive debt that the entire system faces.
Another stab in the gut of small businesses is the centralization of the banking industry. In 1966 there were roughly 24,000 commercial banks in the USA, now there are under 6,000. Research by Professor Richard Werner has shown that small banks tend to loan to small businesses, and vice versa. With the consolidation and rise of these large banks, lending to small businesses has dried up. As these large banks are unable and unwilling to extend loans to smaller businesses. Smaller banks have information advantages in the form of relationships with their community, and thus are much more willing to give out loans to small businesses with that advantage.
The most crucial point in this discussion also comes from Werner in his distinction between productive credit allocation and unproductive credit allocation. Through low-interest rates and the emergence of the wholesale lending system, the global economy has deformed into a debt-based system. Given all this credit creation one would expect that inflation would certainly be higher, and some would postulate that economic growth should be booming. One of the reasons for the lack of inflation in the real economy, as Professor Werner stresses, is the allocation of credit that helps determines inflation and growth.
In the free market, loans would be given out to businesses looking to invest that money in the economy. This expansion of the money supply supports innovation and ensures savings are put to productive use. As the diagram states, the result is growth. As goods and services are created, increasing the standards of living while also increasing productivity. Technological innovation and this competitive creation are deflationary phenomena, so it’s unlikely that excessive levels of inflation will take place. Furthermore, if money demand rises in step with money supply, inflation will not take place.
Conversely, if loans are used for consumption, this causes inflation as excess holdings of money are shed throughout the economy, driving up prices. Money demand falls as money supply rises. While profits increase for the businesses, this is only nominally and temporarily. Productivity nor investment has increased here, and the Austrian Business Cycle Theory will play out with an inevitable bust.
Finally, and most pertinent to today, is the scenario where new credit is spent on financial assets. As I’ve detailed above, it is this scenario that has occurred because of the deformation of capitalism in this nation due to state intervention and eradication of sound money. Much of the money creation in the shadows of the Eurodollar System have gone towards this mode of allocation. Under this framework, we can see just why economic growth, wages, and productivity have all seemingly struggled despite rampant asset inflation and ostensible money printing. Of course, this asset inflation only serves to benefit the already rich, further exacerbating the disparity between Wall Street and Main Street. Over the last 50 years or so, the economy has been increasingly decapitalized and exported offshore. Spurred by cheap credit, financialization, and a central bank backstop, scarce savings have flowed to the benefit of CEO bonuses and asset prices instead of productive and beneficial investment.
One of the biggest problems the global banking system faces is a systemic lack of pristine collateral. This collateral typically takes the form of US T-bills, but also corporate bonds and the like. This in turn causes acute dollar shortages to arise every so often that have real economic impact. It is here where a feedback loop has been plaguing the entire system, not allowing the invisible hand to right the wrongs of the past. Given systemic risk and unprofitable lending conditions, banks pull back their lending and resort to buying safe financial assets. Because of that lack of lending, real economic conditions falter, especially for small businesses. If banks were able to lend efficiently and businesses invested productively instead of gambling through stock buybacks and M&A takeovers, banks would have high-quality collateral to conduct their day-to-day operations and the real economy would improve likewise. The allure of cheap credit and crony capitalism has seduced and corrupted both banks and businesses to gamble in the casinos of Wall Street, leaving the real economy out to starve.
For over a century the free market has been mangled by quixotic intervention to “save the economy”. Gorging the system with the delusion of grandeur that can only be obtained through debt and deficits. Like a drug addict, our crony capitalist system fiends for deficits, cheap debt, and political favors. Yet these are not economic panacea, they are the very malady that rendered our system compromised to begin with.