Did Capitalism Fail?

NEW YORK – Until six days before Lehman Brothers collapsed five years ago, the ratings agency Standard & Poor’s maintained the firm’s investment-grade rating of A. Moody’s waited even longer, downgrading Lehman one business day before it collapsed. How could reputable ratings agencies – and investment banks – misjudge things so badly?

Regulators, bankers, and ratings agencies bear much of the blame for the crisis. But the near-meltdown was not so much a failure of capitalism as it was a failure of contemporary economic models’ understanding of the role and functioning of financial markets – and, more broadly, instability – in capitalist economies.

These models provided the supposedly scientific underpinning for policy decisions and financial innovations that made the worst crisis since the Great Depression much more likely, if not inevitable. After Lehman’s collapse, former Federal Reserve Chairman Alan Greenspan testified before the US Congress that he had found a flaw in the ideology that self-interest would protect society from the financial system’s excesses. But the damage had already been done.

That belief can be traced to prevailing economic theory concerning the causes of asset-price instability – a theory that accounts for risk and asset-price fluctuations as if the future followed mechanically from the past. Contemporary economists’ mechanical models imply that self-interested market participants would not bid housing and other asset prices to clearly excessive levels in the run-up to the crisis. Consequently, such excessive fluctuations have been viewed as a symptom of market participants’ irrationality.

This flawed assumption – that self-interested decisions can be adequately portrayed with mechanical rules – underpinned the creation of synthetic financial instruments and legitimized, on supposedly scientific grounds, their marketing to pension funds and other financial institutions around the world. Remarkably, emerging economies with relatively less developed financial markets escaped many of the more egregious consequences of such innovations.

Contemporary economists’ reliance on mechanical rules to understand – and influence – economic outcomes extends to macroeconomic policy as well, and often draws on an authority, John Maynard Keynes, who would have rejected their approach. Keynes understood early on the fallacy of applying such mechanical rules. We have involved ourselves in a colossal muddle, , having blundered in the control of a delicate machine, the working of which we do not understand.

In , Keynes sought to provide the missing rationale for relying on expansionary fiscal policy to steer advanced capitalist economies out of the Great Depression. But, following World War II, his successors developed a much more ambitious agenda. Instead of pursuing measures to counter excessive fluctuations in economic activity, such as the deep contraction of the 1930’s, so-called stabilization policies focused on measures that aimed to maintain full employment. The New Keynesian models underpinning these policies assumed that an economy’s true potential – and thus the so-called output gap that expansionary policy is supposed to fill to attain full employment – can be precisely measured.

©RIPRODUZIONE RISERVATA