Imagine an oven that only had two settings. It is either at 500 degrees or off. The oven is still useful, even essential, especially if it is the only means available to heat anything. But it is a blunt instrument, liable to burn things and destroy tastes. I think this is a passable metaphor for global capitalism today. It is great, we need it, it does good things, but wow, it would be so much better if we could regulate the heat.
Before getting to ways of regulating, here is a recap on how we ended up with such a powerful but blunt oven over the past forty years or so.
We have to remember that capitalism has transformed the world for the better. Markets and rewards spur innovation, allocate capital and labour where they can be productive, and drive human progress, especially in combination with social changes such as female emancipation.
Just look at China, transformed within two generations and taking a billion people out of poverty, with another billion or so on the way thanks to Belt and Road. That is the power of capitalism, and it illustrates that capitalism is not the same as democracy, and also that capitalism is not an antonym of communism.
It is also clear that capitalism always requires regulation, in the same way that civilised societies require police. Regulation is especially important where markets are necessarily impure such as healthcare, banks or utilities – practical constraints limit competition and consumer knowledge. But in general a key to good capitalism is to maximise competition – something the US has forgotten and China has yet to fully grasp. What a shame Elizabeth Warren has had to withdraw - this is one of her big messages.
Capitalism always drives inequality of outcomes. Markets create winners and losers, and there has to be some incentive to take risk. But inequality of outcome has some justice, while inequality of opportunity does not. The injustice is that winners work to skew the playing field in favour of their own offspring and rich states do the same, via trade rules and the like.
The main change since 1980 is the globalisation of capital and the maturation of finance. Money flows much more easily and transparently these days, which is in part a good thing. But, like water in the absence of barriers, it will flow where the returns are highest, and eventually all returns will have to be that high to avoid a drought. There are still a few exceptions, such as some sovereign wealth funds and private companies, but nowadays most money rapidly flows to investments able to claim a minimum benchmark.
That benchmark is essentially set by the largest pension funds and other funds taking in and investing cash now in return for liabilities long into the future. If you run a pension fund, you need to make a base assumption about average real investment returns to run your business. By some unknown process, that assumption has converged at around 6% real annual return. The funds have grown to be a significant share of global capital, so most of the rest has come to accept that same assumption.
That 6% real assumption is the 500 degree setting on the oven, and has huge consequences. Firstly, it entrenches a rapid widening of inequality, because natural economic growth per person can only get close to that level in exceptional circumstances. As Piketty concluded, r > g.
Worse, the fact that 6% real is such a stretch forces anybody managing capital to strive harder and harder to achieve it. The next myth is that banks and business leaders are just driven by greed. In reality they are driven to keep their jobs, and that requires a series of credible business plans returning 6% real. Fail that test just once and the vultures will swoop. Collectively fail the test and we have a national or international financial crisis.
Most businesses cannot continue to grow organically at such a rate, especially as populations get older and Amazon swallows more and more of the cookies. So what do they do? They merge with each other, take in more debt and risk, and push profit flows to the short term. They squeeze all their costs, throwing out good human relations and offshoring. They lobby like heck to create regulatory tailwinds. And sometimes they just cheat. Don’t blame them or their greed, blame 6%.
So, how can we fix this oven? Smart politicians of the left, sometimes supported by thoughtful publications such as The Economist, have policies to attack the symptoms. Starting with more equality of opportunity, there need to be higher estate and property taxes and maybe even a wealth tax, with proceeds mainly going to improve the chances of disadvantaged kids.
My top policy prescription tries to put a speed bump in the frantic flow of capital, especially the most speculative sort. This is the so-called Tobin tax on financial transactions. We might be getting close to a place where a global form of such a tax could be used to fight global heating.
Then there are a raft of actions to stop businesses finding ways to skew the playing field in their favour. Start by removing the crazy advantages for debt over equity, including the carried interest loophole (and US tax reform has to do this to be credible). Then restore more corporate taxation, trying to make it progressive like income tax, crack down on devices, havens and loopholes, and restore regulation to favour citizens over corporations, especially in those areas where markets cannot work at full efficiency. If politics can be reformed to favor citizens too, so much the better.
From the other direction, there is a growing consensus that living minimum wages, long demonised by business, are proving effective in making sure workers accrue a share of economic gains. These must be subtle, reflecting cost of living differences (so not $15 per hour everywhere), but set aggressively and without loopholes. We can also make progress in defining things like decent housing and healthcare as human rights, enabled by sufficient central funding.
The resistance to this package would be huge, not just in the US, and the reason is clear. The corporate and financial edifice would collapse – they simply can’t afford it and retain 6%. Once financiers had run out of ways to cheat (which would take a long time), profit expectations would reduce back to long-run levels and markets would plunge, and pension funds would have to revise their actuarial assumptions and declare massive under-funding, creating huge liabilities for future pensioners. This rightly scares politicians – it is hardly a recipe for re-election, so even the centre-left continues with the charade and perches uncomfortably in the oven.
So we have to address the cause at the same time as the symptoms, and somehow replace 6% with a more sustainable figure such as 4%. The only time this would be feasible would be during a financial crisis. Obama might have been able to get through such a package in 2009, should there have been full diagnosis and sufficient time to plan. So this is what the great and the good of the economic world should be doing now – planning not to waste another good crisis. A crisis is surely coming, and maybe coronavirus might trigger it. In the US, history might repeat with a crisis timed just when the White House shifts red to blue – not a coincidence in any way, of course.
The uncomfortable part of the required package is the necessary compensation. Last time bailouts went to banks. Hopefully, reforms will mean less of that will be needed this time, and the focus can be on funds linked to pensions. Shortfalls in the funds could be met in part by federal money, sufficient to restore confidence and avoid condemning millions to poverty in old age. For the rest of the financial industry, I would not be so generous.
It does feel very optimistic to suggest that politicians and economists can define and implement this sort of transformation, given their history and their immediate interests. But the alternative is just frying in the oven, while humanity is also frying in the other oven of climate change. Eventually, both scourges must be faced, and the time it usually happens is during a crisis. I hope some smart people are thinking this way – now Ms Warren has more time on her hands maybe she can start a coalition?
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