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Capitalism Is Regulation

THE FINANCIAL CRISIS of 2008 shook the faith of many people in free markets. It marked the end of a political consensus in favor of limited regulation and low taxes that began in the late 1970s. In that decade, an influential group of commentators blamed economic stagnation on strict regulation, high taxes, and lax monetary policy, arguing that these policies undermined incentives to invest and hence suppressed economic growth. Although their major policy proposals—deregulation of industry, low taxes, and control of inflation—are frequently identified with the Republican Party, deregulation began in the Carter administration, and this free-market agenda was advanced during the Clinton administration.

One of the most heavily regulated sectors of the American economy in the 1970s was finance. Banks were generally small, highly specialized institutions that could take deposits and lend money but by law stayed out of most other areas of finance (insurance, securities underwriting, and so forth); regulators limited the types of loans banks could make, their personnel, where they opened branches, the liabilities they held—almost every aspect of their balance sheet and their operations. Banking was extremely stable from the late 1930s through the 1970s, with no real crises. But critics pointed out that small banks could not compete with vast financial conglomerates in other countries, and noted that foreign banks were just as stable as American banks. Thus, the American system of highly regulated finance seemed to sacrifice economic growth without any gains in the form of enhanced financial stability.

It was this analysis that led Congress and regulators, starting with the Carter administration, to allow financial institutions to enter new markets and to borrow more and more against their assets, enabling them to grow more rapidly. Deregulation made its most rapid strides during the Clinton administration. A huge new market in financial derivatives developed; regulators did not attempt to regulate it despite worries about its size and opacity, or those who did were slapped down by the administration and Congress. And deregulation seemed to pay off. The size of the financial sector swelled, as did employment and bonuses.

But the financial crisis prompted a reappraisal. Critics of Wall Street argue that the crisis proves that deregulation failed. The erstwhile defenders of financial deregulation are on the defensive. It is against this background that one can best understand Edward Conard’s book. Conard presents himself as a critic of the move back toward regulation, exemplified by the Dodd-Frank Act, and as a defender of free market principles. He hopes to revive the deregulatory spirit of the 1980s and 1990s.

Conard makes his argument in two parts. First, he argues that the American economy did well in the 1990s and early 2000s, all the way up to the crisis, and remains in strong shape. The light regulatory policies of that era, including low taxes, delivered prosperity and thus should not be abandoned. Second, Conard argues that the financial crisis does not justify a heavy load of new regulation. He argues that financial crises are inevitable, that the government responded appropriately to the crisis of 2008, and that the economy is recovering as it should. The type of regulation that would be needed to prevent such a crisis from recurring is either impossible or likely to produce very negative consequences for economic growth. But certain sensible regulations could minimize the risk of another crash.

Conard’s first argument rests on an important point—that it is necessary to distinguish the financial system from the “real economy”—as well as financial regulation from other areas of the law. The financial crisis and the ensuing recession were not caused by low taxes, deregulation in other sectors of the economy, or other pro-market trends such as the collapse of labor unions. As Conard points out, American productivity increased rapidly from the ’80s to the ’00s—faster than in Europe and Japan—and a case can be made that this was at least partly the result of the American system of low taxation and light regulation—and not of technological advances such as the commercialization of the Internet, which took place in other countries that did not enjoy such robust growth. Nor did the trade deficit and the high rates of consumer debt detract from the economic accomplishments of the era. The trade deficit reflected the superiority of the American economy: foreigners did not buy American goods because they preferred to make profits by buying American investment assets. Meanwhile, Americans could be employed in more productive occupations because low-skill manufacturing jobs were outsourced to foreign countries where people make 75 cents per hour to produce goods for American consumption. The relatively low rate of income growth for lower-income workers since the 1980s reflected globalization, immigration, and technological change—not low taxes and deregulation.

Conard further argues that low taxation on the rich largely accounts for economic growth. Only the rich can spare the capital to make the long-term, risky investments that are essential to economic growth. When a rich person invests, most of the social value of the investment is enjoyed by the non-rich. Mark Zuckerberg made billions off Facebook, but the social value of Facebook to users is far higher. By contrast, the middle class and the poor use their wealth to buy goods, which generates fewer benefits for other people. High marginal tax rates that take from Zuckerberg and give to you and me will deter the Zuckerbergs of the future from making investments that will benefit us far more than the wealth transfer will. (Assuming that you and I consume the transfer we receive rather than invest it—but Conard also thinks that even if we invest, we will do a bad job, because, unlike the rich, we have not proven that we are any good at picking winners.)

But while Conard is right to distinguish taxation from financial regulation—and to emphasize that they serve different functions and respond to different problems—he will not persuade supporters of progressive taxation to abandon their position. The problem with his argument is that although he is correct that at some point high taxes will stifle economic growth, no one knows where that point lies. Sophisticated recent work by economists suggests that marginal rates over 50 percent would not hamper growth. Conard labors hard to defend his view that investment, which is necessary to economic growth, is highly sensitive to much lower levels of taxation, but the empirical evidence is ambiguous. Someone like Zuckerberg may act the same regardless of whether his return is $10 billion or $10 million. After all, what is Zuckerberg going to do with all that money, which he cannot possibly spend on houses and cars? Conard ends up relying heavily on his theory that people are motivated by status rather than income, and so they will work harder for more income because the marginal dollar will buy more status (“I am richer than you”) even if it will not buy new meaningful consumption opportunities (one can own only so many houses and cars).

Conard’s theory depends on rich people endlessly reinvesting their profits in new investments in a kind of joyless treadmill of capital-slavery. If they manage to consume their returns, then they benefit the economy no more than the non-rich. Indeed, Conard goes so far as to criticize rich people for giving away their money to charities when, according to Conard, they should use it for further long-term equity investments. Conard makes a good point that much philanthropic giving generates little social gain. Many rich people do not think very carefully when they give away their money—after all, they are buying status, not trying to maximize social wealth. But Conard does not realize that his criticism of the generosity of the rich contradicts his explanation for why tax rates on the rich should be low. The same factor that causes rich people to throw away their money on worthless philanthropic activities—that the value to them of the billionth dollar is zero, so one might as well give it away—will also prevent rich people from devoting the necessary time and effort to ensure that the marginal dollar is intelligently invested.

In any event, sacrificing some growth at the margin to help poor people is a price worth paying. Conard laments that the long-term victims of pro-equality policies that suppress growth will be the working classes and middle classes in the future, but this just re-states the trade-off. Should we help the poor today at the expense of future generations, who will be much wealthier than people alive today? Still, Conard’s contrarian chapter on the benefits of low taxation for the rich is powerfully written. It should be read by anyone who takes for granted the superiority of progressive taxation and has not thought carefully about the trade-offs involved.

Conard’s second argument is that the financial crisis does not justify a surge of re-regulation. Conard argues, plausibly in my view, that a major cause of the financial crisis was simply excessive optimism about housing prices—the type of “irrational exuberance” that periodically causes financial booms and busts. But surely a bust of this type does not necessarily lead to a collapse across the entire credit market; the essential link for Conard was the government’s failure to explicitly guarantee short-term debt. When housing prices sank, consumers did not withdraw their FDIC-guaranteed funds from banks. The magic of government insurance is that when depositors trust it, they do not make withdrawals, so taxpayers do not pay a dime. But FDIC insurance does not cover the bulk of large deposits made by firms, and does not reach other short-term markets—the money market and, crucially, the repo market, where investments banks retrieve short-term funds. When housing prices fell, the housing-linked collateral used in those markets also lost its value, causing funders to stop rolling over loans, and suddenly depriving large financial institutions of their funding and driving them into insolvency. The securitization of mortgages—which increased the demand and ultimately the quantity of high-risk mortgages—and the opaqueness of derivatives exacerbated the crisis.

Conard puts the problem nicely by describing the different roles of what he calls “long-term equity” and “risk averse short-term capital” in the economy. Long-term equity refers to purchasing power that people have accumulated, which they are willing to put into risky investments that might take a long time to pay out, and might pay out nothing or a lot—for example, an early investment in Facebook or Webvan stock. The vast majority of long-term equity acts through corporations and rich people—people who have so much money that they can risk a large portion of it without making sacrifices in their daily lives.

“Risk averse short-term capital” refers to purchasing power that people (or firms) can set aside temporarily but will need to draw on in the short term, and possibly at any moment, for everyday expenses. While long-term equity will park itself in illiquid investments that cannot be cashed out for years, short-term risk averse capital will put itself only in accounts where it can be quickly moved away at the slightest hint of trouble. Traditionally, this meant demand deposits in banks. In the modern era, there are other vehicles such as money market mutual funds and, for large firms, the repo market, where pensions and other large institutions lend money overnight; these loans are typically rolled over, but if money is needed, the lender can simply refuse to roll it over and thus access it within a day or two.

Conard makes a claim that ought to be striking when you consider that he presents himself as an advocate for the free market. While low taxes are needed to ensure that long-term equity flows toward risky but potentially lucrative and (hence) socially valuable projects like Facebook and Google, people will refrain from investing their risk averse short-term capital unless the government guarantees their funds. Or they will put it in banks but withdraw it on a hair-trigger basis in response to any real or imagined threat to the health of banking, which either prevents banks from deploying the capital to valuable projects or destroys those projects when the inevitable panic ensues—again, unless there is a government guarantee.

In a way, there is nothing remarkable about this point. The entire system of banking regulation is based on it. Yet it is insufficiently appreciated that at the heart of capitalism is a kind of socialism, which is taken for granted even by free-market advocates like Conard. Economic growth requires that the government guarantee savings. Conard goes farther than most by arguing that the government should not just guarantee bank accounts up to the current FDIC limit of $250,000 and vaguely (“implicitly”) guarantee the financial system by serving as lender of last resort. It should provide explicit guarantees of all short-term debt. Conard does not explain clearly how far he would take this proposal—does he mean all deposits in the banking system, plus the repo market and other short-term debt markets, markets worth many trillions of dollars? If he does envision such an extension of government guarantees, then all these markets would need to be regulated as well to prevent risk-taking by subsidized market participants, which implies a massive extension of banking regulation, so that it covers not only traditionally tightly regulated commercial banks, but any firm that relies on short-term debt financing for long-term investments.

A government guarantee at the heart of capitalism means that regulation is necessary, and Conard does not deny this. If all people (and firms) know that their short-term savings will be guaranteed by the government, they have no incentive to put their savings in safer, better-run banks. Riskier banks will offer higher interest rates on deposits and attract short-term savings, so the government must step in and force banks to lend prudently. This, too, is conventional wisdom, and reflected in the law. Conard gestures at some market-based solutions to this problem, but he ultimately embraces government regulation as he must, insisting correctly that the government must price deposit insurance, regulate the balance sheets of banks, and forbid them to make excessively risky loans. He even praises the Bush administration for closing a loophole in capital adequacy rules in 2001.

Conard spends a lot of time debunking the theory that predatory lending caused the financial crisis, pointing out that zero-down payment loans do not harm borrowers but benefit them. And he defends bankers, pointing out that they kept housing-related assets on their balance sheets and lost money on them, so they must have believed in their products. Still, zero-down payment loans added a huge amount of systemic risk to the financial system, and we can certainly blame the bankers for making them available, as Conard admits. And the problem with banking is not that bankers deceive people but that they gamble with taxpayer-guaranteed funds. Like any gambler, they lose as well as win, so the fact of loss in the financial crisis tells us nothing unless we tote up the wins as well. Bankers did very well over the last decade, even if you include their losses during the crisis. Unlike casino gamblers, they enjoyed a government subsidy.

Where does this leave us? Conard presents himself as a defender of the market. At the start of the book, he asks portentously, “Do free markets optimize on their own, or can private investors put our economy at risk for their own gains? Nothing less than the credibility of capitalism is at stake.” It is clear where Conard thinks he stands. Throughout the book, he rails at regulation, blaming it for the financial crisis and other problems. He attacks Dodd-Frank and many other regulatory initiatives. Yet at the level of theory Conard is just as much in favor of regulation of financial markets as, say, the “ultraliberal” (Conard’s word) Paul Krugman. Indeed, the regulatory system he favors could be massive. It is impossible to reconcile his Manichaean vision and his endorsement of regulation.

In a revealing passage, Conard tries to square the circle: “The widespread failure of banks from temporary withdrawals is not a failure of free markets. It’s a consequence of a logical policy decision.” The policy decision he is referring to is the decision not to give banks an explicit government guarantee. In other words, the widespread failure of banks is not a failure of free markets; it is the result of insufficient government intervention! The passage makes no sense, and perhaps should best be understood as an attempt to reduce cognitive dissonance, an effort by a free-market advocate to persuade himself that his support for massive banking regulation is not a rejection of free market principles.

What accounts for this feature of the book? One can only speculate. Conard worked at Bain for many years, and one senses from occasional allusions to his former master-of-the-universe status that his experiences there have influenced the way he understands the financial system. Bain is a private equity firm, and the job of people such as Conard is to spot undervalued businesses, buy them, reorganize them, and then sell them at a profit. This is obviously a high-stakes enterprise, with a great deal of risk and a great deal of reward. If you make a mistake—think a business is undervalued when it is not, or end up ruining the business rather than improving it—you lose your own money, and the money of partners and investors, and you might even feel guilty about destroying jobs. Your investors if not your conscience will flush you from your ecological niche. By contrast, if you do well, not only do you make money for yourself and others, but you may obtain satisfaction from improving a business, potentially saving jobs and increasing employment. One can forgive Conard for seeing in private equity a fierce Darwinian process that chews up the weak and yet advances the public good. Conard can take pride in the fact that he helped society while enriching himself and crushing competitors who are not as high on the evolutionary scale as he is.

But he should be cautious about attributing similar virtues to the bankers. The free-market nostrums that may apply to private equity do not easily transfer over to the topsy-turvy world of finance. Because the heart of the financial system is a massive government intervention, the losers—people who park their savings in the wrong firms—survive. Darwin is not at work here. The lords of finance—unlike the lords of private equity—face perverse incentives. They obtain profits not by replacing bad businesses with good businesses, but, in major part, by inventing new methods for companies to evade the very types of financial regulation that Conard supports. Indeed, an enormous amount of trading is simply a kind of legal gambling—a vast quantity of zero-sum transactions that generate no benefit for society while creating systemic risk. So there is tension between Conard’s Bain-inspired advocacy of free market principles and his attempts to apply those principles to finance.

Conard tries to insist that the financial system adds value to the economy. He cites a paper by the economist Thomas Philippon which shows that the financial industry has grown when it has needed to grow, in response to economic demand for financial innovation produced by the railroads in the 1800s and dot coms in the 1990s. Conard neglects to mention that this paper was unable to account for the enormous growth of the financial sector from 2001 to 2006. A more recent paper by Philippon provides evidence that the financial sector has become less efficient over the past thirty years, a period during which the advance of information technology should have made it more efficient. Of course, we would all be in bad shape without the modern financial industry, but there are very good reasons to believe that it is too big and highly inefficient.

Conard’s book is a hodgepodge of the good and the bad. Most of the book has a certain impressive intellectual rigor. Conard thinks in abstractions—human beings are almost entirely absent from an analysis that emphasizes the movements of capital through the market—and writes in a highly abstract way, which will defeat readers who do not bring some background in finance, but which also enables him to make his points compactly and to cover a lot of terrain. He draws on the academic literature intelligently but selectively, and clearly has thought through the logic of his argument rather than relying on the theories of others. The book has a point of view—Conard is unapologetically conservative—but it is in places pleasingly unpredictable, and does not toe the Republican Party line. One sees a logical mind working its way through the evidence, and engaging with its own deeply entrenched prior assumptions, not always successfully, but often illuminatingly.

Yet there is also much not to like. The book has a silly if inevitable subtitle (“Why Everything You’ve Been Told About the Economy Is Wrong”): many of the ideas that Conard presents are textbook economics although presented in his distinctive idiom. He presents certain technocratic quibbles as large disagreements in philosophy, just as Republicans and Democrats portray their conflict over five percentage points in the marginal tax rate as an epic showdown between socialism and Social Darwinism. If many of his proposals are interesting, they are not always adequately defended. Conard does not explain how explicit government guarantees of short-term capital would work—taken literally, the proposal implies a huge expansion of banking regulation to cover the entire financial system—and he seems to back off it at the end. He favors capital adequacy regulations but does not discuss the immense difficulties that are involved in implementing them—they were gamed mercilessly by the financial industry in the years leading up to the financial crisis—while cavalierly dismissing other proposals as unworkable when they face difficulties of similar magnitude.

When not writing about the economy, Conard’s thinking can be weak indeed. He argues that Roe v. Wade caused the advance of free market principles by enabling Reagan to form a coalition of economic libertarians and social conservative. But Roe v. Wade did not secure Margaret Thatcher’s election. Conard forgets that deregulation began under the Carter administration and that free-market principles advanced worldwide thanks to global causes such as the failure of Keynesian economics in the 1970s, globalization (which made national regulation and taxation more difficult), and the collapse of communism.

In another passage, Conard attacks the new health care legislation without explaining what is wrong with it, instead tossing off the talking point that the Obama administration has harmed the economy by introducing “uncertainty”—an unfalsifiable theory if there ever was one, and unfair in light of the extraordinary economic upheavals that the administration has had to confront. In his better moments, Conard might have noticed and addressed the parallel between the case for health regulation and his own case for banking regulation: that once we decide not to let banks fail and people die, we create moral hazard, which can be addressed only with regulation that compels banks and people to buy correctly priced insurance and constrains their risk-taking behavior.

Eric A. Posner is a professor at the University of Chicago Law School.