A New Dawn for Democratic Capitalism

The presidential campaign in the US has taken an ironic twist in recent weeks, as John McCain, in his latest attempt to steer the electorate away from focusing on substantive issues, has used the "S"-word to describe Barack Obama - socialist. This, in a season in which everyone from Republican legislators to Wall Street bankers have been heard to ruefully proclaim that "We're all socialists now."

To describe the current wave of government interventions in the financial markets as socialist is not that much of a stretch. In the US, at least, the federal government is taking equity stakes in financial institutions, sometimes forcibly.

Ultimately, however, the West will want to preserve its legacy of democratic capitalism. But in order to do so, it will have to rewrite that legacy.

That governments will have a role in shaping markets for some time to come is axiomatic. The transactions which will see governments ultimately pouring trillions of dollars into markets and institutions will take a long time to unwind. At what point governments will be willing to withdraw from this intervention is an open question.

The greater challenge for governments will be to forge a political economy which is designed to prevent the market meltdown we are now witnessing. This means moving away from direct market interventions and towards a regime of intelligent regulations in which democratic institutions act to preserve the benefits of free markets.

"Market capitalism is a dangerous tool," said Alice Rivlin, a former director of the Congressional Budget Office, at a recent appearance before the US House of Representatives Committee on Financial Services. "Like a machine gun or chainsaw or a nuclear reactor, it has to be inspected frequently to see that it is working properly and used with caution according to carefully thought out rules."

In one sense, the task of establishing some new rules right now should be relatively easy – at least politically. The ideology of pure free marketers has been dashed on the rocks of reality. We have seen the results of an ideology that eviscerated the regulatory authority that had prevented abuses in the past. In the US, even the purest of free-market ideologues agreed that government intervention was necessary in the current crisis. The debate centered on the shape and scope of that intervention.

On the other hand, bringing the developing world along may be a steeper challenge. The developed world may see the task as preserving free markets - and the benefits of innovation and economic growth that they bring - while curbing their excesses. But many in the developing world are not sold.

Developing economies are still deciding, not between more or less financial regulation, but as to whether they should rely on a system of free enterprise or government planning. The current financial mess has not helped the cause of capitalism. As Honduran President Manuel Zelaya told the UN General Assembly last month, the lesson of the crash was that "the market's laws are demonic, satisfying only the few."

The direction of the global economy may hinge on the success of reforming financial markets and institutions.

Free market conservatives, no less than liberals or socialists, deny they are out to enrich the few at the expense of the many. They say free markets with a minimum of government regulation are the best tool to achieve the economic growth that benefits all. In other words, "Greed is good, greed works," as it was put by Gordon Gecko, the character played by Michael Douglas in the 1987 film Wall Street.

Conservatives have long touted the evils of government and the almost transcendent perfection of markets. But lately we have seen that markets, as human institutions like governments, are imperfect and subject to failure.

"Prudence and judgment are needed in order to discern which failure is the graver threat to the common good at any particular point in history," said William Galston, a senior fellow at the Brookings Institution, a Washington think tank, in a recent CNN interview. "In the early 1930s, we made a judgment that market failure was a more significant threat than the expansion of government. We appear to be on the verge of another moment like that."

The US Congress, even in the midst of an election season, has already taken up the cause of enhanced financial market regulation. When Alice Rivlin appeared on Capitol Hill on 21 October, she brought with her a whole raft of recommendations.

Rivlin identified several regulatory gaps, and proffered suggestions for filling those gaps. "The most obvious regulatory gap is also the easiest to fill," she said, referring to the failure to regulate new types of residential mortgages.

"Giving people with less than sterling credit access to home ownership at higher interest rates is basically a good idea, but it got out of control," Rivlin argued. "Federal authorities should have gotten on the case and imposed a set of minimum standards that applied to all mortgage lending."

Another regulatory gap is more difficult to fill: regulating complex derivatives. "Much of the financial crisis stemmed from over-leveraged unregulated trading in complex financial derivatives," Rivlin noted. "The question is: Should we clamp down on the leverage or on the products themselves? I incline to think that we will be more successful if we operate on the leverage by imposing higher capital requirements on all financial institutions."

Another regulatory conundrum will be how to deal with the securitization of mortgages. This phenomenon creates incentives for the lender to ignore repayment risk because it knows it will be able to sell the mortgage in a secondary market. "We need to clear up the legal responsibilities of loan originators, servicers, packagers and owners of mortgage-backed securities," Rivlin said. She also advocated beefing up the roles of the Federal Reserve and the US Securities and Exchange Commission in insuring that banks manage their risk competently.

Other commentators are advocating segmenting financial markets in a manner analogous to the division of financial institutions under the Banking Act of 1933, also known as the Glass-Steagall Act, which imposed a separation between the commercial banks that accept deposits and make loans and investment banks that underwrite securities.

William Gruver, a professor of management at Bucknell University in Pennsylvania, writing in the New York Times, advocated not the breakup of financial institutions, but "building a new wall of separation."

"Instead of trying to limit what products innovative financial firms can offer," he wrote, "it would be more prudent to limit the markets to which they can sell their wares."

Under Gruver's scheme, "the customers, not the companies" would be divided. Investment experts and high net-worth individuals "could be given a pass into the caveat emptor world of modern Wall Street." Investors lacking "the sophistication or the deep pockets to qualify would be limited to the more closely regulated menu of stocks, bonds, and mutual funds."

Gruver also advocated matching today's financial behemoths with a "consolidation of the regulatory agencies," creating a supercop that would police the financial system.

The regulatory wave is proceeding globally as well. Australian Treasurer Wayne Swan, in a recent appearance in Washington, outlined a global scheme in which "all systemically important financial institutions would be regulated in similar ways."

He argued that countries should come together in international bodies to agree on enhanced capital requirements for banks, "high capital requirements for firms that reward short-term returns or excessive risk taking in their compensation packages," and "accounting rules [that] do not enforce pro-cyclical valuation changes."

Of course, regulation cannot cure all market ills and governments must continue to be wary of too much regulation. "Bubbles always provide out-sized opportunities for quick profits," noted Rivlin. "They exacerbate greed and fraud and provide excuses for the suspension of common sense. Can we fix this problem by regulation? It is hard to legislate common sense."

Ultimately, the reform and repair of financial markets depends less on the minutiae of regulations - the merits of which are subject to argument - than on a cultural shift away from a free-for-all atmosphere and toward a system in which, at the least, the economy and polity are protected from breakdown due to market excess.

Part of this shift may require a redefinition of what is meant by democratic capitalism. Many who use this term think of a system in which free markets exist side-by-side and unfettered by a democratic form of government. Perhaps the time has come to view democratic capitalism as a system in which the institutions of democratic governance are brought to bear to ensure that capitalism works for the common good.