Was the global financial crisis really a “debt crisis”?

Alexandra Zeitz (St Antony’s College, Oxford)

Speaker: Anatole Kaletsky, Gavekal Consultancy
Chair: Adam Bennett, St. Antony’s College, Oxford

We are accustomed to analyses of the 2008-9 financial crisis that point to and dissect particular causes of the crisis, using these to call for post-crisis reform, regulation and rethinking. In a presentation at the PEFM seminar on January 25, Anatole Kaletsky instead gave a much wider-ranging and sweeping account of the causes of global financial crisis, and outlined the fundamental shifts in the relationship between governments and markets that he believes it has unleashed.

In 2010, Kaletsky published Capitalism 4.0: The Birth of a New Economy in the Aftermath of the Financial Crisis (Bloomsbury). In his presentation in early 2016, he argued that many of the false diagnoses of the crisis that he wrote the book to challenge continue to dominate post-crisis conversations. Rather than placing blame on individual bankers or on high pre-crisis debt levels, Kaletsky sees the global financial crisis as the demise of an entire theoretical and ideological view of the economy, collapsing in on itself as economic rules came to be applied dogmatically. 

Blind faith in the efficient market hypothesis led both regulators and market participants to make bad decisions – foremost among them the Henry Paulson’s decision to allow Lehman Brothers to fail – bringing down the intellectual consensus that had supported the previous structure of capitalism.

In Kaletsky’s view, the rupture the crisis provoked in both economic theory and practice will lead to a new practice and understanding of capitalism. In fact, he argues this reinvention of capitalism is just the latest in an ongoing process of evolution and adaptation. Kaletsky’s historical narrative begins with “Capitalism 1.0,” emerging in 1776 with the independence of the United States, and coincidentally also the publication of Adam Smith’s Wealth of Nations.
This first phase of capitalism, in which markets were unfettered and they and governments operated largely independently, came to an end with the calamities unfolding with the First World War and then the Great Depression. It was replaced by “Capitalism 2.0,” the Keynesian post-war consensus in which governments grew in size and sought to direct and control markets. This structure crumbled under increasing union dominance and the stagflation in the 1970s and was supplanted by the free-market ethos of “Capitalism 3.0”, under which deregulated markets came to dominate governments and union power declined. This era’s most famous prophet was Milton Friedman, who stood beside the Berlin Wall in 1980 and predicted that it would be market forces and not military forces that would bring it and communism down.

This market fundamentalist ethos of “Capitalism 3.0” was definitively undercut by the global financial crisis, argues Kaletsky, and is coming gradually to be replaced by “Capitalism 4.0.” In this arrangement of the economy and understanding of economics, neither markets nor governments are superior, but both are understood to be dependent on each other, and in need of improvement in order to secure more socially optimal outcomes.

There are already strands of “Capitalism 4.0” appearing, contends Kaletsky. He attributes trends in monetary policy to a growing recognition that the role of central banks is not just to provide an environment of stable inflation against which markets can operate—the inflation targeting philosophy that became increasingly the accepted wisdom in the final decade of “Capitalism 3.0”. There is an increasing acceptance of central bank policy being driven by goals in addition to inflation, chief among them financial stability, but also levels of employment—a partial reversion to the earlier policy framework under “Capitalism 2.0”.

Even so, Kaletsky pointed out the continued influence of the arguments and logics of “Capitalism 3.0”. Even as central banks shift to an approach that sets unofficial tolerance ranges for financial volatility, unemployment and inflation, and then apply a series of tools to keep the economy within those ranges, they often continue to insist they are merely targeting inflation.

Members of the audience concurred that markets may have overreached themselves during “Capitalism 3.0” both in the power they had to influence their own structure, e.g., through widespread securitization of assets and the valuation of balance sheets on a mark-to market basis (rather than on an adjusted book value basis), and more generally in their ability to dominate the role of the “state” itself. And here was evidence of its final contradiction—when Lehman was liquidated and all its creditors were paid off, there was still a large surplus of funds to spare. Markets had (in their 2008 hysteria) inadvertently declared Lehman bankrupt (on a mark-to-market basis), prompting the government to walk away from its rescue, when it was arguably only illiquid (and solvent on a hold to maturity basis). Because Lehman turned out to be systemically important after all, despite only being an investment bank, its market-led failure irreparably brought the whole Capitalism 3.0 system down.

In financial regulation, the implications of “Capitalism 4.0” are to recognize that governments and the financial sector are mutually dependent. Kaletsky was critical of ring-fencing attempts (a return to the Glass-Stegal devices of Capitalism 2.0) to separate “casino banking” and “utility banking” in order to demarcate the types of banks that can plausibly expect a government guarantee. Instead, he advocates for a much more direct statement of the types of assets that enjoy a blanket government guarantee, and a fee leveled on banks in exchange for this explicit insurance.

This account of the waves of capitalism has a compelling logic: first markets and government were separate, then governments led markets, then markets dominated governments, and finally the two may come into a healthy symbiosis. And Kaletsky’s analysis does capture the trends in regulation and economic thinking of the years in the crisis, which has corrected for the market fundamentalism that preceded it.

However, it is worth asking which causal mechanism moves history from one form of capitalism to another. As some in the audience pointed out, the relationship between economic theory or ideas and economic reality (between the superstructure and the base) in Kaletsky’s historical narrative was unclear: do transformations in the structure of the economy provoke shifts in economic thinking (e.g. from Keynesianism to market fundamentalism)?

In response to these queries, Kaletsky suggested that ideas generally follow (rather than lead) economic reality: the base drives the superstructure. Nevertheless, he could not resist citing a counter-example when he read a quotation from 1943 from a distant relation and namesake in which the earlier Kaletsky foretold the demise of Capitalism 2.0, more than three decades ahead of the eventual transformation! But though this prescient commentator could see the implications of economic contradictions contained in Capitalism 2.0, the broad shift in economic theorizing did not occur until much later, until the contradictions contained within the structure of the economy shifted became more apparent and Capitalism 3.0 loomed over the horizon.

And what will ultimately become of “Capitalism 4.0”? There is a risk of teleology. It may be too much to ask which of the inherent contradictions will ultimately dialectically resolve themselves in this new economic order that Kaletsky thinks is still emerging. But we may need to be more skeptical about whether “Capitalism 4.0” will turn out—in fact—to be an improvement on previous forms (as Kaletsky claimed each successive stage of capitalism was): it may be too tempting to pick and choose among what are still tentative developments as grounds for hope that a better and more balanced understanding of the respective virtues of markets and governments has replaced the pure market fundamentalism of Capitalism 3.0.