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Healthy wealth

29 October 2012 By Hugo Dixon

Last week I gave a speech on “healthy capitalism” at Oxford University. Before doing so, I tried the idea out on an academic friend of mine. He scoffed at it. For him, “healthy capitalism” was an oxymoron. Five years after the start of the world’s worst financial crisis in decades, it is easy to mock capitalism. The system ran amok – leading to debt, unemployment and shrinking economies.

But that’s precisely why the world needs healthy capitalism. Health involves vigour, well-being and resilience. Capitalism – with its basis in free enterprise and private property – can have all those qualities provided warped incentives are corrected and the culture of greed is tempered. State socialism certainly cannot. The practical alternative is to reform capitalism not throw it away.

But how should it be reformed? After the tribulations of recent years, the conventional wisdom is that the problem has been too much freedom. That, though, is a misdiagnosis. Most of the diseases that have become apparent during the crisis have been caused by a distortion of free enterprise rather than too much freedom.

Sickness number one was Alan Greenspan’s habit of lowering interest rates at the first sign of trouble during the pre-crunch era. Investors dubbed this the “Greenspan put”. The theory was that, since the U.S. Federal Reserve would always ride to the rescue, it made sense to take high risks. Fear was numbed and greed left untrammelled. The natural balance of a healthy organism was distorted.

Central bankers do have a role in mitigating the extremes of the economic cycle. But it is vital that, in doing so, they don’t just stoke up more trouble. They need to have the expertise to recognise bubbles and the courage to prick them – an idea which has, thankfully, gained currency in the post-Greenspan era.

The second malady was caused by an excessive willingness to bail out bankrupt banks. In a well-functioning free market, investors would bear the consequences of poor decisions. If a bank teetered on the brink, shareholders would be wiped out and bondholders would suffer. But, with the exception of Lehman Brothers and a few much smaller cases, bondholders were bailed out instead of being bailed in.

This was understandable given the fear of knock-on effects. But a healthy body sees old cells dying and new ones being born. A well-functioning financial system also has to allow for death and renewal. Propping up zombie banks debilitates the whole economy. Meanwhile, the message that foolish risk-taking won’t be punished encourages more folly. This is why reforms in the pipeline to allow banks to be wound down without causing the entire system to collapse are so important.

The third illness is caused by the heads-I-win-tails-you-lose bets that financiers and traders were able to enjoy during the upswing. If everything went well, they made a fortune; if everything collapsed, taxpayers picked up the pieces. Not surprisingly, they spun the roulette wheel.

Such privatisation of gains and socialisation of losses is not healthy capitalism. It is a caricature of the free market. Again, various attempts are being made to ensure that people bear the responsibility for their actions even if the consequences aren’t apparent for several years. Doing so won’t just mean the right people pay when things blow up; it should reduce the chance of things blowing up in the first place.

The fourth disease is caused by distortions in the tax system. The most egregious is the ability of companies in most of the world to deduct interest costs before calculating the profit on which they have to pay tax. Payments to shareholders, by contrast, are typically not tax-deductible. This skewed playing field incentivises companies to leverage themselves up to the gills. That happened during the bubble particularly with banks, private equity groups and real estate businesses – all of which then got into trouble.

Healthy systems are balanced. The tax-deductibility of interest unbalances the economy. There are various ways of curing the disease – for example, by closing the tax loophole and making compensating cuts in corporate tax rates so that business overall doesn’t pay more. Sadly, only a few countries have started to address this problem.

Most definitions of health talk about mental as well as physical well-being. One can make a similar point for capitalism: values matters as well as structure. The past 30 years have seen the rise of the “greed is good” culture, as epitomised by Gordon Gekko in the film Wall Street.

Greed is a natural emotion which has some healthy aspects. It cannot and should not be removed from economic body. But it does need to be balanced by other motivations. The most important of these is the concept of service. Businesses need to be asking the whole time: how are we adding value to our customers and society at large?

Most successful companies do this. But many financial institutions failed to think through whether their products were socially valuable. Merely relying on the theory that the market’s invisible hand will reconcile private greed with the greater good isn’t enough, when we know how often capitalism is rigged.

Business people and financiers should never forget that capitalism rests on the consent of the people. As years of economic gloom gnaw away at that support, the challenge is to show that capitalism can be healthy. That requires changes in both structures and mindset.

 

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