What does the great credit crunch do to the case for competitive capitalism? Many revisionist left-of-centre politicians not only have risked their careers to make the case for market forces, but have also had to jettison their deepest lifetime convictions. Are they now to stand on their heads and say they have been wrong all along? And if they did so, where would they turn? Even if in the end we suffer no more than an average post-second- world-war recession it will still look like a narrow escape owing to the readiness of leaders such as Hank Paulson, the US Treasury secretary, not merely to jettison free-market principles but to take risks with prudence to bail out US corporate bodies. There will be no “glad confident morning” for free-market principles for a long time to come.
It is for such reasons that I welcome a short and well-written book, The Origin of Financial Crises (Harriman House £16.99) by George Cooper, which attempts to relate apparently esoteric financial issues to elementary economic theory. He quotes from Paul Samuelson, author of what was probably the best-selling economics textbook of the 20th century, Economics: An Introductory Analysis. Prof Samuelson provides a simple introductory outline of a competitive market system. If there is a flood of new orders for, say, shoes, their price will rise and more pairs will be produced. If there is a glut of tea, its price will be marked down, people will drink more and producers will supply less. “Thus equilibrium of supply and demand will be restored.”
Mr Cooper's criticism is reserved for what looks like a throwaway sentence at the end of Samuelson's account. “What is true of the market for consumer goods is also true of markets for factors of production such as labour, land and capital inputs.” Cooper concentrates on capital, the market for which he believes is entirely different from that for consumer goods. The crucial distinction I would put slightly differently: between products that are valued for their own sake – “use value” in Marxist jargon – and those that are valued wholly or partly for their future resale value and are therefore prone to bubbles.
Mr Cooper's main contention is that asset markets are peculiarly vulnerable to boom and bust, and are therefore the real destabilising force in the financial system, while central banks concentrate on consumer prices. Something called the efficient markets hypothesis appears and reappears like King Charles's head throughout Mr Cooper's book. This hypothesis blossomed out into the belief that assets are always and everywhere correctly priced.
I will take Mr Cooper's word that the efficient markets hypothesis lies at the basis of the models prepared by the rocket scientists in the backrooms of banks and hedge funds. And in diluted form it may lie behind the reluctance of modern central banks to act on asset bubbles. This contrasts with the dictum of the old-school Federal Reserve chairman William McChesney Martin that the Fed's job was “to take away the punchbowl just when the party gets going”. His words are doubtless too metaphorical for today's tastes, but he could be right.
Mr Cooper's most novel doctrine is that investors do not have to be irrational to generate bubbles. They simply do not have the knowledge required by the efficient markets hypothesis. But is not this ignorance an obstacle to the official action on asset prices, which some would like to see supplement and others to replace altogether consumer price targets?
Yet, however difficult it is, the rethink that is likely to follow the credit crunch is bound to make more room for asset prices in central bank objectives even at the cost of some intellectual untidiness.
Readers will not be surprised that Mr Cooper traces present difficulties to the rapid growth of credit encouraged by the Fed's ultra-cheap money policy of a few years ago. Interestingly enough, an International Monetary Fund working paper by Noureddine Krichene shows convincingly that during the years 2003 to 2007 there was no one shock confined to oil or any other commodity but a parallel increase in nearly all commodity prices. During this period consumer prices remained subdued, giving false security.
Now the chickens have come home to roost in that combination of inflation and recession that constitutes such a nightmare for central banks. The IMF author has no doubt that we are seeing “the delayed effect of an overly expansionary monetary policy which led to a vast expansion of all types of credits, irrespective of creditworthiness”. I still worry about what the effects of a tighter policy would have been in the face of large Chinese and Organisation of Petroleum Exporting Countries saving surpluses. But it may be that the US could have continued to be a consumer of last resort even without a Fed stimulus.
To return to the broader question about competitive capitalism with which I started. Nothing that has happened suggests that governments are any good at picking winners, that freeing international trade is a bad thing or that consumer choice should be overridden. But we need to be reminded of the dictum of Keynes that “money will not manage itself”. That goes for credit too.