"Uncertainty and Capitalism"

Edmund Phelps defends capitalism:

Uncertainty bedevils the best system, by Edmund Phelps, Commentary, Financial Times: In countries operating a largely capitalist system, there does not appear to be a wide understanding among its actors and overseers of either its advantages or its hazards. Ignorance of what it can contribute has in the past led some countries to throw out the system or clip its wings. Ignorance of the hazards has made imprudence in markets and policy neglect all the more likely. Regaining a well-functioning capitalism will require re-education and deep reform.

Capitalism is not the “free market” or laisser faire – a system of zero government “plus the constable”. Capitalist systems function less well without state protection of investors, lenders and companies against monopoly, deception and fraud. These systems may lack the requisite political support and cause social stresses without subsidies to stimulate inclusion of the less advantaged in society’s formal business economy. Last, a huge social insurance system, with resulting high taxes, low take-home pay and low wealth, may not hurt capitalism. ...

From the outset, the biggest downside [to capitalism] was that creative ventures caused uncertainty not only for the entrepreneurs themselves but also for everyone else in the global economy. Swings in venture activity created a fluctuating economic environment. ...

Unfortunately, there is still no wide understanding among the public of the benefits that can fairly be credited to capitalism and why these benefits have costs. This intellectual failure has left capitalism vulnerable to opponents and to ignorance within the system.

Capitalism lost much of its standing in the interwar period, when many countries in western continental Europe shifted to corporatist systems. This was a low point in the public’s grasp of political economy. In the end, the promises of greater prosperity and lesser swings could not be delivered. The nations that kept capitalism while making reforms, some good and others maybe not, ultimately performed well again – until now. Those that broke from capitalism were less innovative. After the disturbances of the 1970s, they saw unemployment rise far more than the capitalist nations did. They were worse on economic inclusion too.

Now capitalism is in the midst of its second crisis. An explanation offered is that ... the crisis flowed from a failure of corporate governance to curb bonuses and of regulation to rein in leveraging of bank capital...

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? The answer, I believe, is that they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down. The banks’ chief executives, too, had little grasp of uncertainty. Some had the instinct to buy insurance but did not see the uncertainty of the insurer’s solvency.

Much is dysfunctional in the US and the UK... If we still have our humanist values we will try to restructure these sectors to make capitalism work well again – to guard better against reckless disregard of uncertainty in the financial sector while reviving innovativeness in business. We will not close the door on systems that gave growing numbers rewarding lives.

I was glad, and somewhat surprised, to hear Phelps say that "a huge social insurance system ... may not hurt capitalism." However, he does imply that economic growth is necessarily lower as a consequence and I'm not sure that follows. But even if growth is lower - and again, I'm not conceding that - it doesn't mean that people are necessarily worse off. If people value economic stability, and I believe it is highly valued, then this benefit has to be counted against any potential loss of growth. Thus, when this benefit is factored in, even if growth is lower, people may still be better off due to the greater amount of economic stability that they enjoy.

To cast this in terms of a recent (re)post from Brad DeLong, part of what matters here is whose utility function gets the most weight in the social welfare function that is implicitly maximized by policymakers. If the people who benefit most from growth and suffer least from uncertainty get the most weight in this function, and the wealthy fall into this category, then policy will be devoted mostly to growth and security will take a back seat (even if the tradeoff between growth and security is imagined rather than real). But if the weights are changed, then policymakers might be guided to a different choice, one that places a high value on stability. Thus, the choices we have made relative to other countries - the choice of growth versus security - may reflect who has the most influence over the political process as much as anything else, and may have also been driven by a false sense of the size of the tradeoff that exists between the two supposedly opposite goals. (I think the relationship between growth and security is shaped like an inverted-U. If security is very low or non-existent, growth will also be low. Then, as security increases growth also increases and reaches some maximum shown as point A on the diagram, and any further increases in sucurity do harm economic growth. The argument above is that the point where societal welfare is maximized is not necessarily the point where economic growth is maximized. The maximum could lie to the right of point A if security is valued over growth, i.e. there is no reason why point B cannot be the point where the measure of social welfare is highest).