A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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Capitalism for Financial Capitalists
How Edward Conard learned to stop worrying and love the financial crisis
7 October 2012
Unintended Consequences: Why Everything Youve Been Told About the Economy Is Wrong, by Edward Conard (Penguin Portfolio, 310 pp., $29.50)
Edward Conard, former managing director of Bain Capital, has a straightforward explanation for why the United States outpaced other nations in generating innovation and wealth in the decades leading up to the financial crisis. It wasnt the result of rational Americans choosing pro-investment policies, he thinks, but rather a cultural accident: abortion on demand. By the random dint of history, the landmark Supreme Court case Roe v. Wade brought pro-investment voters to power in the United States, he writes. Whereas Freakonomics author Steven Levitt suggested that legalizing abortion cut crime by keeping unborn criminals off the streets, Conard sees abortion as responsible for Facebook.
Conards logic relies on simple math: voters who want low tax rates on the wealthy make up only 35 percent of the electorate, at most. Therefore, they could never gain a majority until they joined forces with the 15 percent of the electorate whose outrage at Roe v. Wade drove them toward the Republican Party. Starting in the late seventies, then, pro-investment tax cutters—Republicans—who endorse the pro-life agenda for no other reason than to bring their minority bloc of voters to power prevailed at the ballot box. They helped cut effective marginal tax rates from a pre-Roe 70 percent to half that. Today, thanks to President Obamas extension of the Bush tax cuts, the top U.S. tax rate remains 35 percent, with rates on investment income at 15 percent.
The rest, Conard says, was inevitable. Because U.S. tax policy rewarded risk-takers, American investors took more risks than investors elsewhere did, and companies from Intel to Google were born. American workers, particularly top-paid ones in engineering and science, could keep more of their own money, so they worked smarter and harder. It all comes down to the idea that money and status are the most powerful motivators of economic risk-taking. People stayed up late to start tech companies because they needed the money to attain beautiful women—even unintelligent, unfriendly ones—for the recognizable status of having attracted a desirable mate. Helen of Troy may have launched a thousand ships, but a generic blonde with an attitude problem launched Silicon Valley.
If everything was so great, though, why did the financial crisis happen? That, too, was inevitable, and government policies—this time, both good and bad policies—helped cause it. In Conards accurate telling, as America imported more goods from China and other developing nations, the exporting countries found themselves with a surplus of dollars—the money we had paid for all those cheap plastic goods. But Chinese and other foreign investors resisted putting their dollars back into our risky equity markets, or even into our less risky corporate-bond markets. They wanted to retain the ability to withdraw their money at any time, and so government-guaranteed securities, including government-sponsored Fannie Mae and Freddie Mac, became an attractive option. They could take their money any time, penalty-free, by selling the securities on an ever-liquid market.
America, in turn, compounded this misallocation of resources with lower-level economic policies, including bipartisan support for universal home ownership. The single largest buyer of subprime mortgages was the U.S. government, Conard notes, through its aggressive subsidy of Fannie Mae and Freddie Mac. Banks, too, became dependent on a huge inflow of short-term debt. Conards explanation of the financial crisis is adequate, if incomplete.
But how to fix things? Conard thinks that the solution is a bigger bailout. Starting in 2008, he writes, defaults on subprime mortgages and other bad investments didnt render banks insolvent, withdrawals did. That is, investors panicked at the thought of losses and moved to take all of their money out of the capital markets at once, making such losses real. The solution, he says, is for the government to offer more explicit protection for short-term capital, pretty much all the time. He counsels strengthening government guarantees of liquidity to reduce the risk of withdrawals. In his view, Washington should just go all in and guarantee all the money that the Chinese government, middle-class Americans, and now-nervous corporations possess but dont want to put at risk. Protected by government guarantees, such investors would take government-guaranteed risk, thus fixing the economy. If these risks fail to pan out, dont worry, Conard says: rich people pay most of the taxes anyway, so middle-class Americans worried about bailouts wont take much of a hit.
But such a course would bring unintended consequences. First, when the government subsidizes something, it gets more of it. If we already have too much short-term capital uninterested in taking any risk, why do we want taxpayers to support more of it? Second, government subsidy of short-term, risk-shy capital ignores a key free-market signal. The market is saying: We dont need this kind of capital. What the economy needs is risk-taking equity. Much of the economys risk-shy capital shouldnt exist. Its owners should either buck up and start taking some risk, or resign themselves to losing their money to inflation, to fees, or to more financial-industry panic. Such a market signal is useful. If Chinas central planners started to worry about their stores of U.S. dollars, they would be less willing to keep so much wealth in our currency, thus lowering the value of the dollar and allowing America to export more goods and services (and preventing us from borrowing so much).
Moreover, though Conard acknowledges that bailouts create bad incentives, he isnt too worried about this risk. In fact, he cant think of any firm that should have failed during the financial crisis. What AIG lacked was liquidity, he writes, referring to the insurer that nearly went bankrupt thanks to bad bets on credit-default swaps that protected investors in subprime mortgages. He further suggests that wiping out the equity of banks like Lehman, Bear Stearns, and Countrywide . . . only accelerated the withdrawals from the financial system and deepened the recession. Allowing banks to fail, he says, was a mistake.
Its troubling that Conard doesnt think that financial executives have some responsibility for their balance sheets. Firms that relied disproportionately on short-term capital and on the presumption that their trading partners could never go bankrupt deserved to fail. Conard dismisses such concerns as misguided political interference. On financial bailouts, he concludes, its unfair to blame bankers, regulators, and credit agencies because they failed to see that defaults would trigger withdrawals. By that reasoning, its unfair for the economy to reward the investors behind Apple and Google because they saw that their investments would trigger financial gain. Why should investors and executives win from betting on success, but win, too, from betting on failure?
Conard is no politician, and he needs to curry favor with neither political party—and it shows! His economic honesty is refreshing. Conard isnt troubled that globalization has meant the loss of American manufacturing jobs. He says it makes no sense for American consumers to pay people $17 an hour to make stuff when they can get almost unlimited 75-cents-an-hour labor from China. Among the many benefits of employing offshore laborers, Conard enthuses, is that we dont have to pay for their medical expenses, their pension costs, their childrens public education, their slip-and-fall torts, their vot[ing] and seek[ing] of political handouts, or their pollution [and] its adverse effects on our health. Nor is Conard troubled that we cant tax offshore workers, because, he says, low-wage U.S. workers pay less taxes than the government services they consume, anyway.
Conard doesnt confine his slaying to left-wing dragons. He brooks no patience for politicians, many on the right, who espouse energy independence. To Conard, whether we buy our oil from Saudi Arabia or North Dakota is irrelevant. We pay for it in dollars that the Saudis have to spend in dollars, so the money eventually finds its way back to us. Similarly, Conard dismisses right-wingers who blame Federal Reserve policy for our economic woes; he says that some people would blame the Fed for anything. No Bush-era ownership society for Conard, either. If a majority of the population sees no income or asset growth, well, so what: middle-class savers demand safety and security for their money, a desire that underwrites too little risk to grow the economy. As for illegal immigrants, they do the housework wealthier Americans want to avoid and thus make them more productive.
Other than maintaining low taxes, Conards main economic prescription is for people to read, write, and think less. Many liberal-arts majors choose selfish solipsism over the burden of shouldering the risk and responsibility critical to increasing economic growth, he writes. They study literature and art history rather than computer programming and engineering. Here, he is especially passionate—far more passionate than, say, about letting failed financial speculators fail. Art history and Elizabethan poetry dont employ workers; the arduous and tedious application of business sciences such as computer programming and accounting does, he concludes.
This assertion, though, is faulty economics—and not just because it is far from evident that the economy is languishing for want of a few good MBAs. Conard confines this discussion to talented people. But talent is not undifferentiated. Conard presents no evidence that someone who is a genius at identifying up-and-coming artists or at writing ad copy would be similarly brilliant at mechanical engineering.
This is a significant error. Its simply not economically efficient for a budding literature superstar to pursue a life, say, as a middle-of-the-pack corporate computer programmer. The best Shakespearean scholar in the world gets paid a whole lot more than the worst HTML coder. Would the world be better off if some teacher had told Woody Allen that filmmaking was selfishly immoral and prescribed an accounting course instead? Allens decision to pursue what he loved was good for the economy and the government fisc, presuming Allen pays his taxes. And it was good for the broader culture.
Indeed, the biggest problem with Conards analysis is his cultural negligence. If the government refused to bail out financial firms, his nakedly utilitarian reasoning tells him, then the economy would suffer more, and poor and middle-class people would suffer the most. Against that logic, who cares if bailouts are unfair—that is, if some bankers who made catastrophically stupid decisions are protected from the free-market consequences of that stupidity? The inconvenient truth is that the American people care. People understand whats fair and whats not, and they know that a policy isnt free-market economics just because some proponent of free markets says it is.
The culture Conards self-styled no-middle-ground version of financial capitalism encourages actually hurts the free-market capitalism he rightly champions. If one accepts Conards reading, the economy did well starting nearly 40 years ago because enough people who felt strongly about the sanctity of unborn human life happened to tolerate low taxes on high-income earners and on investment income. It may be, though, that others who believe in the integrity of free markets and the rule of law will stop tolerating bailouts on demand. Whichever party figures out that cultural calculus first might create the next grand coalition.