Rethinking Capitalism Summary
This is my summary of the course Rethinking Capitalism, one of the optional classes at the UCL Institute for Innovation and Public Purpose’s MPA in Innovation, Public Policy and Public Value.
Videos of this course are available on the Institute of Innovation and Public Purpose’s YouTube channel
Summary
- We need to re-examine our economic theories that are informing our economic policies;
- We should not repeat the mistakes we made in response to the 2008 crisis. We need to ensure that any support we provide firms following future crises (e.g. coronavirus) has conditions attached (e.g. limiting share buybacks, dividend payments and executive pay) so that they create jobs and invest in the ‘real economy’. We should not silo economic growth, social welfare reform, and our response to the coronavirus;
- Investing in the ‘real economy’, instead of the financial one, drives economic growth because it supports capital investments, creates employment, increases wages, and increases productivity;
- Land plays a central role in the economy as (1) it decreases investment in productive areas of the economy because rents absorb economic growth; and (2) housing unaffordability increases inequality and household debt, which decreases consumption and causes wages to stagnate;
- To fight climate change, we need to fundamentally reshape systems of production, distribution and consumption; and
- Institutional reform for the data-driven digital economy is needed to avoid digital feudalism and curb the power of big tech firms.
Rethinking capitalism
Capitalism is an economic system with competitive markets, where privately owned companies seek profits. It involves consumer choice to drive efficiency and maximize welfare using markets that drift towards an equilibrium of demand and supply. The efficient markets hypothesis is that the price of the stock market represents all available information so governments shouldn’t intervene because it would lead to inefficient capital allocation.
By looking at how markets allocate things you create a trained incapacity of how the world works, because it is organizations (governments, householders and firms) that invest in productive capabilities, not markets. What’s more, core assumptions about capitalism have not held up in real life. As a result, failure in our economic theories has resulted in failure of our economic policies over the last 50 years. When we had crashes in 1929 and 1973 we changed our economic theory and policy mix, but we have not seen the same paradigm shift following the 2008 crash. We need another rethink, and to start asking new questions about whether or not our models really work.
An alternative model is complexity economics, which sees the economy embedded in society and politics. It doesn’t believe the orthodox that people are perfectly rational, markets are perfectly efficient, institutions are optimally designed, and that the economy is self correcting towards an equilibrium to maximize welfare. Instead, it sees the economy like an ecosystem that changes its purpose and form through many nonlinear interactions. In response, policymaking must use an adapting portfolio, where policies and institutions can be more flexible to the economic and political reality of the day. Policymakers need to think of themselves less as social engineers and more as system stewards.
The 2008 financial crisis (and lessons for the coronavirus responses)
Before 2008, governments thought they had solved depressions. However, pre 2008, ‘growth’ was actually just more debt, brought about by deregulation of the financial sector in the 70s and 80s, which incentivized bankers to favour property lending over other types of productive investment. Businesses are more risky to invest in because limited liability means banks might not get their money back if firms fail, but property is collateral so is less risky. Securities backed by residential mortgages emerged, which meant banks owned more debt. Banks were not required to have as much savings, so lending was less linked to income, and more people received loans who shouldn’t have. As the value of houses went up, people felt they could spend more and save less, but then they were less prepared for a downturn. When the crisis hit, it meant people had unsustainable mortgages, which reduced consumption and created a further economic downturn, which decreased the value of houses, which decreased lending to firms, and we ended up in a recession.
One major reason why this was not caught sooner was the increasing complexity of financial regulations. In the real world, you can’t account for everything in your financial models so it is about satisficing — you can’t respond to every rain drop but must steer your ship through the storm. More financial crises have brought longer and more complex rule books for the financial sector, which are more opaque. Reflecting on the 2008 crisis, simple models were better predictors of risk than the complex models being used by banks, which indicates the need to simplify how we measure risk.
At the same time, policymakers ignored the fundamental failure of capitalism to generate public and private investment in the ‘real economy’, which supports capital investments, creates employment, increases wages, drives economic growth, and increases productivity. When you have high unemployment, wages go down, so consumption goes down. As a result, you need to stimulate demand with both fiscal and monetary policy. Obama thought that saving banks would increase lending and create jobs in a more efficient way than helping households or businesses directly. This support didn’t come with restrictions for banks to increase lending or stop their abusive practices. Since then, the corporate sector has financialized even more with reinvestments in share buybacks and dividend payments, and increases to executive pay.
Quantitative easing intends to increase private spending by buying assets, replacing them with central bank reserves, which increases the price of assets, increases the capital gains that can then be spent or loaned, and then this stimulates the economy. In 2008, the idea was that the financial sector was starved for cash so buying its bonds and securities, while increasing its reserves would increase the supply of loans for cash strapped firms and households. Instead, most of the financial sector played it safe and invested in existing assets like property. The problem wasn’t the supply of funding for loans, but high unemployment meant that there was less consumption, so there was a lower demand for loans from both households and firms. The Government should have focused more on how to increase employment and drive economic demand. Quantitative easing can also be used more effectively to drive other policy goals by helping to finance more public housing or green initiatives. People think quantitative easing creates inequality and makes the rich richer, which is kind of true, but it also helps young borrowers by reducing interest rates, and helps older people with wealth by driving up asset prices. Overall, most people are better off because the main benefit of quantitative easing is creating jobs, which it did do, but most people see getting a job just as their own good luck.
Some tools to encourage investment in the ‘real economy’ include: providing credit guidance for high value sectors where the central bank provides lower interest rates for lending to certain sectors; use quantitative easing more effectively to finance more housing or green initiatives; or create development banks that are focused on certain sectors. The government shouldn’t be afraid of running deficits because government spending has a multiplier effect. We also need to increase transparency of business strategy, reform executive pay and shareholder governance, tax to reward long term investments, and look for new management models (e.g. employees on boards).
Inequality
Despite shrinking extreme poverty, inequality is rising around the world — represented by the increasing global gini coefficient. Considering housing costs, and capital gains, inequality is even higher. This is having real socioeconomic effects in even some developed countries (e.g. the US), which are seeing a decline in life expectancy, increased infant mortality, increased neonatal mortality, declining happiness, and declining social mobility.
People’s expectations that each generation will have a better life is under threat. There’s high youth unemployment, pay stagnation, more self employment, a lower likelihood to own a home by the time you’re 30, less social housing, and fewer people have pensions. Rising inequality is particularly apparent for people with less education but even some highly skilled people have seen their wages decline recently. Inequality also has large racial, gender and class components.
We saw a breaking of the social contract after the 1970s that has led to a breakdown in politics. Post war incomes went up until the 1970s but then economic growth and productivity growth continued while wages stagnated. Profit and investment also decoupled at this time. People see this stagnation of income as an issue with fairness and outrage, which brings political dysfunction.
What happened in the 1970s? A change in ideas in academia and politics and media and schools. These ideas justified a shift in power from workers to firms because they needed to finance globalization; firms began to serve shareholders over workers and communities; unions were weakened; a neoliberal policy agenda favored deregulation; asymmetric globalization emerged, where capital can move anywhere; and ethics shifted to selfish utility maximization.
The rising tide hypothesis is that economic growth increases living standards for everyone in society. This doesn’t happen in practice. Instead, tax cuts for the wealthy since the 70s have made it harder to fund necessary social reforms. Fiscal austerity to decrease deficits and debt hasn’t restored healthy economies or addressed long term weaknesses. In fact, since 2008, growth hasn’t recovered, and inequality has continued to increase. Developed countries will only see more spending pressures, as an aging population means welfare spending will need to increase.
Solutions to inequality include: taxing the rich to fund private and public investment; increasing budgets for social services; investing in transportation and infrastructure to increase demand and create jobs; investing in education to fix inequality of opportunity; reforming capital gains tax; increasing workers’ rights; breaking up monopolies; basing executive pay on actual performance and not the performance of stocks; increasing the number of women in the workforce; increasing child poverty transfers; creating a minimum living wage; banning 0 hour contracts; rent controls; increasing land tax and taxing empty properties more; and inheritance tax reform. Public opinion matters when designing benefits.
Land
Economists treat land like capital but it’s not. Land is immobile and eternal, so demand can rise but supply cannot, it generally appreciates in value, it has multiple purposes, and it is essential for all economic activity — even the digital economy requires computers, servers, etc. The value of land initially comes from its use but, as the land around is repurposed, its value gradually reflects the value of the surrounding infrastructure.
Land plays a central role in the economy as housing unaffordability increases inequality because the value of it goes up faster than wages do. Mortgages bridge the gap between wages and increasing land prices, but more competition for land increases its prices, which increases demand for mortgages. To pay down these mortgages, consumers must reduce spending, which means firms profit less, so wages stagnate further, which further increases the demand for mortgages. It is one big vicious cycle.
Furthermore, land decreases investment in productive areas of the economy because rents absorb economic growth. Monetary policy that decreases the interest rate increases the value of unproductive fixed assets. When interest rates are low, there is more demand for mortgages, which increases the value of land, reducing the amount of lending available for capital investment. Low interest rates also make capital investment cheaper, but investing in capital increases land prices and rent, so landowners absorb the additional value their tenants generate that could be used for further productive investments.
There are four areas of policy to respond to this: (1) land value taxes might be a challenge for cash poor and equity rich elderly, but it can bring investments in more productive things by encouraging people to sell their land for more productive purposes; (2) financial regulations, which are hard because the housing sector is so international; (3) housing supply policies — have the government build more houses because the private sector will want to maximize land value; (4) change land ownership incentives so that the Government can acquire land at the current value to develop it.
Innovation and productivity
Productivity growth is required for sustainable prosperity. Over the long term, capitalism has increased productivity and reduced inequality, but since the 70s we’ve seen the reverse. The productivity puzzle is where we’ve been disappointed in the forecasting and performance of productivity. Some people worry we’re in a period of secular stagnation, low or no growth, because of demographic changes or low innovation. Some fear we’re in a period of secular innovation, with a long tail of low productive firms and countries, and an upper tear of high and increasingly more productive firms that are, and will remain, leaders. Other reasons for low productivity people claim are: mismeasurement of the economy (not measuring the digital economy sufficiently); crisis-related scaring reduced the availability of credit; falling asset prices meant less valuable collateral for paying back loans; monetary policy bailouts prevented creative destruction of unproductive firms; slowing innovation because this wave of technology doesn’t have the same potential as those in the past — while some see it in its infancy; diffusion dynamics are slower because of stifled competition; natural monopolies; and management failings.
High stock values from innovative products can increase a firm’s ability to invest in innovation, but a high stock value can also disincentivize executives from making more productive investments because their pay does not reflect corporate performance, but stock performance. As a result, they may choose to downsize and distribute through share buybacks (preferred in the US) and dividend payments (preferred in EU/UK). This financialization decreases the amount of money available for innovation, and encourages more acquisitions of innovative startups, which decreases competition, and further decreases innovation. At the same time, the CEO to average employee pay ratio has gone up. As economies grow on the backs of increased productivity, we should be sharing these gains with workers. In response, industrial policy needs corporate governance reform, such as having workers sit on boards or elect management in a ‘democratic firm’ model.
There is always uncertainty around technology, markets and competition, which discourages risky investments in innovation. To decrease this uncertainty, and encourage private sector investment in innovation, governments invest in infrastructure and human capital. Innovation is collective, cumulative and uncertain, so needs to be fostered over the long term. We need to see how we can support young firms — you wouldn’t expect a 15 year old child to be as smart as a 1 year old.
Alternative theories of growth
GDP measures output, not welfare, so ignores the difference between good and bad economic activity, or if the output is a net producer of problems or solutions. Prosperity isn’t just about money but the things that create wellbeing (e.g. antibiotics and safe food). As a result, growth should be measured by the rate of new solutions generated to solve human problems because they are what really improve our lives. Access to solutions must also be included in this new model of growth. It is the diversity of ideas that leads to the most innovation, so it is important to invest in the middle class more than the 1%, as this would create more entrepreneurs and more customers in a virtuous cycle.
Climate change
We need to fundamentally reshape systems of production, distribution and consumption to truly fight climate change, as carbon powers most of the world’s economic activity today. Carbon pricing won’t allow for change at sufficient speed/scale. The tragedy of the horizon means that there will be many difficult choices that will fall to the next generations. Annual GHG emissions misrepresents our fight against climate change because they don’t matter; it’s a stock that we ultimately cannot exceed if we want to save the earth so eventually it needs to be 0 or negative. There are also time lags to being able to record GHG emissions so the harm we do today is uncertain and won’t be seen for a few years. Some say we need degrowth but material growth, economic growth, and human wellbeing can be decoupled.
As GHG emissions go up, so do the social costs, which will mostly be experienced by the poor.
Climate change related events (e.g. flooding, breakdown of infrastructure, food insecurity, health impacts) can hurt productivity and cause huge economic risks. Economists militate against decarbonisation though because of what this jargon does to market expectations. If you keep hearing it’s not going to happen and be expensive, people will keep waiting. If you hear the story as an opportunity, then it changes expectations and facts on the ground. Models for economic simulating and forecasting need to include climate change. Current pricing of GHGs doesn’t capture the fact that it will cost the death of the entire world. It also does not account for the fact that many economies subsidize fossil fuels. Economic models also don’t properly account for innovation. For instance the International Energy Association has consistently overestimated the cost of renewables and underestimated deployment.
Climate change needs a range of policy instruments all working in a mission-oriented way, including regulations, market incentives innovation policy. We have many of the technologies we need for a sustainable transition but continue to spend on R&D over deployment. Consistent support is very important though because this will be a long-term, expensive transition.
The digital economy
Each era of capitalism has seen a new logic of accumulation that was more successful at meeting the evolving needs of the population. New markets emerge and some become the new hegemony while others are parallel to other dominant forms. Entire economies go through creative destruction driven by technological change, with new institutions required following each revolution.
Right now we need institutional change to deal with the data-driven digital economy — particularly big platform companies that work across sectors and geographies like never before. In previous revolutions it’s been about governments having too much power, but now it’s the platforms. Financialization of the tech sector allows it to consolidate power with mergers and acquisitions to reduce competition. This has significant political ramifications, particularly when it comes down to these platforms moderating content that has had real effects on elections.
The EU needs a new, green, inclusive industrial strategy to break up US and Chinese tech dominance, and create EU alternatives. This will require competition law, data sharing, regulations, and more, but needs to stop them from buying up the EU’s industrial capabilities. The EU needs national strategies for key technologies (e.g. AI and 5G) to give digital technologies a direction in solving social challenges. Automation means wealth is being captured and shared in new ways, so there may be a role for more public ownership.
Big data is the foundational component of surveillance capitalism. It is seen as the inevitable consequence of a tech juggernaut, while we are seen as bystanders, to the point that it has developed an ‘everydayness’ to it. Big data has become an intrinsic part of organizational and institutional life, and commercialization strategies. We are now able to observe behaviour that we couldn’t before, which enables new kinds of transactions. It has other uses, but it is founded on extractive principles so we need to question the status quo. Extracting it often comes without reciprocity or consent, entering legally and socially undefended territories. Some call these surveillance assets contraband or stolen goods because they’re taken, not given, and don’t produce reciprocities. Platforms don’t need all of the data they extract from a single interaction. This ‘behavioural surplus’ they extract enables them to spread to new domains. Citizens should own their data and decide what decisions are made about them. Data trusts could help facilitate this while retaining trust and control. The growing techlash will only accelerate if people worry discrimination is not being addressed.
