III Can capitalism succeed? Its economic and political crises: what policies could help?

1. III Can capitalism succeed?Its economic and political crises: what policies could help? 1 Evolutionary success of institutional frameworks 2 Possible crises of capitalist economies 3 Possible policies 4 An extra view: the rationality-allocation problem 5 The rationality-allocation role of financial sector: how it can fail, and what regulations could help 6 Political obstacles: vested interests and limited knowledge

2. 1 Evolutionary success: a sustainable institutional framework (set of rules) An IF’s success: avoiding economically costly and socially disruptive falls of old rules, risky search for new ones (“transformations”), their painful learning, new mistakes? – economic evolution Two necessary conditions: a successful IF must be - economically efficientenough (above all adaptively), must allow industrial development and adjustments to world markets and nature - politically acceptable by the population, both its rulesas suchand the outcomes Not all IFs pass: no socialist & not all capitalist

3. 2 Possible economic crises of capitalism Cyclical (“macro-”): - inherent instability of markets, flock behaviors - cumulating bad debts, financial crises - cycles: simple vs. chaotic  risk of “tsunami” - low growth (macro-policies: may help but often harm) Structural (“micro-”): - wrong development  wrong industries - wrong firms: little productive or maladapted (industrial policies: may help but often harm) NB: crisesmay but need not be caused by policies

4. Political crises Fall of government vs. fall of institutional framework Triggered by dissatisfaction with: - low economic output, high unemployment … - and/or income and wealth inequalities, poverty Dissatisfaction depends on values (culture), importance on work/leisure preferences, envy The danger of excessive demands: economic crises  political crises  economic crises  …

5. Recent crises: economic or political? An economic cause: misbehaving investors (e.g., sub-prime mortgages, their hiding & spreading) A political cause: misbehaving governments (growing state debts, their hiding, wrong regulations) But interrelated: - e.g., government hindered by law investors from discriminating - e.g., investors encouraged governments to borrow by buying their papers Avoid ideological biases, accusing only one side

6. 3 Possible policies Macro: monetary & fiscal - Why is considering macro-policies not enough? - Types of taxes? types of spending? subsidies? - Saving or spending? by whom? on what? Institutional: legislative changes of formal IRs - Private vs. public sectors, hard vs. soft budgetary constraints - Conditions for entrepreneurship, bankruptcies … - Labor law, corporate law, financial regulations … - Legally permissible scope of macro policies

7. A note: the main obstacles to EMU Differences in IRs, both formal and informal, and in economically relevant value-judgments (culture) Needed: not common fiscal policy, but common fiscal discipline: have as much welfare as you wish, but pay for it (e.g., North vs. South) and common competiveness (entrepreneurship, job creation … e.g., again North vs. South)

8. 4 An extra view: the rationality-allocation problem (Pelikan, 2010) • Unequally rational individuals with imperfect knowledge of how rational they are, including themselves; the less rational, the less they know • Rationality-allocation works by organizing the economy into anetwork of markets, firms and government, designing differentlydifficult jobs assigned to differently rational individuals • Two success indicators: (1) the relevant rationality of the individuals selected for top jobs; (2) the losses from competence-difficulty gaps across the network

9. Two results Market IRs compared with government IRs in agent-selection & c-d-gaps-correction (cf. the usual resource-allocation among given agents) Result 1: markets have the potential for selecting far betterentrepreneurs and investors & keeping c-d-gaps much smaller than government, but may fail to realize it Result 2: government has the potential for making markets realize their potential, but may fail, too: no regulations or the wrong regulations Narrow road to “salvation”: the right regulations, but: what are they? how to realize them?

10. Two lessons for policy analysis L1:greater value ofmarket competition: not only resource-allocation among given agents, also agent-selection-cum-rationality-allocation L2:stronger constraints onthe sizes of firms (opposing the weaker constraints of transaction-costs analysis): emphasis on continuation of competition, limited impact of individual firms’ failures, corrections of c-d-gaps

11. 5 The rationality-allocation roles of the financial sector Usual roles: allocating investment; spreading risks; providing liquidity; limiting volatility Rationality-allocation roles: selecting entrepreneurs & investors; minimizingrisks; doubly minimizing c-d-gaps Wanted: fundamentalist investors able to select best entrepreneurs –not trend-traders! NB: micro-fundamentalists, concerned more with specific firms than with entire markets

12. Possible failures of financial markets F1- Financial firms: overgrowing, becoming too big to fail, hindering market selection, protecting rent-seeking and/or managers causing c-d-gaps F2 - Financial instruments: growing too complex, too opaque  c-d-gaps, interconnectedness & failure-spreading (if one fails, many fail) F3 - Macro-development: overgrowth of the entire sector (diminishing “useful output / volume of financial transactions” ratio), excessive volatility with excessively deep crises F4 - Selection criteria: distorted, favoring & encouraging trend-traders, flock behavior  volatility  selecting the wrong investors

13. Some of the causes • F1: Faulty corporate governance of financial firms, weak corrective feedback limiting their growth • F2: Weak corrective feedback on innovations of financial instruments, increasing information asymmetries, allowing cheating, hiding c-d-gaps • F3 & F4: Trend trading, especially HFT  distorted incentives, more rewards for trend-trading than for fundamentalist investing = a new case of the old public-goods problem

14. Regulations supported by rationality-allocation analysis R1: Corporate law, excluding proven bad CG- R1: Corporate law, excluding proven bad CG-rules, imposing proven good ones, but leaving space for promising governance innovations R2: Financial instruments: limit their complexity, decouple, maximize buyers’ information R3: Antitrust, preventing M&As leading to “too big to fail firms,” splitting such firms, forcing specializations (e.g., retail vs. investment) R4: Tobin micro-tax, to discourage trend-trading, especially HFT, help fundamentalists succeed

15. 6 Political obstacles : vested interests and limited knowledge Politicians: - gaining votes for social policies, but less for financial regulations (although this is changing) - oppose regulations that decrease GNP, collected taxes, and their powers Private investors and their employees: - oppose cutting down their firms (but not all) - oppose shrinking the financial sector - dislike taxes hindering their trades Knowledge: rational long-term egoism, but will it work?