Below is a trasncription of the video found here. I realize it is a little out of keeping with normal tech items, but I wanted to refer to this in response to outsourcing conversations. It is primarily about economics of the current financial crisis, but I wanted to use it as a touch stone for other thoughts. If I mis-typed a section or mis-spelled a name or event please leave a comment, I will fix it and give credit.
Its a great pleasure to be here and I am honored to deliver this years Schumpeter Society lecture. When I agreed to be your speaker nearly a year ago who could have foreseen that we would find ourselves this proximate to Joseph Schumpeter's nightmare. Schumpeter who had lived through the Viamar horrors and witnessed the terror of Soviet style Political economy, experienced the Depression and seen the chaos of WWII worried more than any other modern economist about what might be called the fragile condition of capitalism. Prior to these last two months his pressing concerns where considered the the antique and curious addendum to a life's work focused on the ability of the economy to renew itself through the exertion of entrepreneurs driving the process he famously described as "creative destruction". To have called together an audience together to discuss the instability of capitalism let alone its demise would surely have been a fool's errand.
Today we stand on the edge of a frightening economic drama. The conceits of modern economics that the government has appropriately designed counter cyclical tools or that our central banks have shown through their competence through six decades, the ability to bring forth an increasingly stable world wide market for credit or that our securities markets have developed tremendously sophisticated and effective ways to evaluate risk such that these markets are increasingly rational have all been revealed to be largely conventional wisdom rather than settled truth. We have wrapped ourselves in an intellectual security blanket sewn together by our brightest economist and many of their mathematically gifted progeny, the quants of wall street. If Schumpeter, who respected the power of mathematical empiricists more than most where here today he might be asking two questions: What caused this crisis? and is it endemic of to the nature of capitalism itself?
Beneath these questions would lurk his dark curiosity about whether capitalism can survive what could be a reaction that proves fatal. While reasonable persons might differ as to the specifics of the cause of what is likely to be remembered as the financial crisis that began to show itself in 2008 and as to its end point I'll talk about that in a few minutes. There can be no doubt that at its base the question was the housing credit markets. The meltdown has revealed much about the ability of financial entrepreneurs to make risks so opaque that institutions built on trust have vanished overnight. But the beginning of this problem lies with government and not with private markets. By now we are all somewhat acquainted with the role Fannie and Freddy played in this drama. Created respectively in the "New Deal" and "The Great Society" these institutions interestingly known as government sponsored enterprises (sounds rather European) came in to existence to make the market for house mortgages more liquid by providing a secondary market place. Two such entities exist because in 1970 the congress thought that Fannie needed competition in the interest of efficiency. We know and have known for a long time that even after passing into public ownership as stock companies both organizations where unduly influenced by the congress which directed them, in what I believe was an ultra vires fashion to make loans without regard to any standard of underwriting. The so called Ninja Loans, no income no job no assets where encouraged under the justification that home ownership should be available to any and all comers. The expanding business of both Fannie and Freddie seemed to support more and more lavish compensation for executives who in turn used substantial discretionary funds to support members of congress. Who encouraged them, on what have on any other circumstance would have looked like a prima facie reckless course, one that violated the public's trust at every single turn. The rest of this story is known at a superficial level by most everyone. Simply many mortgage bankers, brokers, builders, commercial bankers, investment bankers, portfolio managers, home owners, and housing speculators all saw an opportunity to profit and thus the scheme continued. The bubble unraveled when markets became saturated and house prices began to erode. Suffice it to say that the absence of traditional due diligence on individual loans and portfolios of loans became evident when mortgage defaults occurred and credit was called. The rest of the story is the history we are caught in today.
While this drama is hardly over, it is time to think about what happens next. By this I do not mean to discuss the short term issues and proscriptions. That is a province of a gang of experts who should be by now defrocked, but the same faces keep showing up on television. These are the economists and financial guru's who told us just a year ago the housing let down would be gradual, that there was not much of a nexus between the housing economy and the quote unquote real economy; and oh yes for good measure these are the people that told us we would never see oil trade at less than $100/barrel in the rest of our lifetime. My focus today is on Schumpeter's second question however, namely "What can be done to save capitalism from what is likely to be a fatal reaction?" First however we must consider capitalism itself from several perspectives. Obviously it has proved itself to be enormously robust. It has adapted to all kinds of assaults. We have seen capitalism reviled and displaced by the Soviets. We have seen it stunted in Europe by regulatory approaches, such that it can no longer deliver growth and we have seen it employed by socialist regimes to revivify autocratic political systems.
Some ideologues are ready to consider these outcomes entirely acceptable, a perspective that is entirely justified by the spreading notion that free markets tend to produce more negative than positive outcomes. The externality of pollution alone is enough to drive many from the church of capitalism. And a rather fully developed alternative orthodoxy is always at hand; it is the belief held with near religious fervor that growth itself is bad. An array of abuses, genuine abuses from exploitation of workers in the underdeveloped world to overfishing the worlds ocean, to oil as a necessity for advanced economies as being the ultimate cause of armed conflict among nations served in part as the basis of this system of thought.
Now Schumpeter foresaw such criticisms and as mentioned had seen their antecedents play out across the world. He vigorously embraced capitalism not as a reaction, it was not the second best solution to the unproductive reality of Utopian economic planning. Rather, Schumpeter saw capitalism as the foundation of two complementary forces. The first was economic expansion, and the second was its role in protecting individual freedom. For Schumpeter to sacrifice one was to imperil the other. Or more starkly Schumpeter foresaw the only way freedom would be ensured to any individual was in a growing economy. Political freedom depends on economic expansion. In our own times Amartya Sen has set this duality in the context of a developing economies, where he says that expansion is synonymous with the birth of freedom in the developing world. Now to make the case for growth would be superfluous here. Suffice to say that in the last 25 years the world has seen poverty in rapid retreat for the first time in human history. Over 20% of the worlds poor have escaped poverty as a result of economic expansion in only 25 years. Quite obviously to those who have been so fortunate enough to have climbed out of poverty the potential of freedom becomes concrete in an inarguable way. No longer do these fellow members of our human family fear starvation and death; for the first time they can see the path and start the journey for themselves and the ones they love to achieving their own creative potential. Their own human creative potential, and to enjoy earned personal dignity. If we had only the last 100 years as evidence we would have indisputable record that only only free markets have made gains on poverty and expanded individual liberty. Only capitalism can make wealth and liberty at the same time, and of course capitalism can expand welfare faster than any other social or economic order ever tried or ever experienced.
But you have detected my concern that a future where growth and freedom continue to jointly secure each other and anchor expanding civil society is not certain. Humans appear to have a need to develop alternative views of economic reality. There seems to be an endless capacity to see the market and its workings, the appropriate role of the state, and the best interests of the individual in idealistic, Utopian or romantic ways. It seems that when economic contractions occur in their certain, ye1t unpredictable way that the critique of capitalism itself becomes progressively more powerful and more shrill.
Why is this?
There are two answers. Schumpeter and Mancur Olson provide an institutional perspective. Schumpeter saw that capitalism's very success allows rich societies to use government to relax the impersonal rules that govern markets. Creating new rules that buffer citizens from risk taking and failure. Government invents for itself the task of mediating market outcomes. Schumpeter saw this formulation emerge in Bismarck's welfare state. The elite in the face of Bolshevism secured its position by causing government to operate as the dispenser of new social benefits. Now Olson describes a peculiar American and current Schumpeterian twist that capitalism would be threatened by a federal government captured by interest groups who secure for themselves through regulation, protection from unfettered market outcomes. And while major industries are skilled at getting rather passive regulatory shelter many groups have become competent at securing direct subsidies for their benefit. Government is a continuously active trasnferer of monies to their cause. This includes the obvious commercial interests such as farmers and petroleum producers, earmarks is the current metiér, but other petitioners including aggrieved groups of citizens operating under the theory that government must "level the Playing Field" by dispensing compensatory social welfare benefits. The germ of the housing crisis as mentioned is just such a case. When thoroughly corrupted in such a way free market capitalism can easily be seen as a system that ought to be overthrown. It has been made to work unfairly. Government becomes the agent of subverting fair outcomes, at least as measured on traditional scales of return to work and probity in managing ones personal finances. When a crisis is at hand and various private interests such as these are revealed the barnacles of capitalism's warped institutional forms operate to drag it to the bottom.
Now there is a second perspective if you will as to why it works this way, I believe the answer comes from what might be called the realm social psychology. Certainly since the new deal American's have come to see governments somewhat as the ultimate protector of their financial security. In fact the evidence of government behaving this way during The Depression is actually quite thin, much of the evidence of governments actions during the depression served to greatly increase the suffering of millions of Americans. The second depression of 1937-1938 is universally understood to have been induced by Roosevelt's attempts at manipulating the monetary system. It was Lyndon Johnson who understood this fiction about the New Deal, and sensing the opportunity of an enormous economic expansion largely provided by President Kennedy's extraordinary tax cuts, sought to make real the role of government as economic protector of individuals. The Great Society established a rights based claim on the government resources that was vested expressly in the individual beneficiary. This vested rights approach foreshadowed in Social Security was expanded enormously in transfer payment programs such as Medicare and Medicaid as well as a plethora of subsidy programs including public housing, designed to provide transfer payments to the poor. Taken together and supported by the revisionist institutional fretwork developed as the "new" and "critical" views of American History and Law the gift of our academy. These efforts established government as the necessarily active potter civitas. It determines in legislation, right and wrong, virtue and malevolence. Any unforeseen twist in fate is seen as "someones fault", and governments job is to provide a system of justice that is no longer blind, but compensatory. As Philip Howard has cogently written "there is no such thing as bad luck. Anything and everything with an untoward outcome is someones fault. The law of torts has become the arena in which corporations discover the dimensions of implicit duties of care which have more to do with wealth redistribution than with any rational and more importantly predictable theory of jurisprudence." The very term that once commonly characterized Americans "rugged individualist" has joined an expanding dictionary of impolite usage. Gone are the day with Learned Hand described the risks of participating in society with the indelible phrase "let the timorous stay home". [Possible mistake on the quote it appears that Benjamin Cardozo wrote that.]
So now to the ultimate Schumpeterian challenge:"Can capitalism be saved?"
I believe President Sarkozy proposed a brilliant formulation about a week ago. He said and I quote "The financial crisis is not the crisis of capitalism. It is the crisis of a system that has distanced itself from the most fundamental values of capitalism. Which has betrayed the spirit of Capitalism." The reasons I embrace this quote are many. First, and I do not mean this facetiously it was spoken by a French President. What a short time ago we despaired of France even understanding modern capitalism, Sarkozy does and is courageously engaged in a struggle to rebirth it. Second, his quote comes as it does from a Francophone recalls to us the importance of the entrepreneur, the word itself to the capitalist enterprise. President Sarkozy knows that his countries entrepreneurs are spread around the world insufficient numbers are
working in France itself. Indeed some years ago I heard Gordon Brown at a Bank of England dinner I was at bait his counterpart Minister of Finance with the phrase "If you want to see your entrepreneurs you will have to come to London." Sarkozy knows that to rebirth his economy he needs his entrepreneurs to come home, and alive in his comments is the insight that animates the work that I and my wonderful colleges at the Kauffman do everyday. My partner and College in writing Bob Litan and I have described along with Will Bohmel various forms of capitalism. We argue that igniting the recovery from the malaise of the 1970's and 1980's when the country was at least as dispirited as it is now, and with very good reason. For the youngsters in the room it is hard to imagine mortgage rates at 12% as they where then, that the CPI was running over 12%, consumer price index inflation and the stock market hadn't moved for over a decade. Serious and very dreary times to be sure. [Redacted slightly he stumbles a bit here]Entrepreneurship was the cause of our resurgence from the malaise of the 70's and 80's. Indeed entrepreneurial capitalism is an all together accurate description of the enormously productive period that the last 20 years has become. And before we dismiss our recent history in a bout of instant economic amnesia, we have experienced enormous growth and stable prices for a very long time; and while it can be argued that the relative nominal incomes have stabilized it cannot be argued that the standard of living of every American has increased enormously since 1980. The point is that while the basic rules of trade and supply and demand continued unchanged the ethos of our economy has improved enormously. It was headed in the right direction, we where becoming an economy that as I have said characterized by the phrase entrepreneurial capitalism. Whether it is rational or not we now have an unavoidable sense, totally predictable, totally understandable, among a wide number of Americans that we must have from government more security.
The question is can that impulse coexist with vibrant capitalism. This impulse shows in polling data on health insurance and on jobs. How else could an essentially false argument on the shipping of jobs overseas prove to be so politically powerful? Thus if we are to advance capitalism we must develop a new approach to protecting Americans. I would like to suggest that we call this a new form of a safety net. The challenge is we must figure out how to gain some expansion of security without making government bigger or more intrusive or more powerful or by attenuating an individuals responsibility to attend to his or her own welfare. This is some job. I believe that this is what most Americans want however at the same time they distrust governments enormously. A recent poll the Kauffman Foundation Commission shows that the current crisis is seen by most American as being caused mostly by government and specifically by the Congress. So how is it we square our hope that government will protect us when we don't trust government? It becomes yet more confused because respondents also said that government can't solve the economic the economic problem. Over 80% of respondents said that private firms must get us out of the economic ditch we are headed into. Moreover our polling tells us that nearly 70% want to create businesses, and want to work for themselves. Incidentally this data is only 3 weeks old this week. How can people be so upset with the situation and still have such great faith in themselves, and while they say government must help they profoundly distrust government? Our college students want to be entrepreneurs, they still do. About 70% of students in college say they hope to start a business in their life times and work for themselves. The problem President Sarkozy faces is that after decades of government domination of his economy, and economy that has grown roughly 1% for several decades, his nations college students overwhelming report that they hope to secure a government position for the rest of their life.
So how might we work to forestall Schumpeter's worst dream? Many ideas must be considered, and I will propose 4 that if aren't the most important starting points are at least worthy of thought. The first is that repairing our economy cannot be done by focusing on bankers greed on Wall Street. While there was plenty of that to go around today's problem is first and foremost one that Congress itself created when it sought to change the very nature of risk related to assuming mortgage debt for householders. To proceed on a course of developing a series of complex innovations and regulations for banks and the mortgage market will overlook the problem entirely, and to suggest a particularly clinical view of it I think this political drama will be meant to distract from what the cause was ultimately. One year ago and three years ago there existed all the regulatory mechanisms and all the statutory authority needed to have stopped this crisis from happening. The congress was expressly subverting existing regulatory regimes of the securities and Banking markets in a non-legislative attempt that is aggressive oversight, that's the vehicle to widen home ownership to persons who it turns out could not afford the homes they where encouraged by the government to purchase. Now consider before we go off in a regulatory direction, the Sarbanes-Oxley response to the Enron, Worldcom scandals at the beginning of the decade. Again all the regulatory authority needed already existed in the SEC's enabling statues as revised and amended for the year 2000, but a costly and ill considered regulatory innovation was brought forth in Sarbanes-Oxely. Congress in the space of a few months apparently relying on people who didn't know the essence of the problem, (Causes one to pause here and remember that three weeks ago Sunday the solution to this crisis was completely different from what it was last Sunday.) managed to create legislation that had as nearly all such sweeping legislative reforms attempt to do, or such reforms have always had, hugely unforeseen consequences. Perhaps in the context of Schumpeters vision of how economies work best, the most severe was the dampening effect on public financing for young firms. Sarbanes-Oxley is the main reason that young firms no longer go public, or if they go public they don't do it in the United States; the ipo has as the dodo bird become an extinct species. This discussion tells us of the enormity of the challenge of saving capitalism. Regulatory delegation has always held the potential operate in a way that contravenes the fundamental tenants of democratic government. When the congress effectively reascends its delegation and actively engages in the making of market signals and creation of specific rules, which it does through its developed new approach which we call aggressive oversight, it vitiates the thesis of why it is a Democracy could tolerate and trust regulation in the first place. Namely that non-partisan experts would know best how to oversee complex terrain when markets and social interests collide. Thus for capitalism to work well we must re-establish and respect the doctrine of delegation. Regulation is not the solution to events such as those that have been unfolding.
Role clarity between the Legislative branch and the invented fourth branch, the regulatory branch is the very first step. This is an objective that the federal courts must recognize. The second step should be protecting Legislators, excuse me, regulators from the illegal and thoroughgoingly unwholesome influence of of legislators. The SEC could have stopped Enron and Worldcom from happening, the Treasury the FED and the SEC could have stopped the housing crisis from happening. Our regulators no longer operate under the the cultural precepts that William Landas had envisioned, fixed terms, judge like probity, public spirited experts interesting in advancing the common wheel. Perhaps longer terms and and an absolute bar on subsequent work in the regulated industry may be a step in this direction. Second we must appreciate that we cannot afford all that we seem to think we can buy if only government buys it for us. Taxes used to be the real time cost of government, easily understood, easily comprehended, and somewhat easier to pay. In the last 4 weeks we have further mortgaged ourselves to the future. Speaking as an economist that means we will not be able to take advantage of opportunities that lie ahead and worse we have a debate underway about buying in the public sector solutions that are no longer appropriate to modern times. Take health care for example, an area where I once upon a time had some claim to expertise, the discussion about governments role seems to focus always on the expansion of the model of Medicare and Medicaid. Now no one would design these programs this way today, no one. So why would we compound the error by making these obsolete health care payment solutions the basis of tomorrows promise. Remember that with the debt load we now face governments new safety net must come with a smaller, less costly government. That will require the solutions of entrepreneurs actually, we can do better than we did in 1965 when we think about protecting the nations health. For heavens sake we can bring forth thousands of better ways to deliver medicine than we did in 1965, surely we can come up one better way to share the costs between citizens and their government if this is the appropriate way to proceed. From my own perspective worried about the economic entrepreneurial eco-structure, the absence of health care has become a major bar to people taking the risk of leaving a large company to pursue their dream. Let us also appreciate that globalization has been critical to the expansion of the American entrepreneurial economy. There are students in this city and in this university who have business running that are global from the day they start, they operate on the internet. We gain jobs more jobs from all the jobs we ship overseas. Wouldn't it be nice to have a fact based discussion about on this from politician from both sides? If we turn inward, we will see a depression when we look in the mirror. We will have fewer jobs at home as we attempt to deny the jobs we send abroad. But more importantly will effectively cut ourselves off from the tremendous talent that the world sends to America every year, and that we need in America to fuel our recovery and to defend and expand capitalism as an example to the rest of the family of nations. It may not be well received what I am about to say, but never the less I believe that we should encourage hundreds of thousands of the worlds smartest students to come to the United States to Study, and as they graduate and if they hope to become citizens they should be receiving their citizenship papers the day they graduate.
Let me close with a consideration of the risks we face. The first is the loss of opportunity that happens every time our economy slows. Let me say that again, the great risk we face is that every time our economy slows we loose opportunity we can never capture again. The criminal tragedy of this downturn is that it could have been avoided, we where smart enough to make it happen and some where smart enough to call for its cure at a time when it could have been managed without the terrible losses, we will all carry for many years. Let me be a bit more concrete in the context of lost opportunity. Today roughly 1/3 of all our Gross Domestic Product, that is about 1 of the 3 percent that we have been growing for the 100 years is now attributable to the creation every year of about 1000 high growth firms. Each year in the United States we birth about 600,000 firms 1000 go on to become our high growth firms. So our whole 1/3, the growth sector of the economy rides on the ability to start these firms. These firms clearly fewer than 30,000 in number account for nearly all the job growth in our economy. Over 70% of jobs created in this economy every year are in firms less than 5 years old.
Whatever we do, entrepreneurs who start these firms cannot be scared off. If next year we only birth 500 of those firms, in my own view we is would be lucky to have that number, that is 500 firms, potentially 1 whole 1/2 a percent of gross domestic product that is lost not next year it is lost forever compounding year after year after year, the unending impoverishment of America. Whatever we do entrepreneurs must be encouraged, they can't be scared off. Our tax regime, our regulatory structures, our emerging views of risk and the obligation of individuals to commit to the market success by advancing their own self-interest are all parts of the entrepreneurial ecosystem that is precious to our future. Schumpeter tells us loud and clear that the most important citizen is not the politician, nor is it the big business man, nor is it the banker on Wall Street, they are important but they are not central to the renewal of democratic capitalism, they don't do it. That role that burden that honor falls to our fellow citizen that in the face of all the challenges that we see all around us are ready to undertake the pursuit of what entrepreneurs do. They birth the new, they create our jobs and they make the wealth that will be more necessary that ever before to purchase the future that will be worth living. Thank-you
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