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Wednesday 02 March 2011

The Australian

American enterprise down to the wire

Publication: The Australian (15,Wed 02 Mar 2011)
Edition: 5 - Australian Literary Review
Section: Features
Keywords: immigration (1)

The Illusion of Free Markets: Punishment and the Myth of Natural Order

By Bernard Harcourt

Harvard University Press, 328pp, $32.95

Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States

US Government, Kindle edition, $7.40

Bourgeois Dignity: Why Economics Can't Explain the Modern World

By Deirdre N. McCloskey

University of Chicago Press, 504pp, $56.95 (HB)

ANYBODY who believes the global financial crisis is a metaphor for all that is wrong with the world or that a return of the regulatory state would set us back by decades can have their prejudices confirmed by these books.

Bernard Harcourt argues that the free market is a myth, used as an excuse to imprison millions of Americans. The authors of the majority and minority opinions that make up the US government's Financial Crisis Inquiry Commission Report variously argue the GFC was the fault of either, or both, bankers and/or regulators. In contrast, Deirdre McCloskey builds a much bigger argument, ignoring the present mess and calling on us all to honour the morality and mindset that created the market and transformed the world for the better.

In combination, the three volumes demonstrate the way the GFC has become a metaphor for a debate between believers in the immutable corruption of mankind and the optimists who believe that given half a chance innovators and entrepreneurs will make themselves, and everybody else, much richer.

But if you flag as you wade through these three demanding books you can always turn to David Simon for illustrations of their arguments.

Simon is the creator of that great serial novel in television-form The Wire.

Set in the Baltimore drug trade, one of its enduring themes is the way gangs fight for market share. Most of the time they do this literally. I defy anybody to provide a complete count of the murders across The Wire's five series and 60 episodes. However, the smarter gangsters want to work out ways to make money with less mayhem. Some like cartels and price-fixing while one robber baron capitalist studies economics at a community college and experiments with marketing and pricing, product quality and delivery to keep the cash flowing.

Simon seems no great fan of the spirit of American enterprise. The contempt for can-do characters is palpable and his heroes are on the public payroll, cops, teachers and nurses all of whom are poorly paid and under-resourced compared with the crooks. But for good or ill, market exchange is a driving theme in just about every episode of the show.

Simon may see the drug market as morally corrupt, but he accepts it is the fundamental form of human exchange. This distinguishes him from the corps of commentators who gleefully seized on the global financial crisis as proving free enterprise had failed, that the regulating state was now needed to save the market from its own endemic excesses.

As Kevin Rudd put it in his essay in the February 2009 edition of The Monthly, the GFC ``called into question the prevailing neo-liberal economic orthodoxy of the past 30 years -- the orthodoxy that has underpinned the national and global regulatory frameworks that have so spectacularly failed to prevent the economic mayhem which has now been visited upon us''.

Certainly the then PM paid a cursory compliment to ``the great strengths of open, competitive markets'', but his point was that social democrats had to save the world from ``extreme capitalism and unrestrained greed'' by properly regulating markets.

But even a market malformed by rapacity or regulation is still a way of people exchanging value according to their individual wants and needs, as occurs in The Wire when a middle-ranking police commander creates a free-trade zone where drug dealers and customers use an open outcry system to buy and sell.

For market critics it is a well-made metaphor, proving capitalists place profit above the needs of suffering humanity. But libertarians like it, because it shows how trade is peaceful when the state leaves buyers and sellers alone, that the freer the market the more honest it is.

However, for neutrals in the 300-year debate between believers in subjugating the market to the state and advocates of leaving it to operate independently The Wire's free-trade zone raises questions rather than confirms prejudices: how to maximise the wealth that capitalism creates and how to stop traders and regulators perverting the market to serve their own interests rather than those of ordinary consumers.

Since the GFC these issues have dropped down the agenda. In Europe and the US economists argued and populists proclaimed the market has failed, an easy enough case to make when millions are unemployed or have lost their homes and many more have seen their investments erode.

Even in Australia, where the financial markets worked fine, opponents of the Hawke-Keating-Howard deregulation of the economy used the crisis to hijack the debate, using the manifest need to address regulatory failure, investor folly and trader rapacity as an excuse to attack the free market, the only way to enrich ordinary people.

This is a waste of time, as these books demonstrate. The market will not go away and denouncing it stifles debate on financial regulation, which is a much more manageable issue.

These three works set out the state of the discussion on how we create wealth, what stops us and how we can heal the scars of the current crisis.

Harcourt works from The Wire's playbook, arguing the free market is fiction and claiming a causal connection between its ideology and the size of the American prison population.

He decks his book out in all the accoutrements of an academic argument -- there are forests of footnotes and Harcourt takes a great deal of space to say not much. But in essence this is a tract for the times: a book belonging to the era of the GFC which claims capitalism locks its victims up.

In contrast, the financial crisis inquiry report flies no theories, simply explaining the origins of the GFC and describing what actually occurred in the decades before and the desperate days of 2008. Unfortunately for such a comprehensive project the Republican members of the committee did not agree with the majority's report, crippling its credibility and its use as a valuable source of advice on how to prevent another financial market failure. Frank Partnoy, writing in the New York Times, called it ``a confusing and contradictory mess, part rehash, part mishmash, as impenetrable as the collaterised debt obligations at the core of the crisis''.

Not true. It is clear, concise and very well written, remarkably well written in fact, given it is the report of an official inquiry. (Productivity commissioners take note; turgid prose is not necessarily a sign of policy substance.) But while it is more useful as history than policy analysis at least the Financial Crisis Report pings the people who ignored the ample evidence that there was a crisis coming rather than blaming the market economy itself.

And then there is McCloskey's Bourgeois Dignity, a book of vaulting intellectual ambition and seductive learning which is as liberal with ideas and optimism as Harcourt is conservative and mean-minded, as broad in its scope as the FCR report is limited. Where Harcourt's case cannot admit any hope of an ever-expanding economy enriching ordinary people and the report details the greed and folly of financial engineers, McCloskey explains how the engine that drives prosperity has less to do with economics than innovative individuals.

None of whom appears in Bernard Harcourt's explanation of the fiction of the market and the reality of criminalising poverty in the US. According to Harcourt, markets are never free, generally being governed by rules to suit the rich. But to ensure that everything stays that way market ideology requires the state to lock poor people up. The government does not belong in economics, Harcourt argues: its core function is law enforcement to protect the market.

``This faith in the free market emerged, hand-in-hand, with a theory of legal despotism according to which the states' most legitimate function, and the one it is best able to carry out, was to police and punish. It is precisely this curious combination of market efficiency and a Big Brother state that has become seemingly obvious today.''

Continued on Page 16

Continued from Page 15

The first half of this argument is set out in an analysis of the way the Chicago Board of Trade works, which is fair enough, and a long essay on the way markets were policed in 18th-century Paris, which is not. While the function of the former is to feed people efficiently and profitably, the latter was a means of protecting the status quo among monopolists the monarchy could not afford to upset.

At the book's heart is a suspicion of competition and a belief that only the state can look after the poor. Thus Harcourt argues that by enforcing rules of trade the Parisian police were doing poor people a favour, defending ``the liberty of consumers from the manipulations of the merchants''. It is an argument that, he says, ``should not be entirely foreign to our modern ears''.

Harcourt argues his case that capitalism is a con job with long essays on 18th- and early 19th-century economics and a critique of the Chicago School of market economists. But they read like separate essays rather than the foundations of

his case that there is a causal connection between the adoption of the market as the ideology of the state in the US and the expansion of the prison population.

``Neoliberal penalty facilitates the expansion of the carceral sphere indirectly by reducing resistance to these political strategies,'' he writes.

This is nonsense on stilts. For a start, property may be theft but people who steal or assault others are rarely interested in fair shares for all. In The Wire the ultimate outsider is Omar Little, who upsets the market the drug lords have created by stealing from them.

But what can you expect, Harcourt asks, given the way politicians have punished those who do not accept the rules of the game. So not only is the organising principle of the world's most productive economies a con, it is part of a conspiracy as well.

``Opponents of the welfare system also used crime as a wedge issue to try to dismantle the poverty programs established under president Lyndon Johnson's great society programs,'' Harcourt claims, although the supporting footnote for this expansive allegation cites (but does not reproduce) a quote from a conservative in another book.

Above all Harcourt misses two fundamental points. First, that government properly regulates markets to ensure they are free and fair is the reverse of what occurs when the state manipulates them to deliver policy objectives, which more often than not please powerful rent seekers at the expense of the poor who, Harcourt says, regulation defends.

Second, and more importantly, he confuses process and outcome. Harcourt argues at length that distinctions between free and regulated markets are artificial and pointless. There are, he suggests, efficient government industries (although his example ``mass transport in certain countries'' demonstrates he has never used a Sydney train) and wasteful private ones (but his evidence, ``overpriced office and bathroom renovations for CEOs at private investment banks'' is lame).

This means we should not worry about how wealth is created, it is what we do with it that matters. ``. . . that is the only important goal: to determine how resources are allocated and distributed, and whether those distributions correspond to our political values''.

This is an old-fashioned economist's argument: how wealth is created does not matter, the interesting issue is ensuring it is spent on socially responsible programs. But for anybody focused on ensuring that the state has the resources to spend, the distinction between free and regulated markets is obviously essential. It is in government's interest to back the system that produces the most taxable wealth and that is the market.

In the end Harcourt presents a rant against free enterprise based on market management precedents from pre-industrial Paris, the fallacies of the Chicago school of economics and the extraordinary number of people the US imprisons. Interesting issues all, but in combination they create a critical analysis of capitalism that is as irrelevant as it unconvincing.

The Financial Crisis Inquiry Commission Report, on the other hand, confirms just about all the explosive charges levelled at the financial engineers, investment bankers and mortgage brokers as well the agencies charged with regulating them and central bankers in the US and Europe who were supposed to supervise the whole show.

And what everybody ignored was the way the people in the industry had a vested interest in keeping the cash flowing. By 2007, according to the report, financial sector pay was 80 per cent higher than in comparable positions in other industries. It explains how a property bubble built up in the US, based on selling mortgages in ever thinner slices at ever greater price-to-earnings multiples.

It sets out how lax regulation over decades allowed the problem to go largely unnoticed and how floods of foreign funds, especially the savings of Asian investors seeking security they believed their own financials systems could not provide, kept inflating the bubble.

The securitisation market ``depended on finely-honed computer models -- which turned out to be divorced from reality -- and ever-rising housing prices''.

``When that bubble burst, the complexity bubble also burst: the securities almost no one understood, backed by mortgages no lender would have signed 20 years earlier, were the first dominoes to fall,'' the report states.

But the dominoes stood for many years and penetrated popular culture as homeowners and property developers assumed they could not lose in an ever-rising market. In The Wire, drug dealer Stringer Bell tries to diversify into property development but realises there is more money to be made in a boom by ``flipping'' property than in actually investing in property with the expectation of making a prudent return for decades to come.

The dissenters on the commission claim it was not the financial engineering itself that caused the problem, but that the instruments were not used properly. Fair enough, but this does not diminish the extraordinary damage done by a system which had become a perpetual motion machine, so complex that nobody understood all its dimensions until it finally exploded for want of ever-more money to fund its expansion.

But was the crisis caused by deregulation of the market? And would it have not happened if Harcourt's regulatory state had been in place? Probably. The commissioners single out the regulators and corporate chiefs who ``sought and accepted positions of significant responsibility'' and the ``bad actors'' (a polite term for the spivs and shonks who ransacked financial institutions). But they make it plain the regulators had the power to act many times over many years and chose not to. Dissenting commissioner Peter Wallison makes the point that panic set in when Washington did not bail out Lehmann Brothers, as it had Bear Stearns, and as a consequence banks closed down credit.

He has a point, but the damage was already done by then. Basically just about everybody in the finance industry and millions of home-owners who borrowed more than they could pay back went along for the ride during the boom and suffered when it went bust. Was it caused by market failure? Not as much as the weakness and frailty the flesh is heir to.

As such the GFC is perfectly suited to pessimists who believe that when it comes to cash we are all sinners who need to be protected from our own weaknesses by the regulatory elite, presumably the heirs of Harcourt's Parisian police. Or as Officer Pryzbylewski puts it in The Wire: ``No one wins; one side just loses more slowly.''

It is not an idea that has any place in McCloskey's extraordinary work. This book may not reach the enormous audience it deserves; it requires more patience and effort than the pop economics that has dominated the response to the GFC. While there is no denying Professor McCloskey's erudition, the book ranges across too many disciplines to please utilitarian academics only interested in arguments within their specialisation.

But Bourgeois Dignity is a delight. McCloskey's love of ideas is infectious; the optimism of her thesis is encouraging and her good-humoured dismissal of economic explanations of growth amusing. Above all she makes it clear that enemies of the market completely miss the point -- that creating wealth for all does not come from the state regulating the economy, it comes from honouring wealth creators and encouraging them to have a go.

McCloskey argues that in the 17th and 18th century Dutch and British society changed. Instead of sneering at people capable of creating wealth, rather than just living off the rents from land or the income earned by regulated trade, people began to honour the innovators and entrepreneurs. This unleashed a culture of wealth creation that changed the world, immeasurably for the better.

``By adopting the respect for deal-making and innovation and the liberty to carry out the deals that Amsterdam and London pioneered around 1700, the modern world was born,'' she writes.

That in essence is it. McCloskey describes what followed over 450 closely argued pages. And she explains in exhaustive detail how economic models cannot account for the way once the innovators and entrepreneurs got started they never stopped.

It was not education or imperialism, slavery or technology, Calvinism or commerce, institutions or inventions that transformed Britain and Holland and all the other nations from all the other cultures that followed their lead and are still following now. What did it was allowing and encouraging people to change first industries then communities and countries. And in nations that started to encourage wealth creators 200 years ago today just about everybody is richer by a factor of 16.

McCloskey is less interested in defending the idea of the free market than in explaining the conditions that allow it to deliver for all. But she demolishes the orthodox opinion that rather than protecting the poor marketing regulation rewards the rent seekers and the well connected.

And she sails into those who sneer at wealth creators.

``You can still hear people who do not pretend to have thought very deeply about the matter declaring confidently that the market, of course, needs to be closely regulated, or that trade needs to be fair, or that immigration must be restricted, or that jobs are to be created by governmental programs, or that businessmen routinely cheat, or that markets are chaotic.

``And many still declare that it is ever-so-much more dignified to work as a professor or a civil servant or some other sort of non-profit employee than as someone making deals in the financial services industry or in the wholesale meat trade.''

Granted, arguing for more respect for people in financial services will not impress many people at present, but her point is still well made. Just as the landed gentry and their sons in the church and army used to sneer at the ironmasters it is socially acceptable for employees on the public payroll to feel superior to wealth creators who prosper on the basis of their ideas.

David Simon makes the same point in The Wire, when one character turns his back on the turf wars of the drug lords to try to make a living by establishing a gym and is sneered at by his former friends, trapped in the trade, just as generally occurs when the beneficiaries of all regulated industries are called to account.

But while McCloskey's argument is appealing and her evidence convincing, there are two problems with her case -- she does not adequately explain why bourgeois dignity was all of a sudden recognised in Holland and Britain, nor does she provide evidence that anybody was aware of the transformation occurring. Certainly there is ample evidence of the transformation but, statistics aside, she struggles to illustrate it through the words of the men and women who created the new order. In the end she shows what happened, explains what did not cause the change, admits that she may be guilty of what she calls ``the Fallacy of the Immeasurable Residue'' and leaves her readers to make up their minds.

However, on the evidence she provides it is hard not to accept her argument, even in the absence of literary evidence, that bourgeois dignity drove the great transformation if only because her argument explains so much, so well.

The market for McCloskey is the means used by successful societies to create wealth and to do it they need good policies, the rule of law, property rights, ``and above all dignity and liberty for the bourgeoisie''.

And what worked in the past works now. McCloskey argues Taiwan, Singapore and Hong Kong have created good lives for ordinary people in two or three generations by doing what the British and then Americans and Germans did in the 18th and 19th centuries. Give people liberty to work and to invent and to invest and treat them with dignity and you get people who catch-up fast.

It puts the debate over the GFC in perspective and reminds us all that free exchange and the culture it catalyses has enriched people all over the world by a factor of 16 in about 200 years.

David Simon worries about the way wealth is distributed but, like McCloskey he accepts that it is the best economic system for the most people. As he told Bill Moyers on US public television in 2009: ``Listen, capitalism is the only engine credible enough to generate mass wealth. I think it's imperfect, but we're stuck with it. And thank God we have that in the toolbox.''


Headline: American enterprise down to the wire
  Edition: 5 - Australian Literary Review
 Section: Features

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