How to Cure This Sick System

Fact and Comment

How to Cure This Sick System

Steve Forbes 10.06.08, 12:00 AM ET


Not even during the Great Depression did we witness what is now unfolding--a sizable number of big financial institutions going under. What enabled their taking on so much debt and so many questionable assets was, primarily, the easy-money policy of the Federal Reserve. Chairmen Alan Greenspan and Ben Bernanke created massive amounts of excess liquidity. If the dollar had been kept stable relative to gold, as it was between the end of WWII and the late 1960s, the scale of the bingeing in recent years would have been impossible.

The first prescription for a cure is to formally strengthen the dollar and announce it publicly. A year ago August the price of gold was more than $650 per ounce. In late 2003 it had breached $400. The Fed should declare that its goal for gold is around $500 to $550. That would stabilize the buck--and stability is essential if animal spirits and risk taking are to revive.

Also of immediate urgency is for regulators to suspend any mark-to-market rules for long-term assets. Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline.

Think of the mark-to-market madness this way: You buy a house for $350,000 and take out a $250,000 30-year fixed-rate mortgage. Your income is more than adequate to make the monthly payments. But under mark-to-market rules the bank could call up and say that if your house had to be sold immediately, it would fetch maybe $200,000 in such a distressed sale. The bank would then tell you that you owe $250,000 on a house worth only $200,000 and to please fork over the $50,000 immediately or else lose the house.

Absurd? Obviously. But that's what, in effect, is happening today. Thus institutions with long-term assets are having to drastically reprice them downward. And so the crisis feeds on itself.
The SEC should immediately reverse its foolish decision to get rid of the so-called uptick rule in short-selling. That would provide a small road bump to the short-selling that's helping to destroy financial institutions.

At the same time the SEC should promulgate an emergency rule (which we thought was already the rule): No naked short-selling. That is, you have to own or borrow shares in a company before you can short it. The rules should make clear that short-sellers must have ample documentation proving they truly possess the shares at the time of the short sale. Otherwise, each violation will result in heavy fines. That wouldn't be a road bump but a wall of Everest-like proportions.

Regulators should also be told to instruct banks to keep their solvent customers solvent. The last thing the economy needs right now is for the banking system to seize up.
The federal government should also consider setting up a new Resolution Trust Corp., which was devised during the savings and loan crisis nearly 20 years ago as a dumping ground for bad S&L assets. Today's bad assets could then be liquidated in an orderly way. And, finally, the financial industry should be encouraged to create new exchanges for exotic instruments. This would result in the standardization of these things, which would mean more transparency.

These steps would quickly revive financial markets. Already mortgage rates are coming down. It won't be long before American homeowners start an avalanche of refinancings, which would be an enormous boon to confidence and the economy.

What Makes Our Ever Changing 400 List Possible

Prophet of Innovation--by Thomas K. McCraw (Harvard University Press, $35). An excellent, thorough and smoothly written biography of Joseph Schumpeter, the greatest economist of the 20th century. Too bad most politicos--and economists--don't fully grasp his insights.

Born in 1883 in a province of the old Austro-Hungarian Empire that is now part of the Czech Republic, Schumpeter recognized at a young age that the critical factor in economic progress was the entrepreneur, the innovator. To him it was the risk taker who brought about new products and services and more efficient ways of making and doing things. A free-market, capitalist economy, he emphasized, meant constant change, often disruptive and disorienting to traditional ways of doing things. Competition wasn't just the jousting of existing firms that had similar products but also encompassed the threat that came from a truly new product, new technology or new type of organization.

Schumpeter made the distinction between an inventor and an innovator: The innovator takes an idea or product and figures out how to produce it efficiently and profitably. His term describing one process, "creative destruction," has become a catchphrase of our own era.

Schumpeter's perceptions here were profound, although most of his time's economists--and politicians--downplayed or ignored them. Today, though, things seem different. Even Demo-crats occasionally pay lip service to the risk takers' and entrepreneurs' importance to economic growth. Yet Democratic policies, such as raising the cost of capital and reducing its availability, would devastate them. Similarly, while economists doff their caps to Schumpeter, their professional research downplays innovation because it is impossible to quantify and not conducive to mathematical models. So the appreciation of this genius is still superficial.

One drawback is that Schumpeter was not a "feel-good" economist like Keynes, whose apostles believed that properly manipulating government fiscal and monetary tools would generate perpetual prosperity, with nary a bust or a bout of irrational exuberance. Innovation, however, is not a smooth process but comes in fits and starts. That's why, Schumpeter pointed out, a healthy economy is subject to cycles of boom and bust.

In the early 1980s, for example, personal computers became the hot new product. Then came the inevitable shakeout. Many companies, such as Atari, Commodore and Osborne, bit the dust.

But PCs became more powerful. Innovators learned to network PCs, enabling them to easily replace expensive mainframe computers with the significantly cheaper and more versatile PCs.

In the early 20th century the automobile went through similar booms and busts: Before World War I there were more than 300 auto manufacturers in the U.S. Another vivid testimony to innovation's disruption and destruction is today's fast-shrinking newspaper industry, a victim of the Internet.

Schumpeter recognized that a dynamic economy creates wide inequality. A successful entrepreneur, his investors and even some of his employees (think Microsoft) will get rich.

However, this is not the kind of static inequality one sees in semifeudalistic, oligarchic economies that exist in South America and elsewhere, where the same handful of people are wealthy and everyone else struggles. A truly capitalist economy will see the players change repeatedly. Facts back up Schumpeter's insight. IRS data show that 75% of the very top income earners in the mid-1990s are no longer in that category.

Growing up in a turbulent part of Europe made Schumpeter realize that life did not follow a smooth-running, gentle path. In contrast, Britons such as John Maynard Keynes tended to see the economy in more static terms. Even American economists tended toward a rather static view of the world. Harvard's late, once renowned John Kenneth Galbraith wrote a book in the 1960s whose thesis was that major corporations such as Ford Motor Co. were the epitome of economic development and lived by their own laws rather than those of the marketplace. Today once formidable giants, such as Ford and General Motors, are struggling just to stay alive financially.

Schumpeter was a genius at dissecting the ideologies and prejudices of other economists. Karl Marx, for example, also observed the dynamic nature of entrepreneurial capitalism. But he mistakenly concluded that this kind of change would inevitably, inexorably impoverish the workers. Instead--as Schumpeter laid out time and time again--an entrepreneurial economy means more people earning more and enjoying a higher standard of living. Adam Smith celebrated the importance of free trade, low taxes, property rights, the enforcement of contracts in enabling people to get richer. But he had very little appreciation of the crucial role individual entrepreneurs and innovators play in the process.

Schumpeter acknowledged that governments would have to play a role--one hopes a constructive one--in creating conditions in which creative destruction could play out. In the U.S., for instance, farm subsidies helped ameliorate the political backlash when technology and manufacturing sharply reduced employment in the agricultural sector. A century ago one in 4
Americans made his or her living in agriculture; today it's fewer than one in 75.

What made Schumpeter especially insightful was that he was truly a multidisciplinary individual. He was well versed in politics, sociology and history. By the time he finished his secondary education he had mastered six languages. He would look upon the bulk of today's economists, with their obsession with numbers and regression analysis, as hideously narrow-minded and suffering from academic constipation.

As he grew older, Schumpeter became pessimistic about democratic capitalism. He observed that the sons and daughters of successful entrepreneurs often became leftists or outright socialists. His own varied life undoubtedly added to his gloomy outlook. He had moved numerous times and seen convulsions aplenty. World War I broke up the Austro-Hungarian Empire, creating, among other things, the state of Austria--what wags dubbed "a bureaucracy without an empire." After the war Schumpeter served briefly as its finance minister. It was a disastrous experience. Knowing the right things to do does not automatically make them politically possible.

He lasted less than a year in the job. Only when inflationary conditions worsened did subsequent ministers adopt some of his policies. The rise of Nazism in Germany--Schumpeter taught there until the early 1930s, at which time he accepted an offer from Harvard--was a personally vivid example of how a great nation can self-destruct and threaten civilization itself.

Schumpeter would certainly take a dim view of what many politicians in America are offering up these days. But the actual history of Britain and the U.S., after his death in 1950, might have lightened the darkness of his long-term outlook. As long as a society remains free, entrepreneurs can prevent ossification. The U.S.' great comeback under President Ronald Reagan is one vivid example, as is Britain's under Prime Minister Margaret Thatcher. Once taxes were cut and structural reforms made, Britain morphed from the sick man of Europe into Europe's most dynamic large economy. Schumpeter would also have been astonished by the fall of the Soviet Union.

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