VoxEU Column Financial Markets

Not the end of capitalism

European politicians have been quick to proclaim the bankruptcy of the US model of capitalism “as we know it”. But, this column explains, all this hyperbole is premature. In fact, the US system of today is the outcome of numerous similar interventions and offers further pause for Europe.

"In the Bolshevik Revolution, the slogan was 'Peace, land, and bread'. Today, you are being asked to choose between bread and freedom.” These were the words of Rep. Thaddeus McCotter (R-Mich.) in the congressional debate of the Paulson bailout plan. European politicians have been quick to proclaim the bankruptcy of the US model of capitalism “as we know it”. But all this hyperbole is premature. In fact the US system of today is the outcome of numerous similar interventions since the foundation of the republic.

If we leave aside the more limited savings and loans crisis of the 1980s and 1990s, the most recent economy-wide bailout in the United States was when the Roosevelt administration reduced industrial debt in 1933 by cancelling the gold clauses in industrial bond contracts. Then, as now, a core of Republicans strongly opposed the policy. In the House they voted 64-14 for a motion that would have eviscerated the policy by making it non-applicable to previously concluded contracts and they voted 48-28 against passage. In the Senate, Republican opposition was even stronger.

Depression-era governments also massively intervened in mortgage markets. The economic historian Lee Alston has documented that about half the states legislated moratoria on farm mortgages. At the federal level, the Roosevelt administration intervened in the residential mortgage market, creating public sector institutions. The privatisation of some of these institutions in the 1960s is arguably a basic element of the current crisis.

The interventions in the Depression era were very controversial at the time. Both the cancellation of the gold clauses and the farm mortgage moratoria would appear to violate the contracts clause of the Constitution. The Supreme Court upheld both policies – but by narrow 5-4 majorities.

What was done at the time was not novel for the United States. After the panics of 1797, 1819 and 1840, each arguably more severe than the Great Depression, Congress enacted bankruptcy laws that proved to be temporary and served to allow for massive write-offs of debt. In 1819, many states also passed “stay laws” that prevented creditors from foreclosing on debtors. In the early 1820s, Congress voted to allow debtors to delay or greatly reduce payments on land that had been purchased from the federal government.

The evidence, at least on the gold clause, suggests that these interventions were necessary and in the end strongly beneficial for the economy, even if credit markets anticipated intervention ex ante. The key to avoiding the moral hazard problem is to restrict intervention to truly exceptional circumstances. Actions in the Depression did not result in the permanent collapse of credit markets. Nor will intervention today.

It is unlikely to change US-style capitalism “as we know it”. The US system is the result of a long evolutionary process. For example, it took the entire 19th century to establish key institutions like the Federal Reserve. Seven attempts to establish a federal bankruptcy law, all undertaken at the bottom of severe downturns, either failed or later repealed. It was not until 1898 that the United States had a uniform bankruptcy law valid in all states.

What made these institutions politically possible in the US was the massive realignment after the Civil War, which weakened a reluctant South – and, ironically, a Republican-controlled Congress and Presidency in 1898. But most of all it was the dramatically increasing financial integration of the US. This integration has only increased since and accelerated with the deregulation in the wake of the savings and loans crisis and the globalisation of banking. Massive integration exacerbates the “too big to fail” problems. Fannie Mae and Freddie Mac were the epitome of integration.

The US experience offers further pause for Europe today. The continent is more financially integrated than ever but its institutional structures are lagging and responses by individual governments may not be sufficient. Perhaps the most extreme expression of integration can be found in the financial systems of Central and Eastern Europe, which are 60% and 80% controlled by Western European banks, respectively. For these countries, and for the rest of us, the question of what Europe could eventually deliver is urgent.