9. Economic System and Capitalism – Business Environment

9

ECONOMIC SYSTEM AND CAPITALISM

The study of economic systems is important to a student of the economic environment of business inasmuch as business activities take place within the economic system and are impacted by the policies adopted within the system by the state. In this chapter, we examine what an economic system is, and what problems it usually addresses. We focus on capitalism, its features, and its merits and demerits. We identify why it is the preferred system for most of the developed countries.

WHAT IS AN ECONOMIC SYSTEM?

Economic activities take place within the framework of an economic system. An economic system is the socio-economic and political framework within which an economy functions. The choice of an economic system may be influenced by political, social, historical or ideological considerations. An economic system, whatever its political or social affinities, will have to face and solve the following problems:

  • What goods and services must to be produced and in what amount?
  • How and where should the production be organized so as to produce these goods and services?
  • Are the country's resources fully utilized?
  • How to allocate the available resources among production units?
  • By what methods and under what organizations are these goods being produced?
  • How should the resultant output be distributed?
  • To whom and in what manner should the resultant output (goods) be distributed?
  • How efficiently are the resources being used?
  • Is the economic capacity to produce goods enough for the growth of the community?
  • What proportion of the goods produced shall be capital goods and what proportion consumption goods?

These are some of the important questions that have to be faced and solved by an economic system. In the following pages, we discuss the features, merits and demerits of the most prominent economic systems that are prevalent in the world today:

CAPITALISM

A free-enterprise economy is a feature of capitalism. It was Adam Smith, the father of modern economics, who provided the justification and theoretical framework to it. This type of economic system, variously known as capitalism, market-driven economic system, laissez-faire system and free-market economy, postulates that free and unfettered trade would help economies grow to their fullest potential. The classical economists, led by Adam Smith, envisaged that unfettered functioning of markets and the pursuit of self-interest would lead, as if by an invisible hand, to economic efficiency.1 A free-enterprise economy aims at free trade, freedom of choice in consumption, production and occupation. It has various features, including private property, consumer sovereignty, freedom of enterprise, etc. These are discussed briefly here.

Private Property

Private property is the most important feature of capitalism. Every individual in a capitalist economy has a right to own, buy or sell, bequeath or gift away any property he has acquired or inherited. The ownership of property and its possession give individuals a moral and legal right over its use and to enjoy the fruits of his labour from it. For instance, a farmer owning a piece of land can cultivate it and use whatever he is able to produce from it for his own benefit. Sir Arthur Young, a British writer and agricultural economist asserted, “The magic of private property turns sand into gold.”2 It has been proved time and again that when people enjoy the right to property, they make the best use of it and get maximum benefit out of it by working hard, Conversely, when properties are owned by the state and the individual has no claim on it, they tend to be indifferent as the benefits of their work are denied to them. Therefore, one of the important reasons as to why capitalism has produced excellent growth is due to the fact that individuals in such economic system enjoy the right to property.

Consumer Sovereignty

In a free-market economy, it is said that the consumer is the king. It is the consumer who decides the quality and quantity of goods produced in an economy. In such a market-driven economy, the prices of products and services are also determined by the interaction of consumers through market forces. No producer in a capitalist economy can afford to bypass the free will of the consumer, exercised through his/her demand for goods and services through the market mechanism. In a free-market system the consumer is free to choose whether to work or enjoy leisure. Likewise, he can choose to spend his income or save it. While spending his income, he can choose the type of goods, their quality, the pattern, design, the hues and colours of goods he wants to consume and so on. Though consumer sovereignty is constrained by such factors as the availability of income, possibility or otherwise of choice of goods and services available in the market, existence of government controls, rationing, limits placed on consumption by public authorities and emergence of monopoly and so on, his power cannot be minimized. Even within these constraints, the consumer does enjoy a considerable amount of freedom in a market-driven economy.

Freedom of Enterprise

Individuals in a market-driven capitalist economy or free-enterprise economy enjoy the freedom to start any industry anywhere, any time, within the boundaries of law. As long as they don't infringe the freedom of others or of the State which regulates industry, they are free to discharge and exercise their entrepreneurial functions. If capitalist economies have registered considerable amount of growth and prosperity compared to the other economic systems, it is in no small measure due to their exercising this freedom of enterprise. Apart from providing the protection of law and order, freedom of enterprise enables individuals, to move into new and diversified and even exotic industrial ventures or services. If capitalist societies have registered a much faster progress and prosperity vis-à-vis other economic systems, it is due to the freedom of enterprise enjoyed by their citizens. In such societies, industries are highly diversified with consumer and capital goods industries, services of various kinds, increased growth in technology, and the availability of much greater choice in goods and services reflecting the capabilities of multi-faceted entrepreneurs, who revelled in doing what they are good at in an atmosphere of freedom. All these factors add up to a well-diversified and rapid development of free-market economics.

Enlightened Self-interest

According to classical economists headed by Adam Smith, it is the enlightened self-interest of individuals which makes free-enterprise economies tick. If a baker bakes our bread, it is not his intention that people should be well fed, but he and his family should have their feed. Likewise, if a cobbler mends our shoes, it is not his idea that people should walk in perfect balance, but he and his family should have their food. According to classical economists, if all persons motivated by their own self-interest perform their duties, then the overall activities of the entire nation would be carried out in such a fashion so as to bring about greater prosperity to its entire people. Of course, when we allow a free interplay of people's self-interest in economic matters, it is qualified by the word enlightened to imply that while exercising such self-interest, they do not stand in the way of others exercising theirs or they do something that is harmful to society or they do something that violates the law of the land.

Profit Motive

Under capitalism, it is the profit motive which is both the mainspring of economic activity and the engine of progress. It is this profit motive that prompts entrepreneurs to invest in the production of goods and services and distribute them to the ultimate consumers. Business decisions are made by producers mainly with a view to earning maximum profit. It is not altruism or the love of society that makes manufacturers produce goods and services. Even though producers of cigarettes, liquor, arms and the like know that these could harm the society, yet they do so because these products earn good profits. Self-interest, profit motive and the right to private property are the most important features of capitalism, and it is these that make the system work successfully.

Competition

If we allow the unrestricted play of free-enterprise and the so-called enlightened self-interest, it is possible this will lead to individuals trying to grow rapidly at others' cost. Unbridled and unregulated free enterprise will result in a big entrepreneur swallowing the smaller ones using fair or foul means. This leads to the emergence of monopoly and the concentration of wealth and income in the hands of few individuals or organizations. Examples are galore wherein such monopolies have curbed competition, creating woes for the consumer. Therefore, in every free society, governments take the responsibility to curb monopolies and promote competition. For instance, the US government has filed cases against Microsoft for monopolizing the software industry and killing small players. In India, the Monopolies and Restrictive Trade Practices (MRTP) Act (and its corollary, the MRTP Commission) has tried every means to curb the growth of family-owned companies such as TATA, Birla, Mafatlal and the TVS group. Competition is encouraged in free enterprise economies as it offers customers goods and services at competitive prices, wider choices and superior technologies and enhances their standard of living. Competition also avoids wastage and duplication of efforts and promotes greater efficiency. Incompetent producers with attendant evils of unplanned and anarchy of production and wastage of scarce resources, will not be able to survive in such a system, Competition leads to cost cutting, innovation and introduction of labour-saving devices. A comparison of a competitive society with a state monopoly industry clearly reveals that wealth creation increased the standard of living and innovations abound in the former and not in the latter.

Existence of Markets and Prices

A capitalist economy is a market-driven economy. Competition, be it perfect or imperfect, exists and is assumed to exist in such a market. Prices of products are determined on the basis of demand and supply. Allocation of resources in the economy is done on the basis of what the market demands. While the public authorities fix the price of products in a socialist economy, it is the market forces of demand and supply that do so in a laissez-faire economy. If demand exceeds supply, prices will rise. On the other hand, if supply is greater than demand, prices tend to fall. In the Indian mixed-economy model, where there is a coexistence of both private and public sectors, prices of goods and services that are produced and distributed under the former segment are determined by market forces, while those in the latter are determined by public authorities who own and run them. For instance, the prices of coal, postal articles and railway tickets are determined by managements of the concerned public sector organizations. These are called administered prices.

Absence of a Central Plan

By its very nature, a capitalist economy does not work under a central plan, unlike a socialist, or even, a mixed economy. Central planning refers to “the process of consciously and systematically organizing economic and technical information into an internally consistent conceptual framework within the context of the economic and non-economic constraints towards the realization of a prescribed goal.”3 While some form of economic planning may be prevalent in all economies, free-enterprise economies use a minimum amount of economic planning of the type used by centralized economies of the former Soviet Union and its satellite countries. They may have some sectoral or regional planning to achieve specific targets, and not the comprehensive, all-pervasive and all-encompassing centralized planning as was practised in the Soviet Union until it was dismantled in 1991.

Limited Government

Limited government is one of the salient features of capitalism. Classical economists believed, “that government is the best which governs the least”, since an “omnipotent government is an incompetent government”. They believed in the dictum that “that government has no business to do any business other than doing the business of running the government”. The task of running the government lies in looking after the political functions such as protecting the citizens from external aggression and internal dissension; establishing and maintaining proper system of contracts through the courts of law and providing certain basic public utility services such as water and electricity. Governments are not supposed to run industry or sell goods and services. They are expected only to collect revenues through taxes that would be necessary to run a “limited government”. Profits that individuals make in businesses should be left in their pockets to foster trade and commerce and fuel growth. However, this kind of view has become utopian in the context of an ever-increasing need for governments to promote and regulate industries in the larger interests of society and to ensure growth with equity and sustainable development. Governments are also called upon to combat problems of recession and depression, inflation, unemployment and inequalities of income. Today, governments everywhere play an extensive economic role. Even in the USA, the citadel of capitalism, governments have been playing an active role in economic affairs especially in times of depression or recession, war and in promoting space research, weaponry, etc.

Active Entrepreneurship

In a free-market economy, entrepreneurs play an active role. They invest in and promote industry; organize the factors of production such as land, labour and capital; supervise and superintend their organizations; and bear risk and uncertainty. By doing so, they produce goods and services, which have a bearing on the standards of living and prosperity of nations, offering employment and rewards to factors of production, paying taxes to defray the expenses of the governments and promoting international trade. The role of entrepreneurs is crucial to the economic growth of nations and a critical component of their standing in the international community. For rapid economic growth, governments need to encourage entrepreneurs by making available capital at reduced rates of interest, land at lower prices, good infrastructure, trained manpower and even tax holidays. Entrepreneurs in distress, due to economic reasons beyond their control, are supported by governments. In a recent instance in India, the Central Government provided financial support to textile, software and other export-oriented industries when their bottom lines were adversely affected by heavy rupee appreciation.

Class Conflict

Class conflict is an inherent feature of capitalist societies. There is an innate conflict of interest between the owners of capital and organizations, and the workers they employ. Though both these groups play a complementary role in the economic growth of a society, capitalists think that the workers are out to cause problems for them when they demand unreasonable wages and unsustainable perks; workers think they are being terribly exploited by their bosses. Governments, in free societies generally support workers both for economic and political reasons; economic, because workers are vulnerable due to inadequate compensations being paid to them; political, because they are a major vote bank. Governments offer a third dimension to collective bargaining and are often found to support the workers. To Marxists, the class struggle is an inevitable part in any system in which the means of production is privately owned, leading to a constant struggle between the owners of capital and the proletariat.

Use of Advanced Technology

While analysing the history of economic development of nations, one is struck by the use of advanced technology in achieving a quicker pace of growth in free societies. Technology is a critical input in economic growth. Countries such as the UK, Germany, the USA and Japan are examples of those that have been using advanced technology to register fast-track growth. India is a classic example of a country with low-technology, low-growth syndrome. Here again, we see that during the period 1951 to 1991, the country's growth rate varied between a measly 2.2 per cent and 5.2 per cent because of low induction of superior technology under the strict policy of allowing its import selectively and rarely. After the economy was opened up since 1991, it has registered faster growth, many times exceeding 9 per cent. It is possible for free countries to use advanced technology to foster quicker growth because the economic environment is conducive to entrepreneurs to apply division of labour that leads to innovation, modernization, rationalization and development and induction of technology. By displacing labour, advanced technology enables entrepreneurs to take to massive production, reduce costs and increase their profits and further investments.

Specialization Based on Division of Labour

Modern capitalist economies rely on specialization based on the division of labour. Adam Smith's favourite concept “division of labour” is the fulcrum of specialization. Division of labour leads to invention and innovation which in turn promotes mechanization and large-scale production. This is the basis of economies of scale, cost reduction, cheaper prices and widening of market and growth of economies. Without the extensive use of division of labour, modern free-enterprise economies would not have grown to the extent they have grown today. However, use of division of labour is limited by the size of the market. If the market is small because the demand of the community for goods and services is small due to low incomes, extensive use of division of labour and mechanization would be costly and unjustified. Larger market, on the other hand, provides incentives for entrepreneurs to use specialized methods of production. Besides, capitalists use more and more advanced and sophisticated machinery as labour-saving devices to combat the increased demands of labour and to enjoy economies of scale. Substantial parts of a capitalist economy are dominated by large firms. Galbraith, for instance, “acknowledged that large firms were capable of bringing major gains in terms of innovation and low costs.4

Extensive Use of Money

Economies have grown far beyond the most sanguine hopes of development economists because of the extensive use of money in modern times. Though economists prefer to call money a “veil' or “shadow” of the “real” goods and services, money performs important functions as a facilitator and an agent of growth. In the absence of money, as in a barter system, communities were small, stagnant and localized. It did not enable producers to produce large quantities and reach far-off consumers. Money, by being a medium of exchange, measure of value, store of value and standard of deferred payments, has lengthened and deepened transactions across geographies. By being the basis of credit, money has enabled high growth in production, consumption, distribution and exchange. By being a liquid asset, money has made markets grow to dizzy heights. Modern plastic money has multiplied transactions in goods and services to unheard of levels of growth. Extensive use of money has made capitalism deliver faster and broader economic growth. However, money has to be used judiciously as its poor management by central banks could cause aberrations such as inflation and deflation with deleterious impacts on populations and their economic well-being.

MERITS

Capitalism has not only survived for centuries notwithstanding the prophecy of doomsday socialist philosophers including Marx and Engels, but also shown tremendous resilience due to its inherent merits. The following are its merits.

Automatic Functioning

The classical economists claimed that capitalism does not require any direction, control or regulation. Unlike in socialist economies where there is a central planning authority that directs, regulates and controls the working of the economy, capitalism does not require any such external agency. It works through the market cum price mechanism and if at any time there is any disturbance in the working of the economy, it is set right through the market. For instance, if investments on any sector take place on a large scale, it results in over-production and reduced prices. This will tell the producers that there is an over-production and they may withdraw their investments and go in for investments in some other sector where there is a greater possibility of making profits. Besides, unlike in socialism and in any centralized planned economy, capitalism is simple, easy to operate and cost effective since it does not require any outside agency to administer. On the contrary, under socialism, things can work or get corrected if necessary only through active State intervention. Thousands of people work for drafting, evaluating and executing a plan in which millions of dollars are spent. This is avoided under capitalism.

Greater Efficiency and Incentive for Hard Work

In a free-enterprise system, entrepreneurs are encouraged to enhance their efficiency and put in hard work for their own benefits. They are induced to work hard and put in more efficient work so as to earn higher profits. Since under the free-enterprise system the more efficient and hard working can earn higher emoluments, the system encourages them to improve their efficiency.

Therefore, under capitalism, the entire human resources of the country work much harder and more efficiently. It is also a system that reflects intelligence, hard work and enterprise of individuals who constitute it in its outcomes. This way, under capitalism every country's output increases manifold and their economic developments highly accelerate. It is, thus, seen that even developing countries are able to register faster economic growth if they adopt a market-driven economy. If India has been able to register growth rates of 9 per cent and above after 1991, it is due to its adoption of, albeit partially, a market-based economy. Figure 9.1 illustrates the merits and demerits of a free-enterprise economic system.

Higher Rate of Capital Formation and Growth

In a capitalist economy, citizens have the right to hold property and use it in any manner they want. Under this arrangement, people are prompted to save as much of their incomes as possible so that such saved money is invested to earn more incomes and leave larger property shares to their descendents. Under capitalism, the rate of capital formation increases faster as savings are largely invested. This in turn enables economies to register faster economic growth. One reason for India accelerating its growth rate after 1991 is the high rate of capital formation realized after the economy was liberalized.

Economic Development and Prosperity

Proponents of capitalism point out the fact that the system enables people to produce a vast variety of goods and services and enjoy such abundance as consumers. Entrepreneurs are also lured by profits that make them take risk and bear uncertainty and to conquer new frontiers of production. People in these societies enjoy an abundance of goods and services, amenities and appurtenances that enrich their standards of living and comforts of life. Capitalism as a system also encourages innovation and technological progress and the maximum utilization of available resources. Owing to all these, the incremental growth available to capitalist economies is much larger and quicker, all of which adds to the comforts and prosperity of inhabitants. It is all these that add to economic growth and progress.

Optimum Utilization of Resources

Every society has shown increasingly unlimited wants but there are limited resources to satisfy these. Capitalism ensures that such limited resources are put to maximum use with little waste and duplication. There is also severe competition among entrepreneurs to produce and sell goods. Unless they are able to compete successfully to use the productive resources at their disposal in the most economic and efficient manner possible, they will not be able to maximize their profits. A free economy has achieved increased production and has enhanced the standards of living of people. The limited resources of the country are put to maximum use. It is easy to operate and lets only the fittest to survive. Those who are weak, inefficient and unenterprising have no place in this kind of system. Whoever is responsible for waste and inefficiency would be penalized for their imprudence and miscalculations in the form of losses or inefficiency. Thus capitalism encourages the most efficient use of resources of the economy.

 

 

Figure 9.1 The Merits and Demerits of Capitalism

A Just System of Reward and Penalty

Although there are critics of capitalism who argue that capitalism is a destructive system that offers unjust punishment and penalty, the advocates of capitalism argue that it is the most absolute system of rewards and penalty. They argue that the richest award in a free-market economy goes to the ablest, the most prudent and daring of producers and sellers of products and services. A man who shows pioneering initiative and exhibits extraordinary resourcefulness, grit and determination is rewarded with highest profits. The system ensures that rewards are given to the meritorious while penalties are meted out to those who are not only devoid of any merits but also imprudent, wasteful and inefficient.

Democratic System

Capitalism almost everywhere works under a democratic framework. Both producers and consumers have their own choices and exercise them with the best of their abilities judgements and enterprise. Producers, though have a choice to produce what they like, are guided by the collective judgment of the consumers. There has to be a greater cohesion and synchronization between producers and consumers. Consumers exercise their choice of sovereignty by choosing what they like and not what is offered to them by the producers. The freedom that is part and parcel of capitalist system is one of the major characteristics of a free and democratic society.

Adaptability

Adaptability and resilience are the important hallmarks of capitalism. The critics of capitalism have prophesized long back that it would one day be destroyed under the weight of its own inner contradictions. They pointed out that trade cycles, evils such as inflation and unemployment, anarchy of production and the like will destroy the working of capitalism. Even though the system itself has undergone a great many crises one after another, yet the system has emerged stronger every time after a crisis. If the survival of the fittest is any criterion of the soundness of resistance, capitalism is indeed strong and sound. While socialism and mixed economy have been traumatized and have lost their bearing and have undergone changes with no semblance to their original systems, capitalism has stood the test of time. What better proof do we need to prove the adaptability and resilience of capitalism than to see how more strongly it has emerged every time it has undergone the terrible pangs of war and depressions?

Encouragement to Enterprise and Risk Taking

Capitalism as a free-enterprise economic system encourages enterprise and risk taking. Every business has a certain amount of risk and uncertainty. The higher the risk, the greater is the reward in the form of profit. The profitability of a firm is the outcome of how successfully one manages risk and uncertainty. It is said necessity is the mother of invention. Entrepreneurs resort to innovation and inventions to cut down the costs and to maximize their profits. These also result in the improvement of techniques and production and cost cutting. In no economic system have innovations and inventiveness played such a greater role than in capitalism. No wonder most capitalist societies are also the most innovative.

DEMERITS

Though the proponents of capitalism advance a number of reasons and justifications to uphold capitalism as a most productive and advantageous system that human ingenuity has ever produced, it is no un-mixed blessing. The critics of capitalism propose characteristics such as materialistic nature, class conflicts, periodic instability and unemployment, etc. as being the demerits of the system which are discussed below.

Excessively Materialistic

People in a capitalist society are given to Mammon-worship. Engaged in an interminable money-making rat race, these people focus on enjoying all the material benefits and comforts that money can buy. They endanger nature in their attempt to produce more and more goods for their consumption. They neither care for their fellow human beings nor bother much about the tremendous inequalities of income the system has generated. The rich becomes richer while the poor becomes poorer. The system also leads to human misery through unemployment, loss of jobs, rising prices and so on. People in such a society pampered themselves in consumerism and conspicuous consumption.

Not As Productive As Other Economic Systems

In capitalism, given the fact that there is an anarchy of production, wherein each producer produces in the hope and anticipation that whatever he produces is likely to be bought by consumers, the producer goes on widening his areas of production until such time that he is unable to sell his products because of lack of demand and loss of market which results in monetary losses and is reflected subsequently in over-production, reduced profits and under-investments. Trade cycles including phases of recession and depression are the order of the day in advanced economies wedded to capitalism. The United States has not seen a decade in which, at some point of time or the other, its citizens were not concerned about recession and its consequences including deflation, unemployment and widespread poverty. Such situations are avoided in a centrally planned economy where resources are allocated according to priorities, as decided by the collective wisdom of the authorities of the State.

Gives Rise to Class Conflict

The free-enterprise system has sown the seed of eternal social unrest by splitting the society into two warring camps of capital and labour—the haves and have-nots. These clashes and conflicts of interest arise mainly because they posses two uneven qualities; for instance, capitalists have all the wealth they want to protect while labour has a highly perishable commodity which cannot be stored; therefore, labour accept lower wages when they find that their supply is greater than demand; if not adequately compensated by capitalists, it will lead them to starvation and perishability. While labour wants higher wages and shorter working hours, capitalists want exactly the opposite to make more profits. Millions of man-hours have been lost due to strikes and lockouts which are the outcomes of class conflict, and the collective action of trade unions.

Social Injustice and Economic Inequality

In a free society, wealth and incomes are distributed in a most inequitable, unjust and even inhuman manner. Unfortunately, the inequality of income and wealth distribution gets more and more accentuated with the passage of time even when governments make earnest attempts to reduce the wide disparities. Moreover, the rich who seems to make more and more profits flourish on the miseries of the poor and incur the wrath of the latter by conspicuous consumption. There is also a great degree of “absentee landlordism” in which inheritors of wealth enjoy a luxurious life even without working, whereas the poor and the downtrodden lead a miserable and squalid life. In India, for instance, almost one-fourth of our people have hardly one meal a day while the top 10 per cent enjoy more than 80 per cent of the country's productive resources. In a country where billionaires emerge almost every year in a geometric progression since our economy has been opened up, an increasing number of poor are getting marginalized, underfed, poorly clad and undernourished with no roofs over their heads to call them their homes.

Ignores Human Welfare

In most of the free societies, especially those where there is no concept of welfare state, human misery has affected a large number of people who have been increasingly ignored. In most of the societies, the consumer has become the victim of exploitation, and in these societies, as we have seen, the economic decisions have been made by individual entrepreneurs and producers based purely on their self-interest and not for the well-being of the society. Lack of free competition, fraud and deceit perpetrated by unscrupulous producers compounded by ignorance of consumers are all evils that perpetuate the problems such free societies face. The twin evils of unemployment and low income, coupled with rising prices and falling consumption, are all issues that governments and capitalist societies find difficult to solve as a result of the inner contradictions in the capitalist order.

Periodic Economic Instability and Unemployment

The regular occurrence of business cycles in free societies due to over-production and intense competition and low consumption leading to a mismatch between production and consumption, two of the basic parameters of an economy, is one of the by-products of capitalism. Unlike in socialism, production in capitalism is unplanned and is being accelerated by increasing accumulation of capital while a large bulk of consumers are being impoverished by rising prices and falling incomes due to unemployment. As a result, there is no proper balance between production and consumption which leads to economic instability. Prosperity is being followed by recession and ultimately by depression and large-scale unemployment. The poor and the workers who constitute the bulk of the society have to live under a perpetual threat of losing their jobs and incomes. They have no sense of security. The capitalist economies undergo a regular cycle of prosperity interspersed with periods of depression, recession and slow recovery causing innumerable problems to the poor and the marginalized.

Precedence of Property Rights over Human Rights

Critics of capitalism point out that under the system, property rights take undue precedence over human rights. People who do not have property have no rights, while people with property care too little about the sufferings of others who are not as blessed as they are. People with property pose enormous clout, both economic and political. Besides, property begets more property and corresponding influence. In India, for instance, the Ambani brothers, Mukesh and Anil, have multiplied their wealth in a matter of a decade and wield enormous influence in every aspect of Indian economy.

Emergence of Monopolies

The rights of property, the concept of self-interest and profit motive are lethal weapons that lead to a series of evils under capitalism—cut-throat competition, collision and emergence of monopolies. Since every entrepreneur wants to grow and rule the market, he uses every opportunity to create a monopoly. In developing countries like India, family owned businesses acquire monopolistic positions. These big monopolies try to control the market by virtue of the large productive resources they possess. They try to squeeze out small producers. They use every conceivable trick in their trade, bend government rules, and strengthen their position by means, both fair and foul, to have a commanding position in the market. For instance, over the license-inspection raj between 1951 and 1991, many Indian companies owned by promoter families grew by abusing the very laws enacted to curb them. Indian monopolies, besides, not only command a lot of economic and political power but also take undue advantage of their position by exploiting consumers charging higher prices for their products and services and creating artificial scarcity most of the time. The concentration of economic power and wealth in the hands of few individuals and firms causes a lot of economic, social and political problems and often leads to social unrest.

Misallocation of Resources

In capitalist economies, there is a lot of misallocation of resources. In these economies, production is not carried out to merely satisfy the basic needs of masses of people. Rather, resources are used more for the production of luxury goods for the rich than for meeting the needs of the poor. In India, for instance, although agriculture is an important link to supply essential goods to the poor, this is under-invested and as a result the so-called wage goods are not produced in required quantities for mass consumption. On the contrary, a lot of resources are utilized for production of luxury goods such as consumer durables including colour televisions, washing machines, music systems and so on. These most well-known items of consumption attract more attention and investment, while the most essential goods for the poor get very low investment.

Case 9.1 Barefoot Capitalism!

The Miracles of Barefoot Capitalism by Jim Klobuchar and Susan Cornell Wilkes is a highly interesting and engaging book that chronicles the story of a stunning and worldwide liberation movement that has lifted more than 100 million people out of the quagmire of poverty and deprivation and into the sunlight of new lives. The movement is called microcredit or microfinance or microenterprise. The so-called barefoot capitalists are none other than the poor people who for the first time in their lives were able to secure a small loan with no guarantor or collateral. The loan has to be repaid with interest. The repayment rate on those loans is an astonishing 95 per cent, a figure that cannot be matched by even commercial banks that are saddled with huge non-performing assets. The movement that started three decades ago has expanded throughout the world especially in Africa, Asia and South America. In Tamil Nadu, Karnataka, Andhra Pradesh and elsewhere in India, there is a virtual White Revolution in milk made possible by women, who owned cows, helped by microcredit NGOs. The microcredit movement is the story of the poor who have pulled themselves out of their wretchedness and built small enterprises with the help of tiny loans. It is also the story of how the magic of private property turns sand into gold in a free-enterprise system.

The book highlights some of the pioneers in microcredit who have made this happen. One of them is Nobel laureate Muhammad Yunus, the founder of the Grameen Bank of Bangladesh, who became the universal model for microcredit. His creed has inspired the movement for three decades: “Human beings we're not born to live like animals. The poor aren't poor because they're dumb or lazy. They're poor because they were born poor. They can be trusted like you can be trusted.”1

It is now common knowledge that there is virtually no corruption in microcredit. The source of capital comes in the form of grants and contributions from foundations, individuals and governmental agencies. It flows through non-government agencies that raise the funds and pass them through to solidarity banking groups made up of small entrepreneurs, poor people who want to lift themselves out of oblivion. While commercial bank will not give them a loan because they have no collateral, they get it as a member of that solidarity group they are connected with—their own informal but reliable bank maintained by an accredited partner of those non-profit funding agencies that raise the money. That means they can receive tiny loans of $35 to $100, which they must repay within 4–6 months.2 And the miracle is that these poorest of the poor DO repay those loans. The jobs that are done by the recipient of the loans are as humble as they are—selling curry in a market in India, making pots and pans in Kenya and fattening a goat in Bolivia. The transformation in the lives of the borrowers, 90 per cent of whom are women, is remarkable. It brings them a sense of worth, a dignity they never experienced. It brings food and clothing to their children.3 In many cases, it adequately supplements the meagre incomes brought by their husbands. And because much of microcredit is accompanied by education and training in social development, it can produce unimaginable benefits to the people concerned, the civil society and bring the weakest link in the chain of society acquire strength and confidence. Many ignorant and illiterate women learn through the movement to read simple letters, and more importantly, to sign their names. When an illiterate woman achieves this, her friends in the group gather around her and hug her; and they weep with her in her joy, this is a very precious moment for a poor woman of the hills. It is indeed a miracle and something to be seen to be believed!

It is a truth that has fostered thousands of microcredit groups and led to the empowerment of women in places where that phenomenon was considered impossible. Previously, poor women wouldn't get a loan anywhere. Today, their group is their collateral in the developing world. It gives their children a chance where before they had none. It gives a life to the orphans of AIDS, by bringing more money into the homes of their foster parents. It is an extraordinary story.4

 

Sources:

1 Naresh Singh, “The Miracles of Barefoot Capitalism: A Compelling Case for Microcredit,” Journal of Microfinance, available online: http://www.highbeam.com/doc/1P3-783091961.html.

2 Ibid.

3 Jim Klobuchar and Susan Cornell Wilkes, The Miracles of Barefoot Capitalism, available online: http://www.kirkhouse.com/pdf/miracles.pdf.

4 Naresh Singh, “The Miracles of Barefoot Capitalism: A Compelling Case for Microcredit,” Journal of Microfinance, available online: http://www.high-beam.com/doc/1P3-783091961.html.

Malpractices

In today's world, the image of capitalism has been badly tarnished because of the malpractices adopted by entrepreneurs who are the chairpersons and CEOs of public limited companies. In the beginning of twenty-first century, for instance, US companies such as WorldCom, Enron, Adelphia Communications and Waste Management have gone bankrupt because of the malpractices and frauds by the entrepreneurs, impoverishing billions of dollars of investors' money. They got enormous salaries and pecuniary benefits, evaded taxes and laws, lived a luxurious life at the cost of the shareholders and that of the country, through clandestine deals and surreptitious transactions. The seamy side of capitalism has been thoroughly exposed by the scandals created by these businessmen. Although many laws and regulations such as Sarbanes–Oxley Act have been put in place to check the corruption and malpractices in capitalist organizations, it is still not possible to combat these evils in such free societies.

SUMMARY
  • An economic system is the socio-economic and political framework within which an economy functions.
  • A free-enterprise economy also known also as capitalism, market-driven economy, Laissez-Faire and free-market economy, postulates that free and unfettered trade help economies grow to their fullest potential.
  • Private property is the most important feature of capitalism. Other characteristics include consumer sovereignty, freedom of enterprise, free play of enlightened self-interest of individuals and profit motive being the mainspring of economic activity and the engine of progress.
  • Unbridled and unregulated free-enterprise leads to the emergence of monopoly and the concentration of wealth and income in the hands of few individuals or organizations.
  • Competition leads to cost cutting, innovation and introduction of labour-saving devices. A capitalist economy is a market-driven economy. Competition, be it perfect or imperfect, exists and is assumed to exist in such a market. Prices of products are determined on the basis of demand and supply.
  • By its very nature, capitalist economy does not work under a central plan. Limited government is one of the salient features of capitalism. However, today, governments everywhere play an extensive economic role. Governments have been playing an active role in economic affairs especially in times of depression or recession, war and in promoting space research, weaponry, etc.
  • In a free-market economy, entrepreneurs play an active role. They invest in and promote industry, organize the factors of production, supervise and superintend their organizations, and bear risk and uncertainty. Class conflict between the owners of capital and the workers they employ is an inherent feature of capitalist societies.
  • The modern capitalist economies are built by the use of specialization based on division of labour. Technology is a critical input in economic growth. Capitalists use more and more advanced and sophisticated machinery as labour-saving devices to combat increased demands of labour and to enjoy economies of scale. The extensive use of money is another feature of capitalism.
  • Capitalism has survived for centuries. It has shown tremendous resilience due to its inherent merits. Capitalism does not require any direction, control or regulation. It works through the market-cum-price mechanism and if at any time there is any disturbance in the working of the economy, it is set right through the market. Entrepreneurs are encouraged to enhance their efficiency and put in hard work for their own benefits. The right to hold property and use it incites people to save, invest and leave larger property to their descendents. This enables economies to register faster economic growth. Capitalism enables people to produce a vast variety of goods and services and enjoy such abundance as consumers. It has achieved increased production and has enhanced the standards of living of the people. The limited resources of the country are put to maximum use. The advocates of capitalism argue that it is the most just system of rewards and penalty. Capitalism almost every where works under a democratic framework. Adaptability and resilience are the important hallmarks of capitalism. Entrepreneurs under capitalism resort to innovative and ingenious measures to cut down costs and to increase sales.
  • The critics of capitalism advance the following arguments as being the demerits of the system: It is too materialistic; it gives rise to class conflicts; it is less productive compared to other economic systems; it favours misallocation of resources; it propagates social injustice and economic inequality; it ignores human welfare; it leads to the emergence of monopolies; it results in periodic economic instability and unemployment and it is riddled with malpractices.
KEY WORDS
adaptability advanced technology anarchy of production
automatic functioning capital formation capitalism
central planning class-conflict competition
consumer sovereignty democratic system development and prosperity
division of labour economic instability economic system
emergence of monopolies existence of markets extensive use of money
freedom of enterprise human welfare just system of reward and penalty
limited government mammon-worship misallocation of resources
optimum utilization of resources private property profit motive
risk taking self-interest social injustice and economic inequality
DISCUSSION QUESTIONS
  1. What are the main features of capitalism? Discuss its merits and demerits.
  2. What are the essential characteristics of capitalism? In what respects it is superior to socialism?
  3. What are the essential characteristics of capitalist economy? How far can its drawbacks be removed by a planned economy?
  4. What are the basic problems of an economy? How does a capitalist system of economy try to solve them?
  5. Critically examine the concept of consumer's sovereignty. Is it desirable under the present conditions?
  6. Describe the demerits of capitalism and explain in what way socialism seeks to overcome them.
  7. How far is market mechanism effective in efficiently allocating the resources in a capitalist economy?
SUGGESTED READINGS

Baran, Paul A. and Paul M. Sweezy. Monopoly Capital: An Essay on the American Economic and Social Order. New York: Monthly Review Press, 1966.

Copeland, M. A. Toward Full Employment in Our Free Enterprise Economy. New York: Fordham University, 1966.

Dobb, M. H. Studies in the Development of Capitalism. London: Routledge, 1963.

Friedman, M. Capitalism and Freedom. Chicago: University of Chicago Press, 1962.

———“Monopoly and Social Responsibility of Business and Labour.” In Monopoly Power and Economic Performance, edited by Edwin Mansfield, 3rd ed. New York, N.Y.: Norton, 1974.

Galbraith, J. K. American Capitalism. Boston, MA: Houghton Mifflin Company, 1952.

———The Affluent Society. Boston, MA: Houghton, Mifflin Company, 1958.

———The New Industrial State. Boston, MA: Houghton Mifflin Company, 1967.

———Economics and Public Purposes. Boston, MA: Houghton Mifflin Company, 1973.

Gregory, Paul R., and Robert C. Stuart. Comparative Economic Systems. 5th ed. Boston, MA: Houghton Mifflin Company, 1995.

Griffin, C. E. The Free Society. Washington D.C.: American Enterprise Institute for Public Policy Research, 1965.

Hansen, Alvin. A Guide to Keynes. New York, N.Y.: McGraw Hill, 1953.

Hayek, Frederich. “The Price System as a Mechanism for Using Knowledge.” American Economic Review, 35 (September 1945): 519–30.

Heilbroner, R. L. The Economic Problem. Englewood Cliffs, NJ: Prentice-Hall, 1968.

Hicks, J. R. Value and Capital. 2nd ed. Oxford: Oxford University Press, 1946.

Hobson, J. A. Work and Wealth: A Human Valuation. New York: Macmillan, 1926.

Keynes, John Maynard. The General Theory of Employment, Interest and Money. New York, N.Y.: Harcourt, 1936.

Kitch, M. J. Capitalism and Reformation. New York, N.Y.: Barnes and Noble, 1967.

Landes, D. S., ed. The Rise of Capitalism. New York, N.Y: Macmillan, 1966.

Marshall, Alfred. Principles of Economics. 8th ed. New York: Macmillan, 1948.

Reed, L. E. The Free Market, and Its Enemy. Irvington-on-Hudson, N.Y.: Foundation for Economic Education, Inc., 1965.

Salvadori, M. The Economics of Freedom: American Capitalism Today. New York, N.Y.: Doubleday, 1959.

Samuelson, Paul. Foundations of Economic Analysis. Cambridge, MA: Harvard University Press, 1948.

Shonfield, A. Modern Capitalism: The Changing Balance of Public and Private Power. New York, N.Y.: Oxford University Press, 1966.

Smith, Adam. The Wealth of Nations, edited by Edwin Cannan, (New York: Modern Library,1937.

Sombart, W. The Quintessence of Capitalism. New York: Howard Fertig, 1967.

Stigler, George. The Theory of Price. Rev. ed. New York: Macmillan, 1952.

Tawney, R. H. The Acquisitive Society. New York: Harcourt, Brace & World, 1924.

Tsuru, S., ed. Has Capitalism Changed? An International Symposium on the Nature of Contemporary Capitalism. Tokyo: Iwanami Shoten, 1961.

Case 9.2 Capitalism and Business Upheavals: Is Capitalism Infallible?

Adam Smith, the founding father and staunchest advocate of Laissez faire economy, while enunciating its principles argued that its self-correcting system ensured that it worked automatically for the benefit of the society guided by the invisible hand, unless it was being tampered with either by the State or trade unions. He has been proved wrong time and again. The free-enterprise system is neither self-correcting, nor the hand that guides it is invisible, but often that of the very visible and powerful State, which the captains of industry would not like to meddle with in their affairs in normal times. Adages were coined in the early days of capitalism to convince the civil society that the State should keep away from industry. A couple of them runs like this: “That government is the best that governs the least” and “An omnicompetent government will be an incompetent government”. However, whenever there were problems created by the cyclical downturns, people in free-enterprise economies looked up to the government of the day to rescue them from the grips of depression, which occurred once in every 18 years on an average in the USA,1 starting with the panic of 1893 followed by the depressions of 1907 and 1929 and then again in 1939. Though the Wall Street crisis of 2008 was very severe in its impact on global economy due to reasons discussed hereunder, there were several crises, both small and big, local and widespread, which had brought capitalism nearer to brink, but had been arrested before much damage had been done because of the stabilization tools developed in the aftermath of the Great Depression. Some of the major crises of the free-enterprise system are The Panic of 1907, The Stock Market Crash of 1929 etc. These along with Wall Street crisis are discussed here.

The Panic of 1907

During the financial crisis in 1907 when Theodore Roosevelt was the President of the United States, “Markets were crumbling, venerable companies were going into receivership, and banks were about to go under as crowds of people lined up to get their money out before the entire edifice collapsed.”2 In the summer of 1907, the American economy was showing signs of weakness as a number of business and Wall Street brokerages went bankrupt. In October, the respected Knickerbocker Trust in New York City and the Westinghouse Electric Company both failed, touching off a series of events known as the Panic of 1907.3 The crisis was dissolved thanks to the charismatic intervention, not of the President but, of J. P. Morgan who assembled the leading bankers and financial experts of the day in early November at 5.15 AM. Over the course of the next 3 weeks, they diverted money from the strong financial institutions to the weaker ones in an effort to keep them afloat. The outcome of the combined efforts of the government and the business leaders improved conditions in a short span of several weeks. While the crisis passed, political parties believed that the American banking system was basically flawed; calling for fundamental change, while businessmen argued that Roosevelt's “progressive” legislations had upset the natural order of the economy. They wanted the government to stop meddling with the economy. Following the Panic of 1907, the reformers gradually gained the upper hand ultimately leading to the passing of the Owen-Glass Federal Reserve Act of 1913 and the creation of the Federal Reserve

System. The “Fed”, autonomous, flexible and responsive to the economy, has evolved through the years and implemented many strict checks and balances. As a result, it was believed that the American economy and society were made more stable.4 However, it was found wanting still and the Fed failed to prevent the worst ever bank failures during the days of the Great Depression.

The Panic of 1907 shook the confidence in the US financial system and the Congress moved towards greater federal control of money and banking, a policy which failed to prevent the Great Depression and led to the continuous inflation since World War II and also to more recessions.5 “The federal government's control of the money during and after the Civil War created a rigid money supply that did not respond to the demand for money. During that era, agriculture dominated the economy, and the inflexible money supply created a crunch and a spike up in interest rates whenever farmers and others need to borrow funds.”6

The Stock Market Crash of 1929

The 1920s, called the “Roaring Twenties”, a time of continued peace and prosperity, fuelled by increased industrialization and new technologies, such as the radio, aeroplane and the automobile, witnessed a booming economy. Stocks were seen as extremely safe due to the powerful economic boom and investors quickly snapped up shares and purchased them on margin, i.e., the borrowing of stock for the purpose of getting more leverage. For every dollar invested, a margin user would borrow 9 dollars worth of stock. Because of this leverage, if a stock went up 1%, the investor would make 10%! This also works the other way around, exaggerating even minor losses. In such speculative transactions, a volatile swing of the stock market made and unmade millionaires. Dow Jones rocketed from 60 to 400 between 1921 and 1929. To make quick bucks through trading in stock market became the Americans' favourite pastime. Investors mortgaged their homes, and without a thought invested their life savings in hot blooming stocks. Stocks became sure bets to the average investor. Most of these novices hardly understood the fundamentals of the companies they invested in. Taking advantage of such ignorance, thousands of fraudsters floated companies to hoodwink ignorant investors who thought a crash was simply impossible. They felt, interestingly enough, that the stock market always went up. The dramatic crash of the stock market on 24 October, 1929 which sowed the seeds of the Great Depression of 1939 that followed it, witnessed the disposal of 46 million shares of stock by panicking investors who had by then lost faith in the American economy.

The Great Depression 1939

The more significant convulsion of capitalism took place in 1939 in what is now picturesquely called the Great Depression during the presidency of Franklin D. Roosevelt. It all started with the stock market crash of 1929 that continued to inflict its side effects on the American economy for many years to come. The Great Depression was a worldwide economic downturn starting in most places in 1929 and ending at different times in the 1930s or early 1940s for different countries. It was the largest and most important economic depression in modern history, and is used in the 21st century as a benchmark on how far the world's economy can fall. It originated in the USA; historians most often use as a starting date the stock market crash on 29 October, 1929, known as Black Tuesday. The end of the depression in the USA is associated with the onset of the war economy of World War II, beginning around 1939.7

At the height of the Depression in 1933, more than 12.8 million people, constituting 25 per cent of America's work force lost their jobs. For the remaining employed, wages fell almost by 43 per cent between 1929 and 1933. With steeply falling farm prices, farmers lost their lands and homes; hungry and dejected, they became nomads in their own land. Families were split up and people migrated from their homes searching for jobs. They lived in “Hoovervilles”, shanty towns named mockingly after President Hoover, and in houses made of packing crates, abandoned cars and dumped scraps. Factories were closed in thousands; mills and mines were abandoned; and fortunes were lost as never before. Both business and workers were in deep trouble. When companies went burst like a set of crackers, millions of Americans lost their jobs and incomes and families went through a traumatic experience as recession matured into depression. It was Lord Keynes who advised the President to pump-prime billions of dollars into the economy by undertaking projects that the government would never have done in peaceful times, to create demand for goods, jobs and confidence. Fannie Mae, which is very much in the news now, was created by the then President Roosevelt to shore up the housing market during the Great Depression. Freddie Mac was created later to compete with Fannie Mae.

Some analysts tend to find a similarity between the present situation and the Great Depression of 1929. But this is to underestimate the capacity of governments to deal with such crises which has increased enormously since 1929, thanks to stabilization measures authored by J. M. Keynes.8

The Wall Street Crisis 2008

Boom and bust cycles in an economy are inevitable, lamented a recent article in The Times, while discussing the latest phase of business cycle in the USA. The 2008 convulsive crisis of capitalism was triggered by the sub prime mortgage crisis in the USA.9 It was not totally unexpected. In the past decade, which was considered the golden era of the financial industry, most of the retail bankers, mortgagers and investment banks made pots of money, particularly through real estate loans. Increasing property values were only adding to the profits of these companies who experienced an exponential surge in their revenues.10 The cavalcade of the crisis started from retail banks lending enormous housing loans to borrowers with inadequate security and uncertain creditworthiness. These banks repackaged these doubtful loans as tradable securities and sold them to investment banks such as Lehman Brothers and Merrill Lynch. When the borrowers defaulted, as was expected, the market for these securities crashed. Some of the investment banks, like Lehman Brothers, had also invested substantially in the booming property market. When the housing boom went bust, the property market also collapsed, adding to the losses of the investment banks.11 The housing bubble was created, fundamentally, by government policies and institutions seeking home ownership for all Americans, including low-income earners. Politicians rooted for such inclusive finance.12 Fannie and Freddie who should have kept a watchful eye on the housing market as mortgagers of last resort became active participants in inflating the bubble. Many experts including those from IMF had warned that the bubble would burst sooner than later. These warnings were ignored by politicians, who refused to rein in the bubble makers. In fact, they cheered the housing finance boom for making housing available to all. Wall Street investment banks like Lehman Brothers and Merrill Lynch have been pilloried, rightly, for magnifying the bubble. Yet, they did not create it—that was done by politicians and government-backed institutions.13 This dramatic roller coaster of profits and losses is perhaps best summed up by a quote of former Morgan Stanley MD Anson Beard: “If you're betting with other peoples' money, you're more willing to take risk than if it's your own.”14

 

Sources:

1 Fred Foldvary, “The Panic of 1907,” available online: http://www.freeliberal.com/archives/002739.html.

2 H. D. S. Greenway, “What JP Morgan did in 1907!,” The Boston Globe, Reproduced in Hindu Business Line, 26 September, 2008.

3 u-s-history.comPanic of 1907, available online at http://www.u-s-history.com/pages/h952.html.

4 Ibid.

5 Fred Foldvary, Panic of 1907, available online: http://www.freeliberal.com/archives/002739.html.

6 Ibid.

7 Stanley L. Engerman and Robert E. Gallman (eds), The Cambridge Economic History of the United States. Cambridge: Cambridge University Press, 1996.

8 Nitish Sengupta, “No Need to Panic,” The Times of India, 25 September, 2008.

9 Open Space, “What Goes up Must Come Down,” The Times of India, 28 September, 2008.

10 Atul Thakur, When Godzillas Fall, World Trips, The Times of India, 22 September, 2008.

11 Nitish Sengupta, “No Need to Panic,” The Times of India, 25 September, 2008.

12 Swaminathan S. Anklesaria Aiyar, “The Perils of Inclusive Loans,” The Times of India, 28 September, 2008.

13 Ibid.

14 Atul Thakur, “When Godzillas Fall, World Trips,” The Times of India, 22 September, 2008.

Case 9.3 The Genesis of the Global Financial Melt Down

What caused the Wall Street crisis of 2008?

This serious global financial crisis since the Great Depression has occurred because of the combination of several factors:

  1. Like the ones before, the current credit crisis too has been triggered by over-optimism and poor understanding of economic ground realities. A high level of confidence that reached a historic high in the US stock market around 2000, spreading to other countries too, “was related to the booming markets and booming economy of that time. The booming markets and booming economy were in turn substantially buoyed by the high confidence in a feedback loop.”1 “All crises have the same origins. They are rooted in buoyant economic growth that promotes over optimism, excessive risk taking and extreme demands on liquidity.”2 Over the past 15 years, as the US economy was enjoying continuous economic expansion with low level of inflation—financial institutions and capital market regulators were complacent and failed to notice the emerging real-estate-induced price inflation risk, the inevitable setting business cycle and its consequences.
  2. The enormous growth of investment banks, their huge appetite for unmanageable risks encouraged by increasing profits, selling of complex financial products such as credit derivatives devised by brilliant highly paid B-school graduates and understood neither by the top managements nor by the investors, created an unreal situation that camouflaged the lurking danger in a success-coated euphoria. Moreover, the banks which took higher and higher risks did not adequately cover the risks with capital to match these in times of failure;
  3. “There was major failure of leadership at most FIs. Dealmakers took charge and risk managers were completely sidelined. Credit was mispriced so much that there was only a small difference in the yield between junk bonds and US treasuries”3.
  4. There was laxity of regulation on the part of the Securities and Exchange Commission (SEC), Fed and the Treasury. Though there was sufficient advance warning from economists and the IMF about the impending disaster, these authorities failed to act with alacrity to prevent the systemic failure and oncoming recession. By the time they collected themselves to arrest the disaster, things have gone beyond reparation.
  5. Americans have been living beyond their means for years atop a mountain of debt. They were living in a fool's paradise, as it were “through the magic of easy credit, ever lower taxes, ever rising property values, stock market bubbles and the gift of denial”4 which they used to assure themselves that the bills would never become due.
  6. The cost of running business has been rising to unrealistic levels because of excessive compensation of top corporate executives and highly inflated and unchecked administrative expenses. Companies like Lehman Brothers recruited raw graduates by offering them unbelievably high salaries and poached executives from other companies in their lateral appointments and offered them huge pay cheques and bonuses. This has been going on for the past four decades. It was reported that the “after-tax income of the top one percent of Americans rose 228 percent” between the late-1970s and 2005, while the earnings of working families, especially of men in their 30s, remained flat during the same period. The resultant high administrative costs were camouflaged in dressed up balance sheets. Table 9.1 lists the huge pay packages the CEOs of companies earned in the year before the Wall Street catastrophe.

     

    Table 9.1 Excessive Executive Pay—CEO Pay Packages in 2007

    Company CEO Pay package (in million USD)
    Goldman Sachs Lloyd Blankfein 70.3
    Morgan Stanley John Mack 41.6 (2006 and 2007)
    Lehman Brothers Richard Fuld 34.0
    Bear Stearns James Cayne 33.9
    JP Morgan Chase James Dimon 28.0
    Freddie Mac Richard Syron 18.0
    Merrill Lynch John Thain 17.3
    AIG Martin Sullivan 14.0
    Fannie Mae Daniel Mudd 11.6

    Sources: AFP, “U.S. seals bailout deal,” The Hindu, 29 September, 2008; and Joseph A. Giannone, Pay pressures on Wall Street, The Hindu Business Line, 30 September, 2008.

     

    Only after the precipitous fall of the American economy from the high pedestal it occupied for almost two decades, that the U.S. government recently placed a ceiling of USD 500,000 on executive pay of companies that were the recipients of government bailout.

  7. Commercial banks by definition and by their very nature are not expected to invest in projects of long duration. However, American banks resorted to high-risk home loans that extend between 20 and 30 years. To reduce the risks and earn more profits, these banks sold the home loans to investment banks like Lehman Brothers which by “cutting them into smaller pieces based on return (interest rate), value, and tenure (duration of the loans), sold them to investors across the world after giving them fancy names such as ‘High Grade Structured Credit Enhanced Leverage Fund’”5 Investors such as pension funds from Japan and life insurance companies in Finland invested their monies in these spurious financial products without adequate evaluation of the high risks involved in them. These collaterized debt obligations (CDOs) were being insured by the insurance giant AIG, which apart from insuring them also convinced itself to invest in them. In this totally unreal scenario, banks were pressurized to issue more loans, which in turn were sold to investment banks for a commission. Banks started granting loans to unworthy clients without proofs of income, assets, credit history or even of job. Insecure loans called NINA “no income, no assets” became the order of the day. As prices of homes, both for living and for investments, went on increasing due to high demand, speculative chain reaction started. By late 2006, bankers were unnerved to see their customers choose houses, sign mortgage papers and then defaulted on their very first payment. By 2006, the level of confidence has been fading, hitting even below the lowest levels reached in the 2001 recession.6 As home buyers started defaulting with enhanced rates and high cost of living, there was a mad scramble to seize homes of defaulters and sell them. But there were not enough buyers. This accentuated the collapse of FIs.
  8. Analysts of the crisis argue that the American regulators have failed to protect consumer rights, and prevent excessive risk taking, malpractices and fraud. “The regulators did not take cognizance of the first fact that the financial system had undergone a paradigm shift in the past decade and it is not the banks alone that matter. The broker-dealers or investment banks have become the bigger players, but the regulators forgot to keep adequate watch on them.”7 By the time they woke up, things had gone far beyond salvation
  9. It was not as if the impending catastrophe was not foreseen or foretold. Global Financial Stability Report of International Monetary Fund had warned in good time that the lax lending practices of the past few years by banking and investment companies would cause serious problems to investors and the economy. IMF's unheeded warning has materialized in what is widely acknowledged to be the worst crisis recorded in the economic history surpassing even the 1929 stock market crash and the Great Depression. These cataclysmic events led to the crashing of the global stock markets that tanked on 15 September, 2008, when the Dow Jones Industrial' Average lost over 500 points. Major European markets also fell sharply with the major stock indices in the region showing falls of 3–5 per cent. Bombay Stock Exchange's sensex crashed by 3.3 per cent echoing the ultra bearish global sentiment. Asian markets joined the sell-off the very next day and lost as much as 5 per cent.8 Things started going sour towards the end of 2006, with the bursting of the housing bubble in the USA. Fannie Mae was the first to feel the heat, incurring a whopping $2.3 billion or 26% drop in net income. Freddie Mac, Fannie Mae and Merrill Lynch started incurring loss from the third quarter of 2007. In the calendar year, Merrill Lynch lost $7.8 billion, which were more the $7.5 billions it has earned as net income in 2006. The losses of Freddie Mac and Fannie Mae were $3.1 billion and $2.1 billion, respectively.9 The biggest Wall Street firms were pygmies compared with two quasi-government entities, Fannie Mae and Freddie Mac. These two held mortgages and other assets totalling $5 trillion, five times India's GDP.
  10. Corporate greed, egged on by aggressive traders, took on greater risks. Internationally acceptable corporate governance practices have been totally ignored, causing serious repercussions in their business activities. The problem with greed is that people easily consider it as a vice and closely associate it with unethical behaviour. Excessive greed blinds and corrupts a corporate boss, as has been demonstrated in the Satyam's case. There was, of course, a plethora of greedy characters in the financial services sector. Capital market and banking regulators who have been preaching the lofty ideals of corporate governance to the outside world, especially to developing countries like India, indirectly hinting that the corporate society in the USA was doing well in terms of ethical practices, seemed to have gone into a deep slumber during the time the financial crisis was developing.

    All these proved that notwithstanding the best intentions of Sarbanes–Oxley Act and under the nose of Securities and Exchange Commission, nothing much could be done to rein in corporate greed to make fast bucks. “The bailout of Bear Sterns by the Federal Reserve, the takeover of Fannie Mae and Freddie Mac (with the U.S. treasury extending USD 5.3 trillion government guarantee to private debt), Lehman Brothers filing a Chapter 11 petition with the US Bankruptcy Court in Manhattan”,10 followed by the takeover by Bank of America of Merrill Lynch and emergency funding of AIG by the country's central bank point out to a larger malaise: a devastating crisis of confidence.

Sources:

1 Robert J. Shiller, “India and The Global Financial Crisis,” The Economic Times, 20 October, 2008.

2 Ruchir Sharma, “Panicking like 1907 in 2008,” The Economic Times, 6 October, 2008.

3 Arun Duggal, “Global Financial Crisis: Slippery Slope,” The Economic Times, 1 October, 2008.

4 Bob Herbert, “US: Living in a Fool's Paradise”, The Hindu Business Line, 10 October, 2008.

5 Shyam P., “When The Bubble Bursts,” The Hindu Magazine, 5 October, 2008.

6 Robert J. Shiller, “India and the Global Financial Crisis,” The Economic Times, 20 October, 2008.

7 Rudra Sensarma, “Regulate…‥ in The Right Measure,” The Hindu Business Line, 25 September, 2008.

8 Oommen A. Ninan, “A Stitch in Time Saves Nine,” The Hindu, 22 September, 2008.

9 Atul Thakur, “When Godzillas Fall, World Trips,” The Times of India, 22 September, 2008.

10 Manoranjan Sharma and Arun Kumar Misra, “Convulsive Crisis of Capitalism,” The Hindu Business Line, 26 September, 2008.