Monday, January 26, 2009

Will Obama Dampen the Flame of Innovative Anglo-American Entrepreneurial Capitalism With Socialist-Leaning French-German Continental Over-Regulation?

A New Direction in Global Financial Regulation

By John Kemp


January 26, 2009

LONDON, Jan 26 (Reuters) - UK Prime Minister Gordon Brown's call today for a new G20 charter of principles on financial regulation [ID:nLQ293854] reflects an emerging consensus among policymakers that, once the immediate crisis has passed, the regulatory framework must be fundamentally redesigned.

In particular, policymakers are concerned with how to correct the basic moral hazard problem in which bankers have an incentive to extend too much credit, while private firms and households have an incentive to take on too much debt.

A consensus is emerging that the volume of credit expansion needs to be restrained and managed as a separate policy objective. This marks a sharp break with past practice -- in which central banks attempted to control the cost of credit by manipulating short-term interest rates, but have increasingly left its quantity to decisions by individual banks and borrowers.

There is also something of an emerging agreement that if credit control is a separate economic objective alongside "internal balance" (output-inflation) and "external balance" (trade and capital flows) then a new instrument needs to be developed to achieve this target.

With three targets (internal balance, external balance and financial balance) Tinbergen's Rule says there need to be three independent policy instruments -- fiscal policy, monetary policy, and a distinct credit policy.

In his recent speech to the CBI Annual Dinner in the East Midlands last week, Bank of England Governor Mervyn King alluded to the need to develop a new policy instrument to achieve credit-policy objectives. He stated a strong preference it should not be interest rates. King argued rates should continue to be used to target output and inflation.

The clear implication is the "new policy instrument" referred to by King will have to be some form of direct quantitative control, so as not to interfere with interest-rate strategy, and allow the authorities to manipulate the volume of credit for any given level of interest rates.


In 1945-1975, banking crises were few, but credit was expensive and unavailable to many households and businesses. The banking system was tightly controlled and the quantity of credit was rationed through a variety of direct mechanisms (reserve requirements, intensive bank examinations, margin requirements and a host of other direct lending controls).

Most of these were dismantled during the 1980s and 1990s. They could be resurrected but this would face stiff opposition from within the industry. It would also face hostility from within the economics establishment (broadly in favour of market solutions) and among politicians (worried about the impact of reduced access to credit for many households, and voters, in the lower half of the income distribution).

Fed Vice-Chairman Don Kohn and Prof Lawrence Summers (now head of the Obama administration's National Economic Council) both poured scorn on what they saw as a rose-tinted view of the heavy regulatory past at the Fed's annual Jackson Hole symposium in 2005.

Both men are presumably chastened by the subsequent meltdown. But their personal opposition to intensive quantitative controls is probably still intact, and shared by many policymakers at the top of the new administration, in Congress, and among the wider regulatory community.

So the search is on for a compromise. The idea is to create a new instrument or instruments that would work with the grain of the market, rather than cut against it, and enable regulators to exercise some control over the quantity of credit being extended while preserving flexibility for banks to innovate.

If the old pre-1980 quantitative controls are seen as "first generation" methods, the hunt is on for more sophisticated market-friendly "second generation" methods that promote stability while protecting growth.

The first design issue for these new quantitative controls is whether to impose them directly or indirectly.

First-generation quantitative controls were formulated within the central bank and consisted of a series of prescriptive lending ratios.

The trend in recent years has been towards a more indirect approach, in which the central bank and other regulators set out general principles and a flexible framework; banks are then free to manage their business and risk-taking within this. One key question is how far second-generation controls will build on the modern principles-based indirect approach, or revert to a more prescriptive command-and-control one.


The second design issue is how to make quantitative controls "active" rather than "passive". First-generation controls were largely specified in passive terms: fixed capital and lending ratios that were invariant over the cycle. But there is an emerging consensus second-generation controls should be more active and capable of varying over the cycle, limiting credit growth during the expansion phase, but also mitigating the collapse of credit during a contraction.

Contra-cyclical bank regulation policies are especially popular at the moment, because the industry is in the contraction phase, and contra-cyclicality implies a loosening of policy. The real challenge is to create a contra-cyclical approach that is sufficiently robust it can compel the banks to increase their capital cushions during an upturn.

One option is to impose reserve requirements or risk-weightings which rise above the long-term mean during expansions and are allowed to fall below it during the contraction phase. But that raises thorny questions of who measures the cycle and how. Dating and measuring business and credit cycles, and identifying turning points are notoriously difficult in real time.

To take a recent example: the start of the most recent expansion is controversial, with many commentators now arguing the Fed missed the beginning of the upturn and failed to raise interest rates in a timely manner. If the Fed, or another regulator, had been responsible for adjusting reserve requirements or risk-weightings, as well as interest rates, would the adjustments have been any more successful?

If relying on regulators' discretion to identify turning points in the credit cycle is problematic, is there a way to make contra-cyclical controls endogenous to the lending system?

The aim would be to make reserve requirements, risk-weightings or other instruments depend on the volume of credit extended in the immediate past period(s). Credit controls would be progressively tightened the longer and faster credit expands, and progressively loosened the longer and further credit falls.

The problem with endogenous credit control policies (like endogenous interest rate policies) is that they do not work well around cyclical turning points. In the summer of 2007, an endogenous contra-cyclical policy would probably still be tightening conditions in response to the explosive credit growth in 2004-H12007 rather than loosening them to forestall the calamitous collapse of credit that occurred later in the year.


In practice, credit is hard to define, measure and restrict.

Conventional bank lending is only one element of an increasingly complex and diverse credit-creating system.

Finance companies, commodity brokers, special investment vehicles, and even hedge funds, all of which are increasingly active in wholesale money markets, may be engaging in credit-creating processes.

The question of what types of credit to control is analogous to the debate during the 1980s about what measure of the money supply to target. Moreover, Goodhart's Law suggests any statistical or economic relationship between the chosen target measure and the wider economy will tend to break down once pressure is applied for control purposes.

In fact, as soon as the authorities decide on which forms of credit are subject to regulation and control, there is an immediate incentive to create other forms of credit in other institutions that are not subject to control and therefore more profitable. This was precisely the reason for the huge growth in the "shadow banking system" during the 1990s and 2000s.

To have any chance of being effective, the new credit policy will need to cover the whole range of institutions which create credit, not just commercial banks, and need to be applied on a fairly international basis, to prevent this sort of institutional and jurisdictional arbitrage.
Soros Sees 'Reflexivity' Theory of Economics as Life's Work

By David J. Lynch

USA Today

May 13, 2008

WASHINGTON — For most people, being known as a fabulously wealthy investor, prominent global philanthropist and outspoken critic of the current occupant of the White House would constitute sufficient acclaim.

But George Soros, now in his eighth decade and enjoying a personal fortune estimated at $9 billion, yearns to be seen as something other than a financial oracle or Democratic Party sugar daddy. The Hungarian émigré, who built a worldwide reputation by out-thinking markets, desperately wants to be acknowledged as a philosopher.

His bid for such recognition — in a new book published last week — lies in a theory called "reflexivity," which Soros argues should supplant conventional economic thought that's based on coolly calculating rational actors. Soros, 77, who first read philosophy as a teenager during World War II, has promoted the concept for more than 20 years with little success.

But hailing reflexivity as his "life's work," Soros now says the current financial crisis offers an opportunity for him to garner wider acceptance. "I'm actually hopeful this time I'll break through," he says.

It'll be an uphill fight. Critics of reflexivity, especially among the economists Soros disparages, have been brutal. A reviewer of one of his earlier books savaged his "windy amateur philosophy" and attacked him for being unfamiliar with basic economics.

"It is difficult to conceive of a more mistaken understanding of the profession's research in the last 10-15 years. … The great danger of the (earlier) book is that non-economists will take seriously his ill-founded criticism of economic research," wrote economist Christopher Neely of the Federal Reserve Bank of St. Louis.

In his latest work, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, Soros traces a straight line between today's financial turmoil and what he says are fatally flawed conventional assumptions about how markets behave. If banks, investors and regulators had embraced reflexivity years ago, there never would have been a financial crisis, Soros insists.

Here's why: Since the days of Adam Smith, economists have taught that markets sort out issues of supply and demand by settling at a point of equilibrium. Prices may temporarily deviate from that balanced state, but eventually, they return to it.

Classic free market theory holds that everyone in an economy acts rationally, based on complete information while seeking to maximize their individual welfare or profits.

Of course, real life never matches up exactly with the theory's assumptions. But they represent, economists say, a useful way of making sense of a complex world.

To Soros, the conventional approach is rubbish. Instead of a world of near-identical actors, coolly assessing their economic interests and acting with clear-eyed precision, he sees a world (and markets) governed by passion, bias and self-reinforcing errors. Because fallible human beings are both involved in, and trying to make sense of, this world, they inevitably make mistakes. Those mistakes then feed on themselves in "reflexive" ways that, when taken to extremes, result in situations such as the now-deflating U.S. housing bubble.

Standard economic theory is flawed, Soros says, because it treats markets populated by thinking human beings as if they operated according to the natural laws that govern atoms and molecules. Economists say Soros badly exaggerates the limitations of standard theory and ignores subsequent refinements. But if conventional economics teaches that markets are always (eventually) right, Soros insists they are always wrong.

What does this have to do with house prices in Las Vegas or credit availability in Tampa? Plenty. Only people who were overly confident about how markets operate could have come up with the innovative financial instruments — such as collateralized debt obligations (CDOs) — that ultimately proved so toxic. The banks that developed and sold these products did so comforted by arcane mathematical models that ostensibly demonstrated how these securities would behave under various scenarios.

The only problem was that when the crunch hit, the securities didn't behave the way the models said they should. That came as a surprise to the bankers responsible for the models. Soros said it wouldn't have come as a surprise to anyone who believed in reflexivity.

"They would not have designed these CDOs, for instance, or CDOs squared. They would not have engaged in trading strategies that assumed that markets, that deviations are random. They would change the amount of leverage that they use, the amount that they are willing to borrow, because of the element of uncertainty," he said in an hour-long interview last week.

So far, so good?

Soros received a harsh lesson in uncertainty, false truths and the vagaries of human behavior at an early age. He was a teenager when Nazi soldiers occupied his native Hungary in March 1944. Within less than two months, more than 440,000 Hungarian Jews were deported, many to Auschwitz.

The Soros family was among the one-third of Hungary's Jewish population who survived the Holocaust, thanks to Soros' father, Tivadar, who arranged false identities for his family.

"My life, my sort of formative experience, was the Nazi occupation, you know, when (I was) 14 years old. They would have exterminated me," Soros says quietly. "And everything grew out of that. I always tried to understand reality — and that's been my passion."

By February 1945, advancing Russian soldiers had replaced the Germans, bringing a new totalitarian ideology just as certain of ultimate truth as the National Socialist ideology it supplanted. As conditions deteriorated under the postwar Soviet occupation, Soros eventually emigrated to London. He studied at the London School of Economics, got a foothold in finance, and moved to the USA in 1956.

In 1970, he started the Quantum fund, a hedge fund that returned better than 42% per year for a decade. The explanation for that outsize success, Soros says, is reflexivity.

"You have got to make decisions even though you know you may be wrong," he says. "You can't avoid being wrong, but by being aware of the uncertainties, you're more likely to correct your mistakes than the traditional investor."

Soros retired from full-time investing in 2000 and concentrated on philanthropy through a network of non-profit organizations he had established in the 1980s and his Open Society Institute. Together, the groups distribute $400 million to $500 million each year to "civil society" projects in more than 50 countries, such as election monitoring in Tajikistan and a network of community libraries in Haiti. Soros also has emerged as a major financial contributor to the Democratic Party and harsh critic of President Bush and the "war on terror."

The financier's political views have made him the bête noire of many in the conservative movement. Fox News commentator Bill O'Reilly, for example, has criticized Soros for seeking to impose a "radical left agenda" on the USA, while conservative websites such as routinely assail him as "anti-American."

The credit crunch that erupted last year prompted Soros to return to investing, to protect his portfolio from the gathering financial catastrophe. Several months later, Soros says the U.S. has weathered the "acute phase" of the markets crisis. "But the impact on the real economy is yet to be felt," he says.

Soros makes no bones about his judgment that the current financial crisis is the "worst since the 1930s." He sees the subprime mortgage debacle as the signal event that unhinged both this decade's housing bubble and a 25-year-long "super-bubble" that originated in the debt-laden policies of the Reagan administration.

But despite Soros' apocalyptic rhetoric, the Dow is hovering near 13,000 and unemployment is a relatively low 5%. Soros explains the disconnect with the tale of the man who falls off the Empire State building and thinks to himself halfway down: "So far, so good."

"That's where we are right now," Soros laughs.

Still, for anyone who's listened to some of the gloomier economic prophets, such as economist Nouriel Roubini or The Trillion-Dollar Meltdown author Charles Morris, Soros' analysis of the financial crisis itself is unremarkable. Like others, he blames a failure of regulators, including Alan Greenspan's Federal Reserve, to keep a tight enough rein on Wall Street. He anticipates further sharp declines in housing prices and says, when pressed, that Americans ultimately won't escape this episode without suffering a noticeable decline in their standard of living.

"I'm afraid that will be the case, and it will be hard to take," he says. "And it will be politically unpalatable, and it will probably give rise to all kinds of populist political appeals (for) a way out that will also be very dangerous."

The Federal Reserve's aggressive efforts to pump cash into the banking system and the government's $168 billion economic stimulus, which began sending taxpayers checks this month, will be insufficient to stir a recovery, he says. Talk — from Bush administration officials and Wall Street optimists — of an economic recovery later this year "is totally without foundation," he says.

Even as clean-up continues on the housing bubble's aftermath, new bubbles are forming in commodities markets and perhaps China, he says. Soros acknowledges that his crystal ball is "cloudy" on the Asian giant, but predicts that the country faces serious domestic inflation and export weakness if the U.S. downturn spreads abroad. "China is not immune to the worldwide dislocation that started here," he says.

What Soros sees as the market economy's inherent tendency to lurch from bubble to bubble and excess to excess makes it all the more essential that those at the economy's helm embrace reflexivity, he says. Reflexivity cannot provide firm predictions about the future, only a better understanding of the past and an awareness of all that could go wrong, he says. Regulators and market participants alike will need to accept a much greater amount of uncertainty — as Soros says he has.

"Being aware of reflexivity, I am often overwhelmed," he says. "Genuinely, I am actually overwhelmed by the uncertainties. And I'm constantly on the watch being aware of my own misconceptions, being aware that I'm acting on misconceptions and constantly looking to correct them."
What accounts for Europe’s and America’s different attitudes toward the free market?

By Augustin Landier, David Thesmar, and Mathias Thoenig

STERN Business

(Fall/Winter 2007)

Throughout the Western world, a vast region generally viewed as dominated by capitalism, people’s attitudes toward the virtues of free markets vary widely. According to the World Value Survey, only 22 percent of French people believe that owners should run their businesses and appoint their managers, while as much as 58 percent of Americans agree with this statement, to cite one example. Academics have focused on a range of issues to explain the dispersion of pro-free market attitudes. Some argue that the uniqueness of US history – a large, ethnically heterogeneous society – has endowed modern American citizens with persistent anti-redistributive beliefs. The political economy view holds that people that gain the least from globalization are less likely to support it (for example, unskilled workers in the North, skilled workers in the South, people working in industries with high trade exposure). Still others argue that differences can be ascribed to cultural factors such as patriotism, neighborhood attachment, or a strong sense of identity.

We set out to understand what determines attitudes toward free markets by investigating how beliefs about the market economy vary across individuals, time, and countries. We constructed a dataset based on economic data like pension funding and stock market participation, and on opinion surveys, like the World Value Survey (WVS), which collects data on age, gender, and income, and measures attitudes toward economics, marriage, and religion across dozens of countries; and the Internal Social Survey Program (ISSP), whose 1996 wave contained questions on ethnicity, private property, and attitudes on state interference with free competition. By running regression analysis on this data, we were able to investigate the influence of certain factors in accounting for the differential attitudes. Our analysis of the WVS focused on the answers given to questions about (1) the benefits/harms done by competition; (2) whether owners, employees, or the state should run the firms; (3) the merits of private ownership of business and industry; and (4) the trustworthiness of large firms. The data show a large variation in cross-country attitudes toward free markets. Two examples are given in Table 1, which focuses on the 18 richest countries in our sample and displays mean variables for all three waves of the WVS.

In the cross section of countries, preference for redistribution and attitudes toward free markets showed little, if any correlation. But this was less true at the individual level. People that tended to favor income equality also tended to distrust competition, large companies, and shareholder control of firms. In order to isolate the pure effect of “pro-free market” beliefs, we used as control variables attitudes such as: trust (many existing studies have shown that trust explains well the cross section of various economic outcomes, such as GDP growth); aversion to inequality (defiance toward free markets may stem from a concern for equality); pro-trade (in many instances, defiance toward market forces can be defiance toward globalization); and religion (academic work has shown, in general, that being religious is positively correlated with a positive perception of work and thrift). When we ran the data, we found that the unconditional correlations were not very high, which suggests that individual determinants of opinions are very diverse across attitudes. And yet we found that all four “market” variables are positively correlated with each other. Pro-competitive people also tend to support less equality, seem to favor free trade, and tend to be less religious and less confident in other people, for example.

Self-Interest Why do attitudes toward free markets vary so much across individuals?

The political economy view holds that self-interested individuals hold the beliefs that suit them best. In the developed world, for example, those least supportive of free trade also tend to have lower levels of education or work in industries where foreign competition is high. To test this hypothesis, we explored responses on two broad and distinct sets of issues: attitudes toward competition and attitudes toward the profit-motive. Attitudes toward ownership and competition shared some common determinants that proved to be statistically significant. Support for competition and owner control was also more prevalent among older people. (One possible explanation is that older people, being closer to retirement or more entrenched in their jobs, are more sheltered from the shocks of competition.) People with higher levels of income also showed strong support for market forces and self-interested behavior. Our preferred interpretation of this finding is that income is a proxy for the ratio of financial wealth to human capital. Another possibility is that income is a proxy for skill. Skilled labor is more protected from off-shoring and creative destruction that accompany for-profit management and tougher competition.

French legal origin was strongly related to competition aversion, and British common law was related to a strong preference for owner control. These findings suggest that long-run institutional determinants rooted in the history and culture of a country dominate more recent developments in the organization of its economy.” A more powerful test of the political economy view consists in combining the individual characteristics with country-level institutional features. We did so by looking at the cross-country dispersion in pension funding and financial development as a measure of the extent of financial markets institutions and compared how young and old people answered the questions. In theory, older people, who control a greater chunk of financial wealth, should display more free-market support in countries where they are the most likely to hold a larger fraction of financial wealth.

Generally speaking, we found that in countries where pensions are funded, in financially developed countries, the old are much more likely to be supporters of the free market than the young. The probability that the young favor owner control was larger by 18 percentage points in the pension-funded countries. The probability that older citizens do so is larger by 30 percentage points. It’s natural to wonder whether the institutional determinants that impact the support for markets come from very far in the past or are largely driven by recent developments.

Several scholars have argued that in a cross-section of countries, distant legal origins matter. Compared with countries whose systems derive from French civic law, countries whose systems derive from British common law have a stronger propensity to protect debtholders and shareholders, have lower job protection, and facilitate entry by making business creation easier. When we ran the numbers, we found that legal origin has a significant impact. Notably, French legal origin was strongly related to competition aversion, and British common law was related to a strong preference for owner control. These findings suggest that long-run institutional determinants rooted in the history and culture of a country dominate more recent developments in the organization of its economy.

There’s more evidence that culture matters. Consider that only about 48 percent of American households own stocks directly or indirectly. This makes it unlikely that the median voter will support owner control or free competition just because it boosts the return of its portfolio. And yet, 57 percent of US respondents agreed with the statement that the “owners should appoint the management,” and more than 70 percent of US respondents who work for others agree with the proposition that “management should only care about profits.” The diffusion of equity ownership in the US cannot alone explain why American citizens support free markets more than do citizens of other countries. Culture may be a factor in explaining such results. Scholars have argued that attitudes are affected by ethnic origins because they have a cultural component, and that culture is transmitted within the family. To test this hypothesis, we constructed two indices of cultural proximity to seven major western cultures: France, Germany, Russia, Spain, Sweden, the UK, and the US. The first index measures proximity to economic culture using as controls an aversion to inequality and a pro-trade attitude. The second index of cultural proximity is related to non-economic values, such as religious proximity.

We also looked at whether each country has been, at some point in history, a colony of one of the seven countries we mentioned above.

Our tests showed that cultural proximity to French economic attitudes predicts a significantly lower support for owner control, as does proximity to Germanic and Nordic economic attitudes.
Proximity to British attitudes does, however, predict a higher-than-average propensity to favor owner control. Countries with British legal origins and/or who have been, at some point, colonized by the British tend to display a higher degree of ownership control.

Meanwhile, countries that had been colonized by Spain and Russia are systematically less supportive of competition, while former Swedish and British colonies are more pro-competitive.
Generational Difference

For country differences in beliefs about markets to be permanent and unexplained by self-serving behavior, divergent beliefs of individuals need to persist throughout generations. But we also know that ideas and attitudes change over time. We tried to get at this issue by focusing on former communist countries and comparing attitudes toward free markets held by younger generations to attitudes of generations that were already adults when the Berlin Wall fell. We found that in the West, younger generations tend to be less pro-market in general. For people born after 1970, the probability of supporting owner control or competition was lower by 1 percentage point. The probability of supporting state ownership over private ownership was higher by 5 percent, a much larger difference.

But the generational divide was significantly larger in post-communist countries than in other countries. In former communist countries, the young are 7 percentage points more likely to support the for-profit motive, 9 percentage points more likely to support private ownership over state ownership, but only 2 percentage points more likely to support competition. These findings suggest that the forces that shape the preference for redistribution are not necessarily the same as those which shape attitudes toward market forces. Clearly, past shocks and shared experiences shape generation/population-wide attitudes. To investigate further how fast beliefs can adapt from one generation to the next if the economic context changes, we looked at evidence from immigrants. For our purposes, we grouped country/language/ethnicity of origin into four broad categories: English-speaking countries, Continental Europe, Eastern Europe, and Nordic countries. The regressions we ran broadly confirm the results obtained on individual and country data. Respondents from English-speaking countries show consistently more support for both free markets and private property. Respondents of Eastern European origin show the strongest support for state ownership and an activist industrial policy.

We ran the same regressions focusing on US residents. The focus on the US is useful because it is the country where regions of origin are the most diverse. Here, we found mixed evidence that indeed, free market attitudes are strongly transmitted within the family and are weakly dependent of the economic context. For instance, respondents of Eastern Europe origin were 22 percent more likely to support redistribution; US residents of such origin were 6 percent less likely – not statistically significant – to do so. In general, the difference in attitudes between US citizens of Anglo-Saxon descent and other origins was both small and insignificant statistically, while the difference was strong on the worldwide sample. This suggests that such beliefs are much more conditioned by environmental characteristics than by transmission of family values.

What should we conclude from this investigation? First, we find that the traditional political view according to which individuals hold political opinions that are self-serving is consistent with the data. In general, individuals that would benefit more from a pro-market agenda exhibit stronger pro-market opinions. But this tendency alone can’t explain the sometimes significant differences between countries. The attitudes of a country toward markets are slow-varying and seem, on aggregate, to be strongly determined by historical and cultural factors. When it comes to explaining differences between countries’ views toward fundamental issues of markets and competition, economic theory matters. But so, too, do other factors, such as culture, legal systems, ethnicity, and family, matter.

Augustin Landier is assistant professor of finance at NYU Stern, David Thesmar is professor of economics at the Ecole Nationale de la Statistique et de l’Administration Economique (ENSAE) in Paris, and Mathias Thoenig is professor of economics at the University of Geneva.

[See: European Governments Educate Young Against Free Markets & American Capitalism in Favor of European Welfare State Dream - Europe's School Books Demonise Enterprise, ITSSD Journal on Economic Freedom, at: ].



Dynamic Capitalism - Entrepreneurship is Lucrative--and Just.


Wall Street Journal

Tuesday, October 10, 2006

There are two economic systems in the West.

Several nations--including the U.S., Canada and the U.K.--have a private-ownership system marked by great openness to the implementation of new commercial ideas coming from entrepreneurs, and by a pluralism of views among the financiers who select the ideas to nurture by providing the capital and incentives necessary for their development. Although much innovation comes from established companies, as in pharmaceuticals, much comes from start-ups, particularly the most novel innovations. This is free enterprise, a k a capitalism.

The other system--in Western Continental Europe--though also based on private ownership, has been modified by the introduction of institutions aimed at protecting the interests of "stakeholders" and "social partners." The system's institutions include big employer confederations, big unions and monopolistic banks. Since World War II, a great deal of liberalization has taken place. But new corporatist institutions have sprung up: Co-determination (cogestion, or Mitbestimmung) has brought "worker councils" (Betriebsrat); and in Germany, a union representative sits on the investment committee of corporations. The system operates to discourage changes such as relocations and the entry of new firms, and its performance depends on established companies in cooperation with local and national banks. What it lacks in flexibility it tries to compensate for with technological sophistication. So different is this system that it has its own name: the "social market economy" in Germany, "social democracy" in France and "concertazione" in Italy.

Dynamism and Fertility

The American and Continental systems are not operationally equivalent, contrary to some neoclassical views.

Let me use the word "dynamism" to mean the fertility of the economy in coming up with innovative ideas believed to be technologically feasible and profitable--in short, the economy's talent at commercially successful innovating.

In this terminology, the free enterprise system is structured in such a way that it facilitates and stimulates dynamism while the Continental system impedes and discourages it.

Wasn't the Continental system designed to stifle dynamism? When building the massive structures of corporatism in interwar Italy, theoreticians explained that their new system would be more dynamic than capitalism--maybe not more fertile in little ideas, such as might come to petit-bourgeois entrepreneurs, but certainly in big ideas. Not having to fear fluid market conditions, an entrenched company could afford to develop radical innovation. And with industrial confederations and state mediation available, such companies could arrange to avoid costly duplication of their investments. The state and its instruments, the big banks, could intervene to settle conflicts about the economy's direction. Thus the corporatist economy was expected to usher in a new futurismo that was famously symbolized by Severini's paintings of fast trains. (What was important was that the train was rushing forward, not that it ran on time.)

Friedrich Hayek, in the late 1930s and early '40s, began the modern theory of how a capitalist system, if pure enough, would possess the greatest dynamism--not socialism and not corporatism. First, virtually everyone right down to the humblest employees has "know-how," some of what Michael Polanyi called "personal knowledge" and some merely private knowledge, and out of that an idea may come that few others would have. In its openness to the ideas of all or most participants, the capitalist economy tends to generate a plethora of new ideas.

Second, the pluralism of experience that the financiers bring to bear in their decisions gives a wide range of entrepreneurial ideas a chance of insightful evaluation. And, importantly, the financier and the entrepreneur do not need the approval of the state or of social partners. Nor are they accountable later on to such social bodies if the project goes badly, not even to the financier's investors. So projects can be undertaken that would be too opaque and uncertain for the state or social partners to endorse. Lastly, the pluralism of knowledge and experience that managers and consumers bring to bear in deciding which innovations to try, and which to adopt, is crucial in giving a good chance to the most promising innovations launched. Where the Continental system convenes experts to set a product standard before any version is launched, capitalism gives market access to all versions.

The issues swirling around capitalism today concern the consequences of its dynamism. The main benefit of an innovative economy is commonly said to be a higher level of productivity--and thus higher hourly wages and a higher quality of life. There is a huge element of truth in this belief, no matter how many tens of qualifications might be in order. Much of the huge rise of productivity since the 1920s can be traced to new commercial products and business methods developed and launched in the U.S. and kindred economies. (These include household appliances, sound movies, frozen food, pasteurized orange juice, television, semiconductor chips, the Internet browser, the redesign of cinemas and recent retailing methods.) There were often engineering tasks along the way, yet business entrepreneurs were the drivers.

There is one conceivable qualification that ought to be addressed. Is productivity not finally at the point, after 150 years of growth, that having yet another year's growth would be of negligible value? D.H. Lawrence spoke of America's "everlasting slog." Whatever the answer, it is important to note that advances in productivity, in generally pulling up wage rates, make it affordable for low-wage people to avoid work that is tedious or grueling or dangerous in favor of work that is more interesting and formative.

Of course, productivity levels in the smaller countries will always owe more to innovations developed abroad than to those they develop themselves. Some might suspect that the domestic market is so tiny in a country such as Iceland, for instance, that even in per capita terms only a very small number of homemade innovations would bring a satisfactory productivity gain--and thus an adequate rate of return. In fact, most of the Continental economies, including the large ones, have been content to sail in the slipstream of a handful of economies that do the preponderance of the world's innovating. The late Harvard economist Zvi Griliches commented approvingly that in such a policy, the Europeans "are so smart."

I take a different view. For one thing, it is good business to be an innovative force in the "global economy." Globalization has diminished the importance of scale as well as distance. Tiny Denmark sets its sights on markets in the U.S., the EU and elsewhere. Iceland has entered into European banking and biogenetics. France has long done this--and can do more of it. But it could do so more successfully if it did not insulate its innovational decisions so much from evaluations by financial markets--including the stock market--as Airbus does. The U.S. is already demonstrably in the global innovation business. To date, there is an adequate rate of return to be expected from "investing" in the conception, development and marketing of innovations for the global economy--a return on a par with the return from investing in plant and equipment, software and other business capital. That is a better option for Americans than suffering diminished returns from investing solely in the classical avenue of fixed capital.

I would, however, stress a benefit of dynamism that I believe to be far more important. Instituting a high level of dynamism, so that the economy is fired by the new ideas of entrepreneurs, serves to transform the workplace--in the firms developing an innovation and also in the firms dealing with the innovations. The challenges that arise in developing a new idea and in gaining its acceptance in the marketplace provide the workforce with high levels of mental stimulation, problem-solving, employee-engagement and, thus, personal growth. Note that an individual working alone cannot easily create the continual arrival of new challenges. It "takes a village," preferably the whole society.

The concept that people need problem-solving and intellectual development originates in Europe: There is the classical Aristotle, who writes of the "development of talents"; later the Renaissance figure Cellini, who jubilates in achievement; and Cervantes, who evokes vitality and challenge. In the 20th century, Alfred Marshall observed that the job is in the worker's thoughts for most of the day. And Gunnar Myrdal wrote in 1933 that the time will soon come when more satisfaction derives from the job than from consuming.

The American application of this Aristotelian perspective is the thesis that most, if not all, of such self-realization in modern societies can come only from a career. Today we cannot go tilting at windmills, but we can take on the challenges of a career. If a challenging career is not the main hope for self-realization, what else could be? Even to be a good mother, it helps to have the experience of work outside the home.

I must mention a "derived" benefit from dynamism that flows from its effects on productivity and self-realization. A more innovative economy tends to devote more resources to investing of all kinds--in new employees and customers as well as new office and factory space. And although this may come about through a shift of resources from the consumer-goods sector, it also comes through the recruitment of new participants to the labor force. Also, the resulting increase of employee-engagement serves to lower quit rates and, hence, to make possible a reduction of the "natural" unemployment rate. Thus, high dynamism tends to bring a pervasive prosperity to the economy on top of the productivity advances and all the self-realization going on. True, that may not be pronounced every month or year. Just as the creative artist does not create all the time, but rather in episodes and breaks, so the dynamic economy has heightened high-frequency volatility and may go through wide swings. Perhaps this volatility is not only normal but also productive from the point of view of creativity and, ultimately, achievement.

Ideals and Reality

I know I have drawn an idealized portrait of capitalism: The reality in the U.S. and elsewhere is much less impressive. But we can, nevertheless, ask whether there is any evidence in favor of these claims on behalf of dynamism. Do we find evidence of greater benefits of dynamism in the relatively capitalist economies than in the Continental economies as currently structured? In the Continent's Big Three, hourly labor productivity is lower than in the U.S. Labor-force participation is also generally lower. And here is new evidence: The World Values Survey indicates that the Continent's workers find less job satisfaction and derive less pride from the work they do in their job.

Dynamism does have its downside. The same capitalist dynamism that adds to the desirability of jobs also adds to their precariousness. The strong possibility of a general slump can cause anxiety. But we need some perspective. Even a market socialist economy might be unpredictable: In truth, the Continental economies are also susceptible to wide swings. In fact, it is the corporatist economies that have suffered the widest swings in recent decades. In the U.S. and the U.K., unemployment rates have been remarkably steady for 20 years. It may be that when the Continental economies are down, the paucity of their dynamism makes it harder for them to find something new on which to base a comeback.

The U.S. economy might be said to suffer from incomplete inclusion of the disadvantaged. But that is less a fault of capitalism than of electoral politics. The U.S. economy is not unambiguously worse than the Continental ones in this regard: Low-wage workers at least have access to jobs, which is of huge value to them in their efforts to be role models in their family and community. In any case, we can fix the problem.

Why, then, if the "downside" is so exaggerated, is capitalism so reviled in Western Continental Europe? It may be that elements of capitalism are seen by some in Europe as morally wrong in the same way that birth control or nuclear power or sweatshops are seen by some as simply wrong in spite of the consequences of barring them.

And it appears that the recent street protesters associate business with established wealth; in their minds, giving greater latitude to businesses would increase the privileges of old wealth. By an "entrepreneur" they appear to mean a rich owner of a bank or factory, while for Schumpeter and Knight it meant a newcomer, a parvenu who is an outsider. A tremendous confusion is created by associating "capitalism" with entrenched wealth and power. The textbook capitalism of Schumpeter and Hayek means opening up the economy to new industries, opening industries to start-up companies, and opening existing companies to new owners and new managers. It is inseparable from an adequate degree of competition. Monopolies like Microsoft are a deviation from the model.

It would be unhistorical to say that capitalism in my textbook sense of the term does not and cannot exist. Tocqueville marveled at the relatively pure capitalism he found in America. The greater involvement of Americans in governing themselves, their broader education and their wider equality of opportunity, all encourage the emergence of the "man of action" with the "skill" to "grasp the chance of the moment."

I want to conclude by arguing that generating more dynamism through the injection of more capitalism does serve economic justice.

We all feel good to see people freed to pursue their dreams. Yet Hayek and Ayn Rand went too far in taking such freedom to be an absolute, the consequences be damned. In judging whether a nation's economic system is acceptable, its consequences for the prospects of the realization of people's dreams matter, too. Since the economy is a system in which people interact, the endeavors of some may damage the prospects of others. So a persuasive justification of well-functioning capitalism must be grounded on its all its consequences, not just those called freedoms.

To argue that the consequences of capitalism are just requires some conception of economic justice. I broadly subscribe to the conception of economic justice in the work by John Rawls. In any organization of the economy, the participants will score unequally in how far they manage to go in their personal growth. An organization that leaves the bottom score lower than it would be under another feasible organization is unjust. So a new organization that raised the scores of some, though at the expense of reducing scores at the bottom, would not be justified. Yet a high score is just if it does not hurt others. "Envy is the vice of mankind," said Kant, whom Rawls greatly admired.

The 'Least Advantaged'

What would be the consequence, from this Rawlsian point of view, of releasing entrepreneurs onto the economy? In the classic case to which Rawls devoted his attention, the lowest score is always that of workers with the lowest wage, whom he called the "least advantaged": Their self-realization lies mostly in marrying, raising children and participating in the community, and it will be greater the higher their wage. So if the increased dynamism created by liberating private entrepreneurs and financiers tends to raise productivity, as I argue--and if that in turn pulls up those bottom wages, or at any rate does not lower them--it is not unjust. Does anyone doubt that the past two centuries of commercial innovations have pulled up wage rates at the low end and everywhere else in the distribution?

Yet the tone here is wrong. As Kant also said, persons are not to be made instruments for the gain of others. Suppose the wage of the lowest- paid workers was foreseen to be reduced over the entire future by innovations conceived by entrepreneurs. Are those whose dream is to find personal development through a career as an entrepreneur not to be permitted to pursue their dream? To respond, we have to go outside Rawls's classical model, in which work is all about money. In an economy in which entrepreneurs are forbidden to pursue their self-realization, they have the bottom scores in self-realization--no matter if they take paying jobs instead--and that counts whether or not they were born the "least advantaged." So even if their activities did come at the expense of the lowest-paid workers, Rawlsian justice in this extended sense requires that entrepreneurs be accorded enough opportunity to raise their self-realization score up to the level of the lowest-paid workers--and higher, of course, if workers are not damaged by support for entrepreneurship. In this case, too, then, the introduction of entrepreneurial dynamism serves to raise Rawls's bottom scores.

Actual capitalism departs from well-functioning capitalism--monopolies too big to break up, undetected cartels, regulatory failures and political corruption. Capitalism in its innovations plants the seeds of its own encrustation with entrenched power. These departures weigh heavily on the rewards earned, particularly the wages of the least advantaged, and give a bad name to capitalism. But I must insist: It would be a non sequitur to give up on private entrepreneurs and financiers as the wellspring of dynamism merely because the fruits of their dynamism would likely be less than they could be in a less imperfect system. I conclude that capitalism is justified--normally by the expectable benefits to the lowest-paid workers but, failing that, by the injustice of depriving entrepreneurial types (as well as other creative people) of opportunities for their self-expression.

Mr. Phelps, the McVickar Professor of Political Economy at Columbia, was yesterday awarded the 2006 Nobel Prize for economics. Click here to read a selection of his previous articles from The Wall Street Journal.

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