Market capitalism is "the engine that runs most of the world economy", wrote Alan Greenspan, the former chief of the US Federal Reserve in his recent memoirs. And the banking crisis is its first big test.
What are the features of market capitalism? Looking only at the last few months, one might suppose that more volatile patterns of consumption have become the rule. One moment we feel richer than ever, we borrow more, we spend more, but then quite suddenly we find that house prices are falling and that signing up for a third or fourth credit card is no longer the answer.
Must we now also expect violent moves in financial markets such as the pound in terms of the euro with the result that last year winter sports seemed pretty good value but this time the ski resorts feel much more expensive? Are runs on financial institutions to become a regular occurrence? Perhaps no more Northern Rocks but on Friday, for instance, Scottish Equitable told private investors in its property funds that they will have to wait for up to 12 months to withdraw their money.
Give notice of withdrawal straight away, I say. Form a queue. When your turn comes, you could still decide not to withdraw. But at least you will have given yourself the option. Is this how things will be, or are they only a passing phase?
The politicians are irrelevant to all this. It is no use Mr Brown, the Prime Minister, saying that he has banished "boom and bust". That thinking belongs to an age when governments had more control over their national economies than they presently have. The fact is that we have just had a boom and now we are experiencing a bust.
And the boom and the bust have been spontaneously created by the financial markets themselves, not by governments. At first I thought, wonderingly, this is a return to 19th-century capitalism. After all, the Northern Rock run was the first since the 1860s. But no, this is 21st-century capitalism, created during the 1980s and 1990s, and become fully formed during this decade.
The history is important. The story is well told in "Capitalism unleashed" by Andrew Glyn, the Oxford economist who died a few weeks ago. In the 1950s and during the first half of the 1960s, countries such as the UK enjoyed an unprecedented boom – low unemployment, little inflation and rapidly growing living standards. Glyn argued that the very success of this golden age seems to have undermined its basis. Full employment had unduly strengthened the labour movement, high demand had pressed against the limits of available energy sources, Japan and Europe had nearly caught up with the US and put the system of fixed exchange rates under pressure.
And so everything unravelled in the second half of the 1960s and the 1970s – strikes became commonplace, oil prices began their sharp rise, inflation shot up, unemployment rose to its highest level since the 1930s. The so-called misery index, the inflation rate plus the unemployment rate, showed very high readings.
In the 1980s came the counter revolution. Reagan was in the White House, Mrs Thatcher was in 10, Downing Street. Interest rates were sharply raised to squash inflation. Never mind the additional unemployment that was the immediate consequence, it would come down when the job was done. And thus it happened. The monetarists were right. But this wasn't yet market capitalism. That required two further policy changes, privatisation and deregulation.
In particular, it needed liberalisation of financial markets. Exchange rates could no longer remain static but must float freely. Fixed commissions must be abolished. Restrictions that confined financial firms to particular activities must be lifted so that, for instance, building societies could do banking and banks could provide mortgage loans to home buyers.
And again, the theory of the counter-revolution proved to be correct. Innovation by financial institutions was indeed stimulated. New ways of splitting up risk and spreading it widely were devised. Schumpeter's notion of "creative destruction", was right. He had argued – 40 years earlier – that a market economy would incessantly revive itself from within by scrapping old and failing businesses and then reallocating resources to newer and more productive ones. And so, broadly, it has turned out.
Except that no sooner had market capitalism been developed than it received an inflow of funds so huge that it has hardly been able to cope. There has been a cascade of surplus savings from fast-growing emerging economies such as China and the smaller Asian countries, to which has been added the unspent funds of oil producers benefiting from high energy prices.
Only about half of the savings of these countries is employed locally; the remainder is injected into the financial markets. It is this big increase in world liquidity which has driven down interest rates. Estimated world financial assets grew from one times the value of global output in 1980 to three times in 2005. As one banker, looking back to the months before the crisis broke, said recently, "liquidity was free. You could get liquidity at the local drug store".
But before noting the abuses that have been generated by all this liquidity slopping around, it is important to state the benefits. Economists refer to the Great Moderation, the long period of growth lasting some 15 years since the early 1990s, accompanied, as it has been, by low interest rates, subdued inflation and enhanced levels of employment, a new golden age if you like, interrupted only at the turn of the century by the dot-com episode.
Ample credit increased house prices in many countries. These capital gains then provided the backing for further borrowing, which consumers could use to finance purchases of cars or holidays. For the time being, consumption by individuals became the motor of economic expansion.
Now all this is threatened, if only in the short term, by the foolishness, the greed and the occasional dishonesty of the very people who direct the banks, the core institutions of the market capitalism. Bankers have contrived to transact business in such a manner that it is beyond the scope of regulation. That is why descriptions of the crisis refer to "shadow" banking and will soon mention "shadow" insurance.
At the same time, their remuneration arrangements reward the amount of business they do without regard for its quality. As a result, bankers find themselves in a very severe crisis. These faults will have to be rectified; if not, the system itself will be called into question.
Glyn, a Marxist, would surely have argued, as he did convincingly in the case of the post-war golden age, that market capitalism already exhibits the features that will lead to its replacement. Is this right? That is the big question that now stands to be answered. And that is why, so far as the economic life of nations is concerned, we live in historical times.Reuse content