Don't Panic: Capitalism Recovers from Financial Crises

William Easterly March 23, 2010

I am just beginning to dive into the awesome book by Carmen Reinhart and Ken Rogoff, This Time is Different: Eight Centuries of Financial Folly. Along with great analysis, they have some wonderful pictures, evidence, and data. What I say here is my own take on it.

First, financial crises are remarkably common. Their Figure 5.1 shows the number of countries that have defaulted on their external debt (one possible dimension of a financial crisis) over the last two centuries. The numbers come in episodic waves of defaults and involve a remarkably high number of countries in each wave:

Second, the global capitalist system does well in the long run anyway. Average per capita income in the world (a shaky estimate, but probably right order of magnitude) increased by a multiple of 12 over 1800-2008, despite repeated epidemics of financial crises.

The US is arguably the country with democratic capitalism the longest, and it also shows a steady upward trend from 1870 to the present, despite repeated banking crises (using those identified by Reinhart and Rogoff), with usually little effect of each crisis on output relative to trend (except for the Great Depression).

Reinhart and Rogoff calculate directly the growth pattern before and after crises in advanced capitalist economies, and growth does indeed recover quickly to the trend growth rate of around 2 percent per capita per annum. 2 percent per capita is roughly the same growth rate that increased US per capita income so much from 1870 to the present.

y-axis reads "Real GDP Growth (Percent)"

I don't mean to minimize the short run pain that the current financial crisis has caused. It's horrible. But there is no reason to panic about the long run growth potential looking forward.

The obvious rejoinder is Keynes' "in the long run, we are all dead." But we can't ignore that Capitalism already survived repeated financial crises and has made us all vastly better off despite them. So here's a counter-quote: "In the long run, we are all better off because our dead ancestors stuck with capitalism."

You make it sound like financial crises are self-correcting, but that does not seem to be the case. In just about every financial crisis since 1825, governments have had to implement some combination of bank bailouts, monetary loosening or fiscal stimulus in order to get things on track again. Except for the start of the Great Depression, when the government sat on its hands for too long, and we know how that turned out. So you could also call this a story of how government repeatedly rescues capitalism from itself.

Jim, Totally agree , such a simplistic and false conclusion by Mr Eastman. The upward curve he show is for the US only. Take a wider sample of countries do the same analysis and see what the curves look like. Then maybe look at different sections of society and see how they have faired in countries with capitalist economies with limited government intervention. Then look at countries with higher levels of goverenment support and service provision to their populations. That would also be interesting!!

Jim and Rachek – Maybe you are both wrong. Correct, governments have always intervened after financial crises. And, correct, crises have continued to repeat. But perhaps the former is the cause of the latter. If governments did not intervene then perhaps creative destruction would teach capitalists the true evolutionary lesson of risk, i.e. extinction. One day we will have to try the theories of Weber, Schumpeter, and Hayek just to see what happens when a society does not respond with Keynesian theory. It’s quite possible that crises might then be smaller and less frequent, instead of ever bigger and ever more frequent. That’s because governments and capitalists would better understand the consequences of bad decisions (extinction).

Nice graphics. But if you read some of Heckman Works, you will see that family environment is very importat in the developing of children. So, arguably, for the most affected family, the kids may not be dead in the long run, but they will be stucked in a bad fate (crime, unemployment, low salaries etc.).

Capitalism yes, but socialism is like hardening of the arteries, harder to “bounce back” Economy needs a “Statin” now !

I disagree with the top two commentators. Almost any economy is going to recover from a financial crisis. The question is, how painful and how prolonged do you want it to be? I think the Long Depression illustrates this beautifully. Due to terrible monetary policy (including not acting as lender of last resort), well arguably a bad monetary system; the Long Depression was, well, long and painful, but we eventually recovered. The goal of good monetary policy is to dampen those fluctuations and making the pain shorter so the capitalist engine can get moving again.

Also, Jim, your history is a bit off. The United States and many European governments were more than willing to let banking panics occur well into the early 1900s. For example, in the Long Depression, it was disastrous how the U.S. let many banks collapse including their own “too big to fail” Cook & Company.

But yes, our economy will recover. Also, I don’t think anyone thinks that capitalism somehow failed because of this crisis. Capitalism has always been a volatile, nasty system, anyone who’s read a shred of economic history can’t honestly contend otherwise. But it also does a lot of good in the world and is thus far the best and most effective system we have found to organize economic activity.

Jim and Rachek, I think you are reading things that I did NOT say into the post. I didn’t say financial crises are self-correcting, and it would be crazy not to attempt to fix specific problems that caused financial crises each time they happen. My point is just that rich capitalist countries have gotten rich IN SPITE OF repeated financial crises (the US is just a representative example, a similar graph could be done for other rich countries). So preventing financial crises is NOT a necessary condition for a society getting rich under capitalism.

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Don't Panic: Capitalism Recovers from Financial Crises

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