By Idries de Vries
The credit crisis of 2007 and 2008, which has since then morphed into a global sovereign debt crisis, has shown fundamental flaws in the economic system of capitalism. This does not necessarily imply the end of capitalism, however, as some have speculated. For this to happen, the Arab Spring must complete its natural course, which is the implementation of the systems of Islam.
Capitalism, as an ideology, is the fruit of what in the history of philosophy is known as the Age of Enlightenment. The Age of Enlightenment developed in 17th century Europe following centuries of despotism by consecutive rulers who ruled Europe and its people with an iron fist solely for their own self-interest as the realization grew that this state-of-affairs was directly linked to the ideas on which society had been organized.
These ideas were the ideas of the Church. It taught the European faithful that God had bestowed earthly power on the king just as He had given spiritual power and authority to the pope. Obedience to king was therefore demanded by the Church from the believers with eternal hellfire being the threatened punishment. Ideas such as these left the European kings free to do as they willed, causing the life of the ordinary people to be characterized by economic exploitation and religious and political oppression.
Various thinkers therefore began exploring the possibility of organizing life according to different ideas. The Dutch philosopher Hugo de Groot (1583 – 1645), better know under his Latinized name Grotius, set Europe on a new path when he argued that life did not have to be organized based on the religious prescriptions of the Church. Before Grotius, the Church had argued that only God knew the correct way of life for human beings since He had created them. Grotius, however, argued that the human mind was also capable of finding this “natural way of life”.
Following this philosophical breakthrough, other thinkers began the exploration to find this natural way of life using only the human mind as a guide. Thomas Hobbes (1588 – 1679), Baruch de Spinoza (1632 – 1677) and John Locke (1632-1704) were amongst the first to argue that personal freedom for all individuals was a requirement for the “natural way of life”. According to Spinoza, for instance, the fact that humans have the ability to reason meant that it was only natural for humans to organize their lives on the basis of their minds. Hobbes argued that the needs and desires of individuals differ, and that since only the individual knows what his personal needs and desires are, humans must be left free to decide and act as they see correct to enable them to live in accordance with their own personal nature. Locke further argued that since all men are created equal, nature would have it that no one dominates others and that all are free to decide and do as desired. Under influence of these (and other) thinkers, personal freedom became seen as the natural way of life.
Adam Smith (1723 – 1790) then became the “father of modern economics” when he argued that in the economic life of man too, personal freedom is ideal. Before Smith, the Church had argued that the pursuit of self-interest was a vice and that people should be restrained from acting based on pure self-interest. Smith, however, argued that self-interested competition in a free market would provide the people with what they want at the lowest possible prices: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” This is the core of Smith’s “Invisible Hand” theory – the pursuit of self-interest is natural for man, and if allowed, society will benefit from it. (Smith should therefore really be considered the “father of capitalist economics” rather than the much more general “father of modern economics”. This is too much credit as it is well known that before him, many other thinkers had developed deep thoughts on the economy and the economic life of man.)
In 2007, this economic system which grew out of the philosophical ideas of the Age of Enlightenment—the capitalist economic system—crashed because many of the world’s premier financial institutions confessed they were in big trouble. Here is what had happened…
America’s free market economy had for decades concentrated ever larger amounts of wealth in the hands of the already wealthy, leaving the masses in society with ever less. Seeing a potential for profit, America’s banks had responded to this trend in the capitalist economy by providing the masses with loans, such that they could at least give the impression that the poor too were getting richer.
The banks then came up with an idea to minimize the risk to their organizations. After handing out a loan to a customer, they would sell this loan on the financial markets. The bank would give out a loan for, say, $100 at 10% interest to a customer, and then turn around and immediately sell this loan to an investor for, say, $105 who would then over time collect the $110 in interest and repayment on this loan. This way, giving out loans guaranteed profit for the banks. From their perspective, brilliant indeed!
But the banks were not yet done. They came with another brilliant idea which they named “securitization”. Rather than selling individual loans, the banks sliced a loan up into small pieces, packaged various small pieces of different loans together, and then sold these packages of small pieces of various loans. According to mathematics, namely, such debt-packages carried less risk than individual loans. So the banks could charge a higher price for a debt package than for an individual loan. (Of course, this securitization also made it virtually impossible for anyone other than the banks to properly evaluate the risk associated with the debt-package which helped the banks maximize the selling price of the loans even further!)
American banks made billions doing this. So they kept the loans flowing, and household debt in America kept growing.
Although mathematics said that the chance of a mass default on the outstanding loans was essentially zero, in 2007, millions of Americans nevertheless stopped paying interest and repayment. Their debts had become so high compared to their income they simply could not afford it anymore. Once this became know, billions of dollars worth of debt-packages lost all their value. For who would buy the right to receive interest and debt repayment if no-one was paying them? This brought the financial industries of America and Europe who had invested in the debt-packages to the brink of bankruptcy. Some financial institutions lost billions as they had to write down the value of the debt-packages in their possession. Others lost billions as they had promised to pay the buyers should the debt-packages decrease in value. Some lost further billions as they had taken out loans using these debt-packages as collateral. The sudden decrease in the value of the debt-packages triggered an “immediate loan repayment”-clause on these loans, forcing them to scramble for money which they could only find at much higher interest rates. This limited the ability of the big financial institutions to loan out money, while the need in the financial world to borrow money went to an all-time high. In other words, the financial sectors of America and Europe were on the brink of collapsing.
So the governments of America and Europe intervened. They borrowed large sums of money from their central banks to help their financial institutions meet their obligations. In addition, the central banks of America and Europe made loans available to the financial sector at ultra low interest rates. This removed from the financial sector the existential problem caused by unsustainable household debt.
Bank of America
Royal Bank of Scotland
State Street Corp.
JP Morgan Chase
Hypo Real Estate
Belgium / Netherlands
This is an overview of the amounts borrowed by the world’s main financial institutions from the American central bank, the Federal Reserve, at the height of the crisis. It is an indication of the need for money in the world financial sector at that moment. (See Bloomberg, “Wall Street Aristocracy Got $1.2 Trillion in Secret Loans”, www.bloomberg.com/news/2011-08-21/wall-street-aristocracy-got-1-2-trillion-in-fed-s-secret-loans.html.)
Understanding the credit crisis of 2007 to 2008 in light of the philosophical underpinnings of the capitalist economic system makes clear that this crisis was an internal one. The capitalist economic system got close to collapse not because of some external force such as a natural disaster or an invasion of aliens bent on taking over the world, but because all the participants in the system followed what they thought was their own self-interest. It was the outcome of the natural workings of the systems.
It is a proof, therefore, that the ideas on which this system is build—the idea that the human mind can correctly determine man’s interests, and the idea that the individual pursuit of self-interest will benefit society—are incorrect. The further fact that crises like the credit crisis of 2007 to 2008 happen again and again in the capitalist economic system—the Great Depression of the 1930s, the Latin American Debt crisis of the 1980s, and the Asian Tiger crisis of the 1990s all resulted from a similar chain of events—is therefore a proof that this system is unfit to organize the economic life of man. The errors in the foundation of the capitalist economic system simply have too big of a consequence.
Indeed, some argue the other way round. They say the fact that the capitalist economic system has come through crises such as the credit crisis before is a proof of its resilience rather than of its weakness. So while they might agree that the capitalist economic system has flaws, they argue these flaws are not of fundamental importance. They therefore suggest some tweaking of the system, to proceed again from there as if nothing happened.
The fault in this argument is the assumption that the problem that caused the credit crisis has been resolved. It has not, however. In fact, the problem that caused the credit crisis in the first place, has only grown.
America and Europe increased government debt to support their financial sectors. This kept the financial sectors on both sides of the Atlantic Ocean alive, but deeply frightened by recent events they did change their operating modes. The banking sector is now more cautious when lending out money. And the other players in the financial sector are now more cautious when investing (in effect, when making money available to the banks). This has limited the ability of consumers to consume and of investors in the real economy to invest, reducing economic activity. America has responded to this by further increasing its borrowing, to enable increased government expenditure as a compensation for this secondary effect of the credit crisis. As a consequence, aggregate debt in America has continuously increased since 2007. The Europeans, on the other hand, are in the process of cutting back on government expenditure in order to meet the obligations associated with their now increased debt pile. This will of course only add to the reduction in economic activity. And this reduction in aggregate income will reduce the ability of the Europeans—private individuals, corporations and governments—to meet the demands of their debt.
It is clear, therefore, that a return of the events of 2007 and 2008 will not be avoided by a little “tweaking of the system”.
The only thing that can get the capitalist economy out of trouble is substantial deleveraging, i.e. a significant reduction in the share of debt in the economy. This can be done in one of two ways. Firstly, a reduction in the amount of debt outstanding will reduce the share of debt in the economy. Secondly, growth of the economy can reduce the share of debt in the economy.
However, neither in America nor in Europe can practical ideas be heard about how to grow the economy without adding more debt to the system. Those that argue for economic growth as a way out of the crisis only see increased government debt-based spending as an option and solution.
The only realistic option America and Europe have at the moment, therefore, is the tried-and-tested method of mass bankruptcies which got capitalism in the west through the Great Depression and capitalism in the east through the Asian Tiger crisis. It is the “resetting” of the economy to enable a new start. Though again an option, in today’s world the mass bankruptcy solution comes with an additional problem – from the perspective of the capitalist world, that is.
It is well-known from history, namely, that this solution to a debt crisis comes at immense social cost. The massive and intense poverty caused by the Great Depression and Asian Tiger crisis is easily recalled. Massive and intense poverty motivates the masses to search for an alternative economic system. (In fact, the global Occupy Movement is proof that this search has already begun while the bellies of most people are still full!) For mass bankruptcy to realize its goal, therefore, it is vital that during the transition stage, the masses do not become convinced by an alternative economic system. For, if they do, a revolt would result. And if the recent protests in Greece are anything to go by, the power of a revolt during a Great Depression-like economic situation would most likely be all-overwhelming. It would result in the replacing of capitalism with an alternative system.
This may bring about the west’s greatest fears. Current events like the Arab Spring have the potential of causing the end of capitalism. If the Arab Spring reaches it natural destination—being the implementation of the system of Islam including the Islamic economic system—before the reset of the capitalist economies is completed, then during their deep suffering, the masses in the capitalist world will be able to see an alternative system in action. They will then be able to witness an alternative system that provides real economic well-being, for all—not just for an elite—and lasting—not just in between crises. And if anything convinces people of ideas, it is the witnessing of the success of these ideas.
It is in the hands of the Muslims, in other words, whether capitalism will survive its current crisis or not.
Idries de Vries is an economist who writes on economics and geopolitics for various publications. As a management professional he has lived and worked in Europe, America and Asia.