An Apology for Democratic Capitalism

Until 1989, the most underreported fact of the twentieth century was the death of socialism. Socialism as an economic idea had died, in fact, long before the collapse of the Berlin Wall that November. By the late 1970s, no serious national leader in the developing world was leading his country down the socialist road. By the early 1980s, China had embarked full-tilt on the capitalist road, and India was lowering taxes on the profits of rice growers in order to encourage maximum production.

Throwing off Fabian socialism in India and the stark economic socialism that had so depleted China, these countries would go on to move some 500 million persons out of poverty in just two decades. Today, satellite maps of nighttime India blaze with the lights of countless industrial towns, and China has suddenly become one of the great economic powers of the world. Its leaders proudly boast of their capitalist thrust forward. Premier Wen Jiabao invokes Adam Smith to chide Western questioners: The cause of wealth is enterprise.

True, Cuba still clings to the tatters of a socialist economy, while grudgingly and slyly slipping into capitalist gear. A growing number of Latin American caudillos slide back into the old patterns of anti-American insults, military bluster, the smashing of internal dissent, and the steady aggrandizement of the Leader by submitting virtually every economic entity to his control. “Real, existing” socialism, in a word, still has its nutty devotees. Few doubt the quite predictable economic outcomes.

That, at least, is the usual way the story of the end of socialism is told. But the sharp declines of the world’s stock markets during the fall of 2008 spurred gleeful boasts among the previously dormant socialists in America and Europe that the “end of laissez-faire capitalism” had at last arrived—again. During those same weeks, Western Europeans gloatingly pointed out that there was more than one sort of democratic capitalism. (Even in the European homeland of social democracy, democratic capitalism seems to have become a positive phrase.)

It is, of course, somehow indispensable for Europeans to find Americans inferior. The Guardian's Timothy Garton Ash imagines what his fellow Europeans think: “Ah! If only you Americans had adopted our nice, humane, equitable version of social democratic capitalism!” Then Ash remembers, “But against any easy claim of superiority, we have to remind ourselves that most European economies are struggling to generate jobs, innovation, and entrepreneurship as the American economy has succeeded in doing for much of this quarter century.”

Meanwhile, in the American Catholic magazine Commonweal, Daniel Finn praises some of The Spirit of Democratic Capitalism, my 1982 book on the topic—only to urge me now, in light of the economic downturn, to disown the views of such friends as Robert Sirico and Sam Gregg at the Acton Institute (whom he wrongly calls libertarians). Finn, I think, misconstrues the three sentences of Fr. Sirico’s that he quotes, and Sam Gregg, a prize student of John Finnis, prefers to be called a Whig—a descendant of the party of liberty and civic virtue. In any case, Sirico and Gregg can take care of themselves in argument. But it does seem that a debate—between those who interpret Christian social thought in a social-democratic idiom and those whose idiom is that of the Austrian School of economics—would go a long way toward establishing a richer vision of Catholic social thought. My aim in 1982 had been to set The Spirit of Democratic Capitalism right at that crossroads.

I wish that over the past twenty-six years I would have had the wit to copyright the term democratic capitalism. With a nickel for every use of it, my retirement fund would look a lot better than it does. The appearance of the term has actually increased these last few weeks, though mostly in the context of announcing the death of democratic capitalism—announcements mostly by writers who were reluctant to acknowledge its birth.

What on earth is happening? Is democratic capitalism dead? Has socialism in fact come back to life? Let us try to establish some common ground, without arguing terminology or rival political-economic visions at this early point. I think we can take it as agreed that human flourishing requires at least liberty from torture and tyranny in the political order; liberty from the prison of poverty and hunger in the economic order; and, in the civic, cultural, and moral order, liberties of conscience, thought, word, inquiry, science, the arts, and association. A free society consists of three interdependent systems: the political, the economic, and the moral, each aimed at securing one of these kinds of natural liberties.

If we look at the crisis of 2008 under each of these headings, we find serious errors committed by and within each one of these systems. The core of the crisis lay in the field of mortgages—more precisely, in the foreclosures of just over 5 percent of all home mortgages over the past year or so. This sometimes meant as many as nine thousand foreclosures a day.

Beginning with the Community Reinvestment Act of 1977, the political system helped create this mess. The aim was a noble one: to put as many poor people in homes as possible. And it had its early successes, with more than a million poor people coming to own their own homes for the first time. Indeed, in the 1990s (under the leadership of Franklin Raines and Leland Brendsel) Fannie Mae and Freddie Mac—mortgage lenders secured by government commitments—were given this as their leading purpose.

This was a goal I had shared since at least my 1971 book The Rise of the Unmeltable Ethnics, and I applauded Fannie Mae for this achievement—despite the foresight of my colleagues at the American ­Enterprise Institute who warned of the eventual costs to the nation. Many in Congress cheered as well, but gradually they did more than cheer. They began to violate age-old banking cautions and practices: forbidding mortgage lenders to demand down payments or to do strict scrutiny of the ability of new borrowers to make regular mortgage payments. They also made mortgage lenders subject to lawsuits—by special-interest groups and pressure groups—if they insisted on what for generations had been thought to be due diligence.

These decisions attracted swarms of speculators to new homes to take advantage of these wholly new and unheard-of incentives. A great many mortgages were granted to well-off people who made use of the incredibly lenient terms to buy or build extra homes for re-sale. Many economic conservatives warned against this Ponzi scheme. Several attempts by Republican members of the Congress to introduce serious reforms were rebuffed by the friends of Fannie Mae and Freddie Mac in Congress, who insisted that the financing of these two enterprises were sound and safe: Barney Frank, Maxine Waters, and Christopher Dodd, prominently, with many others joining in.

Independent investigators at last inspected the Fannie Mae accounting books, and massive irregularities were discovered. Top leadership was obliged to resign. But fundamental regulatory changes were blocked. The loose, unregulated practices, defended in the name of noble intentions, were allowed to stand. In a crucial way, the mortgage crisis of 2008 was initiated by specific acts passed by Congress and fiercely defended against detailed warnings about the dreadful consequences to come. All those warnings were dismissed as politically motivated, but they turned out to be ­accurate.

If that was the failure in the political system, the economic system also accrued an immense array of failings. First some too brilliant Wall Streeters got the clever idea of buying Fannie Mae mortgages and packaging them to sell in large bundles. Financial institutions around the world eagerly bought them up—for what could be safer than mortgages backed by the American government, as those of Fannie Mae uniquely were?

The trouble is that, once Fannie Mae mortgages were bundled, no one could tell which ones had high probabilities of default. Once home prices started to fall, sometimes from overheated speculation by those who thought home prices would continue going up, purchasers had to sell off their mortgages at a loss (or go into default) in order to cover their losses.

Meanwhile, other clever Wall Streeters had invented a new type of investment of Olympian sophistication: derivatives. These new packages further blocked transparency into what exactly investors were buying. By this point, nearly all who had invested in these packages of mortgages could not tell which of them held the highest number of rotting oranges in their sack. At bottom, the financial crisis was precipitated by a mortgage crisis, which the geniuses on Wall Street made far worse than it might otherwise have been. Both the political system and the economic system failed the nation.

So did the moral and cultural system. While home prices were rising rapidly over the past fifteen years, ballooning the net worth of millions of homeowners, none of those who benefited complained. For my part, I judge now that I should have known earlier that something was wrong and that this was all too good to be true. It seemed petty to complain as the good times rolled in: Maybe things just work out that way, I rationalized. Instead, morally, we should all have been suspicious. I, for one, wasn’t.

In the pages of the Washington Post, E.J. Dionne wrote just before Election Day that the triumph of the Democrats would mean the end of the age of deregulation, laissez-faire, and tax cuts. Perhaps that’s true, but what does it mean?

In the case of the mortgage crisis, Democrats blame the Bush administration’s commitment to deregulation. Yet the facts do not bear them out. It was the Democrats who blocked the regulation of Fannie Mae and Freddie Mac, and the Republicans insisted that the regulation of these two government-sponsored enterprises was essential.

Most emphatically, regulation that establishes rules without biasing outcomes (like the rules for football or baseball) is necessary for the common good. But regulation that grants undue powers to the government, puts the bureaucrat’s thumb on one side of the scales, or weakens the balance of power between one competitive actor and another is unjust. More, it’s damaging to the economy.

Then, too, regulation that places the government in the position of being easily bribed or influenced by one party is dangerous for the liberties and rights of citizens. All those who argue that lobbyists are the source of corruption are overlooking the role of government in accruing unchecked powers of favoritism. When government has the ability to place its heavy finger on one side of the scales, it invites massive lobbying by all involved. Lobbies wax and wane in proportion to the unchecked powers the government—particularly through the staff-level writers and enforcers of rules—claims for itself.

Out of this aggrandizement is fashioned the famous “iron triangle” of government regulation. Lobbyists and interest groups stir up public opinion demanding action this way or that; the legislators bend to the winds of this pressure; the congressional committees and their friends in the bureaucracy write the immensely detailed and arcane rules that, with little oversight, put legislation into practice. Thus does the behemoth of government bureaucracy suffocate economic creativity, competition, and the invention of new products and new industries that lead to prosperity.

Furthermore, the U.S. government has never truly been informed by laissez-faire principles. From the beginning there were import laws, export laws, tariffs, and other restrictions on trade. The question is not only how much regulation there ought to be, but what kind. The criterion ought to be what, serving the creativity of the private sector, adds to the common good and steadily raises living standards. Further, it is humane and wise to pay special attention to raising the living standards of those in the bottom 20 percent. That is the goal of democratic capitalism: Think for a moment of the proportion of the American poor who own their own automobiles, television sets, and who receive a multiplicity of welfare benefits beyond the imagination of their ancestors.

We live in an age when economic growth is not only possible but a kind of moral imperative. (What sort of government would announce that its people are poor, and that it intends to keep them that way?) Moral approval thus goes to nations that better lift up the poor in their midst. In Asia, the turn to the capitalist way has raised up more than a half billion human beings out of an immemorial poverty just in the past twenty years.

The United States continues to raise millions of its poor people out of poverty, not least among them the ten to twelve million immigrants who arrive in this country nearly penniless and often not knowing the language or the customs of the place. The nation’s poverty rolls remain more or less constant precisely because of this steady annual influx of the poor. But a great many of the individuals who are statistically counted among the poor continue to enter at one end and to graduate from the other, no longer poor, within five or ten years. (Worrisome exceptions are unwed mothers and children born out of wedlock: Some escape from poverty, but others seem trapped in that cycle from generation to generation.)

In any case, if you add up all the money that Congress has designated for the relief of the poor, the total turns out to be more than would be required simply to give every poor family some $30,000 in cash per year. Another way to look at it: Most of the American poor already have significant income, if not quite enough to lift them above the poverty level. If one calculates the gap between the financial benefits they already enjoy and the full sum that would lift them above the poverty level, it turns out to be a much smaller amount than is currently designated to be spent for their benefit. As the economist Thomas Sowell writes, to try to feed the swallows by feeding the horses is an immensely inefficient way to get help to the swallows. The middlemen in poverty programs often fare far better than the poor. Direct cash grants might be far more efficient.

Those on the political left often fantasize about helping employees by punishing employers. Similarly, they fantasize about taking in more revenue from the rich by increasing the tax rates on wealth. (For practical purposes, what level counts as rich necessarily gets calculated on a slippery slope downward into the middle class.) Consider this: Under Ronald Reagan, tax rates were reduced on the highest income bracket from 70 percent to 28 percent. This reduction did not cause revenues from the rich to fall. On the contrary, the rich under Reagan ended up paying a vastly larger amount of revenue in taxes than ever before, and a significantly larger proportion of all taxes paid.

Of course, this was a winning situation for them. The more they earned, the more they paid in taxes, but, at rates reduced to 28 percent on the new dollars coming in, that was for them a good deal. Besides, the rich can neither eat the wealth their creativity brings them nor can they take it with them. They invest a great deal of this surplus in further economic projects and give substantial amounts to charity. In 2006, for example, the last reporting year, the top 10 percent of income earners paid about 71 percent of all income-tax revenues received by the IRS. The top 50 percent paid about 97 percent. A bit less than half of all households paid no revenues at all into the IRS. Some did pay social-security taxes, but these are actually enforced savings for their retirement years. Many, or most, will receive far more in retirement benefits before they die than they actually paid into the system.

In other words, if we stipulate that the new administration will do as it promised, raising the tax rates of the rich, we can expect with high probability that the revenues actually paid into the IRS by these same rich will decline. President Clinton managed to avoid this effect for a large part of his administration—since the tax hikes he imposed were modest and he benefited by an enormous peace dividend from the fall of the Soviet Union. Today’s foreign-policy threats are different, and tax plans announced so far by Obama’s spokesmen are more massive. The sharp leap in social-security taxes to be levied above the former limit of $92,000, for instance, will add another dozen or so percentage points on current tax rates for the middle class earning above that limit.

We may reasonably predict that the present hopes of the left for more revenues from the rich, in order to fund the additional billion dollars of social programs promised in their agenda, are unlikely to be satisfied. To acquire such revenues, they will have to tax downward into the middle class. The effect will be to reduce job creation, incentives, and capital investment. In other words, we can expect a sharper degree of economic decline than would otherwise happen.

The estimable Steve Forbes recently wrote in Forbes magazine that the last twenty-five years have been the most prosperous in the history of the world, particularly in one overlooked respect: During this period, between a half billion and a billion of the poor have seen the shackles of their poverty cut away. However tenuously, they have moved upward into the middle class, and the new aggregate demand for goods and services they exert is everywhere visible in the quantity of economic activity in the world today, as opposed to twenty-five years ago. The world’s new target, I would add, is to lift another billion persons out of poverty during the next twenty-five years.

Forbes also suggests that even in the United States, despite many economic mistakes (which Forbes protested against month by month) committed by the U.S. government, two favorable achievements must be acknowledged. The number of Americans actually employed has risen by nearly ten million since the year 2000. Further, the economy, despite the heavy blow it suffered after September 11, 2001, has added to its own national product since 2002 an amount larger than the entire GNP of China. Regarding the current downturn in the markets, Forbes predicts (and no one has a better record for successful public predictions over the past thirty years) that market values will start turning upward by the spring of 2009. And on the other side, if Mr. Forbes turns out to be wrong, to what other system can the world’s poor turn for their liberation?

Let me conclude by asking: What if Forbes is even roughly correct? Then the present downturn will not turn out to have been as deep or as permanent as the prophets of gloom had said. The road will probably be quite bumpy for some months, Forbes predicts. But this should also turn out to be a favorable moment for investing at bargain-basement prices in the products and technologies of the future.

In sum, the search for liberty from poverty, liberty from torture and tyranny, and the power to do what one ought to do (which is how Lord Acton described true liberty) is almost certain to be intensified. Democratic capitalism’s capacity for self-correction, by the fairly rapid punishment of its own misuse, is not the least of its attractions.

At a state dinner in Washington a few years back, I was seated next to the new economics minister of China, a beautiful woman with a razor-sharp mind. Tentatively, I turned to her: “What do people in China think about Marx these days?” She pushed back her chair abruptly. “Mr. Marx is very old and very dead. We do not think about Mr. Marx.”

With her, I am happy to note that, as an economic policy, socialism remains very dead. Lilliputians may tie capitalism down with a thousand threads. But when serious people wish to create new wealth and to raise the poor out of poverty, they make sure to let capitalism do what it alone can do.

Michael Novak, a member of the editorial board of First Things , holds the George Frederick Jewett Chair in Religion and Public Policy at the American Enterprise Institute. His most recent book is No One Sees God (Doubleday, 2008).

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Image by Anthony Quintano licensed via Creative Commons. Image cropped.