20 October, 2017

Inherent Weakness Of Capitalism

By Hema Senanayake

Hema Senanayake

Hema Senanayake

Global Economic Revolution Is Overdue; Part 8

China’s economy is slowing down. Is China on the verge of economic collapse? This is the talk of many financial capitals around the world with the dawn of the year 2016. About eight years ago two largest economies of the world namely the EU and the United States collapsed in 2008. By 2008 the third largest economy by that time namely Japan has already been experiencing an economic crisis which triggered in early 1990s, even after launching a few rounds of Quantitative Easing.

By 2008 none suspected that Chinese economy would face severe problems some eight years later. The common element of all these crises was and is “debt” no matter countries carry trade surpluses or deficits. Capitalism globally is in a true crisis. This is a fair conclusion when all four largest capitalist economies of the world collapsed or faced with severe problems within a time span of two decades. What is the problem in capitalism?

There is one significant inherent weakness in modern Capitalism. If any socialist system or any other economic model if available, accepts the use of money as a unit of measure of the value of economic produce, then that system too would inherent the same weakness. There is virtually no political revolution which can remove this inherent systemic weakness.

That weakness cannot be removed by narrowing the gap between the rich and poor. However, narrowing the gap between the rich and poor is a necessity but is a different story. Also it cannot be removed by having a global balance in international trade. Yet, it can be theoretically removed by two methods.

One method is to create debt-free money by a designated government authority while stopping the operation of Fractional Reserve Banking System which system we use today. In this method stopping of fractional reserve system is a must. In an economic system in which Fractional Reserve Banking system is used as its core banking practice, most of the money is created as a monetary substitute known as “credit money” during the process of lending by commercial banks.

Under the first method we will stop the creation of “credit money” instead debt-free money would be created by the government. In other words under this method the government does not need to borrow money instead any possible budget deficit is financed by the new money created by the government. The founder of monetarist school of economics Milton Friedman in the latter part of his life has been said to have supported the idea of the creation of new money by around 3% per annum while having done away with fractional reserve system.

The second method is that we accept the use of fractional reserve system but develops a policy tool to regulate the creation of what is known as “credit money” while deflating systemic debt proactively time to time.

The above are the two possible solutions to resolve the most important inherent weakness of modern capitalism. Yet, what is this particular weakness which pulled down the four largest economies of the world within two decades? The weakness is that there is a systemic inability to put the demand-and-supply equilibrium at total output level without creating non-repayable component of debt in the economic system including the global system. This was revealed by a piece of economic theory defined as “System Gap Theory (SGT).”

The demand-and-supply equilibrium is an important thing in the economy. This is not difficult to understand. For example let us assume that a producer produces a certain consumable product. He expects that consumers will buy what he offered to the market. If consumers did not buy, the producer cuts back his volume of production, which leads to an economic recession because reduction of output is defined as a recession.

However, the demand-and-supply equilibrium takes place in three different output levels. First, the said equilibrium takes place at increasing output levels year after year. When that happens we identify it as a growing economy. Second, when the equilibrium takes place at decreasing output levels quarter after quarter then we identify it as a recessionary economy. Thirdly, the equilibrium takes place at constant output levels year after year, and then we name such an economy as a stagnant economy. However, the SGT explains that the said equilibrium in all three situations take place with the creation of non-repayable component of debt in the economic system.

However, this weakness has temporarily been resolved under many variant of Keynesian economic theory by creating a systemic push for extreme consumerism. In fact what it does is postponing the crisis rather than resolving it. This was clearly understood by 2008 through the System Gap Theory. Accordingly, SGT predicts that all major economies would collapse if non-repayable systemic debt is not removed periodically. Let me quote that particular paragraph written in August 2012.

“SGT explains that after a period of economic growth, if the private consumers are not in significant debt, then the government should be. And if both the private consumer and the government are not in debt significantly, then the System Gap must be filling from the income derived from the stock and derivative market, which means there should be a bubble in the stock market with heavy debt on holders or holding companies of stocks and derivatives. If nothing of above is happening, then it must be an immature economy that is expanding by reinvesting the expanded capital and producer credit, mostly producing goods and services that do not satisfy the demand of immediate consumption. In all former scenarios except the last scenario, the economic system should crash sooner than later if partial debt cancellation does not take place proactively. In the latter case, the economy would fall into any one of the former scenarios as the economy grows.” (Page 111; “Occupy the solution not Wall Street – Managing Systemic Bad Debt with SGT”, August, 2012).

According to conclusions mentioned in the above quotation, it is quite clear that China should experience the same crisis experienced by its peers the U.S., the EU and Japan. After the Great Recession of 2008, there is a growing movement in Europe which demands/proposes to adopt the first solution mentioned above. However, I do not support that idea because it removes a lot of flexibility exist in the economy.

Instead, I favor the second solution. By knowingly or unknowingly that is what the United States is going to do. They, including some capitalists like Nick Hanauer, suggest increasing the minimum wage by almost 100%. If they do that, there could be a moderate inflation in short term, but that action would deflate systemic debt significantly. That will pave the way for another growth cycle. Economists with wisdom must now explore which solution is the best to sustain the global production.

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Latest comments

  • 0
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    For Sri Lanka, it is simple : The LKR must go down to its most realistic level against the dollar, and Lankans must live accordingly, and in line with the country’s true worth. No more of credit money-creation, that higher-ups embezzle, leaving the struggling Masses to for.

    Forcing the LKR to rise to the US$ level by destroying the natural structure and heritage of the country through a megapolis and/or land bridge deal, will only put Lanka in a perpetual hole.

    People should not be packed like sardines into a hot and polluted megapolis, for so to uphold the US$ and Pound-Sterling. But we can live within our own money, and own culture, and our wealth will increase slowly and surely.

    Sri Lanka can borrow on credit from places like the IMF, for island-wide transportation services that can create the multiplex livelihood, combining the urban and rural sectors. Such IMF loans will be easy enough to pay back, with no stress on the citizen.

  • 1
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    Well, capitalism was born when man learnt how barter something they own to something they do not have. Just like particles make matter, supply and demand makes economic systems.

    However, there has be a balance in the cycle. The two ends need constant re-balancing. Most countries apply a break by raising interest rates when supply gets too high for example. That applies a brake and a correction takes place.

    What China did was supply more than there is a demand. There are entire brand new cities in China that are unoccupied. There is simply no demand for it. This is the same economic model Rajapske followed.

    In order to generate wealth they kept supplying without keeping at eye out for the demand end of the cycle. So there is large excess that will take time to balance itself. Its simply a correction.

    The consumers who got rich from the supply cycle now need to go and consume their own excess.

    So its not a flaw in Capitalism but how its applied.

  • 1
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    Mr Hema,

    There is an animation video to explain Fractional Reserve System. Is there such a video explaining what you discuss and if not, I suggest you get an IT person to make one so that more people will graphically understand what you say. Could we implement these in our country with the concurrence of the government?

    • 0
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      Your suggestion is well noted. Next article will be my last piece in this series. Subsequently, I will further develop and elaborate the ideas/theories written in this series and would compile a book.

      Sri Lanka can implement these ideas. But it needs to develop certain new monetary and fiscal policy tools based on proper economic theory. Thanks.

      Hema

  • 1
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    In capitalist systems man exploits man
    In communist systems it is the other way around

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