Is there a crisis of capitalist democracy?

Richard Posner’s recent book, ‘The Crisis of Capitalist Democracy’, is mainly about the global financial crisis, how it came about in the US, the lessons that the author thinks we should have learned from it and what governments should do to prevent similar crises in future. According to this distinguished author the crisis came about because of lax regulation; we have learned from it that the financial system is inherently fragile and that Keynes is still relevant; and the way to avoid similar crises in future is to introduce regulatory reform in the financial sector.


To be fair, Posner condemns some of the knee jerk responses of governments introducing tighter financial regulation and acknowledges that he is not entirely happy with his own suggestions for regulatory reform. He views the only ambitious proposal that he discussed sympathetically – the separation of commercial banking from other forms of financial intermediation – as ‘fraught with problems’ (p.362).

It is arguable that the global financial crisis was a crisis of capitalism. A milder financial crisis might still have occurred if central banks had not previously acted in ways that led major financial institutions to expect that they would be bailed out if their excessive risk-taking resulted in major losses. It is even possible to entertain the idea (as I did here) that the financial crisis has highlighted a fundamental problem in that laws governing the financial system currently permit financial intermediaries to make promises that they can’t always keep. But why view this economic crisis as a crisis of democracy?

The title of the book arises from Posner’s view that while the American political system can react promptly and effectively to an emergency, it ‘tends to be ineffectual’ in dealing with longer term challenges:

‘The financial collapse and the ensuing depression (as I insist we must call it) have both underscored and amplified grave problems of American public finance that will not yield to the populist solutions that command political and public support. The problems include the enormous public debt created by the decline of tax revenues in the depression, the enormous expenses incurred by government in fighting the depression, and the boost the depression has given to expanding the government’s role in the economy. These developments, interacting with a seeming inability of government to cut existing spending programs (however foolish), to insist that costly new programs be funded, to limit the growth of entitlement programs, or to raise taxes, constitute the crisis of American-style capitalist democracy’ (p.387-8).

Unfortunately, the quoted passage appears in the final paragraph in the book rather than the introduction. There is not much discussion in this book about this supposed weakness of the US democratic system. The author implies that it is largely a problem of political culture. Republicans favour low taxes but they have been reluctant to reduce government spending. Democrats favour high levels of government spending but they have been reluctant to raise taxes. As a result:

‘From the standpoint of economic policy we have only one party, and it is the party of profligacy’ (p.384).

As a person living in a democratic country in which a large part of the electorate has come to equate responsible economic management with budget surpluses and minimal public debt (to the dismay of some left wing economists who would like to see more public sector investment) I find it difficult to take seriously the idea that the current political culture in the United States involves a crisis of capitalist democracy. I am confident that before too long Americans will insist that their governments balance their books in order to avoid the problems currently being experienced in Greece and other European countries.

However, the picture might look a lot different from within the US. Before a change in political culture can occur in the US it will be necessary for a lot more Americans to become concerned about the future implications of current fiscal policies. Richard Posner claims that he has no idea how to solve the problem of America’s political culture (p.385) but I think he is contributing to the solution by merely raising awareness of the problem.

Does history give undue prominence to scribblers?

I imagine that history does tend to give excessive prominence to writers because historians have to rely heavily on written material. Historians probably spend a lot of time discussing this subject but, not being an historian, I don’t claim to know much about it. What this post is actually about is a minor historical incident in which I think undue prominence has been given to my role because I was editor of a student newspaper. I’m not objecting to the way I have been portrayed. I just think that other people deserve more credit for the contributions they made.


‘A Spirit of True Learning, the Jubilee History of the University of New England’ by Matthew Jordan, was published by UNSW Press in 2004. I confess that I have only just now read the book at the urging of Jim Belshaw, a fellow student at UNE in the 1960s, and now a fellow blogger. Jim referred me, in particular, to a few pages about the history of the room visiting issue (pp 187-191).

At the beginning of the 1960s nearly all students at UNE lived in single-sex residential colleges on the university campus. As Matthew Jordan records, in 1963 the University Council decided to cut back room-visiting between the sexes and then to abolish it altogether from the beginning of 1964. The decision to ban room visiting was taken against the advice of the heads of colleges (which were supposed to be largely self-governing) and was, of course, strongly opposed by students.

My recollection is that before I became editor of ‘Neucleus’, the student paper, the stage had been set for the first issue of 1964 to protest against Council’s decision on the room visiting issue. I was more than happy to go along with that idea and to accept editing responsibility, but at the time (November 1963) I was just completing my first year at UNE and would not have been viewed by other students as a leader of the protest movement. (I can’t recall why the editorship of Neucleus became vacant at the end of 1963. I agreed to edit just one issue to be published at the beginning of 1964 with help from the previous editor and other students who had more experience working on the paper. As it happened, early in 1964, I became joint editor with Jim Belshaw, but that is another story.)

Matthew Jordan writes:
‘Winston Bates led the way. On the one hand, he said, Council talked of moulding students into responsible adults, while on the other, by “imposing blanket restrictions on everyone”, it issued “an insult to the maturity of students and an utter denial of personal freedom”.

The quoted words are (almost) correctly attributed to me but in suggesting that I ‘led the way’ I think Matthew is under the impression that I was also the ‘special correspondent’ responsible for the page one article. Since I was defending the anonymity of the ‘special correspondent’ it isn’t surprising that people might think I was responsible, but the special correspondent knew a lot more than me about Council deliberations. Among other things, the special correspondent wrote:

‘It would seem that the real reason for Council’s action was the fear that certain rumours circulating in North-Eastern N.S.W. about the immorality supposedly rife in the university would lead to a decline in student enrolments’.

My recollection is that the special correspondent was only using the words ‘it would seem’ to further hide his identity.

While I think Matthew’s history gives me undue prominence, 47 years later I am still rather proud of one of the passages in my editorial:

‘Perhaps the concept of freedom in a university needs further explanation. It is not a freedom to do what you want to, full stop; nor is it a relentless search after personal happiness. The college regulations in the “free” university would be framed by members of college with a view to restricting violation of the rights of others.

Surely this is an ideal worth working for. ...’

That could have done with some further editing, but it wasn’t too bad. I hope regulations applying in residential colleges at UNE today have been framed with a view to restricting individual freedom only to the extent necessary to protect the rights of other residents.

How bounded is rationality?

Herbert Simon’s concept of ‘bounded rationality’ captures the idea that although individuals intend to behave rationally, they are constrained by limited cognitive abilities. The concept was put forward as an alternative to the assumption of neoclassical economics that individuals make decisions by maximizing utility functions.


It seems to me that maximizing utility is best viewed as a metaphor, akin to the charioteer, elephant and plane metaphors discussed in a previous post, rather than a description of actual human behaviour. It can be a useful metaphor. (I have used it on this blog to suggest that some seemingly irrational behaviours may in fact be rational.) Nevertheless, as James Buchanan has argued:

‘The modern economist who models the individual as choosing among feasible alternative bundles of goods to maximize a utility function that does exist independently of choice itself presents no evidence that such functions actually exist, and if pushed, the economist would agree that “utility” is little more than a rhetorical artifice that is introduced as an aid in explaining choice behavior within an imposed rational choice reconstruction’ (‘The Economics and the Ethics of Constitutional Order’, 1991).

It is possible to argue that all human action is rational in the sense of being purposeful, but once we acknowledge that humans have limited cognitive abilities then we have to acknowledge that they make mistakes. Economists have often recognized that people make systematic cognitive errors by incorporating arbitrary behavioral assumptions reflecting such errors (e.g. money illusion) in some of their models. This raises the question of whether efforts by economists to obtain a better knowledge of the bounds of rationality will enable them to build better models.

Jonah Lehrer’s book ‘How we Decide’, provides a highly readable discussion of the ways in which limited cognitive abilities can affect decision-making in different contexts. I decided to read the book after reading some comments by Peter Boettke on the Coordination Problem blog.

Lehrer’s main message seems to be: ‘The mind is full of flaws, but they can be outsmarted’ (p.250). He implies that a major source of error is failure to think about the kind of decision being made and the kind of thought process it requires. Insufficient reasoning can obviously result in poor decisions when the mind is strongly influenced by emotional urges and impulses. But it is also possible for the mind to choke on excessive reasoning.

It is common to hear of instances when sporting champions choke at a crucial point in a game because they suddenly become self-conscious and interfere with their performance by consciously trying to avoid mistakes. It is also possible, however, for too much analysis to lead to poor decisions in relation to choices that might be thought likely to benefit from analysis. For example, in considering a trade-off between size of home and time required to commute to work some research has suggested that there may be a tendency for people to give to give greater weight to the size of the house the more time they spend deliberating, even if the additional space is superfluous (p.144). People may often make better choices when they use their conscious minds to gather information and then trust their emotions.

Everyone knows that inexperience is a common source of error but many of us fear the unpleasant symptoms of making mistakes. One of the crucial ingredients of successful education is encouragement of children to learn from their mistakes by praising them for their efforts rather than their cleverness (p. 51-3).

The book contains a chapter on our tendencies to be fooled by feelings – loss aversion, the perception of patterns that don’t exist, the tendency to over-value immediate gains relative to longer term costs etc. Attention has previously been drawn to such problems by Dan Ariely in ‘Predictably Irrational’ (discussed here) and Richard Thaler and Cass Sunstein in ‘Nudge’ (discussed here). Lehrer suggests that the best way to avoid such errors is to be aware of them and to check feelings with a little arithmetic (p.244).

It seems to me that one of the most important contributions of ‘How we Decide’ is to draw attention to the errors that result from our tendency to surrender to ‘shoddy top-down thinking’ because self-delusion feels better than uncertainty. This is reflected, for example, in the influence of party affiliations when voters consider complex political issues. Even expert advice can be biased by adherence to frameworks that are at variance with reality. Lehrer’s suggested remedy is to embrace uncertainty, entertain competing hypotheses and to remind yourself what you don’t know.

Different readers may see different implications for economics coming out of this book. The book has reinforced my support for Oliver Williamson’s view that modes of contracting that make large demands against cognitive competence should be disfavoured (‘The Economic Institutions of Capitalism’, 1985, p.46). Governance structures will fail if they require managers to have unlimited cognitive capacities. Humans tend to be strongly influenced by moral instincts and conventions, but they are also susceptible to temptations. Another implication is that decision-making skills are likely to vary greatly among different individuals. Modellers should be wary of assuming that everyone is equally susceptible to cognitive distortions or that they have equal abilities to learn from experience. Finally, while the book provides plenty of support for the view that the rational voter is a myth rather than a useful metaphor, it suggests to me that the worm – reflecting immediate emotional responses to what politicians are saying – is unlikely to be a good predictor of voter behavior. Focus groups initially gave the thumbs down to some of the most successful shows on television.

Is state sovereignty relevant to resource rent taxation?

The Henry tax review into Australia’s future tax system recommends:

‘Subject to transitional arrangements, the new rent-based tax should apply to existing projects, replacing existing charging arrangements. The allocation of revenue and risks from the new tax should be negotiated between the Australian and State governments’.

The federal government seems to be attempting to ignore this advice in imposing the new tax. It is proposing to reimburse mining companies for existing royalty payments rather than to replace existing charging arrangements. It has decided unilaterally how it proposes to use the additional revenue from the new tax. In selling the tax to the Australian public it is asserting that mineral resources are owned by all Australians, contrary to the legal position of ownership by the Crown, with state governments having constitutional authority for resource management.

The government of Western Australia is threatening a constitutional challenge to the new tax, but the federal government doesn’t seem to be particularly concerned about this. I’m no lawyer, but I imagine the federal government think they are on safe ground in calling the tax a profits tax rather than a resource rent tax.

However, even if the new tax is legal, I think the federal government should be concerned about the viability of their proposal not to reimburse mining companies for any new or additional royalties that might be charged by state governments. Whatever the High Court might decide about the validity of the new federal tax, it is not likely to rule that the imposition of a new tax by the federal government has extinguished the rights of state governments to raise royalty rates.

Are state governments likely to impose additional royalties? Some proposals for higher royalties were already in the pipeline in Western Australia prior to announcement of the new federal tax and it is possible that these charges will be accommodated in transitional arrangements. The state governments review their royalty charges from time to time and I imagine that they will continue to do so. It is quite possible that having read and digested the Henry report a state government could decide to change the basis of their charging arrangements to a resource rent tax and to increase revenues from the resources sector. In considering such a change the state government might note that there is nothing particularly magical about the 40 percent tax rate proposed by the federal government. They might even read in the Henry report that Norway imposes a total tax rate on petroleum rents of 78 percent.

The point I am leading to is that the new federal tax has not extinguished the potential for state governments to raise royalty rates. This remains a potential source of sovereign risk for mining investment in Australia. This consideration is additional to the argument in my earlier post (Does a resource rent tax solve the problem of sovereign risk?) that the proposed application of the new tax to existing mines would lead investors to perceive that they have under-estimated sovereign risks in Australia. Even if the federal government comes up with satisfactory transitional arrangements for the new tax, miners will still need to factor into their calculations an allowance for possible future increases in state government royalties.

In my view the federal government should take another look at the recommendations of the Henry report and seek negotiations with state governments about the allocation of revenue and risks from their proposed resources rent tax.