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What Crisis? This is creative destruction

Is this the end of capitalism? No, this is how capitalism works. But we must get smarter at lending to poor people.

Writing in 1942, Joseph Schumpeter observed that it was in the nature of capitalism to make progress by means of "creative destruction." There has been much destruction in the financial sector over the past year: of asset prices, of banks and of confidence. It is not yet widely recognised that this has been part of a creative process, but there is good reason to think that it is.

Asset prices were overvalued, banks were poorly managed and confidence turned out to be complacency in disguise. The time was ripe for a Schumpeterian mutation.

Those who were uncomfortable with the success of the financial services industry during its good years are now- predictably- celebrating its demise. They say that the events of the past year have shown what they knew to be true all along: that financial markets need to be more regulated and subjected to greater political control.

But the fact that substantial government action has been required to mitigate the economic consequences of the current financial upheaval does not prove that financial markets should be more heavily regulated, nor that capitalism has failed. Systemic problems have arisen in the financial markets despite the fact that most participants have behaved responsibly.

The problems we see today are not just signs of failure; they are also signs of progress. If capitalism were better understood- as an economic system that makes progress both through innovation and failure- it might be recognised that government action in times of crisis is needed only to ensure that the process of creative destruction starts again sooner rather than later.

The most interesting question that arises from the current mutations is not, "who is to blame?" but "what can we learn?" The answer takes us to the matter of sub-prime lending- that is, the provision of credit to those who are normally excluded from the financial mainstream.

The proximate cause of our present financial problems is the fact that large amounts of money were lent to poor people in America who only had a realistic chance of making repayment if the value of their homes, against which the loans were collateralised, continued to rise indefinitely. What should we learn from this? The quick answers- depending upon one's political prejudices- are these: either blame the poor for having aspirations beyond their status and the successive US governments who encouraged wider home ownership, especially amongst minority communities; or blame the banks and mortgage brokers who offered cheap credit without due regard to the quality of their collateral- and without due regard to the longer term risks faced by the borrowers.

But there is no reason why people who suffer from financial exclusion should be denied access to credit, since the evidence shows that they are mostly reliable repayers. Where is the evidence? It is in Asia, Africa and South America. It is in eastern Europe, the middle east and the major cities of America and Europe. It is anywhere that the techniques of microcredit have been used to provide individuals, the self-employed and small businesses with access to credit that mainstream banks would not supply.

There are many people who know how to run sub-prime lending businesses successfully. The key is to offer borrowers flexible loan products that take account of their irregular income patterns and their inability to smooth their expenditure patterns over the year. This approach can be applied to big purchases like property; the key is to ensure that the loan product is suitable.

Time spent face-to-face between lender and borrower is crucial to establish the latter's needs and the amount of credit that they can realistically repay. Sub-prime lending is just like private banking, but for poor people.

In the build up to the current crisis not all lenders were predatory and not all borrowers were fools. But some loans were reckless and others were fraudulent. Some investors took risks that they did not understand. Too few were willing to learn from the evidence of successful microcredit projects all around the world; so now we will all have to learn from the evidence of our mistakes.

We should remind ourselves of Schumpeter's insight, and that the enormous benefits of product innovation and economic growth come at the cost of periodic bouts of market failure. We should remind ourselves that we can learn from these failures: the quality of decision-making in major banks will be much better over the next five years than it was during the past five years.

Finally we should remind ourselves that sub-prime lending per se is not the problem. Providing credit to the financially excluded is being done responsibly and successfully in many parts of the world today. With around half of the world's population still "un-banked," it is more important than ever that banks learn to do this right.

© Mark Hannam 2009