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The Future of Kapitalism October 16, 2008, 5:00PM EST

Forget Adam Smith, Whatever Works

(page 2 of 2)

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The credit boom masked a troubling trend: Over the past decade, strong U.S. productivity growth has coincided with declining real incomes for most Americans.

Nor has the faith in financial engineering proved justified. Through lightly regulated derivatives markets, banks could repackage toxic loans and send them into an ocean of investors ranging from pension funds to Chinese banks. And both households and companies went wild on debt. The IIF estimates at least 30% of the $1.3 trillion in U.S. consumer debt, most of it on credit cards, is bad. Nor has the system sorted through the $1.7 trillion in high-yield corporate debt.

The new American reality will first manifest itself in greater regulation of finance. "The financial landscape is being redefined in fundamental ways," says Mohamed el-Erian, co-CEO of PIMCO, which is managing commercial paper assets the government has assumed. "There is no reset button." El-Erian is convinced the government, even under an Obama Administration, will not intrude in nitty-gritty management or loan decisions. He thinks lasting intervention will come in the form of higher capital reserve requirements and curbs on subprime lending and complex derivatives.

This financial reckoning will focus minds on rebuilding the U.S. manufacturing base. Here, too, government could play a huge role. That $25 billion bailout Congress has promised General Motors (GM), Ford (F), and Chrysler likely will come with strings. The subsidies give Washington considerable leverage over Detroit on strategic matters. U.S. automakers will have to convince the Energy Dept. they will be able to boost fuel efficiency to at least 35 miles per gallon, for instance, by investing in facilities to make electric cars. Obama supports giving another $25 billion to Detroit. On top of that, he promises $150 billion in new spending on clean-energy technologies.

SUSTAINABLE INDUSTRIES

Yet skip Washington for a second. Go instead to states such as New York, Oregon, Pennsylvania, and Texas, where governors, business leaders, and university deans have been leading efforts for the past decade to nurture new industries. States aren't just rolling out tax breaks and offering cheap land. They are adapting strategies from nations known for generous industrial subsidies, such as Singapore, Germany, China, and Finland.

A good illustration is Advanced Micro Devices (AMD), which on Oct. 7 decided to spin off its manufacturing operations into a new company in which the government of Abu Dhabi will own a 50% stake. The venture will build a $4.5 billion silicon wafer plant in Albany, N.Y. The state of New York, which already has invested more than $1 billion in nanotech research and development, worker training, and a state-of-the-art clean room in Albany, will kick in $1.2 billion in tax benefits and outright cash rebates to cover construction and equipment costs. For struggling AMD, one of the last U.S. chipmakers that still manufactures its own wafers, the financial help from New York and Abu Dhabi "was incredibly important," says AMD executive chairman Hector de J. Ruiz. Few private investors in the U.S. are willing to risk such huge sums on a high-tech plant that won't produce returns for at least five years. "In a large economy like the U.S., it is impossible to be successful and thrive if you do not make something, especially in industries in line with your core strengths. The government will have to realize it must play a role," says Ruiz.

Call it industrial policy, or use the euphemism of "public-private partnership." But as America emerges from the rubble of the credit bubble and soberly confronts the task of building a strong, sustainable economy, the new credo will likely be "whatever works."

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The Housing Bust and Jobs

IMF researcher Prakash Loungani crunched some numbers and found that unemployment typically increases by 1.5 percentage points in the 12 months following the onset of a recession. But in recessions accompanied by a housing slump, the increase amounts to 3 percentage points. His findings aren't relevant just to the U.S. Britain, Denmark, New Zealand, and Spain all experienced much bigger declines in home prices in the first half of this year than those the U.S. witnessed.

To read Loungani's article, go to http://bx.businessweek.com/housing-market/reference

Engardio is an international senior writer for BusinessWeek .

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