Can Liberals Save Capitalism (Again) ?
James A. Chamblee
Can Liberals Save Capitalism (Again)?
Seven decades after the Great Depression, Democrats have their work cut out
for them.
Robert Kuttner
In a few short weeks, America's political economy has been stunningly
transformed. The Bush administration, the Republican Party and three decades
of conservative ideology are facing a potential rout. Yesterday's
conservative clichés are today's political embarrassments. Americans are
getting a vivid if painful education about the limits of the marketplace and
the salutary role of government. It will be a very long time before anyone
can say with a straight face that markets always work better than
governments. But market fundamentalism has been so ascendant for so long --
politically, culturally, financially -- that this is only the very beginning
of an ideological sea change. It remains to be seen whether liberals will
manage to save capitalism from itself, for the second time in the past 70
years.
President Bush is suddenly in trouble. As I've observed elsewhere, his is
now a Cinderella presidency. He was abruptly transformed from dubious and
untested pretender into steely wartime leader, only to be suddenly turned
back into a bumpkin. And how utterly fitting. Bush's own financial
biography, on a pettier scale, epitomizes the corruption that now threatens
the whole system. His Wall Street speech of July 9, intended both to
reassure investors and get ahead of the Democrats, was one of his weakest
ever. The Dow responded to his platitudes by plunging nearly 500 points in
two days. Rhetorically, the speech lacked passion and conviction.
Politically, the president was crippled by his need to walk a fine line
between condemning wrongdoing but not attacking the larger Republican
corporate culture. Substantively, the speech stopped far short of embracing
even modest reforms and settled instead for pieties. And personally, Bush
irrevocably symbolizes the tawdriness of crony capitalism, right down to his
insider self-enrichment based on the sale of fraudulently inflated Harken
Energy stock. Could one ask for a better foil?
Republicans in both houses have already outflanked the president by
embracing far tougher remedies. Bush and Vice President Cheney, who urged
the president to deliver an even weaker speech, are far behind the curve.
For the first time in this presidency, and in many respects for the first
time since the Republicans took over Congress in 1994, liberal Democrats are
setting the national agenda -- an agenda of reining in market excesses to
save the larger economy.
We don't know yet whether the stock market has reached the kind of tipping
point where downward spiral just feeds on itself and savages the real
economy, 1929 fashion. At best, the market is likely to be severely
depressed for a long time. Even after a nearly 40 percent drop in the broad
stock market, price-earnings ratios are still high by historic standards.
Moreover, every time another corporation restates its earnings, the real
ratio of its stock price to its true earnings goes higher and the stock
sinks lower. Accounting standards have been retroactively toughened, in a
fashion that perversely deepens the stock market's woes. As corporations get
new auditors, the new accounting firms are determined to show that they are
tougher than their disgraced predecessors.
Neither is it clear whether even the toughest of remedies can repair the
real economic damage that has already occurred. With investors gulled by
stock touts and phony corporate reports -- themselves the fruit of the
antiregulatory mania -- trillions of dollars of investment capital went to
uses that will never recoup earnings. So the stock market plunge is more
than a crisis of confidence. It's a belated appreciation of economic
reality.
If this sounds familiar, it should. much the same thing happened in the
1920s, and of course it was the liberals who then dragged a primitive,
corrupted and vulnerable capitalist system, kicking and screaming, into the
modern mixed economy. It's astonishing that we now have to do it again.
Republicans can't do the necessary job, but will Democrats seize the moment?
Though leading Democrats are maximizing the tactical opportunity, it's not
yet apparent whether Democrats as a party will fully rise to the larger
challenge or whether they will remain besotted by the free market. So far,
Democrats have skillfully gotten out in front of Bush with remedies that he
cannot embrace because of who he is, what he represents and who his friends
are. But the remedies are still fairly narrow and Democrats have yet to
reclaim a coherent alternative narrative about how the economy works, how
the corporate scandals connect to the lives of ordinary people and why
laissez-faire itself is the ultimate corporate fraud.
Even after all we've learned, the Democrats' own romance with the free
market is not entirely over. The financial rewards to be reaped by
cultivating business donors still retain their allure, as the opposition of
some Democratic leaders to treating stock options as expenses makes clear.
Sen. Joe Lieberman, the Democrat who led the efforts to cripple Arthur
Levitt's Securities and Exchange Commission, recently declared that it would
be unwise to overregulate. Al From, head of the Democratic Leadership
Council, warned that this was no time for Democrats to be seen as
anti-business. If New Democrats can't tell the difference between bashing
business and restoring their historic role as stewards of a mixed economy,
they will fumble an opportunity that history is affording them to reclaim
their souls.
We've Been Here Before
How serious is the corporate meltdown? Very serious. It's likely that
American capitalism is facing its most dire crisis since the 1930s. The
parallels are eerie. The crash of October 1929, like the current slide, was
an accurate if belated appraisal by investors that many billions of dollars
of speculative capital investments turned out to be worthless. The market's
unsustainable prices, in turn, reflected diverse stock-kiting schemes in
which insiders made a killing at the expense of ordinary investors. One of
the most notorious industries where such practices were common,
appropriately, was electric power. In a fine anticipation of Enron,
unregulated utility holding companies watered stock, manipulated profits,
enriched insiders, and bilked investors and ratepayers alike. A second cause
of the '29 crash was the ability of Wall Street houses such as Morgan to be
both commercial banks and investment banks. As such, they could float
securities, peddle them to customers and profit handsomely from fees,
mark-ups and insider trades. They thereby abandoned their first fiduciary
duty as bankers -- to certify the soundness of the enterprise -- and steered
a lot of other people's money to sterile investments. This, too, prefigures
the current scandals. And the '20s, like the '90s, was a period of record
debt, both personal and corporate.
Ideologically, the parallels are also uncanny. In the 1920s, "New Era"
thinking proclaimed that Jesus was best understood as an entrepreneur, that
the common American would grow rich as an investor, that free markets could
do no wrong. Three Republican administrations preached this gospel, though
in fairness the wrongly maligned Hoover administration was much more
sensibly economic interventionist than the current Bush administration. As
Lloyd Bentsen might have put it, George W. Bush is no Herbert Hoover.
There is also this political parallel: In the 1930s, most of organized
business fiercely resisted the New Deal reforms. The DuPont family, the
largest shareholders in General Motors, formed the Liberty League to try to
bring down FDR. On key pieces of New Deal legislation, most Republicans
voted no. At the same time, important Wall Streeters such as Joseph P.
Kennedy defected to the New Deal, either for personal careerist reasons or
out of genuine fear for the system, or both. Today, some of the people who
know Wall Street best -- former Fed Chairman Paul Volcker, super-investor
Warren Buffett, and former Goldman Sachs co-chairman and current Senator Jon
Corzine -- are leading the charge for systemic reform. The New York Stock
Exchange has proposed reforms that are resisted by many of the corporations
it lists. Most of the corporate and investment communities remain opposed to
anything but the mildest of remedies. But these schisms and the huge loss of
prestige for both the free-market ideal and for corporate America present
immense opportunities for liberals, just as in the 1930s.
The classic text on the dynamics of such financial meltdowns is Irving
Fisher's The Debt-Deflation Theory of Great Depressions, written in 1933.
Depressions, Fisher explained, are unlike recessions, which are mild,
self-correcting cycles of overbuilding. By contrast, a self-perpetuating
depression occurs when asset prices collapse below the level necessary to
pay back lenders and investors. The economy then drowns in a cascade of
debt.
In the 1930s, what began as a financial collapse turned into a generalized
depression because the federal government was not prepared to spend enough
money to compensate for the shortfall of private demand, and because the
Federal Reserve temporized. So serious was the aftermath of the speculative
rot from the 1920s that even all the public spending of the New Deal was not
sufficient to ignite a durable recovery. Unemployment was still above 10
percent on the eve of World War II. A full recovery awaited the
super-Keynesian stimulus of the war, which at its peak accounted for a third
of the gross domestic product.
While the New Deal is commonly remembered for its public-spending and
social-insurance legacies, its regulatory changes were at least as important
to the stabilization of capitalism. The Roosevelt administration initiated
much tougher regulation of banking, securities underwriting, accounting,
electric power, civil aviation, telephones, broadcasting and labor
relations. It added new teeth to pre-existing regulatory agencies in charge
of railroads and trucking, as well as antitrust.
The rationales for the new spate of regulation were diverse, often ad hoc
and even contradictory. One strand of regulation addressed the problem of
ruinous competition. In a normal economy, competition is good. But in a
depression, if companies keep cutting prices and laying off workers, the
result is a general downward spiral. Some of the New Deal's regulation was
aimed at stabilizing prices and breaking the cycle of deflation. Other
regulations set rates -- in order to stabilize emergent industries, such as
airlines, power companies and telephones -- by assuring profits high enough
to stimulate innovation and investment, but not so high as to gouge
consumers.
At its heart, however, New Deal regulation was about the stabilization of
finance, for financial markets are both the essence of the market system and
its Achilles heel. Congress and the White House wanted to make sure that the
conflicts of interest and speculative ruin that characterized the 1920s
would never be repeated. New Deal regulation, entrusted to the new SEC,
imposed standards on corporate governance, on the issuance and sale of
stocks and bonds, on the accounting profession and on stock exchanges. New
Deal banking regulation put a wall between the operation of commercial banks
and the underwriting and sale of securities. It regulated bank interest
rates, offered deposit insurance, and imposed new conditions on bank safety
and soundness. All of this succeeded in stabilizing capitalism -- for about
70 years.
To infer a consistent theory of the economy from New Deal regulation, one
might say: Some sectors of the economy need to be regulated for purposes of
financial stability, some to introduce greater income security and equality,
and some to provide social goods that markets don't efficiently deliver. But
underlying all these kinds of regulation is a distrust of the market's
ability to regulate itself, and a reliance on government to keep capitalism
efficient and honest. This insight was the centerpiece of the modern
Democratic Party.
What are the parallels with the present economy? One is the vast waste of
economic resources in speculative investments. Despite nonsensical tracts
such as the book Dow 36,000, it's now clear that much of the stock run-up of
the 1990s was an enormous bubble. Until the Enron affair, many analysts
thought that the damage was limited to dot-coms and closely related
technology companies. But as one corporation after another gets a new
auditor and "restates" its recent profits, it's evident that trillions of
dollars of investment in far-flung corners of the economy went to no useful
purpose. It remains to be seen how disastrous the assault on the real
economy turns out to be, and how much lower the stock market has to fall.
The second parallel is that much of the speculative excess was the result of
conflicts of interests that could and should have been prevented. Bankers,
brokers and corporate insiders all enriched themselves by temporarily
pumping up stocks and contriving off-the-books deals. The whole system of
compensation by stock option gave senior executives irresistible incentives
to contrive phony profits and merger deals that made no economic sense.
Corporate directors, never the arm's-length supervisors promised by market
theory, were in fact cronies of the CEO. Auditors were in bed with their
clients.
All of this reflected the systematic dismantling of financial regulation,
causing the economy to revert to the laissez-faire world of the 1920s, with
its myriad attendant vulnerabilities. If the regulation of options-trading
and electricity had not been undermined, Enron would have had to make its
money in the old-fashioned way: selling real products and services and
reporting honest earnings. If the Glass-Steagall Act had not been gutted by
regulatory indulgence and then formally repealed, banks could not have
enriched themselves by making profit-sharing deals with dishonest partners
such as Enron. If the Congress and the SEC had not undercut the regulation
of accountants, corporate books could not have been cooked to artificially
inflate profits. If SEC oversight had held corporate directors personally
accountable for their decisions and their lapses, corporate boards would
never have approved many rotten deals. If stock options had been more
tightly regulated, insiders would not have had an incentive to artificially
pump up share prices in order to cash them in. What deregulation has
produced is an economy and a culture rooted in conflicts of interest. The
SEC already had the power to police most of these, but Congress directed it
not to. And when Bill Clinton vetoed Newt Gingrich's bill that made it
almost impossible for investors to sue for securities fraud, Congress, with
the support of many Democrats, passed it over Clinton's veto.
Bush's law-and-order rhetoric and his call for longer prison terms for
felonious CEOs misses the point utterly. What's needed is tighter scrutiny
and clearer barriers to prevent such double-dealing at every step. Moreover,
regulation is not a one-time action but an ongoing process. Financial
scammers are always coming up with new gimmicks to circumvent existing
prohibitions. For example, New Deal regulators, mindful that speculative
stock investments in the 1920s were made substantially with borrowed money,
limited that practice by regulating "margin" -- money lent to customers by
brokers to finance direct stock investment. But margin is now archaic. You
can speculate with borrowed money by investing in derivatives.
Many of the abuses of the 1990s were the intended consequences of new
inventions. The aggressive use of derivatives was new. The use of huge
personal loans to executives to create off-the-books subsidiaries was new.
Enron-style trading of futures was new. The ubiquity of options to reward
CEOs was new. If the general conceit is that anything invented by markets
should be celebrated as innovation and that any excesses will be disciplined
by investors, existing regulations won't do the job, and there will be a
bias against new regulation to counter new abuse.
In the era that began with Reagan, when the market fundamentalism of The
Wall Street Journal and the Heritage Foundation spread like an oil slick to
the general media and the Democratic Party, markets got a free pass. When
new scams were contrived, it took uncommonly courageous regulators such as
SEC Chairman Arthur Levitt to call for new forms of regulation. That's why
the counteroffensive needs to be much broader than a mere crackdown on the
current spate of frauds. The mixed economy itself needs to be rehabilitated,
and market fundamentalism disgraced.
Assessing the Damage
The economic commentator George Goodman, who wrote in the 1970s and 1980s
under the pen name Adam Smith, liked to say that you don't see the bones
until the tide goes out. A lot of the long-term damage to the economy is
still hidden, and the tide is still going out. For example, it has almost
been forgotten that the Federal Reserve has been keeping interest rates at
historic lows in order to contain the damage of the first stock-market
meltdown, the collapse of the dot-coms. Monetary policy to keep the economy
afloat is already being used to its practical maximum. As Jeff Faux observes
in this issue [See "Falling Dollar, Rising Debt," page 12], America's
chronic trade deficit is a source of hidden weakness that is suddenly far
more precarious in a stock market meltdown. We finance the trade deficit by
importing capital -- about $400 billion a year. Until recently, the United
States had no trouble importing that capital, despite our very low interest
rates, because of America's reputation as the safest investment haven. But
that inflow is now slowing, causing the dollar to lose value, and at some
point the Federal Reserve will need to raise rates to keep foreign investors
from fleeing -- just as the economy is weakening. That will only slow
economic growth and worsen the stock market slide.
The late bull market also provided a lot of economic stimulus, which is now
reversing. In the 1990s, institutions as well as individuals became addicted
to the premise of a stock market permanently rising at four or five times
the rate of economic growth. Pension funds that assumed a 10 percent normal
annual return and thus were considered "overfunded" suddenly have far weaker
balance sheets. So do many insurance companies. Large nonprofit institutions
reliant on endowments -- such as foundations, universities and hospitals --
are suddenly a lot poorer. They must either curtail their existing
operations or raise costs to consumers.
So far, banks have not taken a big hit, but consumer and corporate debt are
at record levels and bank profit margins are thin. A lot of banks
overextended themselves in their own merger binge. As corporate stock prices
fall, corporate ratios of equity to debt worsen. As the economy softens, bad
loans mount. Banks would be in even worse shape were it not for the fact
that some tougher supervision by examiners was restored in the wake of the
banking and savings-and-loan scandals of the 1980s. And as the banks' own
prices fall, their own debt-equity ratios deteriorate.
As the stock market has softened, a lot of money has poured into real
estate -- the last safe haven. But real estate is built and purchased with
borrowed money, and offices and apartments need tenants. If the real economy
falters and vacancy rates keep rising, the real-estate boom could be the
next bubble, and another key sector would succumb to debt deflation. It's
hard to think of any large sector of the economy that is immune to what is
now unfolding.
But aren't rates of productivity growth impressively high? And didn't the
economy bounce back smartly from both the dot-com crash and the shock of
September 11? Yes on both counts, but productivity is not relevant when the
problem is a financial implosion. If retirees lose their stock portfolios
and workers their jobs, the money to purchase products -- no matter how
efficiently produced -- dries up. The history of capitalism is replete with
eras in which new inventions made the real economy highly productive but
chaos in the financial sector still dragged it into depression. The 1930s
was a time of technological progress, in electronics, automobiles,
telephones, electric power generation and basic science. But none of it was
sufficient to compensate for the financial hangover and the shortfall of
total demand. Japan still makes countless products more efficiently than
anybody else, but its financial mess has kept it in a self-perpetuating
slump.
Although the economy still retains a lot of momentum, at some point all of
this corporate unwinding has to translate into a slowdown of growth and a
rise in unemployment. Ideally, the carnage will be contained -- it will be
enough to discredit laissez-faire and corporate excess, but not so serious
that it produces a prolonged slump. Thanks to the part of the New Deal that
the right has not managed to repeal, the economy is far more resilient than
it was in 1929. Social Security, welfare checks and unemployment
compensation are far from adequate, but they do prevent the bottom from
falling out of consumer demand. Despite the efforts of the right to condemn
the interference with free markets, bank deposits are still insured. The
Federal Reserve, given new powers in the 1930s to be a lender of last
resort, is a lot more savvy and effective than it was in 1929. Total public
spending is about one-third of gdp, and this provides a lot of ballast.
The more venturesome Democrats have assembled an adequate package of reforms
to deal with the financial abuses now unfolding. Taken together, legislation
sponsored by key Democrats would sever auditing from consulting, require a
majority of corporate directors to be independent, tighten accounting
standards across the board, define new categories of corporate criminal
fraud, constrain exorbitant stock-option compensation to insiders, protect
ordinary employees' pension plans and hold senior executives criminally
liable for fraudulent practices that are now beyond prosecution. Republicans
are already backing some of these measures in spite of themselves. (A nice
summary is on Rep. Richard Gephardt's Web site.)
None of this is "anti-business." It is emphatically pro-business in that it
prevents the squandering of capital for personal enrichment and because it
is necessary to restore investor confidence. Such measures are only the
beginning of a long struggle to wrest back a mixed economy. The unleashing
of market forces has been harmful to ordinary people and to the modern
liberal project in ways that go far beyond the harm inflicted in the current
crisis.
Why, for example, don't Americans have decent health care? Because the
health-care industry wants it that way, and because the ascendant ideology
says that markets can do the job better than government-sponsored insurance.
Ordinary experience and scholarly evidence both demonstrate that market
provision of health care is a disaster. But the ideological conventions of
the era blind politicians to what their own constituents know and desire. By
the same token, the problem with retirement security isn't just that some
401(k) plans are inadequately regulated and at risk of being looted. Half of
America's workers have no pensions at all save Social Security, and they
will only get pensions when government policy demands it. The free market is
supposed to solve this problem, but it doesn't. The voucher craze, lately
supported even by some Democrats, is another money-making scheme relying on
the spurious claim that markets are superior to public investments. The view
that lifesaving drugs are commodities rather than social goods is yet
another market conceit. Bush's appalling tax cut reflects the belief that
personal income is entirely private rather than subject to social claims.
And the ultimate manifestation of the laissez-faire's hegemony is the global
free market, in which speculative money flows periodically wreck the
economies of developing countries, undercut labor and environmental
regulation in advanced democracies, and invite the creation of tax havens
for the wealthy.
The market fundamentalists also insist that the deregulation of particular
industries, such as airlines and telephones, saves consumers hundreds of
billions of dollars by cutting prices. But these calculations leave out the
sheer economic waste that occurs when a natural monopoly such as telephone
service is fragmented. They ignore the huge financial loss that results from
hundreds of billion dollars of duplicative investments and bankruptcies, the
millions of hours lost to consumers and businesses fighting deteriorating
service and contesting overcharges, and the lost wages to workers when
high-wage industries become hypercompetitive low-wage sectors. The entire
set of free-market era claims are due for scholarly reappraisal and broad
political challenge.
Just as the soaring stock market and the cult of the CEO gave prestige to
markets and deregulation generally, so the disgrace of corporate capitalism
is an opportunity to dethrone the role of the market generally. Only when
that occurs will the liberal project regain the momentum that it enjoyed in
the mid-20th century. Ordinary people are able to connect the dots, if
leaders will only lead. It's a pity that it took this kind of crisis to open
the door. Lately it has been the right, not the liberal left, that it is
ideologically serious. But ultimately, in this pragmatic country, nothing
fails like failure.