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.