Can Liberals Save Capitalism (Again)?
Source Dave Anderson
Date 02/07/27/14:33

The American Prospect August 12, 2002

Can Liberals Save Capitalism (Again)?
Seven decades after the Great Depression, Democrats have their work
cut out for them.

By Robert Kuttner
Issue Date: 7.18.02

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 clich=E9s 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

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

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

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

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

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

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

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

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

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

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

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.

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