Can Liberals Save Capitalism (Again)?
Seven decades after the Great Depression,
Democrats have their work cut out for them.
by Robert Kuttner
The American Prospect magazine, August 2002page
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 y, 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
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
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
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 l920s, 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
19~9, 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 ':9 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 l920s,
"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, selfcorrecting 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 l920s
that even all the public spending of the New Deal was not sufficient
to ignite a durable recovery. Unemployment was still above 1o
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
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
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 l920s 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 7o 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 l990s 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 l920s, 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 profitsharing 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 l990s 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 ... 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 s400 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 l990s, 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
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.
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
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 40l(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.
ROBERT KUTTNER is co-editor of The American Prospect