Financialization and Its Discontents: How Wall Street's Political Triumph Led to Economic Crisis
Robert Kuttner is co-founder and co-editor of The American Prospect. He is the author of The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity (2007), Everything for Sale: The Virtues and Limits of Markets (1997) and five other books. Kuttner is a co-founder of the Economic Policy Institute, a progressive economic think tank in Washington, D.C. He is currently a distinguished senior fellow with Demos: A Network for Ideas and Action.
Multinational Monitor: You begin The Squandering of America by outlining several areas where the promise of the United States has been squandered - lost credibility in international affairs, the destruction of the natural environment, the ability of the economy to underwrite a broad prosperity. The book focuses on the economic squandering, and its connections to political failures. In broad strokes, what are the measures by which U.S. economic potential has been squandered?
Robert Kuttner: For 30 years, policymakers have reversed the [Franklin D.] Roosevelt revolution. With the dramatic increase in the influence of corporate America on both parties, policy has turned away from a more mixed or managed form of capitalism in favor of market fundamentalism. This, broadly, has taken five forms. First, a weakening of all kinds of government regulation, which in turn reinforces the economic power of business elites over workers and consumers; second, a weakening of trade unions and other worker counterweights to the power of employers, which has made employment less secure and worsened the income distribution; third, a failure of social policy to change with changing family realities, increasing the stress on working families; fourth, a trade policy that serves the interests of industry and finance rather than workers and consumers; and most seriously, the dismantling of the system of financial regulation - resulting in the current credit collapse and the risk of a second Great Depression.
MM: You argue the United States has evolved into a windfall economy. What do you mean by this phrase?
Kuttner: Well, it hasn't just evolved. This was the deliberate result of political influence of Wall Street. The rules have been changed so that insiders, such as operators of hedge funds, private equity buyout artists and even blue chip investment banks, can make overnight fortunes that bear no relationship to what they contribute to the nation's economic product. It's also a middleman economy, in which those who are essentially parasitic on producers of wealth take far too big a cut.
MM: Your book identifies many factors undermining a strategy of managed capitalism that began in the United States with the New Deal and lasted through the 1970s. Why do you trace this process back to the 1970s, rather than the election of George W. Bush in 2000?
Kuttner: It was in the 1970s that the U.S. government began turning away from the New Deal and postwar system of managed capitalism. Deregulation - of airlines, trucking, natural gas, finance - and the broader ideology of deregulation really began with Ford and Carter. The first assaults on progressive income taxation began with tax changes in 1978. It was Carter, not Reagan, who first defined government as more of a problem than a solution, in his 1978 State of the Union address. This was also the era of the freeing of exchange rates to float, inviting new forms of international financial speculation. And as successive governments dismantled the mixed economy, this was consequently the era when the income distribution began to become more unequal. Of course, all these trends worsened under George W. Bush, but the direction was set in the mid-1970s.
MM: The leading factor on which you focus is the rise of financial speculation, and more generally the power of finance over the economy. In what sense does Wall Street now have more power than it did in the period of managed capitalism?
Kuttner: We are seeing the power that Wall Street has to take down the entire economy! Economically, entire categories of speculation that were illegal 30 years ago are commonplace, of which the subprime scandal is only the most visible and dramatic.
Three decades ago, investment banks could not merge with commercial banks. Far less leverage [reliance on debt] was tolerated by the supervisory authorities. Antitrust was actually enforced. Things were far from ideal - that's why we needed the public-interest movement that began in the late 1960s - but the power of Wall Street to wreck the entire economy with speculative excesses was limited. As late as the 1970s, we were still getting new forms of consumer protection, such as the Community Reinvestment Act, to counterbalance the power of finance. There has also been an increase in Wall Street's political power over both parties, epitomized by the conflicts of interest in the role of Robert Rubin, who was architect of a public strategy of deregulation that served the private financial interests of himself and his Wall Street colleagues.
MM: How does the transfer of power to Wall Street relate to - as cause or effect - the other factors you identify as undermining the era of managed capitalism? How does financial speculation drive, intensify or multiply deregulatory processes?
Kuttner: Wall Street dominates the political agenda. Pressures from Wall Street prevented the SEC [Securities and Exchange Commission] under Arthur Levitt in the 1990s from keeping up with perverse financial innovations such as off-the-books accounting that permitted Enron and other costly scandals. The same pressures led to repeal of the Glass Steagall Act in 1999, inviting another round of speculative abuses. And such pressures made it impossible for Congress to demand that the Federal Reserve enforce the Home Ownership Equity Protection Act of 1994, whose enforcement would have prevented the subprime scandal. Also, Wall Street certifies which Democrats are "sound." A Democrat who runs and governs as an economic populist risks being caricatured as anti-business, and has much more difficulty raising campaign funds.
MM: By what processes, political or otherwise, did Wall Street gain expanded power? And at whose expense - which social or economic sectors - was this power obtained?
Kuttner: We have had two Democratic presidents, Carter and Clinton, who both turned away from earlier Twentieth Century Democrats who, since Roosevelt, were more explicit supporters of a more regulated form of capitalism.
We also had the rise, beginning in the mid-1980s, of the Democratic Leadership Council, as a center-right lobby within the Democratic Party. Under Clinton, the ties with Wall Street became even more explicit. Also, the countervailing power of the labor movement has been becoming weaker for close to 30 years. All of this was supercharged by the increasing cost of campaigning and Wall Street's growing role as money-raiser.
The process is also ideological. Market fundamentalism has become the conventional wisdom, the dominant ideology of all of the Republican party and half of the Democratic party, and much of the press.
MM: Over the last three decades, what were the key legislative and regulatory steps in Wall Street's ascent?
Kuttner: We have had deregulation in two senses. First, explicit repeal of many forms of regulation that once protected workers and consumers and that prevented the more destructive, self-cannibalizing practices of capitalism; second, we've had failure to enforce regulations that remain in the books, as successive presidents have appointed foxes to guard chicken coops. Everything from the Food and Drug Administration to OSHA [Occupational Safety and Health Administration] and the Securities and Exchange Commission are much weaker than they were a generation or two ago. People appointed to regulatory agencies seldom act zealously in the public interest.
It's important to distinguish "Wall Street," in the sense of powerful banking and financial institutions, from the rest of American business. The pharmaceutical industry, for instance, has far too much power to gouge and to maim consumers and to get overly long patent protection for drugs that are often knockoffs of existing drugs. But the drug industry isn't Wall Street.
Notwithstanding all the other abuses - and they are pervasive - for me, the most dangerous thing about recent decades is the way money markets have escaped prudent regulation. And financial elites don't learn from past mistakes because there is so much money to be made. So no sooner do we clean up the mess from the Savings and Loan scandals than we get the subprime abuses. No sooner do we legislate to prevent the next Enron, than we get abuses of off-the-books "special entities" created by blue chip banks. And the regulators are asleep because there is too little political support for strong, public-interest regulation.
MM: You describe conflicts of interest as pervasive in the financial sector. What are examples of such conflicts? What broad strategies do you suggest for redressing them?
Kuttner: In the 1990s, the classic case was the stock "analysts" who were supposedly agents of investors but who turned out to be compensated based on how successful they were in promoting stocks in which their parent company had a direct financial interest. That's a clear conflict of interest. The people who created Enron enriched themselves rather than their shareholders, employees and pensioners.
In the current decade, the emblematic case is subprime. The mortgage companies that originated the loans were supposed to be underwriting them - attesting to the credit worthiness of the borrower. The bond rating agencies that gave this junk triple-A ratings were supposedly operating on an arms-length basis. But both were compensated with lavish fee income, based on how well they moved the paper. That's a flagrant conflict of interest. And there are dozens more. I would flatly prohibit some practices and require a lot more disclosure in the case of practices that are permitted.
MM: More generally, you suggest that the highly leveraged nature of hedge funds and the banking operations poses systemic risk for the functioning of the financial system. What do you mean by systemic risk, and how does speculation with borrowed money create such risks?
Kuttner: In the 1920s, one of the core abuses that set us up for the great crash was too much speculation with borrowed money. It works very nicely when asset prices are rising, but when the bubble bursts and prices start falling, the whole system unwinds. This is a risk to the entire credit system and the entire economy, since it leads to credit contractions at the very moment when the economy is heading into a recession - which only deepens the recession. We've seen the limits of even the Fed's ability to arrest this process with capital advances and with very cheap credit.
When an asset turns out to be worth less than the debt against that asset, it isn't just a crisis of liquidity, but a crisis of solvency. The economist Irving Fisher wrote in 1933 that great depressions occur when collateral is worth less than the debt against it. That's why the current situation is so dangerous - and regulators and politicians let it occur.
MM: If there is a single bad guy in your book, it may be Robert Rubin. Why is Rubin - a leading Democratic Party power - such a significant figure in your story?
Kuttner: Rubin both personifies and epitomizes the capture of the Democratic party by a center-right economic ideology and by Wall Street. He persuaded Clinton that a balanced budget is the road to economic prosperity. He has been trying - unsuccessfully I am pleased to report - to promote a grand bargain with George W. Bush in which Social Security and Medicare are capped in exchange for a restoration of some taxes. His are the economics of Herbert Hoover. He is also a big promoter of one-sided "free trade" in which mercantilist nations like China get a free ride as long as they let big American banks and corporations play. And of course, he was a key architect of financial deregulation.
Rubin epitomizes why we have a one-and-a-half party system. We have a two-party system on gay rights, separation of church and state, and on other tolerance issues. We sort of have a two party system on the more extreme aspects of neo-con foreign policy. But when it comes to free-market economics, we have a one party system - the party of Davos - and perhaps a hundred Democrats in both houses as dissenters. And Rubin is the princeling of the party of Davos.
MM: As much or more than any business sector, finance is now globalized. What challenges does this pose to regulatory strategies?
Kuttner: Globalization of finance presents both political and institutional problems. First, it becomes easier for finance to outrun national regulatory systems. Although major nations, in theory, do have the power to jointly crack down on outlaw companies, they seldom do because it is harder to get transnational consensus than it is to regulate in one country, and treaties are more difficult to ratify than laws.
A good example is the continuing failure of the so-called advanced nations to put tax havens out of business, even though it would not be all that difficult technically; there are very sophisticated monitoring operations directed at money laundering suspected of facilitating terrorism - though not tax evasion. This of course is a political choice.
The Basel accords are a good illustration of the difficulty of trans-national regulation. The first Basel Accord, known as Basel I, was a common agreement of leading nations on capital adequacy standards for banks. The proverbial ink was scarcely dry when financial engineering innovations made it hard to tell whether banks were really in compliance. So a second protocol, Basel II, relied heavily on banks' own models. However, when regulators took a close look, it turned out that in many respects Basel II was a step backwards. Nonetheless, if the political will were present, it would be possible for the leading nations to negotiate common standards on transparency, leverage and reserve requirements, and apply them to any bank doing business within their territories. Before the 1980s, foreign banks were simply not permitted to have significant operations in other countries. Capitalism still functioned.
MM: At the national and/or international level, in broad strokes, what do you propose to control international financial speculation?
Kuttner: Nationally, we need three basic policies.
First, we need much tighter regulation of excessive leverage. Whether the financial institution is nominally a commercial bank, or an investment bank, or a hedge fund - whatever it chooses to call itself - if it issues paper that is essentially a creation of credit then it needs to have capital reserves against that credit. No institution should have leverage ratios in excess of 20 to one. It's just too risky for the system, and it adds nothing to the efficiency of the economy.
Second, we need far more disclosure of instruments that are currently black boxes - disclosure both to regulators and to the public. Regulators have a right to know who is financing a hedge fund and how highly leveraged it is. Ultimately, government ends up bailing out the failures, so we need far more prevention on the front end to prevent the failures from occurring.
Third, there are whole categories of transaction, such as subprime lending, that simply should be prohibited outright. It is not clear, for example, that hedge funds contribute to economic efficiency. They should be required to make exactly the same disclosures as mutual funds that sell shares to the investing public. And off-the-books entities should be prohibited. If a financial institution is on the hook for a risk, that risk belongs on its balance sheet.
MM: You identify the U.S. trade deficit as baking into the cake a decline in future U.S. living standards. Why should people care about the trade deficit?
Kuttner: America now imports more than 6 percent of GDP more than it exports. We borrow the money from foreigners to make up that deficit. Over time, more and more of what we produce goes to pay interest on that debt. Foreign central banks and so-called sovereign wealth funds have accumulated holdings of dollars well into the trillions. China alone holds over $1.3 trillion. With the exception of the Norwegian fund, most of these are based in non-democratic countries that share few of our values, countries that practice a kind of state capitalism which was once termed, rather impolitely, as fascism. These are not the people you want to become heavily indebted to.
Until recently, a great many economists and Wall Street eminences convinced themselves that these countries would go on buying Treasury securities at low interest rates, indefinitely. Now these sovereign wealth funds are buying up real assets. Until we balance our trade accounts, this vulnerability will worsen.
MM: How has such a large trade deficit emerged? What policy choices enabled such large deficits to develop? Do you connect the trade deficit to the increasing power of Wall Street and the financial sector?
Kuttner: The trade deficit is often mistakenly attributed by economists to America's low savings rate. Supposedly, because we consume so much, we suck in imports. And because we don't save the money we need to invest, we end up with a capital account deficit that is the logical consequence of our trade deficit. But this view overlooks the structural causes of the trade imbalance. We had a huge trade surplus in the 1950s and 1960s without a huge savings rate. And our savings rate went up in the 1990s, but so did the trade deficit.
Unlike those nations with whom we trade, American trade policy is biased in favor of the interests of Wall Street. The government doesn't much care if we retain a manufacturing base. It doesn't much care if Asian nations behave in mercantilist fashion as long as they let American banks into the game. And of course Wall Street is a huge ideological supporter of "free trade," defined as offshoring anything that can be moved.
Finally, Wall Street loves the role of being the intermediary in the "recycling" of the surpluses of foreign nations. Investment banks profit from our need to borrow from abroad, and Wall Street also profits from a regime based in international currency speculation. So the cause is somewhat circuitous, but the political influence of the financial sector is definitely a big influence in our trade imbalance.
MM: You finished The Squandering of America just as the current financial crisis was emerging, but before it was clear how serious it would be. You wrote, "You don't need a crystal ball to know that when the next major financial meltdown occurs - and it will - those who clean up the mess will hold hearings, just as they did in the 1930s. And just as then, it will quickly be clear that one of the prime causes was far too much speculation with borrowed money. One of the first things Congress will do will be to put hedge funds out of business. And commentators will ask why nobody acted before the crash came." Are we now witnessing the major financial crisis you said was inevitable?
Kuttner: Yes, and it is not much consolation to be able to say, "I told you so."
This is the most serious credit meltdown since the 1930s. Fixing it will in some ways be even more difficult because the United States today is such a big international debtor. We will need to re-regulate and recapitalize the financial sector, dramatically change our trade policy, and use massive public spending to restore purchasing power so that we don't rely on asset bubbles to as a source of stimulus.
MM: The political response you predicted is wholly lacking, however. Why is this? Do you anticipate the political response emerging in the months and years ahead?
Kuttner: Well, I didn't really predict a political response. I certainly hoped for one, but I said that the power of the status quo was so immense that it could take both a serious crisis and uncommon leadership to shift course. We now have the crisis. We don't yet have the leadership. Far too few politicians have stepped forward to say that this entire crisis is needless - the result of a failed paradigm of how to run the economy that has dominated both parties since the mid-1970s, and that we need a counter-revolution to restore a balanced form of capitalism. It remains to be seen how much worse the crisis has to get before we get that leadership.
MM: You have criticized the recently enacted U.S. stimulus package as far too modest. What should be the policy response to the housing crisis, and in macroeconomic terms to the current economic slowdown?
Kuttner: We need to re-regulate all of the speculative temptations that have caused the financial meltdown. On the housing front, we need an update of Franklin Roosevelt's Home Owners Loan Corporation, to buy back the subprime securities at a discount, and offer below-market interest rates to the two million homeowners facing foreclosure.
Macro-economically, we need government to spend between $500 billion and a trillion dollars a year for the next several years restoring and expanding public services, rebuilding rotten infrastructure, professionalizing human services jobs and creating energy independence. All of this will stimulate the economy, put money in consumers' pockets and create good jobs to replace the epidemic of bad jobs. Most of this can be financed by restoring progressive taxation, though deficits of 3 percent to 4 percent of GDP are certainly sensible in a deep recession.
The re-regulation is also necessary so that we can have very low interest rates to finance recovery without those low rates being used to underwrite another round of financial speculation.
© Multinational Monitor November/December 2007