[R-G] [BillTottenWeblog] Financialization and Its Discontents

[Bill Totten]

How Wall Street's Political Triumph Led to Economic Crisis

An interview with Robert Kuttner

Multinational Monitor (November/December 2007)


Multinational Monitor: You begin The Squandering of America (2007) 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 US economic potential has been squandered?

Robert Kuttner: For thirty 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 US 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 thirty 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 thirty 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 One,
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 Two, relied heavily on banks'
own models. However, when regulators took a close look, it turned out
that in many respects Basel Two 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 twenty 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 US trade deficit as baking into the cake a decline
in future US living standards. Why should people care about the trade
deficit?

Kuttner: America now imports more than six 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 US 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
three to four 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.

_____

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, DC. He is currently a distinguished senior
fellow with Demos: A Network for Ideas and Action.
	
http://www.multinationalmonitor.org/mm2007/112007/interview-kuttner.html


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