ARCHIVES: WALL STREET / Class Racket

By Doug Henwood
THE LEFT BUSINESS OBSERVER
The author made no money on this book, so please consider a donation.

Wall Street was first published in hardcover by Verso in 1997, and in paperback in 1998. Since Verso chose not to reprint it when it went out of stock, the rights reverted to the author in March 2005.

It’s now available for free download on the web, under a Creative Commons Attribution-NonCommercial-NoDerivslicense. It may be recirculated freely for noncommercial use only. No alterations are allowed, and the author must be credited.

The book is a definitive overview of the financial markets and their economic and political role.

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With the Dow pushing 8,000, and our collective national attention focused on the stock market with a fervor unseen for almost 30 years – with the prominent exception of a little 500 point decline almost ten years ago – and people talking seriously about privatizing Social Security and putting all our public retirement funds in the hands of Wall Street, there’s hardly been a better time to talk seriously about the real meaning of the financial markets. Unfortunately, with triumphalism the national mood, and pundits and politicians promoting the U.S. economy as a model for the world – an example being Clinton’s strutting behavior at the recent G-7 summit – what I’m about to say runs sharply against the grain. By the way, I think the triumphalism is highly unwarranted, a theme I’ll return to at the end of this talk. For now, let’s just talk about Wall Street.

In mainstream economics – and actually a good deal of orthodox Marxian economics, for those of you who care about such arcane things – the real is what matters, and money and finance are either subordinate or peripheral. Insofar as economists consider money and finance, it’s in a fairly mechanistic fashion – the effects of changes in interest rates, say, on real investment. While such considerations are, of course, important, it misses a whole aspect of money, its role as an instrument of power. Or as Antonio Negri put it in one of his more lucid moments, “Money has but one face, that of the boss.”

Innocent money

Let me start by reviewing some of the thinking about money that has prevailed over the years in economics. It’s funny; most academic economists today don’t read anything published before 1980 – or 1970, if they’re of a historical bent. In those old, pre-1970 days, the language of economics was mainly prose. Now, the discipline, at least in the U.S., has been thoroughly mathematized. But the math generally embodies in arcane and priestly form assumptions and arguments that go back decades, or centuries even. Take for example an idea known as “adverse selection.” One of the big names associated with this idea is Joseph Stiglitz, who is regarded as one of the prime theoreticians of the field. Stiglitz, formerly of academe, has just left the president’s Council of Economic Advisors to become chief economist of the World Bank. While he was an academic, Stiglitz published a famous series of papers arguing, almost entirely in math, that high interest rates can cause perverse effects. Obviously, at a given interest rate, lenders will earn lower returns by lending to bad borrowers (because of defaults) than to good borrowers. If lenders try to jack up the interest rate to compensate for this risk, they may chase away good borrowers, who are unwilling to pay a higher rate, while perversely not chasing away incompetent, criminal, or malignantly optimistic borrowers. Such a market doesn’t clear; there will always be unsatisfied players at a given rate of interest.

Though many economists treat this as if it were a recent discovery, it’s really as old as the classics. Adam Smith, in recommending a legal ceiling on the rate of interest, observed that:

If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten percent, the greater part of the money which was to be lent would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition. A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it.

This provides an interesting gloss on the junk bond era. Leave it to the ancient to be concerned more about the social good than the modern, who worries mainly about the mathematics of market clearance and the risk to creditors. Or, as David Ricardo put it:

To the question, “who would lend money to farmers, manufacturers, and merchants, at 5 per cent. per annum, when another borrower, having little credit would give 7 or 8?” I reply, that every prudent or reasonable man would. Because the rate of interest is 7 or 8 per cent. [prevails] where the lender runs extraordinary risk. Is this any reason that it should be equally high in those places where they are secured from such risks?

Michael Perelman, who teaches economics at California State University at Chico, said that when he told Stiglitz about these classic prefigurations of his argument, Stiglitz reacted with surprise. To become a famous economist, you need not be familiar with the founding documents of your discipline.

Back to that discipline’s received wisdom on money and finance. In classical and neoclassical economics, money is “neutral.” Though the term was introduced into English in the 1930s by right-wing icon Friedrich Hayek, drawing on European writers of the 1920s, the concept goes back to the beginning of modern economics in the mid-18th century David Hume famously said “it is of no manner of consequence … whether money be in greater or less quantity.” There are two other famous soundbite versions of the theory – one from John Stuart Mill, who said that “there cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money,” and the second from Irving Fisher, “money is a veil.” That’s probably Fisher’s second most famous statement, the first being his observation in August or September 1929 that stock prices had reached a permanently high plateau.

Making money neutral simplifies your work; you only have to focus on one thing, and you don’t have to worry about how two complex systems, often with a life of their own as well as a life each mixed up with the other, interact. But Keynes noted another fortunate side-effect of neutral money doctrine. The classical economists of the 18th and 19th centuries, said Keynes, wrote as if money didn’t exist, or, more precisely, existed only “as a neutral link between transactions in real things and real assets and does not allow it to enter into motives or decisions.” In such a world, the level of prices has no effect on production, consumption, or the willingness to lend or borrow. But, as Keynes pointed out, wages are “sticky,” meaning they don’t change as rapidly as commodity prices, and debt contracts are denominated in money terms, meaning that if prices fall, entrepreneurs will have trouble meeting their wage bills and servicing their debts. In classical doctrine, a fall in prices would be either neutral, since money prices don’t matter for real exchange, or to some eyes even stimulative, since a fall in prices could increase demand. The 1930s made such ideas disreputable. Conveniently, Keynes noted, in a world of neutral money, “crises do not occur” (emphasis in original). For someone writing in 1933, at the trough of depression, this “assumed away the very matter under investigation.”

A few years ago, Claudio Borio, an economist with the Bank for International Settlements, wrote:

It seems fair to say that central bankers, accustomed to tracing the effects of their actions through the financial system, have probably laid more emphasis on credit than academics, who are more used to thinking in terms of simple paradigms where credit may not even appear explicitly. Similarly, credit has traditionally been more prominent in policy discussions in several continental European countries than in some Anglo-Saxon ones, especially in the United States, partly because of a less pervasive monetarist tradition….

Borio is right that central bankers, and economists working for central banks, are often much more interesting than academics on the subject of how finance and the concrete relate to each other. His “simple paradigms” are the neat mathematical models that economists build to represent social reality, or at least to convey some theory about social reality, pardigms that often ignore money and finance completely, or treat it as an afterthought. It’s ironic that a doctrine known as “monetarism” is partly responsible for this strange indifference to money and credit, but of course monetarist theory has often been a cover for a political agenda of austerity and wage-cutting – and sometimes worse, as in Chile in the 1970s and 1980s.

Guilty money

Back to the safe ground of monetary neutrality. Those American economists who haven’t ignored finance have built their own paradigms, simple and complex, that return the favor by often treating the “real” sector as an afterthought. I want to look briefly at two of those paradigms, which have been enormously influential not only in the field of economics but in the real world as well. First is the so-called Modigliani-Miller proposition, known in the trade as MM, first enunciated in 1958. (Incidentally, the American Economic Review‘s publishing staff found this paper a bit of a typographical challenge. It wsan’t used to setting material with a lot of mathematical expressions in it. Forty years later, that seems very quaint.) The proposition boiled down to the assertion that the capital structure of a firm, the mix of debt and equity on its balance sheet, didn’t matter. It used to be thought, in the naive world before MM, that firms could increase their stock market value with the judicious use of leverage. Firms that didn’t borrow were missing profit opportunities. As long as the return from an investment project was higher than the interest rate paid for outside capital, it made sense to visit your banker or bond underwriter to arrange the use of someone else’s money. But after a certain amount of borrowing, things got a bit riskier. Opportunities to earn rates of profit higher than rates of interest aren’t infinitely available, and a firm with a lot of debt on its balance sheet starts looking risky. A recession, or a bad turn of luck, could turn an overleveraged firm into a bankrupt. So the goal of the financial managers was to find the ideal leverage point and stay there.

MM dismissed this as nonsense, saying, in italics, that the “market value of any firm is independent of its capital structure” and “the average cost of capital to any firm is completely independent of its capital structure.” Or, as Miller put it in an interview, you can’t make yourself richer by shifting money from one pocket. Their argument was that investors would simply undo anything the managers did – selling the stock of a firm that leverages up, for example.

The MM thesis became so widely accepted in the academic literature that interest in the relation between finance and the real world faded to near-invisibility. Economists liked this for a couple of reasons – its formal elegance, its neat theoretical appeal, and the fact that it simplified statisical model building, since you could just forget about finance instead of adding a whole new set of equations. To anyone who knows how much economists rely on neat statistical models, and how little on actual observation of the real economy, this is no surprise.

MM’s influence went well beyond the academy, as leverage artists, their bankers, and their apologists chanted a debt-doesn’t-matter mantra throughout the 1980’s mania. Forgetting the message the 1958 paper about how debt can’t really make you better off, another MM, Michael Milken, used the theory to convince people that debt doesn’t hurt either, and thanks to tax deductibility, it really can make you better off. Here’s how Business Week characterized the popular influence of the MM theory, just after a wave of high-profile leveraged buyouts went bad in the summer of 1989:

The rationale for such financings…dates back to seminal work in the late 1950s by two eminent economists, Merton H. Miller and Franco Modigliani. In essence, the economists reasoned that a company’s earning power, not its financial makeup, is what determines its market value. So high leverage makes sense, since the tax code lets companies deduct the interest they pay…. Depite their bold logic – remember, debt was anathema back then – it was more than two decades before their ideas took hold, and that was largely through Mike Milken’s canny nurturing of the market for less-than-investment-grade [i.e., junk] bonds.

Similar arguments, without the skepticism inspired by sequence of leverage disasters in the summer of 1989, were common in the business press throughout the 1980s. For example, writing just before 1989’s Summer of Defaults, Euromoney argued that the $200-400 billion in recent corporate restructurings were not enough – that work had only just begun, and that a quasi-Trotskyist doctrine of permanent restructuring was well advised by “the rise of modern corporate finance theory.” Work that had originally said that capital structure didn’t matter had spawned an industry, or at least an apology for that industry, based on the perpetual rejiggering of those structures.

The real world experience of the 1980s did a lot to discredit those doctrines. It became quite clear to anyone who was watching that financial structures mattered quite a bit – specifically, that debt can kill. A number of studies published during the 1980s showed that firms’ investments were exceedingly dependent on financial structure. Businesses with large interest or dividend commitments cut back on investment in lean times. This makes perfect common sense, of course, but to become a prestigious economist, you need to leave such considerations behind.

That bit of common sense reflects a very important, but little known or recognized, fact: business firms finance almost all their investment internally. In myth, common both to academics and New York Stock Exchange PR officers, the capital markets – where debt and stock certificates openly trade – transfer the capital of savers to cash-short investors, who in turn thrust the proceeds into productive activity, which will make the paper promises worthwhile and make the economy as a whole grow.

In fact, little real investment is funded on the markets. Corporations fund almost all their capital expenditures internally, through profits and depreciation credits. Since 1952, internal funds have covered 91% of capital expenditure; since 1990, 96%.

Dizzy money

Firms still borrow, yes. But much of that borrowing, though, went not to finance investment, but to finance mergers and acquisitions. Firms rely little, in the aggregate, on stocks; with the exception of the 1920s, little real investment has been financed with fresh stock offerings, and since the early 1980s, more stock has disappeared than has been issued – about $837 billion worth over the last 15 years. The stock disappeared in about $1.4 trillion in mergers and acquisitions (M&A) and through $500 billion in buybacks. Dividends are a more traditional way of siphoning cash to stockholders; because stock prices are so high now, making dividend yields low, it’s easy to miss the fact that firms are paying out near-record shares of their profits to their stockholders – 70% of after-tax profits since 1982, not far from twice historical averages. Through all these mechanisms (M&A, buybacks, and dividends), nonfinancial firms paid their shareholders an amount about three-quarters as much as they spent on capital expenditures. In other words, instead of the markets acting as a way to funnel savings into investment, their more important role is as a conduit for stuffing money into shareholders’ pockets. And I haven’t mentioned a few hundred billion more in interest payments. What portion of that booty that isn’t spent on BMWs and Hamptons beachhouses goes back into the markets, to buy more stocks and bonds, and assert ever-more financial claims.

Of course, some individual corporations do raise money on the stock market, but surprisingly little of the proceeds go to real investment. Typically, the money raised in initial public offerings goes to cash out founding investors rather than to fund an investment program.

I’ve strayed a bit away from laying out classical paradigms; back to theory for a moment. The other major financial theory I’d like to discuss is something called efficient market theory – EM, MM’s fraternal twin. There are several versions of EM theory. In the 1970s, they were called the weak, semi-strong, and strong variants; they have fancier names now, but this is close enough for journalism. The weak form asserts that the past course of security prices says nothing about their future meanderings. The semi-strong form asserts that security prices adjust almost instantaneously to significant news (profits announcements, dividend changes, etc.). And the strong form asserts that there is no such thing as a hidden cadre of “smart money” investors who enjoy privileged access to information that isn’t reflected in public market prices.

On its face, that sounds fairly sensible. But there’s more to it than its surface sense. Start with the theory’s name. To a financial economist, saying that prices are “efficient” means that they reflect all available information. But what information? Is it accurate, or is it noise? And information about what? Stock prices, the subject of most efficient market theory, are supposed to reflect the market’s best judgment of the future course of corporate profits. But who knows the future? We estimate the future mainly by extrapolating from the present and recent past. That will work fine if tomorrow is much like yesterday and today. Quite often that’s the case. But hardly always.

EM theory, like MM, had some important real-world fallout. It contributed greatly to the veneration of markets that has characterized our political culture for the last 15-20 years. The financial economist’s sense of efficency got all mixed up with the more colloquial sense of efficiency, and in a vulgarized version, “fully reflect all available information” became “the market is always right.” That’s become barroom wisdom even among people who don’t know what they’re talking about.

Again, academic work published during the 1980s made it gradually clear that stock prices were partly predictable in at least two not unrelated ways. First, it became clear that stocks that were “cheap” – that is, those with low price/earnings ratios – performed better over the long term than those that were expensive. If the markets were correctly pricing stocks, that shouldn’t have been the case. And second, future prices are indeed partly predictable from past prices, because of systematic overreaction. That is – and once again it’s amazing that it’s taken 20 years for academics to come around to such sensible conclusions – speculative markets get caught up in waves of optimism and despair. When prices are driven to extremes of under- and over-valuation, it’s only a matter of time – though uncertainty over just how much time is why I keep saying “partly” predictable – before they return to some sort of mean. But often, instead of merely reverting to a mean, they overshoot to the other extreme. This over-reaction helps explain why cheap stocks tend to outperform expensive ones.

What about predicting the economy? It’s accepted street wisdom that stocks do a fine job of that. Well, not really. The best predictor of economic strength is the gap between long-term and short-term interest rates. When long rates are significantly higher than short – or the yield curve is steeply positive, in Wall Street lingo – the economy is likely to strengthen or remain strong for the next two to six quarters. When long rates are only slightly higher than short (the yield curve is flat) or if long rates are below short ones (the yield curve is negative – a rare occurrence), then the economy is likely to slow, or remain in the tank. The stock market, by contrast, is less accurate, and can only predict a single quarter ahead – meaning, basically, that its time horizons are just as short as cliche has it.

So the stock market isn’t always right; in fact, it can be quite spectacularly wrong. Unfortunately this discovery hasn’t had quite the real-world fallout that it should. This ideological perimeter will be very strenuously guarded, for reasons made clear in this observation by two very conventional economists, Marsh and Merton: “To reject the Efficient Market Hypothesis for the whole stock market…implies broadly that production decisions based on stock prices will lead to inefficient capital allocations. More generally, if the application of rational expectations theory to the virtually ‘ideal’ conditions provided by the stock market fails, then what confidence can economists have in its application to other areas of economics…?” It’s become very chic to cite Hayek’s metaphor for the price system as a signalling mechanism. It’s clear, though, that there’s at least as much noise as there is signal.

EM theory isn’t strictly a neutral money theory; it argues, for example, that managers should take guidance from stock prices when making investment decisions. But it is a sort of innocent money theory, that treats stock prices as the best real-time evaluation of the allocation of social capital imaginable. But if prices can be systematically wrong for extended periods of time, is the market really a reliable narrator?

Money’s secret

So far, I’ve dethroned – definitively, in my own objective eyes – notions that financial markets are important mediators of real investment and that they serve as useful guides to the allocation of capital. What do they do then? As I mentioned earlier, one of the main uses for outside debt finance has been mergers & acquisitions – much less so now, when the currency is typically stock, than in the 1980s, when it was borrowed cash. That I think offers one important clue about the major function of the financial markets, the organization of ownership. Stock markets, at least in the predominantly English-speaking countries, are vehicles for the buying and selling of entire corporations, and for the establishment of claims to corporate profits. They’re a way for the very rich as a class to own an economy’s productive capital stock as a whole, rather than being tied to the fate of a single firm, as was the capitalist class of the 19th century. Stock markets, in Joan Robinson’s phrase, are a convenience for rentiers.

Mentions of wealth and class and the stock market almost always inspire claims about the democratization of ownership through mutual funds. Shareholders’ democracy is even more a a game of the affluent than the political kind. In 1992, the most recent year available, the richest 1% of households – about 2 million adults – owned 39% of the stock owned by individuals; the top 10%, over 81%. Even if that’s shifted a bit, thanks to the mutual fund boom, there’s no changing the fact that the bottom 90% of the population has a smaller share (23%) of investable capital of all kinds to play with than the richest 1/2% (29%). In 1992, stock ownership was even more densely concentrated, with the richest 5% holding 95% of all shares. Let me repeat that: the top 5% of shareholder held 95% of all stock in the hands of individuals. It would have taken a social revolution to make a significant dent in that concentration over the last 5 years.

Back to power – first, stockholder, and then then the literally political. Back in the Golden Age, the 1950s and 1960s, it was thought by nearly everyone that stockholders were vestigial and functionless. Holdings were widely dispersed, and managers were given free rein. Then, two things happened, starting in the 1970s. First, stockholdings became more concentrated as institutional investors, especially pension funds, came to dominate the markets. And second, economic performance deteriorated, and with it corporate and stock market performance. By the late 1970s, a rentier rebellion was brewing. Along with free-market innovations in the political realm, like tight money and deregulation, came disruptions in managerial autonomy coming from the financial side. At the turn of the decade, Kohlberg Kravis Roberts started doing its earliest leveraged buyouts. At first, they were quite prudent, at least on their own terms, with smallish firms as the targets, and involving reasonable amounts of leverage and reasonable purchase prices. As the decade wore on, the deals became bigger, more expensive, more grandios, and less focused. But in all cases, the idea was that financiers and a new management team – with a tight owner-manager circle taking the place of the conventional public firm – could do a better job than entrenched pre-existing managers. Debt would act as a great incentive to pare costs. Slimmed-down firms with a new lease on life would then be offered to the public again, at great profit to the leverage artists.

At the outset, things worked generally as they were supposed to. There was no great productivity boom, either at the firm or macro level, but the deals did go mostly as planned. But around about 1986, grandiosity gained the upper hand; there were fewer appropriate targets, deals got too expensive, and the debt burden got too heavy. Around about 1989, it became clear that the LBO formula wasn’t working anymore.

Now, I should emphasize that while the point of these deals was to make their sponsors and investors richer, academics and publicists made great claims for their broadly positive effects. The new dealmaking would unleash a storm of imagination – every two-bit hack was quoting Schumpeter’s famous “creative destruction” formula – and revive a tired U.S. economy. In fact, productivity growth in the 1980s was underwhelming, and the economy suffered a near debt deflation during the Bush years. All but the hardiest band of leverage partisans were convinced that a new rentier-enrichment formula was in order.

That new formula was pension-fund activism, led by a handful of public employee pension funds, most notably California’s. There’s a bit of irony here. KKR was legitimated on Wall Street when it got a cash infusion from the Oregon state employees pension fund. KKR deals then went about busting unions and cutting back on employment and wages. A few years later, the California Public Employees Retirement System (Calpers) would become the avatar of the shareholder revolution. That revolution’s most dramatic effect was the wave of corporate downsizings that characterized the headlines for the first half of the 1990s – downsizings that were typically blamed on abstract forces like “globalization” and “technology,” rather than the preferences of portfolio managers. Though Calpers worked mainly with short lists of underperforming firms, the message wasn’t lost on other managers. By 1993, it was clear that the quickest way to add 5 points to your stock price was to lay off 50,000 workers.

It will be interesting to see how this new shareholder assertiveness plays out during the next recession, whenever that happens. Will the rentiers demand cutbacks to sustain profitability and stock prices, or will they be patient? Rather than hazard an answer to this question, I’ll take heed of a Wall Street aphorism – never predict anything, especially the future.

So here the stock market serves as an mechanism through which a small group of rich individuals and professional money managers come to assert ownership and control over the entire productive apparatus of the U.S. economy. In a standard downsizing, the thousands of job cuts are typically blamed on globalization and technology. In fact, the more proximate causes are portfolio managers who want higher profits and higher stock prices. Sometimes you hear it said that this all benefits ordinary folks in the end, through their mutual and pension fund holdings. First of all, this ignores the intense concentration of fianncial wealth; most of us have little or nothing in the way of financial assets – and fewer than half of U.S. workers are covered by a pension plan. Besides, it’s a pretty strange tradeoff that asks people to exchange a few extra points return on their pension fund, on which they might draw 30 or 40 years hence, for a working life full of insecurity and wage stagnation.

Money and state

And now to political power. Wall Street’s political power becomes especially visible during fiscal crises, domestic and international. On a world scale, the international debt crisis of the 1980s seemed for a while like it might bring down the global financial system, but as it often does, finance was able to turn a crisis to its own advantage.

While easy access to commercial bank loans in the 1970s and early 1980s allowed countries some freedom in designing their economic policies (much of it misused, some of it not), the outbreak of the debt crisis in 1982 changed everything. In the words of Jerome I. Levinson, a former official of the Inter-American Development Bank:

[To] the U.S. Treasury staff…the debt crisis afforded an unparalleled opportunity to achieve, in the debtor countries, the structural reforms favored by the Reagan administration. The core of these reforms was a commitment on the part of the debtor countries to reduce the role of the public sector as a vehicle for economic and social development and rely more on market forces and private enterprise, domestic and foreign.

Levinson’s analysis is seconded by Sir William Ryrie (1992), executive vice president of the International Finance Corporation, the World Bank’s private sector arm. “The debt crisis could be seen as a blessing in disguise,” he said, though admittedly the disguise “was a heavy one.” It forced the end to “bankrupt” strategies like import substitution and protectionism, which hoped, by restricting imports, to nurture the development of domestic industries. “Much of the private capital that is once again flowing to Latin America is capital invested abroad during the run-up to the debt crisis. As much as 40-50 cents of ever dollar borrowed during the 1970s and early 1980s…may have been invested abroad. This money is now coming back on a significant scale, especially in Mexico and Argentina.” In other words, much of the borrowed money was skimmed by ruling elites, parked profitably in the Cayman Islands and Z urich, and Third World governments were left with the bill. When the policy environment changed, some of the money came back home – often to buy newly privatized state assets for a song.

That millions suffered to service these debts seems to matter little to Ryrie. Desperate Southern governments had little choice but to yield to Northern bankers and bureaucrats. Import substitution was dropped, state enterprises were privatized, and borders made porous to foreign investment. After Ryrie’s celebrated capital inflow, Mexico suffered another debt crisis in 1994 and 1995, which was “solved” using U.S. government and IMF guarantees to bail out Wall Street banks and their clients, and creating a deep depression; to make the debts good, Mexicans would have to suffer. Once again, a dire financial/fiscal crisis – the insolvency of an overindebted Mexican government – was used to further a capital-friendly economic agenda.

These fortunate uses of crisis first appeared in their modern form during New York City’s bankruptcy workout of 1975. This is no place to review the whole crisis; let it just be said that suddenly the city found its bankers no longer willing to roll over old debt and extend fresh credits. The city, broke, could not pay. In the name of fiscal rectitude, public services were cut and real fiscal power was turned over to two state agencies, the Municipal Assistance Corp. (MAC, chaired by Rohatyn), and the Emergency Financial Control Board, since made permanent with the Emergency dropped from its name. Aside from the most routine municipal functions, the city no longer governed itself; a committee of bankers and their delegates did, Rohatyn first among them. Rohatyn, who would later criticize Reaganism for being too harsh, was the director of its dress rehearsal in New York City. Public services were cut, workers laid off, and the physical and social infrastructure left to rot. But the bonds, thank god, were paid, though not without a little melodrama, gimmickry, and delay.

The city was admittedly borrowing irresponsibily – though the lenders, it must be said, were lending irresponsibly as well. When a bubble is building, neither side has an incentive to stop its inflation. But when it broke, all the pain of adjustment fell on the citizen-debtors. The pattern would be repeated in the Third World debt crisis, in many U.S. cities over the next 20 years, and, most recently, with the federal budget.

Obviously the bankers have the advantage in a debt crisis; they hold the key to the release of the next post-crisis round of finance. Anyone who wants to borrow again, and that includes nearly everyone, must go along. But that’s not their only advantage. The sources of their power were cited by Jac Friedgut of Citibank (ibid., p. 192):

We [the banks] had two advantages [over the unions]…. One is that since we were dealing on our home turf in terms of finances, we knew basically what we were talking about, and we knew and had a better idea what it takes to reopen the market or sell this bond or that bond…. The second advantage is that we do have a certain noblesse oblige or tight and firm discipline. So that we could marshal our forces, and when we spoke to the city or the unions we could speak as one voice…. Once a certain basic process has been established that’s an environment in which our intellectual leadership…can be tolerated or recognized…we’re able to get things effected.

It’s plain from Friedgut’s remarkably candid language that to counter this, one needs expertise, discipline, and the nerve and organization to challenge the “intellectual leadership” of such supremely self-interested parties. I’m told that the unions principal financial advisor at the time didn’t really understand the budget, and just deferred to the bankers, whom he trusted to do the right thing. Politically, the unions were weak, divided, self-protective, unimaginative, and with no political ties to ordinary New Yorkers. It’s easy to see why the bankers won.

What was at stake in New York was no mere bond market concern. In a classic 1976 New York Times op-ed piece, L.D. Solomon, then publisher of New York Affairs, wrote: “Whether or not the promises…of the 1960’s can be rolled back…without violent social upheaval is being tested in New York City…. If New York is able to offer reduced social services without civil disorder, it will prove that it can be done in the most difficult environment in the nation.” Thankfully, Solomon concluded, “the poor have a great capcity for hardship.”

Behind a “fiscal crisis” lurked an entire elite agenda, and one that has been quite successfully prosecuted in subsequent crises for the next two decades. But since these are fought on the bankers’ terrain, using their language, they instantly win the political advantage, as nonbankers retreat in confusion, despair, or boredom in the face of all those damned numbers.

At the national level, rampant borrowing by the U.S. government throughout the 1980s and early 1990s stimulated a boom for a while, but ended with the austerity packages of the mid-1990s. Tripling the outstanding load of federal debt not only made Wall Street a lot of money – underwriting, trading, and holding the bonds – it greatly increased rentier influence over policy. The opinion of “the markets” – essentially the richest 1-2% of Americans and the professionals who manage their money – is now the final word on economic and social policy. Liberals and populists who are sanguine about deficit financing should recall Friedgut’s words: creditors speak with one voice, and they’re able to get things effected. Those effects generally involve enriching the creditors at the expense of everyone else.

The American model

Finally, after this diatribe, I should probably address the current mood of American triumphalism, which holds that our free-wheeling financial system and labor markets are a model for the world. This mood was behind the Clinton administration’s strutting behavior at the recent Denver summit. The rest of the world apparently doesn’t share this opinion; a European diplomat was quoted in the Financial Times as saying “They keep telling us how successful their system is. Then they remind us not to stray too far from our hotel at night.”

The assumption behind the triumphalism is that all those cosseted old ways of running an economy – welfare-statish, as in Western Europe, or regulated and planned, as in Japan – have been discredited by the present U.S. business cycle expansion. Now it can’t be denied that by that most conventional measure of all, GDP growth, the U.S. has done far better than its major rivals. Let’s ignore for now all those softhearted concerns like environmental damage, impoverishment, and polarization, at which the U.S. also excels. And let’s ignore too the fact that for the previous 40 years, the Japanese and European economies outgrew the U.S. The growth rates seen in East Asia over the last 30-40 years are absolutely unprecedented in the history of capitalism – three to four times the rates of growth clocked by Britain and the U.S. during their rise to wealth in the 19th and early 20th centuries. And most of those Asian countries have ignored all the free-market precepts beloved by U.S. pundits and policymakers and their friends at the World Bank.

Enthusiasts for the American way often point to the stock market’s strength as proof of underlying economic strength. In fact, the relations between stocks and the real world are a bit more complex and contradictory. Work by James Stack, reported in his InvestTech newsletter, shows that since the 1950s, the best stock market returns have been when measures of economic strength (like the Fed’s monthly measure of the percentage of industrial capacity actually engaged in production) are slack; when the economy is running at high speed, stock returns are worst.

The stock market aside, has U.S. economic performance really been so spectacular, just by the standards of our own history? No they haven’t. This is by a considerable margin the weakest expansion of the last 50 years. Investment levels are mediocre – and worse, if you strip away investment by financial firms and look just at real-world businesses. It seems that an awful lot of the high-tech gadgetry celebrated by our cybertopians is being deployed in stock and bond trading rooms, whose contribution to human welfare is hard to measure. Those low levels of investment are a consequence of the squeeze demanded by the portfolio managers I was maligning earlier. Stuffing money into Wall Street’s pockets is not a good way to guarantee a prosperous future. But the genius of the U.S. economy is its deployment of vast quantities of low-wage labor. Sure enough, as of 1995, the most recent year available, household incomes hadn’t yet recovered the losses of the 1989-92 slump. But pardon me, I’m slipping into the softhearted mode: stagnant incomes are a sign of our competitive strength. Work harder and run scared: that’s just the way Wall Street likes it.

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