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The Roaring Nineties, Joseph Stiglitz, 2003, London: Penguin

If wars, as Clemenceau famously said, are too important to be left to generals, economic development and global economic stability are too important to be left to the finance ministers and central bankers of the advanced industrial countries, and the international institutions they oversee, the World Bank and the IMF. Certainly that is the case if we want to create a more democratic and stable global system. —page 222

Boom and Bust: Seeds of Destruction

After the recession of 1990–91, the nineties were a decade of progressively more exuberant growth which reached extreme levels towards the end of the decade. When Clinton arrived in 1992 the economy was beginning a weak, jobless recovery, but before long jobs were being created: 10 million from 1993–97 and a further 8 million from 1997–2000. By April 2000 unemployment was down to 4 per cent for the first time in three decades, well below the supposed NAIRU of 6.0–6.2 per cent.1) But, especially in the latter stages, this was a classic bubble, resulting in a sudden crash during the course of 2000–02. The stock market crash and accompanying leap in unemployment from 3.8 to 6.0 per cent was followed by a spate of bankruptcies amid corporate scandal, including Enron and Arthur Anderson.

There were two broad reasons that the bubble was mismanaged, leading to the inevitable and destructive collapse:

  1. A growing imbalance in the role of government: in the aftermath of Reagan and Bush I, the political landscape had moved decisively towards deregulation. The prevailing perception was that any removal of regulation would be good for the economy, that government no longer had a role to play in ensuring that markets had access to good information or limiting the risks being taken by market participants.
  2. A search for growth without investment: under Reagan and Bush I, the gap between savings and investment had been continually growing (and continued to do so under Clinton, accelerating under Bush II). Voodoo economics (Reaganomics), which postulated that cutting taxes would raise tax revenues (by increasing economic activity and thus the tax base) pathetically failed to justify the tax cuts and consequential deficits opened up by Reagan and Bush I. The investment balance between the public and private sector suffered from the culture of downsizing government — investment in education and research dwindled whilst private investment in new technology enterprises increased vastly (which largely turned out to be sheer waste) in an attempt to gain a 'first-mover advantage' in these markets.

To make things worse, this was a decade in which America was evangelically exporting the economic system which was on the brink of collapse, and the world was sharply divided between those areas that accepted this advice and joined the US in its collapse (especially Latin America and later on SE Asia) and those which ignored it and prospered (SE Asia early in the decade).

Miracleworkers, or Lucky Mistakes?

By this point in history, economics lay at the centre of politics and more or less determined a party's electability. Economic models now accurately predicted the results of most presidential elections based on economic variables alone (except in 2000, when they predicted a Gore landslide…). The Federal Reserve, an independent institution, now had a great deal of power over the central government — economic performance was at least as much down to the Fed's management as the government's, and yet the government bore the brunt of voters' reactions to the Fed's decision-making.

When Clinton entered office the double deficit was enormous, and the economy faced further problems: investment in education and research had dived and the economy was mostly surviving on the basis of past investments.

In the early eighties, the Volcker-headed Fed (reasserting the primacy of monetarism in inflation control) raised interest rates to 15 per cent to control inflation that was largely a result of oil price hikes. Inflation came down from 13.5 per cent in 1980 to 3.2 per cent in 1983, but unemployment soared to 9.7 per cent — highest level since the Great Depression. Further, the Savings and Loan (S&L) associations, banks which dealt mainly in home mortgages were devastated by the changes, since they leant mostly at fixed interest but borrowed at floating rates. The Reagan administration tried to cover up their problems by permitting them to invest more riskily in the hope that they would fluke their way out of trouble — in the knowledge that their failure would show up after the next election. Ultimately, Bush I was forced into a $100 billion bailout when deregulation and tax reductions on real estate lead to a bubble which burst in 1988. The high interest rates also made many foreign governments' debts unserviceable, leading to the 1980s debt crisis. The 1991 recession was ultimately a consequence of the bubble bursting, compounded by the Fed's reluctance to reduce rates quickly enough. Bush I blamed his failure to be reelected on Greenspan.

Clinton's presidency quickly descended into a narrow focus on bringing the deficit under control. Although advocated by evangelical conservatives, this seemed like an impossible strategy — reducing a government deficit hoping that this would stimulate a depressed economy (Clinton having been elected on a promise of “Jobs, jobs, jobs”). But it worked. This was not a disproval of Keynesian economics, although it has been hailed as such by those with a vested interest in reducing the role of government. Rather, it was the result of an accident. When Clinton entered office, the S&Ls were still short of funds and thus unable to provide the loans needed to get the economy moving. However, in the aftermath of the collapse, S&Ls had been permitted to treat government bonds as a perfectly safe asset. This was an error: although the probability of default on long-term government bonds is low, they are nevertheless likely to gain or lose value violently, as interest rates alter. The reduction in regulation permitted the S&Ls to invest in these higher-yield bonds (higher yield because they incorporated a risk premium2) This was dangerous: if interest rates had risen, they'd have been in trouble again. But interest rates fell, recapitalising the S&Ls and giving them the funds they needed to increase lending. This lending was what the economy needed to recover.

So deficit reduction worked, but the process was complicated and unexpected — and inconveniently at odds with the beliefs and self-interest of powerful people and institutions, whose true agenda was to overturn Keynesian economics and/or to downsize the government.

Under Clinton, deficit reduction was pushed too far — the economy would have benefited more in the long term if more had been invested in education and healthcare, even if this had added to the national debt. The returns on these investments would have more than covered the future debt servicing they would have created. There is a real danger that the IMF and ECB take the need for deficit reduction too far. In general, there is a lack of appreciation for the importance of budget deficits both to assist a flagging economy and to ensure sufficient investments are made in education, research and healthcare which can ensure the long-term health of any national economy.

The All-Powerful Fed and Its Role in Inflating the Bubble

The Fed failed to act decisively to deflate the bubble, although it is clear that Greenspan already perceived that it existed in 1996, before the Standard and Poor index doubled between 1996 and 2000. There was concern that interest rates are too broad a policy instrument to be used to deflate a stock market bubble, and there is some truth in this. However, other instruments were available. For instance, Greenspan could have raised margin requirements — that is, how much stock can be bought with borrowed money. This requirement stood at 50 per cent (at least 50 per cent of any stock purchase must be made with cash, the remainder can be credit). Increasing this requirement would reduce demand. Extremist conservatives tend to dislike using new instruments of market control which have not been used in the past — margin requirements had stood stable since 1974.

The current religious consensus amongst central bankers that inflation ought to be the primary (if not exclusive) concern of monetary management is based on four assumptions, one with some scientific validity, three patently false:

  1. It takes 6–12 months for monetary policy to be felt: so action must be taken in anticipation of inflation breaking out. This is true and important.
  2. High inflation damages long-term economic growth: this has only ever been shown of countries with far higher rates than the US.
  3. Inflation, once it begins, is very difficult to control: there is no evidence to suggest that inflation is 'runaway'; in contrast, it is more likely to be self-correcting — high inflation one quarter is more often followed by low inflation the next.
  4. The costs of high inflation outweigh the benefits of increased growth: again, studies conducted by the Council of Economic Advisers and the Fed suggest the opposite.

But inflation is bad for Wall Street traders, of course — inflation would erode the value of bonds.

The desirability of neutrality of a central bank is highly questionable — there is a real conflict of interest between high and low inflation and interest rates. Low inflation and high interest rates tend to be better for Wall Street and the rich, whereas the typical worker paying off a mortgage can tolerate moderate inflation but will benefit from low interest rates (and of course low unemployment). These trade-offs ought properly to be in the political arena, debated by society and determined by elected representatives. Real questions can be asked about the Fed's institutional credibility — whether as an institution it truly serves society's needs as well as it might.

America's Federal Reserve Board represents a curious mixture: it is independent; and it is dominated by those from financial markets, and secondarily from business, with the voices of workers or consumers barely audible.

In the early 1990s, the Republicans pushed for a constitutional amendment which would limit expenditures to the level of tax revenues. Clinton resisted this, even though it would not have hurt him (but rather his successors, such as Bush II).

Deregulation Run Amok

Deregulation of the telecommunications industry largely caused the bubble which burst at the turn of the century, wiping $2 trillion off the industry's market capitalisation. Existing regulation dated to 1934 and was clearly outdated: now there existed phone lines, alongside cable and satellite services, all vying for not only telecom services, but TV and broadband internet services. The 'last mile' of the telephone network had been tightly regulated, since this formed a natural monopoly; now all telecom companies were calling for complete deregulation, arguing that the different media could now compete with one another, keeping prices down. But it was a common fallacy that some competition was inevitably enough, whereas in fact competition between a few large firms would merely lead to an oligopolistic market in which each firm had some (though not complete) monopoly power. The companies themselves must have believed that there were supernormal profits to be earned — otherwise they would not have invested so much in lobbying for deregulation. In fact, there would be competition for the market, but not competition in the market — everyone believed there was a strong first-mover advantage and that the first to invest sufficiently and capture market share would enjoy a dominant position and the profits that accompany that.

Much of the US' regulation dates from the 1930s in a reaction to the massive failure of markets in the Great Depression. Faith in markets was largely restored in the 1960s and 70s, and as technology continued to evolve it became clear that the regulatory framework needed to be reviewed. But by the time Clinton took office, many efforts at deregulation, such as airlines and banks (attempted under Carter) had proven detrimental — competition in the airline industry could not be sustained (bigger companies used their financial resources to drive out smaller companies and new entrants) and the S&L debacle proved the problems with banking deregulation.

Corporate welfare was sticking point during the Clinton era. Every businessman that approached the Council of Economic Advisers for help believed the following:

  1. Subsidies are bad for everyone but themselves,
  2. Competition is good, except in their own industry, and
  3. Openness and transparency are important, in every sector but their own.

In Clinton's attempts to balance the budget, corporate welfare was a natural target, but it proved impossible to make any progress.

The US Treasury violently opposed the idea, suggesting that the very vocabulary “corporate welfare” smacked of class warfare, and that the attack on corporate welfare was inconsistent with the New Democratic pro-business image we were trying to create.


I saw the attack on corporate welfare as completely consistent with our attempt to forge a new philosophy, in which markets were at the centre. It was because I believed in markets that I thought we should be circumspect about subsidizing them. Such subsidies distort the ways resources get used.

They tried and failed to tackle the following issues:

  1. Corporate jets do not pay charges that normal airliners pay in support of the costs of air traffic control. In this case, an attempt to privatise air traffic control would have equalised the charges — in this case, business argued strongly against privatisation.
  2. Attempts were made to auction the electromagnetic spectrum, in order to raise revenue and force responsibilities on broadcasters such as providing educational programming and campaign time (which would hopefully have reduced the importance of funding in political campaigning). Obviously, the mainstream media hated the idea, making it politically impossible.
  3. The most egregious case were tax breaks — effectively export subsidies, but not perceived as so because they were reductions in tax rather than being structured as subsidies.
We had long had multi-billion-dollar tax subsidies for exports, which so infuriated our trading partners that in 1998 they brought action before the WTO and won. Rather than abandoning the subsidy, we attempted to make it compatible with WTO rules.

Creative Accounting

A stock option is the right to buy a certain amount of stock at some future point for a fixed price. If the fixed price is beneath the market price, then the owner of the option exercises it and makes an instant profit. The opposite is a 'put', which is the right to sell a certain amount of stock at some future point for a fixed price. By diluting the existing stock, options always reduce the value of existing shares held by shareholders.

The significance of options is the way they are dealt with by corporate accounting. They are essentially ignored. Executives were given options (a financial asset with positive value), but this had no effect on the balance sheet or profit and loss — it was not counted as an expense or a liability. The accountants' regulatory body, the FASB3) tried to alter existing rules so as to make it clear to shareholders that when options were dispensed this had a real impact on the financial position of the company, but this proposal was blocked by industry, using the most specious arguments. And the impact was enormous — if the following companies had been required to acknowledge options then their profits would have fallen thus:

  • Microsoft: profits of $7.3 billion cut by a third,
  • Intel: profits of $1.3 billion cut to $254 million,
  • Yahoo!: losses increased from $93 million to $983 million.

The information was buried in footnotes; the market did not understand it and overvalued these companies massively as a consequence.

Options usually provide a poor incentive. In the nineties, when the stock market was rising in value generally, all executives were rewarded by options. Even bad performance was rewarded generously. Additionally, stock options create a strong incentive to temporarily inflate the current stock market value — which is easiest done through egregious misrepresentation in the company's accounts. Stock options encourage mendacity.

There was a further conflict of interest in the accounting industry. Firstly, auditors are employed by a firm to check their accounts to certify that they are accurate — the accountant is being paid by a client who is supposed to be held to account — a clear incentive to be sympathetic. But increasingly, accountants were taking on a dual role within a single firm, both as auditors and consultants. An accountancy firm, having looked over the books of a company, is in an ideal position to recommend changes — but often changes which help to deceive shareholders about the true position of the company (whilst not breaking any accountancy rules). In the US, there are strict rules governing the preparation of corporate accounts — which result in accountants doing whatever they possibly can within those rules (and blocking any proposed changes to make the rules any stricter). Elsewhere, there is usually no universal set of rules, but each auditing firm must sign off on the company accounts to declare that they are a true and accurate record of the company's financial position. In the nineties, this seemed like a more effective system which was being less openly abused.

The Banks and the Bubble

Traditionally, there are two flavours of bank: commercial banks and investment banks. Commercial banks issue loans. Investment banks broker issues of bonds and stocks. Since the Glass-Steagall Act of 1933, in the US these two types have been kept separate because of various potential conflicts of interest that might arise if they were done by the same organisation.

In the nineties, deregulation of the banking sector allowed the merger of the two types of banks, forming groups like J P Morgan Chase and Citigroup. Proponents of these mergers were not particularly consistent — they were supposed to generate economies of scope, but when challenged on the possibility of conflicts of interest, their advocates claimed that a Chinese wall would separate different operations (in which case, how is it possible to exploit economies of scope?).

Commercial banks have a strong interest in examining the long-term financial position of the companies they lend to — this scrutiny provides an important check on management profligacy, especially attempts by CEOs to artificially inflate short-term profits in order to temporarily push up share prices so as to exploit stock options. However, investment banks' motives are different. They serve two interest groups: the companies whose stocks and bonds they offer, and investors, who trust investment banks' recommendations of particular stock issues. In theory, an investment banks' analysts ought not to put a positive spin on the state of companies for whom they issue stock, because their reputations are at stake. In reality, there is a sharp asymmetry of information and they can often get away with it. This becomes particularly acute when an affiliated commercial bank can lend to a company whose stock they are issuing — it may be in the bank's interest to extend further questionable loans without much scrutiny in order to maintain or inflate the price of stock that they have issued. The most extreme case of this was Enron, whose banks continued to make highly questionable loans, partly because Enron's bankruptcy would inevitably reveal the banks' past indiscretions, so any means of reducing the likelihood of bankruptcy seemed attractive. Analysts talked up the prospects of companies that they knew would never make money. The most obvious way to combat this problem was greater openness — force analysts record of stock recommendations to be published along with their actual performance; obviously, this was sharply resisted by the banks. There is also a system of kickbacks in place: economists have long been unable to understand why stock prices typically rise rapidly directly after an IPO — surely this means that investment banks are systematically underpricing stock when they bring it to market. The answer appears to be that they undervalue stock in order to give a cash gift to those customers who they initially sell stock to. These preferential customers are often CEOs who have chosen their bank to handle their own company's stock issues. This is a means of stealing value from the shareholders of the company issuing stock and giving it to a CEO, who then return the favour by passing more business to the investment bank. Starting with Goldman Sachs on 4th May 1999, the large investment banks then went public, taking advantage of the bull stock market but protecting their executives from the long-run risks of their strategy.

Rational expectations theory has now been decisively challenged in three ways:

  1. Informational asymmetry — rational expectations rely crucially on the assumption that all market participants know and believe the same things. These informational asymmetries are made far worse when those with more information (such as market analysts) do not have strong enough incentives to truthfully advise those with less (such as ordinary shareholders — and these incentives were made very much worse during the nineties).
  2. Different participants have different fundamental beliefs about how the world behaves — different people use different models. Not only must everybody have rational expectations, but they must also all believe that everybody else has rational expectations.
  3. Lastly, research is emerging that people are unable to process information rationally in these circumstances and systematically irrational phenomena are repeatably observed.
Business managers, unlike economists, have always been alert to the importance of irrationality. Marketing experts make their livings exploiting it. Insurance reps know they can sell coverage for low-probability events (rare forms of cancer, for instance) at premiums that far exceed the actuarial odds, because so many people are unable to resist a policy that costs but a few cents a day. Financial analysts too, tend to be shrewd students of irrationality and herd mentality.

Mergers offer a further case in which investment banks' incentives are poorly aligned. An investment bank that handles a merger always earns a sizeable commission, even if the merger turns out to destroy rather than add value. In fact, if the merger creates a less valuable company, then the investment bank is likely to be called in to handle the dismemberment of the company once it becomes clear. This explains why it is that mergers do not, on average, create value. It is always in the interests of the investment bank (and usually the CEOs, who will receive enormous bonuses or retirement packages for handling the merger) to argue that it will create value, since their income relies on this conclusion.

Tax Cuts: Feeding the Frenzy

In 1980, Reagan had introduced a tax cut which he claimed would increase tax revenues. Supply-side economics, dubbed 'Voodoo Economics' by Reagan's VP Bush and 'Reagonomics' by various others, argued that a decrease in taxation would induce such large supply-side effects — labour force participation, savings, and the increase of hours and effort that workers would expend — that a surge in economic activity would more than offset the reduction in tax. In fact, the impact on these inputs was negligible, as the advocates of Reagonomics probably expected. It did, however, force cuts in social spending.

Although this field had been entirely discredited by Clinton's reign, there was one tax for which it was still thought to potentially work, primarily because of a distortionary accounting system. Capital gains tax is only paid when assets are liquidated, so at any one time a government has a pool of unrealised assets in the form of capital gains tax that will not be paid to government until the holder chooses to sell those assets.4) So, by reducing capital gains tax for a limited period, in effect offering a 'sale price' on capital gains, the government encourages early liquidation of these assets, increasing current revenue at the expense of future revenue. This is effectively a means of borrowing — although it is not widely perceived as such. It is also an immensely regressive form of tax break. And it is destabilising — it encouraged greater use of stock options by CEOs and for stockholders to sell and reinvest (more money than they would otherwise be able to) in stocks — both having the effect of feeding the bubble. It also motivated CEOs to manipulate current share price, since there was now greater value in artificially inflate share prices and selling shares than holding on to shares and pursuing long-run improvements in profitability.

As the Clinton years came to a close, I wondered: What message had we in the end sent through the changes that had been brought about in our taxes? What were we saying to the country, to our young people, when we lowered capital gains taxes and raised taxes on those who earned their living by working? That it is better to make your living by speculation than by any other means. The New Economy — the innovations which continue to fuel that productivity growth and form the basis of this country's long-run strength — depend on advances in science, on researchers at universities and research labs, who work sixteen-hour days and more in the tireless search to try to understand the world in which we live. These are the people we should be rewarding and encouraging. Yet it was these people who were being more highly taxed, while those who speculated were taxed more gently While we talked about incentives, most of the tax giveaway had no incentive effect at all. While we were teaching our young people something about our national values, we were also teaching our young people another lesson in political hypocrisy, or, some might say, in the ways of the world.

Making Risk a Way of Life

There were many ways in which changes in the economic environment and government economic policy reduced the ability of individuals and the economy as a whole to manage risk effectively.

Although much hyped, the IT revolution has lead to continual improvements in productivity, which has its negative effects as well as positive. During downturns, productivity has continued to rise, increasing pressure on unemployment when the economy is most vulnerable to it. Simultaneously, the culture of American business has turned against 'labour hoarding' — that is, holding on to surplus labour during a recession in order to maintain the most able staff and to build loyalty between employer and employee so that the firm can reap the benefits of greater employee commitment when these are required. This culture may have been partially fuelled by CEOs' increased incentives to focus on the short-term financial position of the company, maintaining profitability by slashing workforces, even if this would have a negative long-term impact — and arguing that taking 'difficult decisions' such as making workers unemployed justified increased bonuses. This makes the economy more vulnerable to the business cycle — a minor slowdown in demand leads to a rapid surge in unemployment which itself increases the severity in the demand shortfall. Reduced job security increases anxiety which encourages consumers to cut back on consumption, especially when a recession begins, further exacerbating the problem.

During the 1990s, assumptions that the IT revolution would have a permanent effect on the growth of stock value allowed firms to make insanely optimistic projections of the growth of their pension funds. Firms are committed to paying their former and current employees pensions of a given value, and pay into a fund designed to provide these payments whilst employing these workers in order to meet their liabilities later. However, during the nineties they were permitted to assume that these funds, based on stock market investments, would grow at an absurd average rate of 9 per cent per annum. When the stock market crashed they not only much of the value of these funds being wiped out, but also the adjustment of projections of the growth of these funds, forcing them to sharply increase their contributions. Again, a further massive contraction in aggregate expenditure just as the economy was entering a downturn. And in many cases, firms' newly assessed pension liabilities were greater than their total assets.

Increased worker insecurity has made a broad transition from company-managed pensions to portable private pensions. Wall Street loves this idea, although the associated transaction costs are high — much higher than for the government-run Social Security programme.

Critics do not complain about the efficiency of the Social Security system; they simply cannot. The fact is that the public Social Security system is almost surely more efficient, in the key dimension of transaction costs, than any private system is likely to be. Of course, transaction costs to some (the beneficiaries who view it as bad) are income to others (those in Wall Street who would manage the privatised accounts). Wall Street likes transaction costs — the higher the better. Free market ideologues say that competition drives down fees to the minimum level of effectively to zero. Virtually nowhere has it succeeded in doing so.

Social Security invests exclusively in government bonds, so it is very low risk — ideal for a pension fund. Some argue that higher returns could be earned by investing in the stock market — if this is the case, the only agency large enough to do so without passing on the extra risk to pension-holders is the government. Stocks are vulnerable to sudden crashes — if this happens just before a pension-holder is due to retire then the value of his pension is destroyed, but government is in a position not to pass on this risk. Additionally, it would be of broad benefit for the government to issue bonds whose payout is adjusted for inflation. The market is currently unable to provide such assets. They would eliminate the need for private pension-holders to invest in the stock market to hedge against inflation — which is a risk for non-inflation-adjusted bond-holders. Moreover, this would reduce the cost to the government of its debt, since a risk premium would be paid for the security of an inflation-adjusted bond, which the government would essentially be in a unique position to hedge against. Wall Street hates the idea — in the UK, traders complain that nobody trades these bonds, they are merely held long-term until retirement — making them a bad prospect for bond traders. As goes Wall Street, so goes the Treasury.

Traditionally, the rather weak and blunt instrument of monetary policy is supported in its management of aggregate demand by various stabilisers — aspects of government taxation and spending that vary counter-cyclically so as to naturally stimulate the economy during a recession and reduce inflationary pressure during a boom. During the nineties these were broadly reduced, particularly benefits, further increasing the economy's vulnerability to the business cycle.

Globalization: Early Forays

Negotiation between the US and other nations over economic treaties and agreements has a natural tendency to unfairness, given the imbalance of power. But equally importantly, unlike in the domestic arena, most interest groups in international trade negotiations (such as foreign populations and particularly vulnerable groups within those populations) have no effective power over the US government — the only interested party with a significant presence are US special interests.

This fact has shaped trade agreements over the last two decades. 'Free trade' has come to mean deregulation of financial markets (enabling Wall Street to gain a new dominance of overseas markets) and the protection of intellectual property (assisting American biotech and high-tech firms to get a firm grasp of foreign markets that could otherwise have used foreign IP without licenses, if they had followed the development model that America itself used in the nineteenth century to exploit European technologies). In contrast, free trade agreements do not cover industries such as construction and maritime5) — labour-intensive industries in which the developing world could potentially benefit from a liberalised international environment. Not only was the focus of trade liberalisation unbalanced, but sometimes liberalisation had negative knock-on effects in developing economies which provided ample reasons for them to be resisted. It is argued, for instance (although evidence is still inconclusive), that when international banks displace domestic rivals, there is a bias towards funding readily-comprehensible TNCs rather than providing credit on easy terms to small- and medium-sized domestic firms. Horrific US agricultural policy hardly needs to be mentioned: in industries such as cotton US subsidies artificially inflated world production (America accounts for one third of global production) forcing down the market price and depriving several African countries of between 1 and 2 per cent of GDP. Moreover, the US makes frequent efforts to circumvent those agreements that it has signed, using non-tariff means to protect various industries wherever it can get away with it.

The crises in Mexico, EA, Russia and LA provide further lessons. The IMF-US Treasury policies failed again and again. Huge bailouts failed to avert each crisis, failed even to prevent the depreciation of the currency in most cases. Emergency policies to hike interest rates and balance government budgets also failed to avert crises, but did exacerbate the ensuing depressions, increasing bankruptcies. Economies suffered, but the balanced budget and low exchange value depressed imports making foreign exchange surpluses available to service debts. Countries who ignored IMF-Treasury advice often escaped most lightly — particularly China who pursued an expansionary policy (in accordance with standard economic theory) and Malaysia who implemented capital controls allowing it to keep interest rates down and avoid the spate of bankruptcies that hurt other economies so badly — and leaving the government with a far smaller burden of debt.

Bailouts present two further problems:

  1. the moral hazard involved encourages risky lending to firms or countries unlikely to be able to repay, and
  2. speculation and speculative attacks are, in general, a zero-sum game — it is only when public institutions intervene to try to support a currency that it is possible for speculators as a group to gain — in this sense, a routine policy of publicly financing bailouts could be argued to be the only thing that makes speculation a profitable activity.

But too often, foreign financial instability of all forms is good for Wall Street — the investment banks who manage capital inflows and advise foreign governments how to manage those inflows also earn a windfall managing a sudden capital flight. The only situation in which Wall Street is not earning money is a situation of stable, long-term investment.

The international financial architecture also forces a certain degree of subsidy of the US by LDCs. LDCs are forced to hold reserves sufficient to support private sector debt, should short-term foreign debt not be rolled over. These reserves increase as the economy expands and as international lending increases. Governments must invest these reserves in low-interest dollar-denominated accounts, whilst corresponding amounts are being borrowed by the private sector from American banks at far higher interest rates (perhaps 2 per cent versus 18 per cent). Additionally, whilst most LDCs fight to retain an overall trade surplus at the behest of the IMF — against China and Japan's insistence on running a permanent surplus, the US becomes the 'deficit of last resort' — the nation that continually runs a deficit in order that all other countries can balance their budgets. The Treasury, through the IMF, more or less forces balanced budgets on developing countries, whilst running an enormous deficit at home.

The financial system allows the United States to live year after year far beyond its means, even as the US Treasury, year after year, lectures others on why they should not. And the total value of the benefits that the United States gets out of the current system surely exceeds, by a considerable amount, the total foreign aid that the United States provides. What a peculiar world…

The international financial structure urgently needs a recognised international procedure for dealing with national bankruptcy — the suspension and rescheduling of international debts, just as the US has for domestic corporations. It is also important to develop greater transparency requirements for offshore capital and hedge funds. The US is increasingly seen as highly hypocritical in the policies it forces on other countries — privatisation when it recognises the benefits of a public Social Security system at home; balanced budgeting when the Council of Economic Advisers under Clinton rejected a constitutional amendment which would have irrevocably committed the US to balanced budgeting; the extraction of debt servicing at all costs when it recognises the importance of systematised bankruptcy proceedings at home; forcing of central banks to focus exclusively on inflation when the importance of high employment is urgently felt in the management of the domestic economy; and evangelism of free markets abroad when the US has an advanced and subtle array of anti-trust legislation and regulation to ensure the efficient function of domestic markets. The US is generally — and accurately — perceived as pursuing an essentially mercantilist foreign economic policy designed primarily to benefit American special interests and the hostile perception of America that this fosters abroad is extremely dangerous in the long run.


Enron was a tangle of deception, both of the money that its leadership was stealing from its shareholders, and the deception of the stock market which lead to its overvaluation and concealment of its impending bankruptcy. The deceptions are complex, but some approximation of the key ones can be described:

  1. Selling a commodity for future delivery, such as gas, to be paid for now, in reality creates a liability, not unlike a loan. But Enron was able to record these sales as current revenue, leaving the associated future liability off the books. Although the costs eventually appeared on the books when the gas had to be delivered, this could nevertheless continuously inflate apparent profits provided that the company (and volume of its transactions) is growing — in effect, the new loans being received are always greater than the old ones being paid off, creating a profit similar to a Ponzi scheme (a 'pyramid selling' scheme).
  2. The next step is to create a subsidy — call it Raptor — to purchase the gas from Enron rather than selling to an external firm. Enron could then sell future delivery of gas to Raptor, recording the revenue, and then buy it back immediately afterwards, ensuring that no real transaction takes place. Again, the current revenue is recorded, the liability is not. In order to pay immediately for future delivery, Raptor has to borrow from banks — improving Enron's cash position without bank lending showing up in its accounts (essentially an undeclared bank loan).
  3. If Raptor is owned by senior executives of Enron, then Raptor can also function as a means of siphoning money out of the company — the price at which Enron buys gas back from Raptor can be high enough to repay the bank loans with interest and still leave a healthy profit to Raptor's shareholders at the expense of Enron's shareholders.

Energy markets such as the electricity market form natural monopolies, and are thus usually structured as either

  1. state-owned corporations, as traditionally throughout most of Europe,
  2. free-market systems, as virtually nowhere in the world, or
  3. as regulated private monopolies, as traditionally in the US.

Enron was heavily involved in the deregulation of the electricity market in California, moving from a regulated private monopoly to a deregulated 'competitive' system in which multiple electricity providers supplied the state grid and prices were free to move to balance demand and supply. Free-market ideologues claimed that this would lead to rapid reductions in the price of electricity; instead prices rose rapidly and continuously by eight times between April 1998 and 2001. Furthermore, the state experienced supply interruptions completely unfamiliar to the American market. Ultimately, the state had to intervene to dismantle the new system, at a cost to the taxpayer of approximately $45 billion. The market contained too few suppliers to be truly competitive, and the price inelasticity of demand made it especially vulnerable to restrictions in supply — in effect, the suppliers acted as a cartel to restrict supply and drive up prices. They did this by taking capacity offline 'for repair' and shipping electricity out of state. In contrast, Brazil managed deregulation much more effectively by fixing prices for existing sales — forcing companies to provide the same amount of electricity as in previous years to the same consumers at the same price, and only permitting the free market to operate at the margin of increases in demand — in which consumers have a much greater choice of whether or not to purchase additional supply and can realistically refuse to do so if prices are excessive (this component of demand is far more price elastic). Brazil's government was less dominated by the political influence of energy suppliers and more responsive to the anger of electricity consumers.

Enron has been widely criticised for its involvement in third world energy markets, especially for buying political influence both with third world regimes and the US administration, receiving billions in dollars in subsidies through export support and public insurance. The Dabhol II plant in India was a particularly egregious case, condemned by the World Bank as uneconomic, the Indian government agreed to a fixed price-quantity supply at well above the price at which domestic suppliers were selling electricity — at so high a price that corruption must have played a part, as well as the observed pressure from the US government. These types of fixed price-quantity agreements shift all of the project risk to the government and away from the private firm that is undertaking the investment — hardly the typical behaviour of a functioning free market. When the Indian government tried to cancel or amend the contract, important figures both in the Clinton and Bush II administrations (in the latter case Cheney's office) intervened directly to pressure the Indian government to honour its contract.

There was more than a little irony on the side of both [Enron CEO] Ken Lay and the US government: Enron, the seeming champion of free market economics, and Ken Lay, a severe critic of government, were so willing to receive government assistance — billions of dollars of loans and guarantees — that Lay made use of his friends in high places to push his firm, and then did all that he could to avoid taxes (with remarkable success). And America, especially US Treasury officials, was lecturing East Asia on crony capitalism, and then apparently practising it themselves.

Debunking the Myths

Various myths gained credibility during the 1990s which will remain dangerous if they are not widely recognised as false, even though some were temporarily useful. Most have been at least touched on already, but they bear repetition:

  • Deficit reduction creates growth. This arose primarily from the US experience of simultaneous deficit reduction and recovery, but clearly flies in the face of everything that has been learnt about economics since the Great Depression. The dangers of trying to generalise on this experience are clear.
  • Wars are good for the economy. This is an anachronism: clearly there is no doubt that the Second World War was very important in American economic recovery, but this war involved full mobilisation of the economy. More recent wars, notably Gulf I, involving partial mobilisation are much more harmful. They create uncertainty (especially oil-price uncertainty in Middle-Eastern wars) and war expenditures crowd out other investments (since there is no longer support for substantially increased wartime taxation as happened during World War II).
  • Prosperity depends on heroes. There are two competing views of the world; one in which the arc of a nation's progress is primarily dependent on the leadership of those in charge; the other in which underlying forces are far more important, and if one leader is removed he will likely be replaced by somebody facing much the same pressures. Economists and other social scientists tend to favour the latter, as does Stiglitz. The danger of putting too much trust and faith in key figures (in the 1990s, Greenspan and Rubin) is that it deters us from seeing good policy as the key to success, and from pressing our leaders to enact better policies. Instead, if prosperity relies on the genius of our leadership, we ought to stand back and let them do their work — a much more dangerous course.
  • The inevitable efficiency of the invisible hand. Recent advances in economics have shown how narrow efforts to improve share price (especially in the short run) may not lead to efficiency, and further how an amoral pursuit of self-interest will not always create the most efficient market. In particular, the cost of writing and enforcing contracts is important. Traditional economic models assume this to be costless, but in fact most transactions are undertaken without explicit contracts because they would be too costly to write, and litigation to enforce contracts is extremely expensive. In light of this, a functioning market system relies heavily on the mutual trust of its participants — there may be short-run gains in violating this trust, but there will follow an enormous loss of economic efficiency if more general trust is lost. Once one firm has decided to act untrustworthily — by adopting dishonest accounting, for example — then market competition might drive its competitors to do likewise, resulting in a race-to-the-bottom rather than an optimal outcome.
  • The myth of finance. What is good for Wall Street may or may not be good for the economy in general — there should certainly be no assumption that Wall Street speaks for the general interest.
  • The myth that government intervention is always undesirable. Many of those who use this myth to push for greater deregulation and reduced taxation are highly dependent on government in the form of export subsidies and long-term research and development.
The myth that lower taxes would unleash huge increases in savings and work effort has proved remarkably resistant to evidence. Reagan lowered taxes markedly, but neither savings nor work effort increased, and indeed, productivity growth hardly budged. Clinton raised taxes on the rich, and dire consequences did not emerge.
  • The myth of global capitalism. There is a clear double standard in the way that economists view government intervention in different areas of the world: interventions that are (perhaps reluctantly) conceded to be absolutely necessary at home (Social Security, Medicare, education, a central bank mandated to consider employment as well as inflation) are considered too extravagant by market fundamentalists abroad. Somehow 'American-style capitalism' is transmuted in the translation. In particular unregulated capital flows have proved very dangerous for developing countries — a danger to which the large US economy has far greater immunity.
  • The myth that American-style capitalism has 'triumphed'. During the bubble economy of the late 1990s, many in America perceived it as a final vindication that American-style capitalism had triumphed over Soviet state capitalism, but also over all other variants of the market system, particularly in Europe and Japan. The various errors involved in that line of thinking were very clearly highlighted during the collapse, but the gratification that the rest of the world found in America's fall from grace was heightened by American hubris before the fall.
There are other countries which believe that their economic system is better, at least for them. They may have lower incomes, but they have more job and health security; they enjoy longer vacations, and lower stress may be reflected in longer lives. There is less inequality, less poverty, lower crime, a smaller fraction of the population spends a large part of their lives behind bars. There are choices, there are trade-offs.

Toward a New Democratic Idealism: Vision and Values

In recent times, many two-party political systems seem to have collapsed into a single set of policies governed by 'motherhood-and-apple-pie values' advocated by all parties, who are reduced to arguing that they are merely more efficient managers than the other lot.

If we — Democrats and Republicans — are all for the middle class, if we are all for the market economy, unfettered by regulation, then what is it that separates the left from the right, the Democrats from the Republicans? What is it that Democrats stood for? Was it the end of politics… at least as far as the economy was concerned?

One could think of the two parties as two management teams, each claiming that they know better how to run the economy.

Stiglitz uses the term Democratic Idealism to describe a set of concrete policies which he believes ought to set the Democrats apart from the Republicans on the basis of more than merely being slightly less corrupted by special interests.

It is easy to list the aspects of Reaganite policy which Democratic Idealism opposes. Democratic Idealism hopes to restore an appropriate balance in government — in which government plays a legitimate role intervening in markets which would not function properly by themselves (such as education and pollution) as well as by regulating other markets (such as finance) so that they operate more efficiently. Although it is impossible to prove, it is widely suspected that theories of trickle-down and supply-side economics were never believed by those who advocated them — they were merely a cover for policies which would advance a fairly crude class warfare.

One of the key reasons for this collapse of all parties into a 'centre ground' is the success that the right has had in convincing the middle classes that their interests are much more closely aligned with those of the mega-rich than to those of the poor. Tax breaks which benefit the top 2 per cent of the income distribution almost exclusively are widely perceived as being in the interests of the middle class. The middle class has become much more sensitised to the danger of being 'robbed' by the poor than by the extremely rich — welfare is perceived to take money from the median voter, whereas corporate welfare somehow does not.

A quick summary of the practical policy prescriptions of Democratic Idealism:

  1. Weakening government influence in some areas: eliminating agricultural subsidies, examining corporate bailouts (eg airlines) and practices that reduce competition (eg aluminium) much more carefully.
  2. Strengthening government influence in others: increased protection for consumers (health and safety, and against monopoly power), protection for investors by improving regulation of accounting and finance, increased environmental protection, provision of insurance against risk that the market does not provide (eg against inflation and better unemployment insurance).

Democratic Idealism explicitly recognises that policies affect different groups differently, that it is normal for political decisions to have 'class implications' and that a free and open society must recognise these different gains and losses rather than pretend that every government programme is equally beneficial to all members of society (which is what simplistic and unsupported theories such as trickle-down economics try to suggest). Moreover Democratic Idealism considers social justice an important aim of society.

This is not the place to defend basic values of social justice. I shall merely assert: We should be concerned with the plight of the poor.

Stiglitz cites Rawls' Theory of Justice and the literature which followed it as an appropriate basis of such ideas. Social justice requires policies such as:

  • Equality of opportunity: eg providing pre-school education to those that cannot afford to pay for it, and good school meals as a way of ensuring all children have adequate nutrition.
  • Full employment: particularly through recognition that advanced societies (very much including Europe) focus too narrowly on inflation control.
In much of Europe, the employment statistics are far more dismal than in America, and have been for a long time. Bu the solution requires more than just more “labour market flexibility” — which has become almost a code word for saying lower wages and less job security.
  • Intergenerational equity: we must recognise the right of future generations to inherit a world which is at least as liveable as the one that we have inherited, and that requires us to make significant changes to our economy to make it more sustainable.

America also needs urgent changes to its electoral system in order to reduce the influence of money.

Only a few extreme conservatices believe that individuals should be able to sell their vote…But indirectly, through the media, votes are bought and sold. People have to become informed, convinced to go to the trouble of voting, even taken to the voting booth, and all of this costs money. That is why campaign contributions are so important. But individuals, and even more so corporations that contribute, expect something in return. They are buying government support — not in the crass way that politicians may be bribed in some countries, yet the link between policy and money is unmistakable.

Campaign finance reform is therefore urgent — Clinton had the opportunity to make significant progress by forcing the media to carry political advertising for all parties for free, but could not force the legislation through (being strongly opposed by both the media and corporate donors).

The cause of individual rights in America have traditionally been seen as synonymous with constraining the role of government — by forcing the government to respect the individual's right to free speech, a free press, privacy and information about the government's activities. But there has been a growing recognition outside America that many individuals' rights that are becoming more important with growing affluence require active government intervention in the economy — economic rights to work, to free healthcare and education.

Outside the United States these rights are increasingly recognised: of what value is the freedom of speech to a man who is so starved that he can hardly speak, freedom of press to a woman who has not had an education and cannot read?

There is also a role for non-profit non-governmental organisations in the American economy, in cases where the government's special right of compulsion is not required but in which a for-profit corporation is likely to be exploitative or inappropriate. Private universities play an important role, and the markets for raisins, almonds and cranberries are dominated by cooperatives in the US — and cooperatives have a far greater role in other parts of the world, frequently proving to be as efficient or more efficient than for-profit competitors (eg grocery cooperatives in Sweden).

Individuals' development is influenced by the goals society sets for itself, and its central policy debate. However, there does seem to be an observable oscillation — from the selfless idealism of the 1960s anti-war, civil rights generation, through the frenzied greed of the 1980s and 90s and now emerging into an era in which selflessness is resurgent: applications for peace corps are rising again and graduates are choosing their employers on the basis of their perceived level of responsibility.

Internationally, the US needs to apply the principles of democratic consensus building that it claims to believe in, and stop seeking to use its dominant economic and military position to exploit its opportunity as global dictator.

[W]hile America often speaks of the “rule of law”, its pursuit of unilateralist policies reflects a rejection of the rule of law at the international level. It is in favour of global rules of the game, but worries that the WTO or the ICC might infringe its own sovereignty. In short, it is in favour of the rule of law, as long as the outcomes conform with what it wants. A moment's reflection should show that if the US worries about the infringement of its sovereignty by global institutions, how must other countries feel, and especially poor developing countries, who see the global institutions dominated by the US and other advanced industrial countries?

The globalisation of trade has advanced rapidly whilst political globalisation has lagged, leaving a vacuum in which global agreements (such as on climate change) require voluntary support that the US is unwilling to give whenever the issue at hand is not in the US' short term interest (or more accurately, in the interest of special interests within the US). A better division of issues to the global, national and local level is required, based on the fundamental nature of the issue at stake, rather than on the basis of perception of at which level some particular lobby has most influence.

In the US, conservatives have pushed for the delegation of responsibility for welfare to the states mainly, I believe, because they believe that the advocacy groups for the poor are not as strong at the state level as they are at the federal level, and at least in many states, this will imply cutbacks in the provision of welfare.

It is important to reframe global negotiations and agreements using concepts such as 'fairness', rather than narrow national (or special) interests. This should be motivated by our basic moral beliefs, and yet is probably in our long-term interests anyway, considering the potentially disastrous consequences of global resentment at American arrogance, hypocrisy and selfishness, including terrorism.

Further Lessons on How to Mismanage the Economy

Bush II introduced massive tax cuts on entering office, primarily on share dividends. Most American shareholders hold shares in tax-exempt funds, so the major beneficiaries of these tax cuts were the very wealthy (including many in the administration itself). They were justified on two grounds. The first was as a Keynesian stimulation. This wasn't particularly plausible, as tax cuts to the wealthy are the least efficient way of pumping further money into the economy — increased expenditures, especially giving more money to state governments who were then having to scale back social spending to balance their budgets, or tax cuts for poorer sections of society would have been far more efficient stimulators. The second was a slight variation on Reagan's voodoo economics theory — that cutting tax on dividends would stimulate investment in stocks, leading to increases in share price, leading to greater investment by public companies. In the event none of this materialised, and there are reasons to be sceptical about each linkage of the logic. Particularly, the inevitable increase in the long-term federal budget deficit will force up long-term interest rates, curbing private sector investment — public sector borrowing will crowd out private sector investment. The cuts were extremely inequitable and fiscally irresponsible, rapidly turning Clinton's surplus back into a substantial deficit.

Bush II took almost no action on the corporate corruption that had badly damaged investor confidence in the American stock market (various members of the administration and those brought in to consider new regulation had been intimately involved in some of the worst scandals). Whilst Clinton had made some serious mistakes in managing globalisation (for example, blocking the inauguration of an Asian Monetary Fund to tackle the East Asian financial crisis in order to preserve American financial hegemony in the region) Bush II's errors were far more serious. He essentially rejected the rule of law, undermining every significant multilateral treaty that the global community attempted to pass (not least Kyoto, the ICC and the arms treaty), later to find the global community a little reluctant to support initiatives badly needed by the United States. After Clinton had worked out a framework under which agricultural subsidies could be phased out, Bush II promptly doubled them. Fiscal responsibility is now, rather absurdly, a centre-left position in American politics; fiscal profligacy is now a central tenet of Republicanism.

More generally around the world a greater recognition is required that there is a wide range of sensible economic policy packages, from which each population ought properly to choose that which is right for itself via the democratic process. The Washington Consensus is, in many respects, rejected by the US for domestic policy and it is hypocritical to pressure other countries to adopt policy which would not be countenanced at home. In Europe, the ECB has too narrow a focus on inflation, and a greater concern about employment is badly needed in order to reduce an unemployment level that has been far above America's for a long time. Labour market flexibility may be a part of the answer in certain areas, but it is certainly not the only policy which is required to reduce European unemployment.

In short, while in Europe there has been extensive discussion of convergence, that the countries should adopt similar if not identical rules, regulations, and practices, the Latin Americans are gradually realising that while they have thought that the reforms were leading them to converge to the kind of market economy found in the US, they were in fact not doing so. They were being forced to adopt a form of the market economy that might have been some conservative's dream, but did not comport to the reality of any successful democratic country. The failures are already apparent; the backlash has already begun. Market economies are not self-regulating, they are buffeted by shocks beyond their control, they are prone to manias and panics, to irrational exuberance and pessimism, to swindles and risk-taking that verges on gambling, and many of the costs of their mistakes and malfeasances are borne by society as a whole.
Non-accelerating (or more accurately, non-increasing) inflation rate of unemployment: the minimum rate of unemployment at which inflation is stable.
Long-term government bonds were yielding 8.14 per cent; treasury bills (safer) averaged only 5.4 per cent and rates on certificates of deposit were lower.
Financial Accounting Standards Board.
The situation is clouded slightly by the fact that capital gains tax is not paid if the holder passes these assets on in his will, but the effects of this are not important.
I don't really know what he means by this.
the_roaring_nineties.txt · Last modified: 2019/11/08 10:39 (external edit)