SAVING AMERICAN CAPITALISM / THE NEW YORK TIMES OP EDITORIAL ( RECOMMENDED READING )

June 29, 2009

Op-Ed Contributor

Saving American Capitalism

By FELIX ROHATYN


During my four years as U.S. ambassador to France I saw how fascinated the French were by everything American; I believe that to be true of all Europeans. They are fascinated by the economic freedom that is fundamental to American capitalism, by its dynamic, and by the opportunities it offers.

The practice of American capitalism, however, has become very different from the theory.

Market-based capitalism requires a platform of political freedom, the creation of wealth and fairness in its distribution. These values were reflected in the American economy until the 1980s, when American capitalism and European social democracy created reasonably similar economic outcomes.

After Franklin Roosevelt’s New Deal and Lyndon Johnson’s Great Society, an implicit social contract among business, labor and government maintained economic stability, a strong social safety net and an increasingly broad distribution of wealth in America.

We began to diverge with Europe in the 1980s as a result of higher population growth rates in the United States coupled with significantly greater investments in research and technology.

By the 1990s, accelerating changes in our corporate culture and in the functioning of our financial markets, together with cheap money and easy speculation, resulted in the creation of astounding levels of wealth. These in turn led to serious legal and ethical abuses in the business world and to a breakdown in the concept of fairness.

In the late 1990s, as ambassador to France, I spent much of my time singing the praises of American capitalism. But back at home the system was changing. A booming stock market sent executive compensation soaring, but with very little accountability for performance. Deregulation, an easy monetary policy and media-driven hype about new information technologies created essentially “free money” and astronomic stock valuations. Speculation created the dot.com bubble and, in due course, brought about the collapse of much larger companies, with tragic results.

The results were usually the same. Management and directors collected hundreds of millions in bonuses and stock sales while tens of thousands of employees saw their jobs and their savings lost. Hundreds of thousands of stockholders were ruined.

These events struck at the very heart of the most basic requirements of market capitalism: transparency and fairness. In addition, the media treated finance like show business, creating stars out of executives and touting wealth as the sole standard of success. And neither the Securities and Exchange Commission, nor the Federal Reserve, nor the Congress, nor the administrations wanted the music to stop or tried to slow it down.

While no single event can be pinpointed as the start of the single cause of these developments, I believe a great deal of this began in the 1980s. Until then, overall corporate activity was still consistent with the evolution of a largely industrial economy, while the consolidation of the financial sector and the rise of institutional investors pointed to a major shift — late 20th Century finance capitalism.

The advent of the leveraged buyout radically changed the relationship of management to the corporation. As leveraged-buyout firms such as Kohlberg Kravis Roberts and Forstmann Little restructured American companies, they provided management with ownership levels never previously imagined. Time Magazine made it the symbol of a new age.

The 1980s also coincided with the adoption of large-scale stock options. I remember sitting on the boards of some large companies at the time, pressured by institutional investors who demanded changes in compensation packages aimed at greater stock interests for management and lower cash payouts. That meant more stock options.

Meanwhile, stock prices were shooting upward, with no consistent correlation to the performance of their companies.

The glamour of these new entrepreneurs and their new billions gave a new political dynamic to the notion of deregulation. The repeal of the Glass-Steagall Act allowed banks to re-enter the securities field from which they had been excluded since the Great Depression.

Energy deregulation brought new players into the staid utility field where traders such as Enron hooked up with the Internet to create a new culture of trading instead of investing.

The public uproar created by Enron and other scandals finally prompted the passage of the Sarbanes-Oxley Act of 2002. It required more responsibility from independent directors, certification of company finances by chief executives and separation between the investment banking and research analysis functions of the banking industry. It is important legislation but, by itself, it did not suffice; it is now under attack.

We still have much to learn from what happened.

New private equity funds surpassed the original leveraged buyout investors in their size and ability to generate quick returns. Larger and larger hedge funds were created and highly leveraged transactions in the tens of billions of dollars each were being considered. The availability of almost unlimited amounts of bank financing was truly astonishing.

Speculation is back. And the biggest speculator of all has been the U.S. government.

The Bush administration gave in to the conservative anti-tax revolution of the 1970s and 1980s, and went to war in Iraq while greatly underestimating its cost — $300 billion to date. It simultaneously engaged in a policy of massive tax cuts, probably the first time ever that a country cut taxes while at war.

The domestic budget went from surplus to a record deficit, as did the trade balance, and the Federal Reserve pushed interest rates to all-time lows.

And neither the Treasury nor the Fed acted to protect the dollar, which declined sharply and drove our budget deficit still higher.

We have become the world’s largest debtor; the dollar became one of the world’s weaker currencies; and we are now facing massive and increasing deficits for the foreseeable future.

During this period, the fairness so vital to a modern democracy was seriously impaired. As a result of the tax cuts and extraordinary levels of executive compensation, 1 percent of Americans now own 45 percent of America’s household assets, a level not seen since 1929.

In the meantime, we continued to starve domestic public investment. Much of our infrastructure is in a state of decay. The state of our public schools in particular is a disgrace. It would probably require $2 trillion to bring our overall infrastructure up to decent condition, and a decade or more to achieve it, if we tried.
Financial services used to be an extremely personal business; the making of loans, the purchase and sale of securities, the giving of financial advice — these were all activities with high levels of personal interplay, where personal character counted.

Today, more and more of the financial-service business involves capital markets and other trading activity. These consist of individuals facing computer screens buying and selling electronic signals with parties whom they never see in locations all over the world. The only measure of performance is profit or loss for that day.

Quality, trust, confidence or any other non-quantitative measures of performance are of ever decreasing importance.

A global financial crisis was going to happen as a result of our speculative policies. Our economy was vastly over-leveraged and very vulnerable to a major shock. Now, to avoid further crises, we must maintain our credibility with our foreign allies as well as with those less friendly to us.

I am a capitalist, and believe that market capitalism is the best economic system ever invented. But it must be fair, it must be regulated, and it must be ethical.

American capitalism is now driven by the urge to deregulate and to limit the role of government to a minimum.

At the end of the 19th century, Theodore Roosevelt had a different view of the earlier manifestations of American capitalism. He rejected the idea that Washington had no role but to stamp Wall Street’s initiatives. His quarrel was with illegal behavior. He insisted on government’s obligation to regulate the large new business aggregations not so much to address the inequalities of wealth as to police its potentially distorting influence.

I believe that Teddy Roosevelt’s war on the trusts was an effort to reinforce the new system, not weaken it. This should be the purpose of regulation in a more and more complicated world.

The idea of an “ownership society” is an idea which is consistent with the objectives of American capitalism. But it is not credible within the context of fiscal policies that increase our external indebtedness every day to the detriment of our national wealth.

These policies are now the burden of President Obama and cannot be allowed to go on indefinitely. They will require difficult and painful actions, which can only come from a multi-year, bipartisan plan, led by the president and the Congress, with the support of business and labor.

It will require a fair allocation of sacrifice. It must deal with entitlement programs. It must address the problem of alternative sources of energy. It should aim to rebuild the country’s infrastructure with new investment and new employment. It must stabilize our currency. It is a massive, long-term undertaking. Like the GI Bill of Rights, it should enhance the creation of American intellectual capital.

It is very late in the day, and President Obama and the Congress have much work to do if we hope to regain global confidence in American capitalism. It is fundamental to our ability to lead the free world.

Felix Rohatyn is an investment banker known for his role in preventing the bankruptcy of New York City in the 1970s. He was U.S. ambassador to Paris 1997-2000 and is the author of “Bold Endeavors: How Our Government Built America, and Why It Must Rebuild Now.”