A YOUNG ENTREPRENEUR builds up an energy empire that takes the US market by storm. He creates an impossibly complex financial pyramid made up of hundreds of subsidiaries, on most of whose boards he sits. He deftly juggles stock between these subsidiaries, making his company the toast of the stock exchange, until the market crashes, his investors lose millions, and he sinks in a matter of weeks from national hero to figure of hate. He becomes a symbol of greed and larceny and prompts the US president to promise to winkle out corporate crooks like him and clean up the economy. He goes into self-imposed exile. Sounds familiar? But it’s not Enron’s Andy Fastow: it’s Samuel Insull (pictured right), one-time CFO to Thomas Edison and the archetypal bad capitalist of the 1929 crash.
Insull built up what ultimately became known as the Commonwealth Edison Company into one of the world’s biggest corporations. After the crash, he became the figure who more than anyone inspired Franklin D Roosevelt’s New Deal, with Roosevelt, not unlike George W Bush, promising to “get the Insulls”.
Insull’s fall marked the end of a long period of laissez-faire capitalism and the beginning of 30 years of regulation, government intervention and Keynesian mixed-economy strategies. It is one of many similarities between our current economic and political circumstances and those of the 1930s – the return of right-wing extremism to European politics and isolationism to the US, the economic threat of stagnation, and a general public suspicion of free markets and entrepreneurs. So are we standing on the verge of a new New Deal?
One Sarbanes-Oxley Act does not a new deal make. There is apparent confusion at the very top of policymaking about the direction we are heading in and what economic policies are viable.
Whose Consensus is it anyway?
People have been saying that the Washington Consensus is dead almost since the phrase was coined. Partly that’s because it means different things to all those who use it. For example, Nobel-prize winning economist Joseph Stiglitz says: “The Reaganite/Thatcherite philosophy was really the underlying philosophy of the Washington Consensus”. George Soros declares: “The Consensus really came in with Reagan and Thatcher. It became market fundamentalism.”
Moises Naim, editor of Foreign Policy magazine, points out: “Stiglitz, in an article in the New York Times, denounces the Washington Consensus for Brazil’s problems then prescribes the Washington Consensus, ie, trade liberalization, as the solution. The brand name has acquired a life of its own.”
John Williamson, senior fellow at the Institute for International Economics in Washington, DC, came up with the term in 1989. He has since watched it “grow into a monstrous thing that everyone loves to hate”. A mild-mannered Englishman who still seems slightly incredulous at both the success of his phrase and the abuse it has inspired, he says: “I never intended to endorse the whole idea of the minimal state as part of the Thatcher/Reagan approach. Very few seem to have read what I actually wrote. It wasn’t about less spending on health and education but more.”
Williamson also complains that one Washington policy – capital account liberalization – now widely blamed for emerging-market crises, was definitely not in his original formulation.
However, even in Williamson’s original formulation the emphasis is very much on fiscal discipline, privatization, trade liberalization and deregulation. As Stiglitz, a former colleague of Williamson and the public figurehead for opposition to the Consensus, tells us: “There was within the World Bank [before he joined], the IMF, and the US Treasury a strong view that macrostability, privatization and liberalization were of the first order. Everything else was secondary.”
When these policies, particularly capital account liberalization, failed in east Asia and Russia in 1998, the first wave of articles appeared obituarizing the Washington Consensus.
However, writing death notices for laissez-faire economics was still something of a minority pursuit. After all, the US and much of Europe was in the middle of a record boom market, apparently thanks to the virtues of privatization, liberalization and deregulation.
Even newly elected centre-left governments in the US and UK pronounced their conversion to Thatcherism.
But what really shook this consensus was the failure of these policies at the centre of the financial system.
Now it is possible to point to significant policy changes in many of the issues central to the free-market consensus – deregulation, privatization, capital mobility, and fiscal policy – all of which mark a new shift in the relationship between government and markets.
The trend towards deregulation is most obviously being called into question – after all, most of the recent corporate scandals were in the most deregulated industries. The US financial sector, which has enjoyed 20 years of deregulation culminating in the Gramm-Leach-Bailey Act, has seen some of the most drastic legislation since the 1930s, in the form of the US Patriot Act, which enables much greater government scrutiny of capital mobility, and the Sarbanes-Oxley Act, which beefs up financial disclosure and supervision of auditing. The investigation into investment banks’ involvement with Enron, according to George Soros, could well prompt even more far-reaching legislation.
Privatization, until very recently another orthodoxy of the market consensus, has also been called into serious question by such failures as UK rail infrastructure company Railtrack and the fiasco that has resulted from California’s energy privatization. Railtrack has been made into a not-for-profit company: the trend in the UK is towards more non-shareholder “public interest companies”.
In the US as free-market-inclined a commentator as Neal Soss, chief economist of CSFB, is calling for the creation of a government-sponsored enterprise for telecoms and energy utilities – a form of renationalization.
What brings these strands together is an emphasis on stronger government, and a renewed belief in the power of the state to provide efficient public services and to stimulate the economy when markets fail.
This final belief has led to a return in the UK, Europe and even the US of Keynesian-style fiscal policy, where governments are allowing themselves to risk a deficit to spend in the name of avoiding stagnation. As Peter Warburton of the Institute of Economic Affairs (IEA) in London puts it: “There has been a very distinct change in the handling of government finances.”
If these policies are part of a new consensus, they bring with them new dangers – not least a return to high inflation in the west and, more dangerously, in emerging markets. Not all of the returns to strong government can be welcomed – the US’s trade protectionism and clumsy interventions in other countries’ politics threaten to spark a return to the dependencia-style economics of the 1960s in Latin America. Now is the time to ask what elements were wrong and what right in the last consensus – and what elements are needed if a new multilateral consensus is to be found.
The period when the Washington Consensus applied was characterized by frenzied deregulation – in the US often of regulations that had been in place since the 1930s, such as the Glass-Steagall Act.
CSFB’s Soss says in a recent research note: “[I]t is probably neither happenstance nor coincidence that the most intense financial distress and scandalous behaviour is in deregulated industries such as telecom and energy.” And, one might add, banking and accounting. Stiglitz, with a certain amount of “I-told-you-so” relish, says: “The US is now reaping the rewards of excessive deregulation in the financial sector.”
Regulation or bust
Much of the financial boom of the late 1990s was a result of this deregulation. Banks can thank senator Philip Gramm (and indeed have) for a great deal of deregulatory legislation that opened up their activities and allowed them to operate, on occasion, with minimal surveillance.
Gramm is in many ways the archetypal politician of deregulation, and his faith in the market’s ability to regulate itself and suspicion of clumsy New Deal-style regulation led to the freeing of energy derivatives from almost all regulation, and the abolition of Glass-Steagall.
These moves in turn helped the boom in energy and telecom derivatives, the feverish wave of financial mergers and acquisitions in the late 1990s and the creation of banking monsters such as Citigroup and JPMorgan Chase.
Now some people are blaming the bust on the same deregulation. The US energy regulatory compact of the 1930s was set up to protect consumers from market price manipulation and the threat of blackouts. Just over 60 years later, California suffered months of rolling blackouts and Enron has been accused of manipulating energy prices through energy derivatives.
In telecoms, as in energy, utility deregulation was supposed to free up businesses from focusing on the legal and regulatory system, enabling them to focus more intently on marketing. The problem was that companies such as WorldCom focused exclusively on their share prices and earnings management, and not at all on the legal and regulatory system.
In finance, deregulation may have created more problems than it has solved. Never mind the growth in derivative markets such as synthetic CDOs beyond regulators’ ability to understand them. More fundamentally the growth in the size of banks, and the mergers of many different activities – from advising governments to providing research to investors, to offshore and off-balance-sheet services, to M&A advice – has led to obvious conflicts of interest. People have been saying this for several years but now the issue is costing banks a lot in terms of market capitalization, credit ratings and reputation.
The biggest banks – such as Citigroup and JPMorgan Chase – are the ones that have lent to and dealt with most of the companies implicated in recent accounting scandals. Their market share makes that almost inevitable.
It is not a massive leap of logic to conclude that the real problem may be what Louis Brandeis, an adviser to president Woodrow Wilson, architect of the Federal Reserve and later Supreme Court judge, called “the curse of bigness”.
That at least is what the market seems to think – Citigroup’s shares fell 25% in two days in July, and JPMorgan Chase’s market capitalization at one point in July was smaller than that of Wachovia.
Henry McVey, banking analyst at Morgan Stanley, told the financial press: “The market is indicating that the bundling of financial services is an inherently riskier business than the industry previously thought.”
Analysts are now discussing the possibility of a reversal of the tendency to bigness, with a spin-off of some parts of Citigroup widely speculated upon. Citigroup itself has said it will scale back its structured-finance activities, which have come under the scrutiny of the Senate Enron inquiry.
Many are also wondering if the Gramm-Leach-Bailey Act, which banks lobbied so hard to get passed to reverse Glass-Steagall, is not a curse in disguise. George Soros says he believes the Senate hearings on banks’ structured finance assistance to Enron may lead to a flood of class-action suits. The financial status of some of the largest banks could even be brought into question.
He adds that if the Fed has to intervene to support these banks it will probably mean a much greater revision of the regulatory system than we have so far seen. He thinks we could see a regulatory separating of financial functions. “Perhaps we need a modern version of the Glass-Steagall Act,” he says. “But things will have to get worse before that happens.”
The string of scandals involving banks and accountants may also end a brief period of business self-regulation in the past few years, when codes of conduct such as the UK’s Cadbury code on corporate governance or the Wolfsberg principles regarding money laundering were favoured by governments over statutory regulation.
Self-regulatory codes of conduct are based on trust, which is not in abundance right now. Adair Turner, vice-chairman of Merrill Lynch and one of UK prime minister Tony Blair’s team of blue-sky thinkers, tells us: “We may see a move away from self-regulation. The idea that you can do everything with self-regulation is wrong. Business needs the pressure of government to reform.”
Perhaps the most startling and symbolic sign of the shift in the political and ideological climate from the boomtown days of deregulation was the fact that Gramm, after lobbying hard against the Sarbanes-Oxley bill and warning of the unintended consequences of hasty legislation, finally decided to vote for it.
Ironically for a prophet of deregulation, it will be one of his last political acts before he retires this year.
Ho Chi Minh 1: Thatcher 0
It is strange to interview Nicholas Stern, chief economist of the World Bank, in New Zealand House, the Bank’s London headquarters. The tower block is on the site of the old Carlton Hotel where Ho Chi Minh worked as a chef under the legendary Escoffier. But the kitchen ghost of the father of Vietnamese communism might be slightly cheered by Stern’s hesitant questioning of whether privatization is always the answer.
Stern, warning against the danger of a one-size-fits-all approach to economics, says: “I think none of us would argue that the UK’s experience of privatizing the railways has been a complete success. It’s quite hard to find good examples of the privatization of railway track networks. The same is true of power transmission networks. You can’t be universal or doctrinaire, you should learn by experience and treat it on a case-by-case basis.”
It’s hardly communism, but comments like this from policymakers of Stern’s seniority do mark a retreat from the high-water mark of the privatization revolution, which more than any other part of Thatcherism was responsible for the rolling back of the state in the past 20 years.
A former Thatcherite cabinet member, Cecil Parkinson, was interviewed on US TV last year about what the Thatcher revolution had achieved. He said Thatcher’s real triumph was that the UK had become an international example of how to privatize. He pointed to how Thatcherite policymakers had been invited to oversee the privatization programme in Russia in 1990. And, even better, Californian regulators sought UK policy makers’ advice on how to privatize their energy network. Parkinson said: “They felt we had the model for running an electricity industry and they wanted to import it into California”. A triumph indeed.
Along with the UK’s Railtrack, the two obvious examples of the failure of privatization are Russia’s rapid programme of the early 1990s and California’s privatization of its energy market.
Noreena Hertz, one of Britain’s leading young academics, whose book Silent Takeover: Global Capitalism and the Death of Democracy, is currently on the Wall Street Journal’s best-seller list, worked for the World Bank in Russia in 1991, advising the government on its privatization programme. She was a 23-year-old free-market believer fresh out of university.
Hertz now says: “I was spending all this time on the ground in factories, and I realized really quickly that there was going to be this huge human cost associated with the transition to a market economy. There was no safety net in place. When I raised these issues, it was made very clear to me that that wasn’t the primary issue – the primary issue was to remove assets out of the state’s hands so that communism would never reappear. The primary issue was political.”
The consensus now is that while privatization may have made sense in some areas, ideology, government gullibility and companies’ and management consultancies’ desire to make money might have pushed it too far – not just in Russia but in Europe and the US as well. Government still has a natural role in some industries, particularly energy and even telecoms, or areas where there is a concern for public safety, such as transport.
As Stiglitz says: “If you look at the history of the US, our mortgage market was created by the government through Fannie Mae, our telecommunications industry was created by the government supporting the first telegraph line and creating the internet. The idea it was all markets by themselves is a myth.”
As recently as April it was possible for US public service broadcaster PBS to say, in its series The Commanding Heights “hardly anyone calls for a return to old-fashioned state ownership now”. Just a few months later, though, Railtrack has become Network Rail, a state-controlled not-for-profit company, and leading think-tanks such as the UK’s Institute for Public Policy Research are calling for the establishment of more public-interest companies – run at arm’s length from government but without private shareholders. And in the US, one even hears CSFB’s Soss declaring that “we are in a different era”, and calling for the creation of a government-sponsored enterprise for telecoms and energy utilities.
Dreams of grander government
If we are in a different era, it is because inflation is no longer the key issue to be tackled. Thanks to this, and to the government cash provided by a seven-year bull market, government is getting bigger, not smaller. As the IEA’s Warburton, who is an economics adviser to Robert Fleming&Co, puts it: “There’s an increasing confidence in the power of government to find solutions to economic problems”.
Warburton has written a report on government expenditure for the IEA, a UK think-tank that was instrumental in spreading the ideas of free-marketeers Friedrich von Hayek, Milton Friedman and Margaret Thatcher in the early 1980s. He says: “The Thatcher revolution established the view that the public sector as a provider of marketable goods would always introduce inefficiency, through higher levels of staffing, lower levels of productivity and sub-par returns on capital. It had appeared the battle was won. But the new confidence in the ability to change outcomes by increasing expenditure harks back to the 1970s. There has been a very distinct change in the handling of government finances.”
Merrill Lynch’s Turner puts it more positively: “The late 1990s saw an almost Marxist free-market economic determinism. Now, we’ve realized that the most difficult problem our government faces is not how to run a relatively successful low-inflation economy, it’s providing decent services in transport, health, and immigration.”
Inevitably, this has led to a shift in focus away from monetary policy – particularly as US interest rates are near zero and Federal Reserve chairman Alan Greenspan for once seems as human and fallible as the rest of us – towards fiscal policy. Soss has said we need “a new way of thinking about the role of government spending and fiscal policy” as mere rate cuts are not doing enough to stimulate the economy.
President George W Bush seems to agree. At his recent economic forum, he told Congress to vote for his anti-terrorism bill because it would create jobs. And UK finance minister Gordon Brown has committed his government to the goal of full employment, and unveiled enormous rises in public spending.
Government spending is again seen as an important anti-cyclical tool, as opposed to the high interest rate/low government spending approach that the IMF imposed on countries such as Mexico, Thailand and Indonesia in the 1990s, and which president Herbert Hoover followed so disastrously in the US in the early 1930s.
That old phantom John Maynard Keynes appears to be making a comeback. Stiglitz, himself the leading new Keynesian, declares: “Gordon Brown is a new Keynesian. Even Republicans are Keynesians.”
“In the 1990s we overshot on the side of markets,” says Foreign Policy’s Naim. “In this decade, we are running the risk of overshooting on the side of governments.” The danger in an era when states are entertaining thoughts of grander government is that they will forget the lessons of the past, let go of their public finances and try to spend their way out of trouble.
Public finances deteriorate
This is a danger for the US and UK. The US could try to spend its way out of stagnation while increasing tax cuts – this is what the American Enterprise Institute recommends. And even Gordon “prudent” Brown could be in trouble if economic growth proves to be slower than expected. Warburton of the IEA says Brown’s spending plans could mean big tax rises if growth is slower than expected, and British voters may not accept a big rise.
But arguably such countries as the US and UK can sustain government deficits longer than most countries. A more serious danger is that emerging-market countries will follow suit and return to high government expenditure. Naim says: “If Haiti ran a fiscal deficit, or Argentina, or Zambia, it would have an immediately damaging consequence.” Naim, who as Venezuela’s trade minister in the 1980s witnessed the devastation of hyperinflation, is concerned that the prevailing anti-Washington Consensus mood in Latin America will lead some countries to opt out of fiscal austerity, leading to a return of high inflation.
It was an awareness of this danger that led the IMF to tie its bail-out package in Brazil to promises from left-wing leaders to keep public finances in check.
Another danger is that a protectionist strategy for steel and agriculture from the US government, and the arrogance of its dealings with, for example, Bolivia and Argentina, will spark a return to protectionist policies in developing countries. High government expenditure, trade protectionism and suspicion of international markets were all elements of 1960s’ and 1970s’ development and dependencia economics in developing markets. That style of isolationist economics was based on the idea that the international market system favoured the west – “the centre” in dependencia terminology – more than it did developing countries – “the periphery”.
That way of thinking is very much in the ascendancy. Soros says: “Market fundamentalism serves the interests of those in charge of the system. It is controlled by the countries at the centre. The system creates an uneven playing field. It does not bring prosperity to the countries at the periphery.” Kathleen Stephansen, director of global economics at CSFB, agrees. “Countries at the periphery are reconsidering who the Washington Consensus benefits,” she says.
The public spats between Stiglitz and, seemingly, the entire IMF have focused on this issue. Stiglitz claims the IMF primarily serves the interests of Wall Street, though he backs down from his apparent suggestion that Stanley Fischer was rewarded for this by Citigroup in his recent job. (“I probably did not write it as clearly as I should have,” Stiglitz says.)
The thinkers of the “global justice movement” (anti-globalization is a misnomer) agree with Stiglitz that Washington institutions are overly representative of US business at the cost of other interests. Hertz says of the World Trade Organization, in her book: “While developing countries have far too little influence in the WTO, corporations have far too much.” If such people as Soros, Stiglitz and Hertz – affluent businessmen and academics who have done well by the system – believe this, imagine how much more virulently the view is held on the streets of Buenos Aires, Rio de Janeiro or Istanbul.
Combine this with the US’s present tendency to isolationism in matters of international trade and law, and a depressing picture emerges of governments putting up barriers – to trade, capital and people – and failing to act multilaterally through mutual distrust.
Kasper Bartholdy, head of emerging-market research at CSFB and a former IMF official, says: “There are clear cases where countries would have been better off never having dealt with the IMF or the World Bank. Among these cases are several African countries, such as Zaire under Mobutu. The Zaire population, in this incredibly poor country, is now lumbered with this debt it has to pay to the IMF and World Bank, which don’t give debt relief. Wouldn’t they have been better off never having access to that money? I think they would have. So there’s definitely an argument about whether the world is better off with these institutions.”
The World Bank’s Stern says: “I hope these kind of questions will lead to a reaffirmation of the multilateral approach. There is a danger of a unilateral approach coming to the fore – on environmental issues, in trade protectionism, in a questioning of sound economics. And those dangers have increased. But if multilateralism is reaffirmed, we actually now have a real opportunity for development. I’m basically an optimist.”
Naim says the Washington Consensus failed on certain key issues – it failed to address poverty and inequality, it failed to recognize the importance of institutions, it failed to understand the dangers of globalization, and it failed politically.
He believes that the last failure was the most important, because it led to the other failures.
Democratic deficit
The Washington Consensus, in its zeal to tackle government deficits, itself carried a democratic deficit. It carried it from its inception in Chile, when Milton Friedman advised Augusto Pinochet on how best to restructure his economy.
It failed politically throughout Latin America when, according to Naim, almost every country’s government took upon itself unconstitutional executive powers to pass initial Washington Consensus reforms – powers that led, Naim believes, to the later despotism of Alberto Fujimori in Peru and the cavalier regard for the law shown by Carlos Menem in Argentina.
It failed in Indonesia, where Suharto was held up by the World Bank as its model pupil. And it still fails in Turkey, which Stanley Fischer tells Euromoney “is not an authoritarian government”, despite human rights reports of trade unionists and student agitators being routinely tortured or murdered in police custody.
This political failure is not because the IMF or World Bank is morally corrupt – it simply is not always aware of the political realities through which its policies are achieved. As Hertz says of her World Bank superiors in Russia: “My seniors would fly into Moscow, have a meeting, then fly out again. They didn’t set foot in a factory. They didn’t know what was happening on the ground.”
This is not simply a human rights issue. The World Bank Development Report 2003 shows how the failure of government institutions to be open to all interests equally leads directly to a failure to tackle poverty, inequality or environmental issues.
It says: “Coordination fails when dispersed interests have no means of channeling their views or of counterbalancing focused interests [or when] some groups, lacking assets and voice, are excluded from participation in society.”
Any new consensus – be it the “Monterrey Consensus” or whatever – will have to make an effort to balance financial market interests more evenly and openly with other interests.
Oddly, stronger government may ultimately be in the interests of the market, because the lesson of the financial crises of the past few years, particularly Asia and Enron, is that when government regulation is too successfully captured by markets, markets fail.
Williamson of the Institute for International Economics says: “Capital account liberalization was pushed much too much in Washington institutions. A lot of the influence for that came from Wall Street banks. There is probably more truth in that than I wish. It was basically why we had the Asian crisis, why Brazil is in trouble, why Argentina is in trouble.”
Enron is another case in point. The World Bank uses the energy company’s collapse as an example of policy failure “when well-meaning decisionmakers lack the necessary information or when institutions are captured”. Enron’s success at manipulating weak regulation and finding regulatory loopholes, in energy derivatives for example, led to a short-term boom and then bankruptcy.
Freeing government
We are facing a similar danger on such issues as global warming, where government is failing to correct a market failure because, arguably, government has been captured by what Al Gore calls “special interests”. As Hertz says: “When you look at the link between campaign finance contributions and George W Bush’s environmental policy – it’s clearly shaped by the interests of big energy companies.”
The most important step in freeing government from market capture is to make the funding of government transparent. The World Bank’s Stern, for example, calls for energy companies’ donations to third-world governments to be made public. Senator John McCain achieved something similar with his campaign finance act in the US.
The UK is now seeing calls for political parties to be state-funded, because after business donations to government were made public – and people objected to these donations having an influence on policy – companies simply stopped giving donations to the leading parties.
These are positive signs for both ordinary people and the market, because they show the continued health of government institutions. If government was completely captured by markets, then Robert Rubin’s telephone call to Capitol Hill would have been successful – rating agencies would have been persuaded to compromise their independence, Enron would have merged with Dynegy. The Sarbanes-Oxley bill would never have happened, Citigroup and JPMorgan Chase would not be before the Senate, and Kenneth Lay would not be in hiding.
The fact that these things have happened is not only down to what Paul O’Neill called the “genius of capitalism” but also thanks to the genius of democracy.
And that is to the good of the markets – markets work best when government is left unhindered to do its job. When markets intervene too much, governments and markets fail.
