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© The American Interest, 2012

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Contents

Editor’s Forward

POLITICAL ASPECTS

1. Terms of Contention

Adam Garfinkle

2. American Dreams, American Resentments

Walter Russell Mead

3. The Weakness of Liberal Populism

Francis Fukuyama

4. Reading America’s Tea Leaves

Robert Reich

5. The Tea Party’s Unlikely Populists

Jeremy D. Mayer

6. The Foreign Policy of Plutocracies

James Kurth

SOCIAL ASPECTS

7. The Inequality That Matters

Tyler Cowen

8. Democracy and Oligarchy

Jeffrey A. Winters

9. Measuring Security

John Christensen

ECONOMIC ASPECTS

10. Too Big to Fail: The Prequel

H.W. Brands

11. Hedging Risk

Sebastian Mallaby & Matthew Klein

12. Risk and Uncertainty

Jessica Einhorn

LEGAL ASPECTS

13. We the “People” after Citizens United

Robert Reich

14. Courting Plutocracy

Ruth Wedgwood

15. Fighting Lobbying, Then and Now

Ellen P. Aprill & Richard L. Hasen

16. Shells, Shams and Corporate Scams

Lucy Komisar

Editor’s Forward

This book is a compendium of essays that have appeared in the pages of The American Interest in recent years. Many of them saw light of day together in a special Winter 2011 issue on plutocracy and democracy. Others were published either shortly before or after that special issue. All the essays examine some aspect of plutocratic corruption in the contemporary United States. With only very modest exceptions, the essays read today as they did when published. A few of the titles have been altered, however, since what works best in a magazine does not necessarily do so in a book.

We at The American Interest have taken a concentrated look at this topic because we think it accounts for a large part of the variance in explaining what has happened to our country in recent decades. We do not claim that plutocracy is the only source of dysfunction in the contemporary American political economy. As the next book in this series will argue, difficulties in adjusting to both globalization and automation have given us fits, and the decay, distortion and ossification of America’s political institutions are by no means insignificant. But both of these sources of trouble have been magnified, entangled together and made more difficult to rectify by the various manifestations of plutocratic corruption.

By plutocracy, we do not mean simply the tendency for wealthier members of society to become the ruling elite. If that were all plutocracy meant, it would not mean very much because it would describe practically every political arrangement since the Flood. No, by plutocracy we mean the more or less systematic manipulation of political and economic processes in such a way that the riches of the wealthy are protected and expanded at the expense of others. As is made clear in these essays, there are essentially five means by which this may be done: by getting government to extract payment to regulate industries from taxpayers rather than from the profitable industries being regulated; by torquing the tax code in favor of the rich; by influencing the results of electoral politics; by ensuring maximum freedom to lobby, since that keeps the way open for more general influence; and by securing the lion’s share of government contract work so as to raise barriers to entry from sectoral competitors in the economy at large.

All five of these modalities of plutocratic behavior are examined in this volume. Some essays are more historically grounded than others; some are more philosophical than others. Most are even-tempered; a few express some controlled anger. But while methods and temperaments may differ, all of the authors take aim at the same general target. And all do so within the scholarly canon, an important distinction when dealing with a subject that has been the brunt of many a conspiracy theory over the years.

My role in all this has been modest. With the consent and encouragement of the publisher and both the chairman and the executive committee of the magazine’s editorial board, I have solicited, edited and otherwise made ready for public reception all the essays in this book. I have also chosen which essays from the inventory of The American Interest to include and which to leave aside for this volume. Only a single essay within is my own, so credit for any merit the volume may offer clearly resides with the pantheon of authors included herein. It has been an education as well as a pleasure to deal with such fine and dedicated scholars.

Let me also note the enormous contribution my staff has made to this excellent product. The magazine’s managing editor, Daniel Kennelly, and associate editor, Noelle Daly, laid hands on each and every one of these essays as they went through the editing process, and every one of them is much the better for it. Lindsey Burrows is responsible for the beautiful graphic presentation we offer, and has managed to wrangle the text into the convenient and vividly readable E-format before you. Damir Marusic has helped shepherd the process along and keep it reasonably on schedule.

Finally and above all, each and every reader of this book, as well as every author represented in it, has to thank Charles Davidson, the publisher of The American Interest, for its very existence. There are many generous people on this earth, and God bless them for it; but generosity without vision runs the risk of spending itself without lasting benefit. To want so very much, as Charles Davidson does, to raise the general level of intellectual sophistication on matters of policy and politics at a time when most trends point in the other direction is a sign not just of vision, but of faith as well. We can only hope that his faith is vindicated by all our exertions in the longer run.

Adam Garfinkle

Washington, DC

September 11, 2012

Chapter 1

Terms of Contention

Adam Garfinkle

Consider this old yet still active question: What is the relationship between the inequality arising from a mixed but predominantly market-based American economy and the equality principle embedded in American political culture? More specifically, the tension to which the question points resides in this standard observation: Individual citizens (not to speak of corporate entities) vary so considerably in how much money they can devote to political objectives that it hollows out the practical meaning of the one-man/one-vote principle at the core of American democracy. While each vote is worth the same in theory, in practice the extent to which individuals can influence voting behavior, not to speak of the behavior of legislators once elected, is not even remotely equal. That uneven playing field can be frozen over with strategic infusions of cold cash, affecting political behavior well beyond economic and tax policies. What, then, does it really mean for Americans to say that they live in a democracy?

Again, awareness of this tension, one essentially between political philosophy and political sociology, is not new. Nor is it easily fobbed off with the assurance that the political leverage afforded by wealth balances itself out in the end because the rich constitute a politically diverse group. That assurance did not comfort James Madison, who expressed concern about how an inequality of property wealth drove the formation of “factions”:

From the protection of different and unequal faculties of acquiring property, the possession of different degrees and qualities of property immediately results; and from the influence of these on the sentiments and views of the respective proprietors, ensues a division of the society into different interests and parties.

At a time when the line between political parties and interest groups had yet to be drawn, Madison defined factions as “a number of citizens, whether amounting to a majority or a minority of the whole, who are united and actuated by some common impulse of passion, or of interest, adverse to the rights of other citizens, or to the permanent and aggregate interests of the community.”[1] While Madison was thinking along what we recognize today as class lines, John Adams opined even more broadly that the commercial way of life itself could harm republican virtue: “Commerce produces money, money Luxury, and all three are incompatible with Republicans.”

Were Madison, Adams and others of the founding generation justified in such worries? Perhaps they fretted too much. After all, the wealthy and propertied have disproportionately influenced American politics from the beginning, ever since George Washington offered hard cider to all comers at Mount Vernon to encourage their votes; yet the Republic and its Constitution have endured. The socio-economic make-up of Congress has never reflected the mean of American society, notwithstanding iconic images of Mr. Smith Goes to Washington and Davy Crockett patching up the crack in the Liberty Bell; yet through it all, the welfare of the common man has not been entirely ignored, nor the fundaments in the Bill of Rights overturned. To the contrary: Not only has the American Republic pushed back, more than once, against abuses of economic power, but it has propelled a near constant expansion of the equality principle into American life—through the Jacksonian era’s expansion of the franchise, the Emancipation Proclamation, women’s suffrage, the successes of the trade union and civil rights movements, and on to the present day.

Nonetheless, the expansion of the equality principle in American culture has not put paid to plutocracy in American politics. These seem opposing, or at least contending, forces, but what seems so is not necessarily so. This becomes clear if we review the winding road from 1789 to today. A pattern seems to emerge, defined by two cycles of plutocracy and two offsetting reactions to it, culminating in the rise of a third wave in our own time.

American society in colonial times was marked by significant social and economic inequality, largely between landowners, whose endowments often originated as royal grants, and those who came to America as indentured servants, slaves or as immigrants from non-English-speaking and non-Protestant European lands. Subsequent immigration mitigated average differences to some degree, but the aristocratic habits inherited from British society persisted after the Revolution. The Founders, even those who worried about the specter of factions based on economic interests, were thoroughly patrician even when they were not slaveholders. They assumed that property owners would be more vested in the responsibilities of governing than others, and thought it natural that the states would mandate property ownership qualifications for the right to vote. But the Enlightenment ideals of the Revolution, further immigration and new wealth production with westward expansion in time had a significant leveling effect that was extended and ratified in law with the expanded franchise of the Jacksonian era.

So it was after the first and smallest cycle of American plutocracy that—before the coming of the railroads, the great tides of mid-century immigration and the Civil War—extremes of wealth were relatively modest (particularly if one sets aside the regional exception of the plantation/slave system in much of the South). With the great majority of Americans working as farmers, fishermen, craftsmen and shopkeepers, the social significance of money as an expression of wealth differed from what it has come to be in our own time. In an economy largely based on family-scale proprietorships, the average size of economic units was not much larger than one man or one family, and money was of but occasional use—in contrast to today, when Americans use money, or more abstract forms thereof, to buy nearly everything they consume. Wealth might have been unequal in terms of the land people owned and the surpluses they could extract from it, but that did not translate directly into a focus on money’s social or political power. As Mark Twain recalled late in life:

Jay Gould was the mightiest disaster which has even befallen this country. The people had desired money before his day, but he taught them to fall down and worship it. They had respected men of means before his day, but along with this respect was joined the respect due to the character and industry which had accumulated it. . . . In my youth there was nothing resembling a worship of money or of its possessor, in our region. And in our region no well-to-do man was ever charged with having acquired his money by shady methods.[2]

As Twain suggests, however, pre-Gouldian times gave way to a second plutocratic wave in which concentrations of economic power seemed to run roughshod over American democratic ideals. A cross between class-based and regional warfare seemed ready to break out at any of several tumultuous moments during the last three decades of the 19th century, notably during the three election campaigns in which William Jennings Bryan, clutching firmly his cross of gold, tried to ride populist discontent into the White House. And it is not difficult to understand what produced such tumult from the relative economic tranquility of antebellum America: the creative destruction of onrushing modernity, of which the Civil War itself was partly an expression. As the Industrial Revolution bestrode the North American continent, wealth became more concentrated in tandem with the rise in the average size of economic units. That concentration would have been greater still had it not been for legions of roaming Easterners and new immigrants heading west to establish their own farms and ranches. Economic specialization increased as new technologies rewarded it, and money mattered more in an increasingly urbanized social setting both because there were new ways to earn it and more things to buy with it.

The Civil War itself, to a greater degree than is often appreciated, shaped and accelerated the upsizing of economic enterprises and, with it, concentrations of wealth. The scale of production and provisioning that had been a necessity of war echoed loudly after Appomattox, and some insightful men feared the consequences. One of them was Abraham Lincoln, who, in a November 1864 letter to Col. William F. Elkins, wrote:

I see in the near future a crisis approaching that unnerves me and causes me to tremble for the safety of my country. . . . [C]orporations have been enthroned and an era of corruption in high places will follow, and the money power of the country will endeavor to prolong its reign by working upon the prejudices of the people until all wealth is aggregated in a few hands and the Republic is destroyed.

Lincoln was not wrong to worry. The flamboyant hucksterism of the railroad companies was legendary, notably but not only in the way they fleeced farmers with oligopolistic transportation fees and gained possession of lucrative public lands.[3] Everyone knew that politicians on the take were facilitating wholesale thievery. The rise and fall of James G. Blaine, who nearly won the presidency in 1884, and the emergence of the Mugwumps (Republicans disgusted by corruption who fled the GOP to vote for Grover Cleveland), have been forever associated in the American memory with the mega-graft typical of the times.

The power of Gilded Age plutocrats did not go unchallenged, however, and the Republic that Lincoln had striven to preserve was not destroyed. But this was only because, by the time the dust finally settled in the years just before World War I, that Republic had been substantially altered. While Bryan failed to win the presidency and the Greenbackers and Free Silver advocates failed to get their way, the ungainly and diffuse movement around him hardly proved toothless. The grange movement of the 1870s and 1880s, which promoted government regulation of the railroads, gave rise to the Interstate Commerce Commission in 1887. Populist energies soon found their most voluble expression within the Democratic Party, then the party of small government and small business standing in opposition to the banks and trusts of the North. Southerners, having suffered the carpetbagging outrages of the Reconstruction epoch, flocked to the Democratic banner and often led the charge against plutocracy.[4] The Democrats, however, having absorbed populist energies, also provided a comfortable home for the xenophobia that came with them. The party was racist from dimple to duodenum, pointedly anti-Catholic, anti-Semitic and downright anti-intellectual.

Anti-plutocratic forces nevertheless counted some scholars and writers on their side. One was the redoubtable William Graham Sumner, who held court at Yale for several decades. Sumner’s views are too complex to easily summarize; suffice it to say in this context that he was simultaneously skeptical of mass democracy and of plutocracy, the two being closely connected in his mind. Modern industrialized states, he believed, were too diverse and populous to be truly democratic in anything but name. Absent strong laws, institutions and public mores—the Burkean sinews of political virtue, in other words—they were bound to be controlled by well-connected capitalists according to what we recognize today as the logic of collective action. The more universal access to the ballot box became, Sumner believed, and the more pervasive the view that procedural democracy mirrored some egalitarian reality—which he insisted had no scientific (or theological) justification—the faster and more pervasively moneyed interests would dominate the polity. Beating Mancur Olson’s famous 1965 book to the punch by the better part of a century, Sumner wrote in 1877:

A small group . . . who know what they want and how they propose to accomplish it, are able by energetic action to lead the whole body. . . . An organized interest forms a compact body, with strong wishes and motives, ready to spend money, time, and labor; it has to deal with a large mass, but it is a mass of people who are ill-informed, unorganized, and more or less indifferent. There is no wonder that victory remains with the interests.[5]

Sumner’s anti-plutocratic writings were echoed by the muckrakers of American letters as modern journalism hit its stride as the Fourth Estate. The muckrakers found plenty of muck to rake, and the great Thomas Nast plenty of scandal to turn into cartoons. But holding up the muck to view in time produced a more ambitious reformist aspiration: It impelled efforts to refute Social Darwinist excuses for the status quo in order to get to the bottom of the abuses perpetrated by “the malefactors of great wealth”, as Theodore Roosevelt called them in an August 1907 speech. As populism shaded into progressivism, more Americans blamed a growing political deficit rather than mere human frailty among the rich and fatuous for the country’s woes. The political structure, many came to believe, had failed to keep pace with changes in society. Whereas populism was driven by anger over the control of credit and corruption in high places, progressivism as purveyed by John Dewey and those of his mindset was driven by an ambition to apply what then passed for social science to the remaking of a degenerated or atavistic American polity.

Progressive energies surged to a head in the election of 1912, in which versions of the new secular gospel suffused both the Democratic Party and the Mugwumpish Bull Moose campaign. With that election, the first Gilded Age and the second wave of American plutocracy came to an end. It was not World War I that turned the trick, as is often supposed, but rather a series of responses to plutocracy that began with the Sherman Anti-Trust Act and the aforementioned creation of the Interstate Commerce Commission, and continued with innovations such as the creation of the Food and Drug Administration, the ratification of the 16th and 17th Amendments, and the establishment of both the Federal Reserve system and the Department of Labor in 1913. That burst of political ingenuity largely redefined the American Republic itself and solidified the success of the now-forgotten form of liberalism that existed between its original 18th-century and its post-New Deal meanings—that is, the liberalism of William Allen White, Theodore Roosevelt and Woodrow Wilson.[6]

Taking the measure of this excruciatingly condensed pocket history, which could readily be elaborated and extended through the 20th century, it is fair to say that the balancing capacities of American political ideals and institutions at least twice proved themselves a bulwark against plutocracy. But it was not democracy as such that made the difference; it was the space that democratic agitation opened up for creative leadership to redefine the nation’s enlightened self-interest and devise new governmental structures to sustain it. The question of the moment is whether the American spirit can open up door number three.

We once again see agitation against plutocracy because, as in the past, there is good reason for it: A third plutocratic wave is cresting, its precise amplitude unknown but probably large. One notes books by Kevin Phillips, Robert Reich, Robert Kaiser and dozens of others.[7] Veteran journalist William Pfaff titled a 2009 essay “The United States of Plutocracy.” Jim Hightower’s Texan populism has never been more popular. Grad students are reading C. Wright Mills again. Bill Moyers devoted the final, May 2010 broadcast of his Journal to the theme, “Plutocracy and Democracy Don’t Mix.” In it he noted that in 2005 Citigroup decided to publicly “bang the drum on plutonomy”, its laudatory term for a system in which the rich get richer with a supposedly “market-friendly” government on their side. When some of America’s ultrarich, headed by Bill Gates and Warren Buffet, organized the Giving Pledge in 2010, they were excoriated for their pains. Some accused them of orchestrating a PR stunt, others of funding reactionary causes, still others of merely reminding us, as Ellen Remmer, chief executive of the Philanthropic Institute, acerbically put it, that “the reason we’ve had this golden age of philanthropy is because we’ve had this incredible concentration of wealth.”[8]

The capstone of all such signs, however, resides at the very peak of American politics: Barack Obama defined his presidential campaign for change and hope in 2008 by focusing on the depredations of the “K-Street transactional culture.” His campaign succeeded in part because increasing numbers of ordinary Americans believe the system is corrupt and dysfunctional, though the body politic as a whole can’t seem to quite make up its mind whom to blame.[9] But in a stunning demonstration of just how bad the problem really is, the new President, having few chits to play as a popular but in fact politically weak chief executive, soon made a series of deals with this transactional culture through the aegis of Nancy Pelosi and Harry Reid. He concluded, probably correctly, that he had little choice if he wanted to pass anything into law. That certainly includes his signature health insurance legislation, which required, as he saw it, making deferential anticipatory deals with the pharmaceutical industry to purchase its forbearance. So weak (or so meek, according to some critics) was President Obama after the November 2010 midterm elections that for a good long while he seemed unable even to bring himself to support the expiration of the Bush tax cuts for those making in excess of $250,000 per year, something most of his supporters in 2008 would have considered unimaginable. One reason for this is that many Democratic lawmakers, themselves stuck deep in the plutocratic mire, have not supported it.

It’s not just President Obama who sees the problem and suffers the frustration. Many thoughtful veterans of American politics now hold that the de- and mis-regulation of the banking and financial services industry, abuses of “too big to fail” liens on moral hazard, and the toleration of tax avoidance-cum-tax evasion by the rich, all have their sources in machinations of plutocratic power. These machinations, they believe, are not balanced out by political diversity among the ultrawealthy, and they no longer buy mere access to the corridors of power but favorable judgments within their sancta as well. What were once believed to be wild exaggerations of left-wing propagandists during the Cold War now seem to have come true. And how strange is that? Did the West defeat Communism only to prove true one of the latter’s core ideological points?

How does the Tea Party phenomenon, the most energetic citizen insurgency of the moment, fit into this picture? The Tea Party appears to be less anti-plutocratic than anti-government, and far more populist than progressivist. Most of its members seem oblivious to the fact that many U.S. government exertions today arose in the first place to limit the depredations of corporate power. But that might be because today those exertions have become so ineffectual, a sad state of affairs in turn widely attributed to Wall Street plutocrats having suborned the government into a virtual marionette of the financial sector. Hence the Tea Party rage against the TARP bailouts where the animus against big government and big finance merged into a perfect object of populist rage. Part of its anti-government animus seems to bear an anti-plutocratic motive nested within. With more than a wisp of “crunchy con” in the air it breathes, it thus sometimes approaches, even against its own vaguely conscious ideological will, the anti-corporate, “small is beautiful” critique of the yuppie middle-class “soft” Left.

The Tea Party is a phenomenon whose development bears watching, therefore, as a possible harbinger of a broad-based Bull Moose-like third-party movement. Maybe the second coming of W.J. Bryan or TR will arrive in time for the 2015 election, this time wearing L.L. Bean and drinking cappuccino. Perhaps what will be seen a century from now as America’s second Gilded Age is coming to an end, just as the first fell before a polyglot pre-New Deal liberalism. Or maybe not. Maybe we’re off the historical charts with no way to plot a course back to port. This is the difference between believing, on the one hand, that the alignment of a still adaptable American political culture with the ways of the 21st century suffices to ensure self-correction from the excesses of the third wave and, on the other hand, believing that rather than self-correction we are spiraling toward systemic collapse. Which is it?

In light of the centrality of this question it is disheartening that American social science lacks a robust model for relating economic behavior to political polyarchy (to invoke Robert Dahl’s famous term for political openness). We have polemics aplenty, ranging from Trotskyite anti-capitalist screeds to comforting but unconvincing assertions that free markets and democratic politics always reinforce one another. We have islands of research into aspects of the subject, for example, about elite circulation and social mobility generally. We have a mountain of data on trends in income inequality, but not as much insight into what those numbers really mean. Lacking a general theory or model of plutocracy we lack consensus even on what we should want to know about it. Educated intuition tells me that a major source of this deficit lies in the splitting apart of what used to be called political economy into political science and economics as a supposedly “positive” objective discipline. But that’s another story.

We should certainly want to know how to measure trends in income inequality and accumulated concentrations of wealth over time—in other words, a graph of the American Gini Coefficient since July 1776. But since we have seen how technological change can drive and shape social change, as it did between our “era of good feeling” and our virtual Gilded-Age civil war after the Civil War, we should want to know a lot more than that. We should want to know about the overlapping relationships among, at a minimum, concentrations of wealth typical of technologically innovative eras, income inequality, social mobility, the average size of economic enterprises and entry costs to new business. Then we should want to know how American democratic politics copes with the sparks thrown off by these socially seismic relationships. We have barely a clue about much of this.

More than that, we should want to systematize better what we know about how wealth organizes itself to influence law and regulation. Five means of translating money into political (and subsequent economic) benefit seem to exhaust the logical possibilities: persuading Congress and reg-writing bureaucrats to pass on the transactional costs of corporate functioning to the public, as when taxpayers bear the cost of industry regulation instead of the industries being regulated; lobbying to shape tax laws and accounting rules so that accumulated wealth is maintained and protected, most often at others’ expense; lobbying to ensure maximum leverage in the financing of political campaigns; lobbying to ensure maximum feasible freedom to lobby; and efforts to get a lock on government contracts so as to raise barriers to entry from potential competitors.

What we know about these five phenomena is less than comprehensive. Take lobbying itself. We’ve come a long way from the days when Mark Hanna could work simply by depositing bags of cash in strategic locations. A great deal of corporate lobbying today is not intended to influence political judgment, but rather to win lucrative government contracts—to be, in essence, an agent of government itself. Lobbying has come to involve a highly sophisticated and professionalized skill set, far outdistancing what passes for a legal regime to regulate it and the social science effort to understand it.

Similarly, we don’t fully understand the mix of factors that makes government permeable to plutocratic penetration. There has always been some greed, some corruption and usually plenty of hypocrisy in politics, but greed, corruption and hypocrisy, even taken together, do not a plutocracy make. Within bounds, greed can be productive. Corruption can be redemptive of unequal arrangements, and some forms of it indicate deep, if narrow, wells of social capital. Hypocrisy, as La Rochefoucauld’s “homage that vice pays to virtue”, is the mean between the value of high standards and the calamity of no standards at all. Plutocracy is about the absence of adequate boundaries on sketchy behavior. It is about incentive structures skewed in the direction of making legislators vulnerable to entreaties from individual or corporate wealth that can involve many elements beyond the skills and resources of lobbyists: ideology, campaign law and regulation, media culture, the poorly understood connections between levels of social trust and the general propensity to act corruptly, and more. It’s not a simple two-sided phenomenon involving only those who would buy influence from those willing to sell it.

So it matters, for example, that the ideology of market fundamentalism helped midwife a pervasive sense of complacency that enabled otherwise intelligent people, including even some economists, to ignore the difference between risk and uncertainty. It matters that the Supreme Court has so expanded the elasticity of the First Amendment as to grant rights of political voice to corporations—hence the Citizens United decision of January 2010. Less in the news but no less important, the same Court has forced anyone concerned with the power of money in American electoral politics to focus on the supply side of the problem—how to get money to candidates in such a way that it does not produce rank unfairness—and to ignore entirely the demand side. But where exactly has the demand for so much campaign money come from, such that campaign spending has more than tripled on average in just the past few decades? Such questions are for practical purposes off-limits, again thanks to the Court’s interpretation of the First Amendment.

This is frustrating because the failure to ask certain questions impoverishes our understanding of the larger phenomenon of which the plutocratic distortion of electoral politics is but a part. It is frustrating, too, because it blurs the focus on the core relationships within our political economy. If Sumner was right, then the equality principle cannot save us from inundation by the third wave of American plutocracy—only courageous and skilled leadership can do that. The United States is a mass-participation democracy and a deepening plutocracy, a statement that sums up neatly both the source of Barack Obama’s election and his inability to reshape American politics and society except in the most trivial of ways.

How bad are things really? We don’t know that either, but the evidence is not encouraging. One incident among a great many may best illustrate the point.

In November 2009 it came to light that Genentech lobbyists had provided healthcare policy talking points to the staffs of several House members that made their way verbatim into the congressional record via the official statements of a clutch of representatives, Democrats and Republicans, who “said” exactly the same things. Genentech had, of course, earlier poured many dollars into these Representatives’ campaign coffers. But Evan L. Morris, head of Genentech’s Washington office, claimed (without anyone prodding him to do so), “There was no connection between the contributions and the statements.” Heaped on this insult, another lobbyist commented, “This happens all the time. There is nothing nefarious about it.”[10] The fact that, indeed, it does happen all the time is precisely what is nefarious about it. Not that plutocratic machinations explain all that is wrong with American politics today, but that someone could say such a thing with a straight face, and to all appearances actually believe it, well describes the decay of American democracy.

When lobbyists not only put words in the mouths of elected officials but also draft legislative tomes for their staffs that no normal citizen could possibly read or understand, it’s hard to imagine significant legislation that could stand against the riptide of plutocratic influence—or, if one prefers a less emotive phrase, against the logic of collective action. Can we realistically expect to reform any dimension of American government that abuts on such logic? The tax code, and the creative legal chicanery that opens up vast spaces between illegal tax evasion and legal “tax avoidance”? Dealing with the subsidies that benefit agribusiness conglomerates? Getting a handle on rising healthcare costs, as opposed to merely the health insurance market? Rationalizing our energy infrastructure or regulating our carbon footprint? I’m not holding my breath.

There is another way to think about the matter, which becomes clear as we circle back to Mr. Madison and the Founders to examine their understanding of democracy. If we want to understand plutocracy and democracy in mutual context, variation in the meaning of the latter will matter just as much as variation in the meaning of the former. One example should get us started. Bill Moyers, like most who are unsettled by the specter of plutocracy, thinks the antidote to it is more democracy:

So it is that like those populists of that earlier era, millions of Americans have awakened to a sobering reality: they live in a plutocracy, where they are disposable. Then, the remedy was a popular insurgency that ignited the spark of democracy. Now we have come to another parting of the ways, and once again the fate and character of our country are up for grabs. . . . I am biased: democracy only works when we claim it as our own.

It’s a great applause line; but is it true? As Professor Sumner might have said, it depends on what is meant by democracy.

The Founders, their classical educations guiding them, did not put democracy on a pedestal as most Americans do today. That place was reserved for liberty and republican government, each in its way an expression of fear of excessive concentrations of power (with Samuel I, chapter 8 serving as a proof text for most of them). Liberty meant freedom from the impositions of a cloying state, a definition dating at the least from the clash of Roundheads and Cavaliers in the English Civil War. Republican government à la Montesquieu meant protection against the kind of monarchy that sought to suborn the judiciary, the law being, in addition to the social power of the nobility, a check on concentrated royal authority. Democracy, as the term was then understood, embodied a hearty capacity for abuse—for mob rule and the triumph of passion over reason to serve the ambition of the demagogue. Though to the sharp side of this point of view, Alexander Hamilton said it best on June 18, 1787 at the Constitutional Convention in Philadelphia: “Your ‘people’, sir, is nothing but a great beast.”

American electoral democracy as the Founders established it was therefore heavily mediated by the balances inherent in federalism, the indirect election of the Senate, the Electoral College and, above all, a Supreme Court set off at a healthy distance from the citizenry. Perhaps in moral theory the individual was the epicenter of political judgment, but in practice the Founders’ system privileged the political agency of social constituencies (albeit with a uniquely broad tolerance for the rights of minorities). As a light on what really concerned them, note that they spent precious little ink in the Constitution and the Bill of Rights defining citizenship and voting rights. This they left to the states and to the courts of the future to agonize over.

It is important to recall these facts of the American founding because republican government tolerates wide-open political space in a way that democracy, seen not just as method to elect leaders but as the embodiment of an egalitarian ideal, does not. The former accepts a wide swath for politics, defined as the means by which the natural lack of consensus among competing interests is narrowed but never eliminated. The latter, precisely because it posits an ideal, would more tightly bind where politics may lead. Republicanism acquiesces to the reality of hierarchy, to, as Jefferson put it to Adams, the consequences of “the natural aristocracy of talent and virtue.” Democracy qua egalitarian ideal, however, bristles at distended economic outcomes, seeing their source in structural distortions of political economy rather than in any natural aristocracy of talent and virtue. It therefore often presumes to engineer the progressive reduction of inequality if not its ultimate elimination.

It follows that the definition of what is and is not fair is unstable between these two conceptions of democracy. The former is not much bothered by the talented, the clever and even the merely lucky doing very well, and is thus reluctant to shout plutocratic foul when they do so. It is not bothered much either, it seems, by the boom-bubble-bust economic cycles so common to American history. To this day most Americans affirm the free play of the market and the unequal outcomes it allows, as long as those outcomes cannot be locked in by subterfuge to produce an aristocracy that would deny the rewards of merit to less well-situated others. The latter conception of democracy, as egalitarian ideal, is bothered, and here we encounter a paradox: Those toward the bottom of the American socio-economic ladder are considerably less likely to express resentment of rich people than those considerably above the middle but below the very top.

Ample data testify to the fact that the professional classes, often enough those with liberal arts educations and liberal views, are far quicker to take umbrage at inequality, and to see the machinations of aristocracy in those of a higher station, precisely because they connect it not to differences in “talent and virtue” but rather to corruption born of structural distortion. This has a lot to do with acquired habits of mind. Whereas the less formally educated hear abstractions but see actual people and behaviors, the more formally educated hear actual people and behaviors but see abstractions. That is largely why advanced levels of education track with the impulse toward meliorism, and why those with graduate degrees tend to vote Democratic.

This is not to say, of course, that Jefferson, Adams and Madison were wrong about natural aristocracies or that meliorism undertaken by government actually works as intended; Tocqueville addressed the latter point more than 175 years ago in his Memoir on Pauperism (1835). But lest conservatives smile too broadly, in truth it is not easy to distinguish the sources of inequality in a rapidly changing socio-technological context, to know whether natural differences in virtue and talent or exploitation explains unequal outcomes. Even the Founders, after all, as forgiving of human foibles in political life as they were, recognized the capacity of factions to act in ways “adverse to the rights of other citizens, or to the permanent and aggregate interests of the community.” They would not have looked fondly on Mark Hanna, Boss Tweed or Jack Abramoff.

The essence of the problem comes down, perhaps, to this: By construing democracy as we do today, we simultaneously lower our tolerance for the outcomes produced by the logic of plutocratic collective action and nurture an environment that enables that logic to flourish. It doesn’t help that the potential for plutocratic abuse is, if anything, greater at a time when its excesses are no longer as ostentatious as they were in Mark Twain’s day. They have rather been routinized, institutionalized and even bureaucratized like so much else, as a look into the subculture of the major Washington lobbyist-for-hire firms shows. Obsessed with vacuous celebrity, Americans make it easier than ever for plutocrats to sail under the radar. Corporate heavyweights and bankers may be suborning Congress and ripping off “we the people” left and right, but we’re too busy dancing with the stars to notice. On this point, at least, Professor Sumner was really on to something.

The more one ponders the interplay of plutocracy and democracy the less straightforward it seems. An endless sea of questions now stretches out before us, whereas in the beginning there was only one. Sorry about that. But these, I think, are the terms of contention.

____________________________________

Adam Garfinkle is the editor of The American Interest.

1 The Federalist (No. 10).

2 Autobiography of Mark Twain, Volume 1 (University of California Press, 2010), p. 364.

3 This and other plutocratic outrages were described by former South Dakota Senator R.F. Pettigrew in the widely circulated Triumphant Plutocracy: The Story of American Life from 1870 to 1920 (Academy Press, 1921).

4 Two Southern Congressmen wrote popular screeds against plutocracy: Milford Wrairson Howard of Alabama and Thomas M. Norwood of Georgia. See Howard, The American Plutocracy (Holland, 1895), and Norwood, Plutocracy: or, American White Slavery (American News Company, 1888).

5 Robert C. Bannister, ed., On Liberty, Society, and Politics: The Essential Essays of William Graham Sumner (Liberty Fund, 1992), pp. 84-5. Sumner, in turn, depended on an earlier source for this insight: Condy Raguet, Principles of Free Trade (1835).

6 On White, see Stephanie Abbajay, “What’s Right with Kansas”, The American Interest (May/June 2009).

7 Phillips’s most recent book, written before the collapse of Lehman Brothers, is Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism (2008). See also Reich, Supercapitalism (2008) and Kaiser, So Damned Much Money (2009).

8 Quoted in Stephanie Strom, “Pledge to Give Away Fortunes Stirs Debate”, New York Times, November 11, 2010.

9 As Reich argues in “Reading America’s Tea Leaves”, The American Interest (November/December 2010).

10 Robert Pear, “In House, Many Spoke With One Voice: Lobbyists’”, New York Times, November 14, 2009.

Chapter 2

American Dreams, American Resentments

Walter Russell Mead

If there is a single frustration that unites members of the American upper-middle class today, it is the unpleasant surprise of finding oneself a target of populist rage. Angry and concerned themselves about the rise of a plutocratic elite of super-rich financiers and entrepreneurs, upper-middle class professionals are by and large ready to start up a political movement to rein in the plutocracy. It is therefore a rude shock to many of these Americans to realize that, for many of their less well-off fellow citizens, they are a primary target of voter rage. The upper-middle class wants to lead an aroused populace against the true enemy, but the populace isn’t listening.

Upper-middle class Americans, notably those in the professional classes, have seen their incomes rise over the last generation, but not nearly as rapidly as those of the truly wealthy above them. It is that gap that has arrested their attention, not the one between themselves and blue-collar workers below. Doctors, professors, journalists, even most lawyers today are, generally speaking, absolutely and relatively better off than plumbers, retail workers, machine operators and truckers when compared with the 1970s, but the gap between most professionals and high-flying investment bankers and the superstars in every field, whose recent rise has been truly extraordinary and historic, is even wider than it used to be. The professional upper-middle class identifies with populist anger about the wealthy and Wall Street. What it cannot understand is that the plumbers, factory workers and truckers often seem angrier with them than they are with Wall Street malefactors of far greater wealth.[1]

Analysts like Thomas Frank interpret the failure of the lower- and middle-middle class to focus on the real plutocracy rather than the upper-middle class as a symptom of the false consciousness of American workers that has historically stunted the development of genuinely progressive ideology and social movements in the United States. There is something to be said for this point of view, but it is important to understand that the real social crisis in the United States is not marked or caused by the appearance of great fortunes. Rather, it lies in the economic crisis of middle-class life. The anger fueling the populism of both the Left and the Right is not so much jealousy and envy that a tiny minority is making pots of money; it is anxiety and disappointment about the darkening prospects of everyone else.

There are of course connections between the middle-class crisis and the rise of the New Rich, but they are not simple or even direct. There are also connections between the current crisis and similar ones of previous epochs. These are not simple either, but studying them may help us understand something about what is happening today.

The contemporary crisis of the middle strata in American society is perhaps best compared to the long and painful decline of the family farm. The American dream we know in our time—a good job and a nice house in a decent suburb with good schools—is not the classic version. The dream that animated the mass of colonists, that drove the Revolution and that drew millions of immigrants to the United States during the first century of independence, was the dream of owning one’s own farm. Up until the 20th century, most Americans lived in rural communities. Well into the 20th century, agriculture was by far the most important occupation in which Americans were engaged (to say nothing of the rest of the world).

The difference between the overwhelming majority of Americans in agriculture and the large majority of people elsewhere (except for similarly blessed places like Australia, Canada and New Zealand) was that Americans and their Commonwealth cousins generally owned the land they farmed. With the exception of Southern sharecroppers, American farmer families had no landlords. They were therefore free to decide what to grow and how to grow it, and they alone enjoyed the benefits of their hard work and productivity.

The reality of Americans as independent owners of land not only formed the critical socio-economic datum of the Republic’s formative era, it also served as the inspiration for a romantic political idealism about pastoral life. From Jefferson to Lincoln, American leaders envisioned a benign union of new science and new politics, with the innovative, prosperous and intellectually active gentry farmer as the model of the future. In the Old World, farmers may have toiled at the mercy of barons with minds rendered brutish in the process; in the New World their liberty and property would enable them to become a mass landed nobility of a kind the world had never seen. Together, the facts and the romance of farming led antebellum American farmers to believe that, by historical standards, they were not only very prosperous but were bound to become even more so. This was, in a nutshell, Whig agriculture.

That dream began to fade after the Civil War. The technology of the 19th century did not just open the Great Plains to farming; new farming areas opened up all over the world. The agricultural boom came to a gradual and painful end as endemic overproduction lowered farm incomes globally. Undercapitalized family farms were unable to adjust or compete—especially in the marginal areas settled under the 1862 Homestead Act. A slow process of agricultural decline and dispossession started in the 1870s and culminated in the disasters of the Great Depression. Essentially, popular demand for the American dream of a family farm led the government into policies that encouraged a farm bubble. Americans overinvested in farms even as family farms were becoming less sustainable. Over time they sought various forms of government subsidy and income support as they clung to the only American dream they knew. But the laws of economics could not be gainsaid, and the independent family farmer, the class Thomas Jefferson believed above all guaranteed the future of the American republic, gradually decayed and largely disappeared into the maw of contemporary agribusiness.

Much of the drama of American politics in those years revolved around the efforts of agrarian America to save its way of life. The return to the gold standard following the Civil War and the high interest rates and deflationary economic policies required to keep the dollar level in gold terms against the British pound intensified the stress on farmers. Small farmers produced goods like wheat, corn and livestock. Those goods were in chronic oversupply as American farmers competed with Argentines, Australians, Ukrainians and others around the world. The Greenback and Free Silver movements thus sought to inflate the cash value of farm produce and reduce the real value of farm debt.

The epic struggle of farm interests against those of the railroads sprang from the same causes. Farmers had to ship their bulky commodities to distant markets, and freight charges ate away at the farmers’ slender margins. William Jennings Bryan voiced the desperation of the family farmers in his presidential campaigns, but the future of the United States lay with the upper-middle class urban progressives who supported men like Theodore Roosevelt and Woodrow Wilson—and who tended to focus more on addressing the problems of the cities rather than those of the country.

The struggle for “parity”, payments and subsidies that would allow farmers to achieve income parity with urban consumers, was another political movement that sought to reverse the economic tide flowing against the classic form of the American dream. Depression-era novels and songs about the desperate Okie migration to southern California reflected the accelerated pace of agricultural decline that took place during the 1930s. The Farm Aid concerts and protests of the 1970s and 1980s were the last gasps of a movement that once expressed the interests of the mass of the American people.

So the old American dream died, but Franklin Roosevelt and Harry Truman reunited urban progressives with the American masses to recast the dream in a new form. In the old dream, property and production were allied. The American was a property owner, and that property produced the livelihood that made Americans prosperous and independent. In the 20th century, America shifted from a nation of independent farmers to a nation of homeowners. They were still property owners, but they no longer derived their income from the homestead. American families used to have a farm; now they had a home and a job.

FDR and Truman had figured out how to use progressive means to serve populist ends. The growing professional upper-middle classes and the institutions in which they worked would protect the average American from the ravages of big business and economic turmoil. Keynesian economics applied by technocratic economists would maintain full employment while holding inflation at bay. A regulated economy, mostly consisting of stable large monopolies (like AT&T) or oligopolies (like the Big Three media networks and the Big Three auto companies), provided good and lasting jobs at good wages to blue- as well as white-collar American workers. Scientists and engineers would come up with technological advances that raised productivity and allowed a generally rising living standard. A professional civil service regulated business in the interest of the “little man.” Professionals like doctors and lawyers lived better than the average blue-collar worker (my grandfather was a doctor; his wife bought a new Buick every three years, whether she really needed one or not), but the gap between upper- and lower-middle class incomes was much less than it has since become. And social mobility was such that it was not far-fetched to suppose that the son of a plumber or an auto mechanic could become a doctor or a lawyer, and that the son of a university professor could become a used car salesman.

So it was that the “crabgrass Jacksonian” recreated the historical sense of American independence and prosperity in a suburb. Fannie Mae, born in 1937, amounted to a new Homestead Act that put home ownership within reach of the masses. The rapid rise in blue- and white-collar incomes after World War II, aided greatly by the GI Bill, allowed working Americans to sustain a prosperous and stable lifestyle that made them the envy of the world.

The phenomenon of rapid income increases that are also socially broad-based has now dimmed. One result is that the crabgrass Jacksonians are today experiencing some of the fear and frustration their great-grandparents felt as the crisis of the family farm deepened in the late 19th century. This populist anger and anxiety may in time attach itself to the great fortunes of entrepreneurs like Bill Gates, investors like Warren Buffett and speculators aplenty. The populism of the Left—the antiwar and anti-Halliburton movements that fringed the American scene during the long-sagging decline of the Bush Administration—is already there, if surprisingly weak in its political voice.

In a worst-case scenario, that populism could turn anti-Semitic as it did during the 1920s and 1930s, when a resurgent KKK and figures like Father Charles Coughlin linked fears of cultural disintegration and the domination of high finance to the wicked machinations of the Eternal Jew. We are, I think, still far from that today. Pat Buchanan and his ilk have so far been unable to stitch together a big-picture lie of Hollywood Jews destroying religion and culture, Wall Street Jews attacking the middle class, and Zionist Jews dragging the United States into unwinnable foreign wars all to serve the dark agenda of the Chosen People. What we have instead is an anger aimed at another target.

The most prominent example of class warfare in America today is a class civil war arising out of an American middle class divided against itself. It is divided vertically, with the lower-middle and middle-middle classes resenting the professionals in the upper-middle class; the upper-middle class, meanwhile, is divided horizontally, with small businesspeople angry at the professionals and the civil servants among them. (Doctors get a partial pass; they are expensive, but they can save your life. Lawyers and bureaucrats, on the other hand, are just as expensive but not nearly as helpful.)

This resentment is a potent cocktail of financial envy (upper-middle class incomes have risen even as other middle-class incomes stagnated or fell), status envy (the professor and the lawyer look down on the car dealer and the hardware store owner as well as the store clerk and the waitperson), and political resentment. The political resentment is particularly complex. Essentially, much of America believes that the outcome of the Progressive movement and the New Deal was a new kind of society. The rich remained rich, though they were taxed at higher rates and their social power was checked; the crabgrass Jacksonians got a house and a job; and the professional class would keep everything running. “Experts” trained in universities would keep their eye on the system, making the necessary adjustments to ensure that the basic features of the American economic model remained in good operating order.

There is a widespread perception in America today that the professionals and intellectuals of the upper-middle class have betrayed that calling—that, essentially, they forgot who was paying their salaries. During the past thirty years of falling real incomes for non-supervisory private-sector workers, the upper-middle class did little or nothing to change things. Au contraire, the intellectuals and the academics mostly served as cheerleaders for globalization, automation and other processes believed responsible for the breakdown of the old model. Organizations like Fannie Mae, with the blessings of the intellectuals and the political class, promoted precisely the developments in the mortgage market that have led something like 20 percent of American mortgage holders to be underwater, owing more on their mortgage than their home is now worth.

The administrators and professionals were supposed to regulate financial markets to prevent wild crashes. They didn’t; Wall Street caused a huge mess but for the most part did not suffer from it nearly as much as those on and around Main Street. They were supposed to provide an intellectual framework for American trade policy which ensured that the middle class would benefit from the gains resulting from trade. They didn’t; Americans have been able to buy a lot of cheap imports but largely at the expense of the manufacturing jobs the middle class depended on. They were supposed to manage the housing system to make it part of a stable, sensible and prudent mechanism that generated wealth for the middle class. They didn’t; instead they abetted a bubble. They were supposed to exercise a dignified restraint in their pursuit of money. They mostly didn’t; instead they forgot their responsibility to the general good as they engaged enthusiastically in a private scramble for wealth.

The professional ethos was very different in those earlier days when FDR and Harry S. Truman rebirthed the dream. When my grandfather’s patients couldn’t pay their bills during the Depression, he carried their debts for years without interest or seeking payment. Baskets of corn, peanuts and other agricultural goods would often appear on his back porch—something between a note of gratitude and a little interest in kind. When his medical partner left to serve in World War II, my grandfather treated all of his patients and, when his partner returned, presented him with a check covering every single dime the partner’s share of the practice had earned. My grandfather was considered an honest man and a good one, but he did no more than live up to a personal code that many professionals of the day took for granted and unquestioningly obeyed.

To those outside the professional middle class, the shift between the old and new styles can look like a pattern of rapacity and incompetence. The institutions managed by the professional classes—law, health, education, government—are all witnessing costs that rise faster than overall levels of inflation while the perceived quality of their output is diminishing. Almost every interaction that the professional upper-middle class has with the rest of society contributes to the perception that this segment of society has lost touch with its basic responsibility to serve the public interest and is obsessed instead with raising its own income, power and status. It is profoundly unfair to the many honorable and decent people serving in the professions, but the image of these professions in society at large looks a little like that of John Edwards: the sleazy and hypocritical charlatan who professed an undying love for his wife and the poor as he amassed a huge fortune and broke his marriage vows. The high ideals he professed only made his betrayals more disgusting.

The political argument of the professional classes today boils down to this: Give us more resources and more power and we will tame the malefactors of great wealth and bring decent governance back to the country. That argument is not working very well. The marriage of progressives and populists is in trouble. Crabgrass Jacksonians do not trust the professional class anymore: not the journalists, not the professors, not the bureaucrats, not the career politicians. They believe that if these folks get more resources and power they will simply abuse them. Give the educators more money and the professors will go off on more weird and arcane theoretical tangents and the teachers’ unions will kick back and relax. In neither case will they spend more time helping your kids get ready for real life. Give the bureaucrats more power and they will impose more counterproductive regulations that throttle small business. Give the lawyers more power and they will raise prices and clog commerce with lawsuits and red tape. Give the politicians more time in office and more tax money to spend and they will continue stroking the fat cats while calling rhetorically for change.

In no case (with the possible and partial exception of the military) do crabgrass Jacksonians believe that the professional upper-middle class is sincerely determined to bend its efforts and its power to the single and sole goal of maintaining the well-being of the people who pay their salaries and fees. In that sense they see the emergence of the real plutocrats and financial powers as simply an extreme case of the disregard for the public welfare that marks the professional class as a whole. Investment bankers are simply better at doing what the whole upper-middle class is trying to do: loot and pillage the population at large by wielding its cleverness and its connections as a weapon.

This seems crazy to the average upper-middle class professional couple, struggling with high mortgages and education bills of their own, haunted by the difficulties of balancing family and professional commitments, consumed with status anxiety about the future of their children, and fixed on the immense distance between themselves and those (often classmates in college) who have gone on to true wealth. But that is what always drives class warfare: The world looks very different to people in different places on the social hierarchy.

The reality is as complex today as it seemed to those living in William Jennings Bryan’s time. Technological change rather than professional malfeasance is in truth driving the breakup of the Crabgrass Utopia of populist Jacksonian memory. The forces breaking up the old American social system are as irresistible as the forces that destroyed the family farm. The failure of American intellectuals and upper-middle-class professionals is not that we failed to preserve the old industrial system; the failure is that, so far, we have not yet come up with a viable and attractive alternative. Until and unless we do, we should expect the middle-class warfare we are experiencing to continue, and even to intensify.

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Walter Russell Mead is the James Clarke Chace Professor of Humanities and Political Studies at Bard College and the editor of The American Interest Online.

1 For evidence of this see the series of surveys cited and summarized in Scott Rasmussen & David Schoen, Mad as Hell: How the Tea Party Movement Is Fundamentally Remaking Our Two-Party System (HarperCollins, 2010).

Chapter 3

The Weakness of Liberal Populism

Francis Fukuyama

The answer to the question “Is America a plutocracy?” might seem either trivial or obvious depending on how one defines the term. Plutocracy, says the dictionary, simply means “rule by the rich.” If the query is taken literally to mean that the non-rich—the vast majority of American citizens—have no influence in American democracy, or that the country is self-consciously ruled by some hidden collusive elite, the answer is obviously “no.” On the other hand, if the question is taken to mean, “Do the wealthy have disproportionate political influence in the United States?” then the answer is obviously “yes”, and that answer would qualify as one of the most unsurprising imaginable. Wealthy people have had disproportionate influence in most polities at most times in history. Of course, one can argue endlessly over who qualifies as being rich, whether the rich constitute a social class capable of collective action, how open or closed that class is, what constitutes real political power in today’s America, and so on. But if the question remains as simple as those articulated above, the basic answer will not change or be of much interest.

This is not, however, what we ought to mean by plutocracy. We mean not just rule by the rich, but rule by and for the rich. We mean, in other words, a state of affairs in which the rich influence government in such a way as to protect and expand their own wealth and influence, often at the expense of others. As chapter 1 shows, this influence may be exercised in five basic ways: lobbying to shift regulatory costs and other burdens away from corporations and onto the public at large; lobbying to affect the tax code so that the wealthy pay less; lobbying to allow the fullest possible use of corporate money in political campaigns; lobbying to enable lobbying to go on with the fewest restrictions; and becoming a dominant contracting agent of government.

Of these, the second has perhaps the deepest historical legacy. Scandalous as it may sound to the ears of Republicans schooled in Reaganomics, one critical measure of the health of a modern democracy is its ability to legitimately extract taxes from its own elites. The most dysfunctional societies in the developing world are those whose elites succeed either in legally exempting themselves from taxation, or in taking advantage of lax enforcement to evade them, thereby shifting the burden of public expenditure onto the rest of society.

We therefore raise a different and more interesting set of questions regarding the relationship between money and power in contemporary America. All these questions come together, however, in a paramount political puzzle: Why has a significant increase in income inequality in recent decades failed to generate political pressure from the Left for redistributional redress, as similar trends did in earlier times? Instead, insofar as there is any populism bubbling from below in America today it comes from the Right, and its target is not just the “undeserving rich”—Wall Street “flip-it” shysters and their ilk—but, even more so, government itself, a government whose policies intend to protect Americans from their predations. How do we explain this?

Let us start by describing the contemporary landscape in which this question arises. It is well established that income inequality has increased substantially in the United States over the past three decades, and that gains from the prolonged period of economic growth that ended in 2007–08 have gone disproportionately to the upper end of the richest layer of society. A study by Thomas Piketty and Emmanuel Saez shows that between 1978 and 2007, the share of U.S. income accruing to the top 1 percent of American families jumped from 9 to 23.5 percent of the total. These data point clearly to the stagnation of working class incomes in the United States: Real incomes for male workers peaked sometime back in the 1970s and have not recovered since.[1]

The growing disparity in outcomes has coincided with a period of conservative hegemony in American politics. Conservative ideas clearly had to do with the rise in inequality: The liberal (in the original 19th-century meaning of the term) economic model favored by Ronald Reagan was intended to open the doors to greater competition and entrepreneurship, which necessarily meant that gains from growth would go disproportionately to those best prepared to create wealth. Periods of rapid growth nearly always increase concentrations of capital and hence income inequality, but, as pro-market advocates have repeatedly told us, growth also nearly always trickles down over time to all or nearly all class cohorts.

As the years went by and those outsized gains at the top of the income distribution pyramid failed to trickle down in any substantial way, one would have expected growing demand for a Left-leaning politics that sought, if not to equalize outcomes, then at least to bound their inequality. That did not happen. The Democratic Party, which one would have expected to be the principal focus of such political advocacy, floundered. It managed to regain majorities in the House and Senate, and it did hold the presidency between 1993 and 2001 (and, of course, regained it in 2009), but its electoral successes have not turned on economic fairness issues. To an unexpected degree, Democrats drank the Kool-Aid of market fundamentalism during the 1990s and in so doing reflected larger intellectual trends. (Indeed, when Al Gore’s 2000 campaign deigned to invoke class inequality issues as one of its themes, it arguably backfired.)

The financial crisis of 2008–09 only deepened the mystery. The crisis laid bare some unpleasant facts about American capitalism. The banking industry lobbied heavily in the 1990s to further free itself from regulation, a trend that began in earnest with the Depository Institutions and Deregulation and Monetary Control Act of 1980. This resulted in, among other things, the 1999 Gramm-Leach-Bliley Act, which enabled the emergence of large “universal” banks and the Commodity Futures Modernization Act of 2000, which enabled a non-transparent market in derivatives. Before the bust in the U.S. housing market, the rapidly expanding financial sector took home some 40 percent of all corporate profits, and yet it was responsible for an implosion that not only wiped out the banks themselves but imposed huge costs on innocent bystanders both in the United States and abroad. It also cost the U.S. economy an enormous sum in bailouts (some of which have since been recouped, but most not).

What was truly troubling, however, was that the collapse undermined the fundamental moral justification for material inequality in a politically egalitarian society. Basic to the legitimacy of market capitalism is the efficient market hypothesis—that is, the notion that in a truly competitive market everyone earns something close to his or her “social” rate of return. This means, in other words, that if your investment banker earns 100,000 times as much as your plumber, it’s because he or she is contributing roughly 100,000 times as much to society’s total pool of wealth.

The crisis made it glaringly obvious that the efficient market hypothesis was wrong: Oversized returns were flowing to innovative financial entrepreneurs who, in their avidity to create new and more complex financial instruments and products, were destroying rather than creating value for society as a whole. The crisis also shed bright light on the fact that corporate America was doing very well for its officers and shareholders (many of whom were not American citizens), but much less well for those Americans awaiting the trickle as jobs were outsourced and automated by the millions. Perhaps corporate America’s social rate of return may have approximated the expectations of the efficient market hypothesis, but only if “social” no longer referred to American society alone.

The crisis, exploding as it did in the midst of the 2008 presidential election, clearly helped Barack Obama at the expense of his Republican rival John McCain, in part because the public associated Wall Street with Republicans, and also, of course, because the debacle broke forth during the tenure of a Republican President. The new Administration went into office believing, however, that its victory signaled a fundamental realignment of American politics along the lines of the 1932 election that swept Franklin Roosevelt into power. Administration principals thought they had a mandate to move the country sharply to the Left—hence the fiscal stimulus bill, a bailout of the auto companies that left the government owning a large share of them, a major healthcare reform initiative, and an attempt to design a new regulatory framework for the banks.

But as it turned out, Obama was not riding a tide of Left-wing populism. While the Democratic majorities in Congress succeeded in moving this ambitious legislative agenda forward, the results fell far short of expectations. The stimulus package did not produce stunning economic successes. The healthcare bill did not include a public option, and failed to address the real sources of cost inflation. Above all, the Dodd-Frank financial regulation reform bill did not change the perverse incentives that led to the crisis in the first place. Indeed, while Wall Street brought considerable opprobrium on itself, it was arguably the sector of the U.S. economy that suffered the least in the long run. Bank earnings were restored after a couple of quarters. And though the banks now face tougher regulation, Congress failed to do anything about the fact that investment banks are still too large and too interconnected to fail, and will surely be bailed out again when they get in trouble. Indeed, the U.S. financial sector is now concentrated in fewer hands than it was before the crisis.

One of the reasons for all these political shortfalls is that populist momentum swung sharply to the Right, as evidenced by the rise of the Tea Party movement and the Republican capture of the House of Representatives in the 2010 midterm elections. This swing did not happen all by itself. Wall Street spent a huge amount of money lobbying to make sure that the inevitable financial regulation was as weak as possible. This led former IMF chief economist Simon Johnson to argue that the United States was dominated by an oligarchy not too different from the ones he encountered in Russia and a variety of developing countries. Huge pharmaceutical companies and their lobbyists loomed over the healthcare legislation, as well, to the point that the White House, sensing their clout, deferred before the fact to most of their preferences.

But money alone does not create political trends in the United States. Within a year of Barack Obama’s inauguration, the most energized and angry people on the American political scene were not the homeowners with subprime mortgages who faced foreclosure as a result of the crisis, but rather those who faulted the government for taking steps to protect those homeowners, and to prevent the crisis from deepening. It was a strange phenomenon that saw many of those most deeply injured by the crisis become, in effect, objective allies of those who caused it.

This, then, is the contemporary context in which we raise the question of plutocracy in America: Why, given the economic history of the past thirty years, have we not seen the emergence of a powerful Left-wing political movement seeking fairer distribution of growth? Why was Obama pilloried during the 2008 campaign for even using the word “redistribution”, when all modern democracies (including the United States) already engage in a substantial degree of redistribution? Why has anti-elite populism taken a Right-wing form, one that sees vast conspiracies not among private-sector actors like bankers and hedge-fund operators, but among government officials who were arguably trying to protect the public against real collusions if not outright conspiracies? Why have there been so few demands for a rethinking of the basic American social contract, when the present one has been revealed to be so flawed? How can it be that large numbers of congressional Democrats and arguably the most socially liberal President in American history seriously considered extending, and even making permanent, the Bush tax cuts of 2001 and 2003? Is this not prima facie evidence of plutocracy?

There are several possible answers to these questions. The most frequent response from the Left is “yes”—corporate America can protect its interests through lobbyists and campaign contributions, and money does lock in their advantages and defeat all efforts at, say, campaign finance reform. The American plutocracy, they add, has also profited from a pliant Supreme Court, which in its Citizens United decision of January 2010 ratified the view that corporations are tantamount to individuals with constitutionally protected rights not only to be a party to business contracts but also to political speech.

There is no question that money buys political influence in ways large and small in contemporary America, and that lobbying has become a form of legitimized corruption in many cases. But there are a number of problems with seeing this as the sole explanation for the absence of a cohesive political Left. Corporate America is not the only source of campaign donations; labor unions, Hollywood moguls and many liberal Wall Street financiers donate generously to their favored causes. Corporate America, moreover, is not a monolithic actor, but represents a huge variety of often-conflicting interests. Money often follows grassroots political trends rather than creating them.

A second explanation has to do with American exceptionalism. Many observers through the years have noted that Americans are much less bothered than Europeans by unequal economic outcomes, being far more concerned about equality of opportunity. The classic explanation for this has to do with the fact that America was (for recent immigrants, at least) a land of new settlement with few inherited status privileges, imbued with a Lockean liberal belief in individual opportunity. Americans tend to think that individuals are responsible for their own life outcomes; they often distinguish between the “deserving” and “undeserving” poor, the latter of whom are poor as a result of their being, in Locke’s phrase, “quarrelsome and contentious.” Americans care less about equality of outcomes than the possibility of social mobility, even if such mobility takes generations to achieve.

This Lockean emphasis on individual responsibility manifests itself in several distinctive ways. Large numbers of Americans, for example, favor abolishing all inheritance taxes (commonly denounced by the Right as the “death tax”), even though only a very small minority of them can ever hope to leave the world with sufficient assets to be subject to it. It also explains why Congress, with the support of President Clinton, abolished the New Deal program Aid to Families with Dependent Children as part of a broad welfare reform, under the rubric of legislation tellingly labeled the “Personal Responsibility and Work Opportunity Reconciliation Act of 1996.”

This aspect of American political culture is still insufficient, however, to explain why there has been so little Left-wing populism in the early 21st century. For despite their Lockean beliefs, Americans of past generations have supported substantial redistribution, not just during the New Deal and Great Society eras, but when the nation first imposed a highly progressive national income tax around the time of the First World War.

Moreover, while there is no evidence that America’s rate of intergenerational social mobility has declined over time, that rate is not nearly as high as many Americans believe, and indeed it is not as high as the rate in some other developed countries. The distinction between equality of outcome and equality of opportunity is in any event not as clear as it might first appear: Better-off people employ all sorts of strategies for passing their status on to their children, from the sorts of neighborhoods they can afford to live in to legacy admissions to elite universities. So we need further explanations for why there has not been more of a backlash from those left behind.

A third possible reason for the absence of redistributionist populism is much more time-specific: Americans have learned to distrust big government in a way they had not in the period from 1933 to 1969. Like taxpayers in Latin America, but unlike various Swedes, Danes and Germans, Americans don’t want to pay taxes because they are convinced that the government will waste whatever it takes in. Whether this is a fair assessment of our state capacity is a different matter; the efficiency of the U.S. government varies tremendously depending on level, geography, function and the like. It has both excellent agencies (the Marine Corps) and terrible ones (the former Immigration and Naturalization Service). Since the Reagan years, however, many Americans have come to believe that the experience of the New Deal and Great Society demonstrated the inability of “big government” to spend money wisely, or indeed to spend it at all without producing harmful unintended consequences. They are therefore unwilling to countenance expansion of the state into areas like healthcare even if they do not object to such spending in principle.

A fourth explanation is offered by Raghuram Rajan in his recent book Fault Lines: How Hidden Fractures Still Threaten the World Economy (2010). Rajan argues that the working and middle classes whose incomes either stagnated or fell during the past generation were in effect bought off by cheap credit: The flood of capital coming in from Asia and other surplus countries, creatively packaged by the banks and quasi-public institutions like Fannie Mae and Freddie Mac, allowed people to borrow against the future and enjoy standards of living that were in the end unsustainable. In his view, the day of reckoning has finally arrived: Cheap credit masked inequality at least in the sense that it enabled many people to increase their consumption, even if they could not keep up with richer cohorts who were increasing their consumption even faster. Now that easy credit has dried up, people grow angry when confronted with the stark reality that their bankers have done far, far better than they.

A final explanation lies in the realm of ideas, and comes closest to a Marxist plutocracy-conspiracy theory. Simon Johnson’s view that Wall Street constitutes an oligarchy manipulating the political system in a manner uncomfortably similar to the Russian oligarchs or other developing country elites does not ring true because it does not take account of ideas. At some level, corrupt developing-country elites know they are getting away with murder (sometimes for real); they rarely try to justify their self-enrichment to themselves in moral terms. American elites, however, tend to believe they are helping society as a whole even as they help themselves. Thus the centrality of the efficient market hypothesis: Financiers proudly see themselves as “value creators”, not as highbrow pickpockets of widows and orphans.

Standing behind this moral view is the entire edifice of modern neo-classical economics, which has played a hugely important role in legitimating the contemporary, finance-heavy version of market capitalism. The intellectual turn taken by the economics profession from Marxist or Keynesian models to strict monetarism and the Chicago School occurred right about the time that Reagan and Thatcher emerged on the political scene, and served to provide a seemingly scientific justification for market liberalization. As Seth Colby and I have argued, much of this framework was empirically justified with regard to trade and investment, but little empirical ground existed for believing that capital market liberalization would have beneficial effects.[2] (Indeed, as Kenneth Rogoff and Carmen Reinhart’s 2009 book This Time Is Different demonstrates, data from the past two hundred years shows that hasty liberalization of the financial sector is highly dangerous.) Well-founded microeconomic theories concerning the efficiency of single markets were blown up and applied to all sectors of the macroeconomy, despite the fact that at an aggregate level many get rich by taking advantage of market failures, asymmetric information or political influence. The mathematization of modern economics, too, gave it the aura of a true science, the only one of the social sciences whose practitioners believe they stand in the same league as physicists. Ben Bernanke’s “great moderation” of the 2000s was in effect just the latest iteration of the mantra “this time is different.”

So here is the evidence for an American plutocracy of a narrow and discrete but hardly harmless sort. Wall Street seduced the economics profession not through overt corruption, but by aligning the incentives of economists with its own. It was very easy for academic economists to move from universities to central banks to hedge funds—a tightly knit world in which everyone shared the same views about the self-regulating and beneficial effects of open capital markets. The alliance was enormously profitable for everyone: The academics got big consulting fees, and Wall Street got legitimacy. And it has kept the system going despite the enormous policy failures it has generated, not to exclude the recent crisis.

Another set of ideas was of even more direct help to the wealthy: Reaganomics. Supply-side economics provided a principled justification for the rich paying lower taxes on the grounds that entrepreneurial incentives unleashed by lower marginal tax rates would not merely trickle but pour down both via public finance and through the creation of employment. This argument was likely true at the near 90 percent marginal rates that prevailed after World War II, but those rates were reduced in several waves beginning in the 1960s. Clinton’s tax increases of the early 1990s brought rates up only slightly, and didn’t have the growth-killing effects widely predicted by Republicans—just the opposite, they preceded one of the great economic expansions of recent memory. The benefits of the Bush-era cuts flowed overwhelmingly to the wealthy, and yet were promoted on the grounds that lower rates would redound to everyone’s benefit. This is still a gospel that many people continue to believe, including, oddly enough, all too many of those left behind.

These different explanations are not, of course, mutually exclusive. In the end, they do not make a simple, straightforward case for or against the existence of American plutocracy. They do, however, point to the fact that money, power and class continue to play out in American politics in highly complex and puzzling ways.

____________________________________

Francis Fukuyama is Olivier Nomellini Senior Fellow at the Freeman Spogli Institute of Stanford University.

1 From an updated version of “Striking It Richer: The Evolution of Top Incomes in the United States”, Pathways Magazine (Winter 2008).

2 Fukuyama & Colby, “What Were They Thinking? The Role of Economists in the Financial Debacle”, The American Interest (September/October 2009).

Chapter 4

Reading America’s Tea Leaves

Robert Reich

November 3, 2020. The newly formed Independence Party pulls enough votes away from both the Republican and Democratic candidates to give its own candidate, Margaret Jones, a plurality of votes, an Electoral College victory and the presidency. A significant number of Independence Party members have also taken seats away from Democrats and Republicans in Congress.

The platform of the Independence Party, as well as its message, is clear and uncompromising: Zero tolerance of illegal immigrants; reduced legal immigration from Latin America, Africa and Asia; increased tariffs on all imports; a ban on American companies moving their operations to another country or outsourcing abroad; a prohibition on foreign “sovereign wealth funds” investing in the United States. America will withdraw from the United Nations, the World Trade Organization, the World Bank and the International Monetary Fund, end all “involvements” in foreign countries, refuse to pay any more interest on our debt to China, essentially defaulting on it, and stop trading with China unless China freely floats its currency.

Profitable companies will be prohibited from laying off workers and cutting payrolls. The Federal budget must always be balanced. The Federal Reserve will be abolished. Banks will be allowed only to take deposits and make loans. Investment banking (and derivatives) will be prohibited. Anyone found to have engaged in insider trading, stock manipulation or securities fraud will face imprisonment for no less than ten years.

Finally, but not least: In order for the government to balance the budget, provide for national defense, guard our borders and pay down the national debt, all personal incomes will be capped at $500,000 per year; earnings in excess of that amount will be taxed at 100 percent; incomes above $250,000 are to be taxed at 80 percent. The capital gains rate will be 80 percent. All net worth above $100,000 will be subject to a 2 percent annual wealth tax. Any American found to be sheltering his income in a foreign nation will be stripped of his citizenship.

In her victory speech, President-elect Jones is defiant:

My fellow Americans: You have voted to reclaim America. Voted to take it back from big government, big business, and big finance. To take it back from the politicians who would rob us of our freedoms, from foreigners who rob us of our jobs, from the rich who have no loyalty to this nation, and from immigrants who live off our hard work. [Wild applause.] We are reclaiming America from the elites who have rigged the system to their benefit, from the money manipulators on Wall Street and the greed masters in corporate executive suites, from the influence peddlers and pork peddlers in Washington, from the so-called intellectuals who want to impose their socialist views on the rest of us—from all the privileged and the powerful who have conspired against us. [Wild applause and cheers.] They will no longer sell Americans out to global money, and pad their nests by taking away our jobs and livelihoods! [Wild applause, cheers.] This is our nation, now! [Wild applause and cheers that continue to build.] A nation of good jobs and good wages for anyone willing to work hard! Our nation! America for Americans! [Thunderous applause.]

Her opponents’ concession speeches are bitter. George P. Bush, the Republican candidate, is irate. “I cannot stand before you and congratulate my opponent who based her entire campaign on fear and resentment”, he tells his supporters. Chelsea Clinton, the Democratic candidate, is indignant. “Margaret Jones and the Independence Party pose a grave danger to the future of this nation.” Foreign leaders try to be respectful but cannot hide their anxieties. The presidents of the U.S. Chamber of Commerce and the Business Roundtable issue a joint statement warning that Margaret Jones and the Independence Party “will push America into another Great Depression.” And the CEOs of the four remaining giant Wall Street firms warn of economic collapse.

On November 4, the day after Election Day, the Dow Jones Industrial Average drops 50 percent in an unprecedented volume of trading. The dollar plummets 30 percent against a weighted average of other currencies. Wall Street is in a panic. Banks close. Business leaders predict economic calamity. Mainstream pollsters, pundits and political consultants fill the airwaves with expressions of shock and horror. Over and over again, they ask: How could this have happened?

How indeed? To get some insight, let’s examine what could very well occur in the decade preceding the election of Margaret Jones.

History teaches us that politics is inextricably bound up with economics. Presidents are not nearly as responsible for the economy as voters assume, but they are held accountable nonetheless. Jimmy Carter lost his bid for re-election in 1980 because the economy had been suffering double-digit inflation, mostly brought on by soaring oil prices. In order to “break the back of inflation”, Paul Volcker, then chairman of the Fed, raised interest rates so high that he also broke the back of the economy, pushing unemployment into the stratosphere. That also broke the back of the Administration. Voters blamed Carter and elected Ronald Reagan.

Reagan, by contrast, won re-election handily in 1984 largely because the economy was surging by then and voters credited him. George Bush lost his re-election bid in 1992, this time at the hands of Alan Greenspan. Greenspan raised interest rates to ward off inflation, which also raised unemployment. Voters blamed Bush and gave Bill Clinton a plurality of votes because he promised to fix the economy (in the words of his colorful political adviser, James Carville, “it’s the economy, stupid”). Clinton was re-elected in 1996 mainly because jobs were returning. Barack Obama won in 2008 as the economy teetered precariously on the edge of a precipice. Many blamed the bad economy on George W. Bush, and that blame spilled over to John McCain, the Republican candidate. (It’s not just the economy: George W. Bush defeated Al Gore in 2000 by the narrowest of margins, even though the economy was still in fine shape and Gore had been part of the Administration that was credited for it; and in 2004, Bush won re-election mainly because of the political psychology surrounding the War on Terror. The only thing that can be said with confidence is that jobs and the economy are almost always high on voters’ list of priorities.)

But even accepting the powerful effect of the economy, a backlash on the scale of my hypothetical Margaret Jones scenario would have as much to do with voters’ cumulative frustrations and pent-up anger as with specific economic conditions on Election Day. It is not difficult to foresee a plausible trajectory: After the stimulus ends and the Federal Reserve tightens the money supply and raises interest rates, and after businesses replenish inventories and consumers replace worn-out products, the jobs machine stalls and economic growth slows. Over the slightly longer term, more companies decide their American employees are overpaid relative to equally productive workers elsewhere in the world who work at a fraction of American wages, or to readily available software and automated equipment. Consequently, large numbers of middle-class Americans have to accept lower pay if they want to stay employed.

Poor families with minimal education are especially hard hit. The middle class adapts in various ways. More middle-class young adults choose to live with their parents and delay marriage and children. Most Americans search harder for bargains, buy more private-labeled groceries and generic drugs, settle for lower grades of meat at the supermarket, stay home more and take fewer vacations. Many give up second cars and consequently depend more on public transportation. A significant number grow their own food, do their own home repairs and mend their own clothes.

This new frugality will not come naturally. According to common stereotypes, the French draw deep satisfaction from good food and wine, the Germans from music, the English from their parks, and Americans from shopping. These facile generalizations are not entirely baseless. Just before the Great Recession, personal consumption in America equaled almost 70 percent of the country’s Gross Domestic Product (more than 75 percent if you included the purchases of homes). By contrast, personal consumption constituted only 65 percent of the British economy, 55 percent of Germany’s and 52 percent of Japan’s. (Personal consumption did not always constitute 70 percent of the American economy. During the Great Prosperity of 1947–75, it held fairly steady at 62 percent, without noticeable concern. But the economy was different then. Income and wealth were far more equitably shared, and most Americans were on an upward trajectory.)

Yet forced frugality alone is unlikely to ignite a political firestorm. We have had to pull in our belts before. To understand why Margaret Jones and the Independence Party (or their reasonable facsimile) could take control, we need a deeper understanding of the confluence between economics, politics and behavior.

Behavioral research shows that losses are more painful than gains are pleasurable. Most of us put a higher premium on the cost of giving something up than we do on receiving an item in the first place. Princeton psychologist Daniel Kahneman demonstrated this by placing people into two randomly selected groups. Those in the first group were shown a particular type of mug and asked how much they would be willing to pay for it. Those in the second were given the mug and then asked how much money they would want in order to give it back. It turned out that the second group demanded twice as much to part with the mug as those in the first group were willing to pay for it.[1]

Gains and losses aren’t symmetrical because whatever we possess sets a minimum standard for how we judge our material well-being thereafter. When we lose something of value, we retain the memory of having once had it and regret the loss. If we lose a convenience or benefit that we relied on, even worse: We must also forego our dependence on it. Someone who has enjoyed the benefit of air conditioning and then has to do without because he can’t afford to fix it after it breaks, for example, is likely to feel much worse off than someone who could not afford air conditioning in the first place.

Societies whose living standards drop experience higher levels of stress than do those that never had as much to begin with, and the deeper the drop, the higher the stress. Suicide rates offer some evidence. When even a wealthy economy like the United States dips, the rate of suicides rises; the longer the downturn lasts, the higher the rate becomes. Behavioral economist Christopher Ruhm has found that for every 1 percent rise in a state’s unemployment rate, the number of suicides increases 1.3 percent. If people remain jobless for long, the suicide rate rises further. The stock market crash of 1929 caused an increase in suicides, and the suicide rate rose as the Great Depression wore on. In 1929, there were 15.3 suicides for every 100,000 people; by 1930, 17 per 100,000; by 1932, 18.6.[2]

An extreme example of the social and psychological stresses accompanying prolonged economic loss occurred in Germany after World War I, when most Germans became far poorer than they were before. The Treaty of Versailles required Germany to pay the Allies substantial sums in reparations for the cost of the war, making it difficult for Germany to rebuild and subjecting it to continued economic distress, including hyperinflation in the 1920s followed by widespread unemployment. By the time Adolf Hitler made his political debut many Germans were eager to turn to anyone who seemed to offer a solution to the problems they had long endured, as well as an easy set of scapegoats.

Perhaps the hardest loss for middle-class Americans will be the expectation that the future will be materially better. We’re used to personal advancement in America, surpassing ourselves, trading up. Middle-class Americans have long assumed that hard work will ensure a better future for themselves, and especially for their children. What will happen to an America where optimism becomes a species of nostalgia?

Social psychologists have long understood that people typically measure their own well-being by comparison to how others are doing. When the incomes of people at the top soar and they live better as a result, everyone else feels relatively poorer. This psychological truth is likely to become more important. While Americans have suffered economic reversals before, and the middle class has suffered relative deprivation, the years ahead are likely to mark the first time Americans will experience both together.

America’s rich did take a hit in the crash of 2008. Yet by 2010 most of the rich had bounced back, and the gap between them and everyone else was widening again. One major reason: Most of the assets of rich Americans are held in stocks, bonds and other financial instruments, whose values rose in the wake of the Great Recession as companies cut costs (especially their U.S. payrolls) and expanded their global operations. By contrast, the major asset of middle-class Americans has been their homes, whose prices took a beating in the downturn and, in most parts of the country, won’t return to their 2007 levels for many years.

In 2009, JP Morgan Chase more than doubled its profits from 2008, generating record revenues and paying out $27 billion to its already well-heeled executives, traders and other “vital” employees. Goldman Sachs posted its largest profit in history and distributed $16.2 billion in bonuses. (Goldman could have distributed bigger bonuses but, concerned about its tarnished public image, held back. According to the New York Times, Goldman’s employees accepted the less-than-expected payout but soon expected to be rewarded for going along with what one characterized as “a temporary public relations exercise.”) The 25 most successful hedge-fund managers each took home $1 billion. One billion. Few financial trends are as certain as the outsized rewards the denizens of Wall Street will continue to claim as their rightful winnings.

The compensation packages awarded to corporate CEOs and executives likewise continued to soar in 2009. Here again, top executive pay was back on the same trajectory it had coasted on before the Great Recession, as if nothing had happened in the intervening time. Executive pay was linked to the profitability and stock market performance of their companies. Both were on the rise, reflecting the increasing ease by which payrolls could be cut and work automated or parceled out overseas, as well as the telling fact that many foreign markets were emerging from recession more rapidly than the United States. This trend will surely endure.

“Wealth”, said H. L. Mencken, “is any income at least $100 more a year than the income of one’s wife’s sister’s husband.” Times have changed and many women are now breadwinners, but a family’s relative position (and not just compared to one’s relatives) still matters. Yet the desire to do better when the incomes of people at the top are rising is not just due to envy or some other character flaw. It is connected to an implicit upward shift in the social norm of what constitutes a good life. Even people whose incomes haven’t actually dropped feel deprived relative to how those at the top now live; people whose incomes have dropped feel even poorer.

Social psychologists have found higher levels of satisfaction among people who live in states where incomes are more equal than where the gap is wider. The same holds among nations. Scandinavians express more contentment with their lot in life than do inhabitants of southern Europe, where inequality is higher. Researchers have found that inequality also correlates with health, for much the same reason. Richard Wilkinson of Nottingham University in England has discovered that once economic growth lifts a country out of extreme poverty, its citizens are likely to live longer and healthier lives—but only if there are not large differences in their incomes. The inhabitants of poorer countries with more equal incomes are healthier on average than are the citizens of richer countries whose incomes are more unequal.[3]

Even people whose incomes rise feel less satisfied than beforehand when they are exposed to others whose incomes are higher still. After the Berlin Wall tumbled, living standards for the former inhabitants of East Germany soared, but their level of contentment declined. The reason: They began comparing themselves to West Germans rather than to others in the former Soviet bloc.

Few middle-class people aspire to live in a 44,000-square-foot mansion like the one Bill Gates built for himself near Seattle. But by building that mansion Gates set a new norm for other exceedingly wealthy people, some of whom subsequently built mansions just as big. These giant mansions also ratcheted up the aspirations of people below them, who were rich rather than exceedingly wealthy, and who began building larger homes than they had ever lived in before. And so on down the income ladder, until the new norm reached the middle class.

As economist Robert H. Frank has pointed out, something like this chain of comparisons helps explain why the typical new home built in the United States in 2007 (2,500 square feet) was about 50 percent larger than its counterpart built in 1977 (1,780 square feet), even though median incomes barely rose.[4]A similar comparative process operated on other purchases. As the exceedingly rich threw million-dollar birthday parties and even more extravagant weddings, a chain of comparison also pushed up the price of middle-class celebrations. The typical American wedding cost $11,213 in 1980; by 2007 it cost $28,082 (both adjusted for inflation).

The middle class couldn’t really afford these homes, weddings and many of the other things it bought, which is why so many people went so deeply into debt. But by 2008 that debt option disappeared—which may help explain why, for example, the typical new home in 2009 slipped back to 2,392 square feet. Yet the chain of comparison has not disappeared.

The very rich may have become somewhat more guarded about displaying their opulence. During the Great Recession, conspicuous consumption became unseemly. “Shopping is a little vulgar right now”, said an editor at Allure magazine. Yet in a world of instant and pervasive communication, the rich cannot easily hide their wealth. Shortly after Lehman Brothers went bust, the Daily Beast reported that Kathleen Fuld, wife of former Lehman Brothers CEO Richard Fuld, selected a plain white bag to conceal her purchase of three $2,225 cashmere scarves at a Hermes boutique in New York. One website, created in 2009, allows the curious to type in the name of any CEO or financial tycoon and zoom in on a bird’s-eye view of their personal estates.

As income and wealth have continued to accumulate at the top, the rich also have been able to buy more highly desirable things whose supply is necessarily limited. Prestigious universities have only a limited number of places, which is one way they maintain their prestige. Because those schools are often gateways to the best jobs, competition for admission is intense. As the rich have grown richer while the middle has lost ground, children from wealthy families have been at an increasing advantage in this regard: They attend high-quality private high schools (or, which amounts to the same thing, top-ranked public high schools accessible only to families wealthy enough to live in the areas they serve), even as the quality of public schools available to most families has declined. Their children have access to pricey private tutors to help them with difficult subjects, to test preparation services that guide them through SATs and other entrance exams, and to coaches to help ready their applications. Some children of the wealthy also gain favorable treatment by admissions officials because their parents are major donors to the college (or are likely to become so if their child is admitted).

Increasingly, too, the most accomplished doctors and medical specialists, and the best hospitals and healthcare facilities, have become available only to the very rich. The recent health care legislation will extend care to more people and necessarily limit what doctors and hospitals can charge, as does Medicare. For this reason, the reform is unlikely to dramatically increase the supply of either. One likely result will be to raise the market price of the most desirable physicians and facilities, making them accessible mainly to those who can afford them.

Whether it’s been prestigious schools, excellent medical facilities or even gorgeous ocean-front property, anything that’s desirable but in limited supply has become less accessible to the vast middle class as purchasing power has concentrated at the top. As the income gap continues to widen, deprivations like these are likely to cause many Americans to feel even poorer and, in many cases, more frustrated. In other nations, at other times, wide disparities in income and wealth have led to political instability. Summarizing the research, economists Alberto Alessina and Roberto Perotti have found that “[i]income inequality increases social discontent and fuels social unrest. The latter, by increasing the probability of coups, revolutions, [and] mass violence.”[5]

This has not been the case in America, at least not so far. Here, opulence has provoked more ambition than hostility. In this respect we are different from older cultures with feudal origins and long histories of class conflict. For most Americans, the rich have not been “them”; instead, they’re people whom we aspire to become. Given the chance, most of the middle class want to join the ranks of the rich and gain all the perks that come with great wealth. We worry only when private wealth exercises political power—in other words, when democracy morphs into plutocracy. It was here that Theodore Roosevelt and Woodrow Wilson drew the line on the trusts, and Franklin D. Roosevelt damned the “economic royalists.” Private wealth applied to ostentatious consumption is perfectly appropriate; applied to the purchase of political power, it becomes diabolic.

Thus, the real frustration, and the final straw, will come if most Americans no longer feel they have a chance because the dice are loaded against them.

Something like this is already happening on a national scale. Even before the Great Recession, evidence was accumulating that the game tilted in the direction of big business and the wealthy. In the 1980s, irresponsible bets by some savings and loan banks cost taxpayers $125 billion. One such bank was owned by Charles Keating, who “donated” $300,000 to five U.S. Senators, thereby greasing the skids with Federal regulators. Insider-trading scandals involving junk-bond kings like Ivan Boesky and Michael Milken did their damage. The BCCI money-laundering scandal ruined the reputation of Clark Clifford, adviser to four Presidents. Then came the corporate looting scandals: In 2002, CEOs of giant corporations like Enron and WorldCom were found to have padded their nests at the expense of small investors. Other corporations that cooked their books included Adelphia, Global Crossing, Tyco, Sunbeam and ImClone, to name a few. Every major U.S. accounting firm either owned up to negligence or paid substantial fines without admitting guilt. Nearly every major investment bank played a part in defrauding investors, largely by urging them to buy stocks that the banks’ own analysts privately described as junk.

In the years leading up to the crash of 2008, Goldman Sachs, among others, created bundles of mortgage debt and persuaded investors to buy them, hawking them as good investments. Goldman even lobbied credit ratings agencies to give the mortgage bundles high ratings as solid bets. Yet Goldman simultaneously, but quietly, bet against them—“shorting” them, in the parlance of Wall Street. When the bottom fell out of the mortgage market, Goldman made a huge profit. Through it all, government regulators slept.

The giant bailout of Wall Street was sold to the American people as a way to save Main Street and jobs. But it appeared to do neither. The bankers on Wall Street saved themselves, using the taxpayers’ money to keep their banks sufficiently solvent to do a new round of deals that generated billions of dollars for them. Yet little or nothing trickled down to Main Street. Not surprisingly, in a poll taken by Hart Associates in September 2009, over 60 percent of respondents felt that “large banks” had been helped “a lot” or “a fair amount” by government economic policies but only 13 percent felt that the “average working person” had been.

When Treasury Secretary Henry Paulson and New York Fed chief Tim Geithner considered whether to bail out giant insurer AIG, which owed Goldman Sachs $13 billion, they consulted with Lloyd Blankfein, CEO of Goldman. They did not demand that Goldman (or any of the other parties to whom AIG owed money) accept a single penny less than they were owed—even though, as the Inspector General who oversaw the bailout subsequently noted in a critical report, Goldman would have collected far less had AIG been forced into bankruptcy. In effect, $13 billion went from the U.S. government to AIG and then promptly from AIG to Goldman—although for many months Geithner and the Treasury refused to disclose that, and Goldman refused to acknowledge it. The Inspector General concluded that the AIG deal “offered little opportunity for success”, and left taxpayers holding the bag. When Blankfein tried to defend Goldman’s giant $16 billion bonus pool for 2009 by saying the firm had been “doing God’s work”, he was roundly criticized. A week later he issued a formal apology, admitting that Goldman “participated in things that were clearly wrong.” He did not offer to return the $13 billion, however.

After the bailout, there was much talk in Washington about regulating Wall Street to prevent a similar collapse and bailout in the future. But remarkably little has come of it. New rules to constrain the trading of derivatives—bets made on changes in the values of real assets—are riddled with loopholes big enough for bankers to drive their Ferraris through. The new rules do nothing to alter the conflict of interest at the heart of credit rating agencies—paid by the very companies whose issues they rate. Nor did Congress allow distressed homeowners to declare bankruptcy.

Nor was there any enthusiasm in Congress or the White House for using antitrust laws to break up the biggest banks—a traditional tonic for any capitalist entity “too big to fail.” If it was in the public’s interest to break up giant oil companies and railroads a century ago, and years ago the mammoth telephone company AT&T, it was not unreasonable to break up the extensive tangles of Citigroup, Bank of America, JP Morgan Chase, Goldman Sachs and Morgan Stanley.

Why didn’t politicians do more? It may have had to do with Wall Street’s money. The Street is where the money is, and money buys campaign commercials on television. It is difficult to hold people accountable for bad behavior while simultaneously asking them for money. In recent years Wall Street firms and their executives have been uniquely generous to both political parties, emerging as one of the largest benefactors of the Democratic Party. Between November 2008 and November 2009, Wall Street firms and executives doled out $42 million to lawmakers, mostly to members of the House and Senate banking committees and House and Senate leaders. In 2009, the financial industry spent $300 million lobbying members of Congress. During the 2008 elections, Wall Street showered Democratic candidates with well more than $88 million and Republicans with more than $67 million, putting the Street right up there with the insurance industry as one of the nation’s largest equal-opportunity donors.

Had the banks not been rescued from their wildly irresponsible bets, several would have disappeared just as Lehman Brothers did. Yet less than a year later they were back at it, confident they would be bailed out by taxpayers if their new bets went sour. And they were using a portion of their winnings to essentially bribe lawmakers to keep the game going much as it had been before. Who could blame the public for believing the game was fixed?

Modern Washington is far removed from the Gilded Age at the end of the 19th century and start of the 20th when, it’s been said, the lackeys of robber barons literally deposited sacks of cash on the desks of friendly legislators. Today’s culture of political corruption rarely takes the form of outright bribes or campaign contributions expressly linked to particular votes. It is more subtle. As lobbying has become more lucrative, an ever larger portion of former Federal officials have turned to it. In the 1970s, only about 3 percent of retiring members of Congress became Washington lobbyists. But by 2009 more than 30 percent did, largely because the financial incentives had become so great. Starting salaries for well-connected congressional or White House staffers had ballooned to about $500,000. Former chairs of congressional committees and subcommittees commanded $2 million or more to influence legislation in their former committees. When Dick Gephardt ran for President in 1988 he said, “I’m running for President because I’ve had enough of the oil barons, the status-quo apologists, the special-interest lobbyists running amok.” By 2009, the former House Majority Leader was heading up a major Washington lobbying firm that counted among its clients Goldman Sachs, multiple insurance companies and Peabody Energy, the self-proclaimed “world’s largest private-sector coal company.” When Democratic Congressman Elijah Cummings threatened to investigate Goldman, it was Gephardt who ushered Goldman’s president to a Capitol Hill meeting. A longtime advocate of universal healthcare when he was in Congress, by 2009 Gephardt was chairing the Council for American Medical Innovation, a group sponsored by the pharmaceutical industry.

In order to be enacted, almost all major legislation now requires payoffs to powerful corporations and industries. If he was to have a prayer of passing healthcare reform, President Obama felt it necessary to guarantee the executives and shareholders of big health insurers and pharmaceutical manufacturers that they’d come out ahead—promising them millions of new customers along with generous Federal subsidies—lest these powerful moneyed interests use their clout to kill the legislation, as they did with Bill Clinton’s healthcare reform proposal. Yet this payoff would necessarily mean higher costs for middle-class Americans than otherwise. Similarly, in order to get off first base with legislation to cap greenhouse gases and allow companies to trade permits to pollute within the cap, Congress had to promise generous subsidies for the nuclear industry and big agribusiness’s ethanol, and for the development of so-called “clean” coal. (Wall Street was supportive, one expects, because the Street would collect billions of dollars on the “trade” part of cap-and-trade, and the market for trading permits would include derivatives and be open to speculators.) Here again, the middle class would be left with much of the tab.

There is an old Russian story about a suffering peasant whose neighbor is rich and well-connected. In time, the rich neighbor obtains a cow, something the peasant could never afford. The peasant prays to God for help. When God asks the peasant what he wants Him to do, the peasant replies, “Kill the cow!”

In Russia, the game was often rigged, and peasant uprisings were directed more often at bringing down the rich than at bringing everyone else up. Unless present trends are reversed, we could find ourselves in a similar position. The Independence Party or its facsimile will kill the cow—and bring with it nationalism, isolationism, intolerance and paranoia.

For years I’ve conducted a simple experiment in my classes. I ask my students to pair up with a classmate, and I then announce I’m going to give one member of the team a simulated $1,000 bill and ask that person to write down on a piece of paper how much of that will be shared with his teammate. The person is then to silently pass the paper over. I make it very clear to both that unless the teammate accepts the offer on the slip of paper, neither of them will receive anything.

Some recipients willingly accept a small amount, as little as $1. After all, they reason, they’re better off than they were before, regardless of how much their teammate has ended up with. But most of my students on the receiving end refuse anything short of $250, and a surprising number refuse any offer less than $500. They would rather end up with nothing than have their teammate “get away with” far more. Are such students being vindictive? Are they allowing feelings of envy and spite to obstruct rational thinking? When I ask them why they’re willing to sacrifice so much, they often say it’s worth it to them in order to prevent an unfair outcome and disrespectful treatment.

It is no great leap from my simple classroom exercise to a national movement. Americans who would slash trade and investment with other nations, for example, might fully understand that this would deny all Americans access to cheaper goods from abroad. Yet they might still support such a move if they believed it would cause people at the top even greater loss. Likewise, they’d support confiscatory taxes on the wealthy, even understanding that such rates will discourage investment and thereby hurt everyone, because such taxes would hurt the rich most of all. They would favor all sorts of policies that slowed the economy and reduced efficiencies if those at the top would lose out to a greater extent than they did. In short, they would opt to kill the cow.

Economic anger could be detected in March 2009 when, after the government bailed out AIG with more than $150 billion, the firm awarded its top executives $165 million in “retention bonuses” and a $440,000 spa retreat at the St. Regis resort. Angry citizens traveled by bus to the estates of AIG executives to tell them exactly what they thought. Others wrote threatening letters and emails. AIG executives were forced to hire private security guards to protect themselves and their families.

It could be detected in voters’ reactions to wealthy and well-connected politicians. In May 2010, Utah’s GOP refused to support the re-election of conservative senator Robert Bennett because of his vote in favor of the Wall Street bailout. In November 2009, New Jersey governor Jon Corzine lost his re-election bid despite spending a substantial fortune on his campaign. Pundits assigned part of the blame to his being a former head of Goldman Sachs. In 2010, Connecticut Senator Chris Dodd did not run for re-election in part due to voters’ disquiet over his history of cozy relations with the financial industry. New York City’s Mayor Michael Bloomberg won a surprisingly narrow re-election in the fall of 2009, despite his creditable record and sizeable campaign spending. Voters, it seemed, were turned off by his vast wealth and his willingness to spend it on the campaign. (Just prior to the election, New York magazine blared, “Michael Bloomberg Is About to Buy Himself a Third Term.”)

It could also be seen in Americans’ sharp turn against international trade. By 2010, the so-called Doha round of multilateral tariff reductions, initiated in 2001, was still on life support. President Obama’s single trade request during his first year of office—duty-free status on exports from Afghanistan and Pakistan in order to boost employment in these countries and thereby counter terrorist groups—was shot down by Congress despite its obvious importance. Pending trade agreements with South Korea and Colombia were put on hold. In a December 2009 poll conducted by the Pew Research Center, only 43 percent of Americans thought trade agreements benefited the U.S. economy.

Economic resentments lay behind the public’s growing suspicions of the Federal Reserve Board and its Chairman. In early 2010, reflecting that backlash, the Senate nearly blocked Ben Bernanke’s confirmation to a second term. Members of Congress from both parties pushed legislation to make the Fed’s actions more transparent to political scrutiny. Bond traders on Wall Street feared the Fed’s independence would be compromised.

The shrillest part of the backlash could be heard in the increasing bitterness and virulence of the nation’s politics. In early February 2010, at the first national convention of the self-described “Tea Party Nation” in Nashville, Tennessee, Tom Tancredo, a former Congressman and presidential candidate from Colorado, brought the crowd to its feet by denouncing the “cult of multiculturalism” and accusing immigrants of threatening America’s Judeo-Christian values. “This is our country”, he declared to wild cheers. “Take it back!” Later that month, at the Conservative Political Action Conference, Governor Tim Pawlenty of Minnesota attacked “the elites” who believe Tea Partiers are “not as sophisticated because a lot of them didn’t go to Ivy League schools” and “don’t hang out at our Chablis-drinking, Brie-eating parties in San Francisco.” After his son Rand Paul was selected for Kentucky’s Senate seat in May 2010, Congressman Ron Paul explained that voters wanted to “get rid of the power people who run the show, the people who think they’re above everybody else.”

Talk radio and yell television emit escalating vitriol. The ire has been directed at a variety of targets: immigrants, African Americans, the poor, foreigners, “East Coast elites” and “intellectuals”, as well as corporate leaders and Wall Street executives. While the Right has railed at big government and the Left has fulminated against big business and Wall Street, there is a widening overlap. “The wizards in Washington and on Wall Street have us figured out”, says Chuck Baldwin, as quoted in the Pocatello Tea Party’s online newsletter. “Along with their compatriots in the propaganda press corps, they know that no matter how loudly we scream, how much we protest, or how angry we become, the system is rigged to protect them.” It was the bailout of Wall Street that really “got this ball rolling”, says Joseph Farah, publisher of WorldNetDaily, a website popular among Tea Party adherents. “That’s where the anger, where the frustration took root.” At the Utah state convention that unseated Robert Bennett, the mob repeatedly shouted “TARP! TARP! TARP!”

Prolonged and severe economic stress could open the door to demagogues who prey on public anxieties in order to gain extraordinary power. A classic sociological study of 35 dictatorships found that when people feel economically threatened and unhinged from their normal habits they look to authority figures who proffer simple remedies and blame scapegoats. Just before Roosevelt’s inauguration, as the nation fell into the depths of the Great Depression, some influential Americans thought the nation needed a dictator. Even Walter Lippmann advocated a “mild species of dictatorship” that would “help us over the roughest spots in the road ahead.” Some of Roosevelt’s closest advisers warned him that unless he assumed dictatorial power, the country would face revolution.

The revolution never happened, nor did the dictatorship. So far, the American political system has shown a knack for stopping backlashes before they get out of hand. Will the current backlash raise Romney and Ryan to the White House? The question is whether reform will come this time on the scale that’s needed. By the time someone like Margaret Jones and something like her Independence Party take control, it will be too late.

____________________________________

Robert Reich, former U.S. Secretary of Labor, is professor of public policy at the University of California at Berkeley. This essay is adapted from, Aftershock: The Next Economy and America’s Future (Knopf, 2010).

1 D. Kahneman, Jack L. Knetsch and Richard H. Thaler, “Experimental Tests of the Endowment Effect and the Coase Theorem”, Journal of Political Economy (December 1990).

2 Ruhm, “Are Recessions Good for Your Health?” Quarterly Journal of Economics (May 2000).

3 Wilkinson and Kate Pickett, The Spirit Level: Why Greater Equality Makes Societies Stronger (Bloomsbury Press, 2009).

4 Frank, Falling Behind: How Rising Inequality Harms the Middle Class (University of California Press, 2007).

5 Alessina and Perotti, “Income Distribution, Political Instability, and Investment”, NBER Working Paper No. W4486 (October 1993).

Chapter 5

The Tea Party’s Unlikely Populists

Jeremy D. Mayer

As with the Beatles and the Roman Empire, there are contending versions of when the Tea Party movement began. It is most likely, though, that had it not been for a televised outburst by CNBC financial analyst Rick Santelli on February 19, 2009, the Tea Party would never have become a household name. Santelli flew into a rage over President Obama’s plans to help distressed homeowners. In the thick of a crowd of commodities traders on the floor of the Chicago Mercantile Exchange, whom he absurdly described as “a pretty good cross section of America”, Santelli proceeded to whip them into a frenzy against Obama’s market intervention: “How many of you people want to pay for your neighbor’s mortgage?!”

Ironies abound. For one, you would really have to go a piece to find a stranger location than the Chicago Mercantile Exchange for the birth of a movement that relentlessly characterizes itself as being worried that “the little guy no longer has a fair shot in America”, as Sarah Palin puts it in her book, America by Heart.[1] Earlier populists of both the Right and the Left would have seen the Merc floor as a den of elitist privilege and financial intrigue. Never has an American populist movement been launched by so many who fart through silk.

Another irony is that the gross iniquity responsible for sparking Santelli’s rant never happened. Very little government money actually went to the “losers”, to use Santelli’s charming sobriquet for those who could not meet their mortgage obligations. Instead, most of the funds eventually ended up safely gathered to the bosoms of the financial institutions that employed these frenzied Merc floor minions. Santelli’s rant failed to include the tens of billions of dollars his own network’s then-parent company, General Electric, received from the government. The average folks whom Santelli was so concerned might receive some of his hard-earned money, he should be comforted to know, are still struggling in an America of high unemployment and rampant foreclosure. Meanwhile, the profits of banks and Wall Street firms have rebounded nicely; compensation levels for their putatively blameless executives are at record highs.

Finally, Santelli was and remains a member in good standing of the media elite, another typical target of populist ire. It was an elite political activist group, FreedomWorks, funded by some of the wealthiest corporate interests in America, that quickly set up the iamwithrick.com website, whose declared purpose was to rally citizens to attend tea parties across the country. In short, this is not your father’s populism, and its books are remarkable mostly for their avoidance of these and other truths about the Tea Party.

It may seem particularly condign to attempt to understand this movement via its books, since the chief brewers of Tea Party energy purport to base their views on careful readings of the founding documents of the American nation. Reading their books transports one back to an eighth-grade civics class lorded over by a particularly earnest and naive teacher. It quickly becomes clear these books aren’t meant to give a full, rich picture of the founding documents, America’s revolutionary leaders or the times in which they lived. Rather, each book, in its own way, is a self-servingly selective interpretation of the Founding in service to what its author wants those documents to mean today. Perhaps the best that can be said about my chosen textual approach to understanding the Tea Party is that it will save many readers the unenviable chore of reading these books themselves.

And it is not just a chore but also a disquieting one. While we cannot expect politicians on the make to write with the care and nuance of professional historians, none of these books even mentions that the Founders were not united on many key topics, or that they kicked many a can down the revolutionary road to bedevil future generations. Not a single one of these authors finds history or constitutional interpretation difficult. Now, the Tea Party is not precisely the Christian Right in new wineskins, but there is enough overlap in membership to suggest an explanation for the strong tendency of some of the movement’s leaders to adopt a flatly literalist style of textual interpretation coincident with that of the least sophisticated Christian fundamentalists. Sarah Palin is a case in point.

Sarah Palin, perhaps the highest profile figure associated with the Tea Party, has put her name on a book that is well written in the sense that it reads smoothly. It is lamentably disjointed, however, lurching from topic to topic with little perceptible order or logic. There are also priceless moments of obvious contradiction whose birth evidently did not even require softball questions from Katie Couric. Americans like herself, she writes, “are not saying we’re better than anyone else” by exclaiming how exceptional America is. It’s just that America is a “model to the world” as well as the “light of the world.”

Palin opens her book with a speech she gave to a rally of “rowdy patriots” shouting “USA! USA!” She pauses to say, “If you love your freedom, thank a vet. . . . God bless you guys! . . . We salute you!” Her second chapter is devoted to “Why They Serve.” Palin repeats the common delusion that numerous Vietnam veterans were “spit on” when they returned home, and cites no lesser source than dimly remembered childhood perusals of issues of Readers Digest collected by her mother.

Palin questions the patriotism of nearly everyone who works in Hollywood, pausing after uncharacteristic praise of Steven Spielberg to ask, “But can you imagine any Hollywood types personally putting themselves on the line for freedom the way Stewart, Fonda, and [John] Ford did?” It’s not enough, Mr. Spielberg, to make Saving Private Ryan to earn Palin’s respect; you have to enlist. The only celebrity who earns full praise from Palin for his respect for the military is country music star Toby Keith, who wrote “Courtesy of the Red, White and Blue” in response to 9/11. Palin quotes her “favorite part”:

And you’ll be sorry that you messed with the U S of A

’Cause we’ll put a boot in your ass

It’s the American way.

Palin includes a poem, too, in which all that is good about America is attributable not to politicians, preachers, poets, lawyers, teachers and the rest, but to veterans. She then highlights her understandable pride in her eldest son, Track, who served in Iraq, by including an anonymous, maudlin prose tribute to the American soldier:

Not yet dry behind the ears, not old enough to buy a beer, but old enough to die for his country. . . . He feels every note of the National Anthem vibrate through his body while at rigid attention, while tempering the burning desire to ‘square-away’ those around him who haven’t bothered to stand, remove their hat, or even stop talking.

So, we should be grateful to the military not just because they single-handedly provide everything good about America but also because they somehow manage to restrain themselves from “squaring us away.”

No one who has spent time with American soldiers, sailors and marines doubts their patriotism, honor, courage and integrity. But that’s really not the point. It never seems to occur to Palin that the Founders she claims to revere above all but Jesus would be stunned to behold the modern American national security apparatus. While many things the Founders thought are difficult to ascertain, they manifestly believed in a tiny peacetime army and navy. And if the gigantic size of our permanent military establishment would stun the Founders, the idea that a professional soldier is somehow inherently superior to an average citizen would have driven them up the wall. As Hamilton says in The Federalist (No. 8):

The violent destruction of life and property incident to war . . . will compel nations the most attached to liberty to resort for repose and security to institutions which have a tendency to destroy their civil and political rights . . . by degrees the people are brought to consider the soldiery not only as their protectors but as their superiors.

Palin’s misconstrual of the historical record knows as few limits as does her regard for the military. At a time when most Americans have concluded that the Iraq war was a mistake, she has no regrets for her support because “America doesn’t go to war for big business or for oil or for the sake of imperial conquest. The reason, inevitably, is freedom.” As I recall, the main reason we went to war in Iraq was interlaced concern about weapons of mass destruction, a rogue regime and terrorism, with freedom on the side like parsley at a Texas steakhouse.

Even if the war in Iraq had been conducted principally in the name of freedom, as Palin believes, it was done on behalf of freedom for Iraqis, not freedom for Americans. Early American leaders were opposed not only to large standing militaries, but also to foreign wars fought on behalf of the liberty of others. One can find marvelous quotes from Jefferson, Madison and John Quincy Adams making these points in The Tea Party Goes To Washington, by then-new Senator from Kentucky, Rand Paul. Paul bravely lambastes figures in his own party who talk like Palin on such issues:

Many Republicans treat war like Democrats treat welfare . . . no matter how long we fight the War on Terror—how many billions we spend, what kind of results we get or how many unintended consequences arise—Republicans have typically insisted we must do more.[2]

Paul’s adherence to limited and small government requires him to boldly advocate “seriously reducing, substantively reforming, or even abolishing much of the national security state.” Pace Palin, Paul does not see good in everything American power has ever done abroad. And pace Toby Keith, not every American boot was deployed in a foreign ass on behalf of freedom. Paul quotes approvingly a Bush critic who argues the Iraq war was “based on a series of lies” and argues that the war was part of a neoconservative conspiracy rooted in liberal ideas. Paul believes Islamic extremists attacked America not because of our liberties but because of our Middle Eastern foreign policies. He even suggests that paying Israel $4 billion and its neighbors about $6 billion annually to not kill each other might not be money well spent. This might come as a shock to the sage of Wasila, Alaska. As Paul recounts, Palin had just two questions for him before she decided to back his Tea Party challenge in Kentucky: Did he support Israel? And was he pro-life?

Despite the subsequent endorsement that Paul received, Palin and Paul symbolize the most important split within the Tea Party movement at the elite and presumably the mass level. It goes far beyond foreign policy. Palin’s primary theme, if her disconnected set of anecdotes and quotes may be said to have something as elitist as a theme, is that God blessed America, and we must bring God back into public life. Paul, while at pains to establish his Christianity, does not dwell on how God chose America for greatness. He’s most excited about reducing government to the smallest possible size. Just as Palin believes the Founders were practically Bible-thumpers, Paul believes they were all libertarians at heart. Both prove it with selected quotes. In essence, Palin and Paul are resurrecting within the Tea Party a division of long standing among Republicans between moral majority conservatives and libertarian conservatives. If you substitute Jesse Helms for Palin and Barry Goldwater for Paul, you have more or less the same dynamic, only catapulted back in history 40 years.

Palin and Paul may disagree on matters of substance, but not, apparently, on matters of style. The Tea Party, as understood through its own literature, holds that the trump card in every argument is a pithy quote from a Founder that serves as the functional equivalent of an infallible constitutional I Ching. The answers to all political questions are to be found in short bursts of brilliance, almost randomly organized, as with these two Jeffersonian gems Paul serves up:

My reading of history convinces me that most bad government results from too much government.

A government big enough to give you everything you want is big enough to take away everything you have.

What a prescient guy that Jefferson was to anticipate that 200 years later the most important debate would be about the size of government. Except that there is zero evidence that Jefferson wrote or said either of these things. One-sided history isn’t always enough; sometimes you have to make stuff up.[3]

I doubt that Paul knowingly included falsehoods in his book, but a U.S. Senator might at least do an Internet search on the attribution for the quotes that supposedly undergird his beliefs. There are many gaps and conflicts between the 18th-century political philosophies of the Founders and the 20th-century free market economics of Ludwig von Mises and Friedrich von Hayek; there simply must be, given the divergent historical contexts. You would never learn that from reading Paul, however.

Still, unlike Palin’s book, which is mostly self-serving pablum and patriotic pathos, Paul’s does contain actual ideas, some of which merit full baking. For example, Paul proposes multiyear health insurance with fixed rates, like term life insurance. He suggests that we tolerate a little more risk of terror attacks in the name of personal privacy and smaller government. His foreign policy heresies include questioning why neoconservatives believe in individual responsibility at home but not for Iraqis and Afghans who, for all practical purposes, must rely on us. Yet he cannot help but repeat some of the worst canards in current American politics. He finds “some truth” in the death panel claim made by Palin, and he avers that the health insurance crisis isn’t so bad because everyone can just go to the emergency room, and so on.

The great no-show in The Tea Party Goes to Washington is one he shares with the Palin’s book: race. According to Paul, racism in the Tea Party is “virtually non-existent.” Calling the Tea Party, or any element within it, racist is simply a calculated tactic by the Left to discredit the movement. He lambastes the NAACP for passing a resolution asking the Tea Party to repudiate some statements by self-avowed Tea Party leaders and members, but he fails to remind us of the ugly rhetoric that prompted the resolution. Instead of pondering what various alleged Tea Party race incidents might mean about the movement, Paul simply states that the NAACP can be justifiably ignored until it repudiates the racism of Reverend Jeremiah Wright and the New Black Panther Party.

While Palin and Paul are divided on foreign policy and God moving about in public spaces, they are one when it comes to avoiding questions about race. Palin concedes that ending segregation in the South was a rare example of the Federal government doing good—the exception that somehow proves the rule that most things should be left to the states. Worse, however, she blames the suffering of blacks in New Orleans during the Katrina disaster on their weak family structure, since whites in other parts of the Gulf Coast fared better, presumably because of their family values:

Hurricane Katrina revealed . . . a population of Americans dependent on government and incapacitated by the destruction of the American family. . . . An astonishing 70 percent of African American babies were being born to single women in 2004, [and] fatherlessness among poor African Americans in New Orleans was estimated at between 60 and 80 percent. . . . Americans all along the Gulf Coast were victimized by Hurricane Katrina. And yet those in New Orleans seemed to be the most vulnerable. . . . What was the difference? In many cases, the difference was strong, intact families.

It wasn’t Bush’s fault, nor was it black families’ fault, she implies; rather, welfare left blacks without the rugged individualism to escape New Orleans before the storm hit. Pity the poor blacks who drowned because of the wicked liberals who caused their fatherless dependency. Seldom have the innocent dead been so cheerfully and ignorantly insulted—all in just a few sentences. Coming from someone who throws around the phrase “blood libel” as casually as Palin does, it’s an infuriating passage, and it’s almost the only thing she says about race.

Avoiding race also means avoiding the Civil War, even on this, its sesquicentennial anniversary. While these books are not works of history, each throws around selected thoughts from the 1775–89 period as if that were a sure guide to the ways things ought to be. The Civil War, however, fundamentally altered American constitutionalism and government, even as it resolved some key ambiguities left behind by the Founders. In these books, it’s as though it never happened.

The most glaring absence in the contribution by Dick Armey and Matt Kibbe is not the Civil War but the name Koch.[4] FreedomWorks, the organization from which they both earn their salaries, is chiefly bankrolled by Koch Industries, the largest privately owned petroleum services corporation in the world. Kibbe has been lapping up Koch dollars for years now as a leader of the organization that became FreedomWorks, Citizens for a Sound Economy (CSE). Jane Mayer has suggested in the New Yorker that CSE had no actual members at all, and the authors concede that CSE was an exercise in astroturfing (that is, fake grassroots). Its use of direct mail and television ad buys to attack carbon regulation were overpriced and less effective than their current tactic, mass action. But the authors never mention who paid those high prices for CSE, or for the much more “real” FreedomWorks. The name Koch never appears, even in the acknowledgements. FreedomWorks is just a bunch of Americans who care about liberty and limited government, funded by...nobody.

Armey and Kibbe, like Paul, scarcely mention God at all beyond pro forma references to the Creator who gave us the inalienable rights we must cherish. The crux of their beliefs is that the “human condition” is “self-interest.” “We know that public officials act in their own self-interest, like everyone else”, so government cannot be trusted when it claims to be interested in helping us. But if this is so, it applies not only to Armey and Kibbe but also to the Kochs and their armies of followers in local chapters. What, then, have the Koch brothers gotten for their millions of dollars? What have our two authors gotten? And what, pray tell, are the Tea Partiers getting?

The authors tell us, inadvertently, what Koch Industries gets when they describe the alleged opponents of the Tea Party:

For the big money contributors we’re fighting . . . . Washington lobbying is currently the best return on investment going. . . . [T]he federal government controls the spending of trillions of dollars each year. So big business, big labor, trial attorneys, and other well heeled interests spend lavishly on lobbying with the expectation that it will more than come back to them in the form of government handouts and subsidies.

Now, all this happens to be true. But big businesses like Koch Industries also use lobbying to secure tax breaks and to weaken or defeat laws that regulate labor or pollution. It is no accident that CSE’s main focus in its early years was stopping carbon taxes and environmental regulation.

Social science joins aphorism to make what is going on here a bit clearer. The late Mancur Olson, a founding father of the public choice school of economics that the authors adhere to, wrote of privileged groups as being those in which at least one member would be willing to pay all the costs of a group endeavor because the benefits of its achievements to that one member would at a minimum make up for its entire cost. A privileged group thus gets around the inevitable problem of “free riders” who seek benefits for doing little or no work. Despite numbering in the millions, the Tea Party is a “privileged” group precisely because the billionaire Koch brothers would willingly underwrite its entire budget, if that were necessary, in order to prevent the body politic as a whole from solving collective action problems (for example, determining who should pay for pollution remediation) whose continued non-solution benefits them immensely.

If, in the end, all the Tea Party does is elect dozens of hyper-conservatives to Congress and scare other Republicans away from supporting compromises with the Obama Administration, it will have been money well spent. Given the level of wealth the Koch brothers possess, their donations will be more than repaid during the years in which the Tea Party delays or prevents a return to even Reagan-era tax rates on income, wealth and estates. And that doesn’t include what they have already reaped in preventing oil industry taxation and regulation.

So what to make of the hundreds of thousands of Tea Party activists who work so hard at FreedomWorks rallies and chapters? Are they simply chumps being had by clever manipulators in the service of the plutocracy? Not according to the authors of Give Us Liberty. Armey and Kibbe see these Americans as heroes, some of them unemployed and struggling, who pour countless hours into citizen activism. They are not free riders; in Olson’s definition, the free riders are those who sit at home and enjoy the lower tax rate and regulatory burden that the Kochs and the Tea Partiers provide them. Nor are they getting handsomely paid for their activism, like Armey and Kibbe. What motivates them, if the “human condition” is really one of pure self-interest?

Armey and Kibbe’s version of the Tea Party rallying call to the unpaid masses is, in effect, “unselfishly join with me in my (paid) fight on behalf of selfishness!” It bears an odd similarity to the problem faced by early Marxist organizers, who, thanks to the absurdity of a tautology they called a dialectic, were forced to argue that a proletarian state was both inevitable and in desperate need of activists to bring it about. FreedomWorks argues simultaneously that self-interest explains almost all behavior, but that its followers are the epitome of selflessness. Unlike their opponents, they actually care about the country, and about the difference between right and wrong. Talk about your ironies.

Here we arrive at another point of difference between economic Tea Partiers and social/military Tea Partiers like Palin. Palin’s “Kick Ass, U.S.A.” Teapartyism respects the emotional and communal motivations of its followers. At its core, Palin’s populism, however misguided it may be, is genuine. It certainly makes much more sense on its own terms than the FreedomWorks brand. A common hero for Paul and FreedomWorks is Ayn Rand, the avowed atheist, self-appointed philosopher and author of truly terrible books. In her two main novels, it is no accident that the heroes neither join political movements nor engage in mass activism. They just give leather-lunged speeches on behalf of selfishness in courtrooms or over the radio. Ayn Rand could not come up with a way to credibly motivate unselfish mass behavior on behalf of selfishness, even fictionally.

In the end, Palin is right to see the Tea Party rank-and-file as normal Americans who are afraid for their country and for what is happening around them. Paul believes it was mostly the sudden increase in the national debt that brought the masses out. Armey and Kibbe point to “years of broken budgets and wasteful spending.” Only Palin’s more diffuse and emotion-centered explanation hits the mark. Consider: If the national debt led to mass populism, we would have seen some of it in 1946, when the debt hit an all-time high as a percentage of the GDP. And while Ross Perot talked about the deficit endlessly in 1992, his remarkable popularity had more to do with what turned out to be a brief recession than with a widespread conviction that Treasury bonds were being issued too promiscuously. American history gives up little to no evidence of concern about debt at the mass level, as distinguished from the elite level, where banking and investment are daily concerns around many a breakfast table.

As with earlier populist outbursts, the Tea Party’s rise stems from sudden, deep economic upheaval. Unemployment in America has not been as bad as it is today for this long since 1938. Some research has established a relationship between Tea Party activism and home foreclosures at the county level. Entire communities have undergone an extraordinary few years in which the most important asset most Americans hold, their home, has become either unreliable or near to worthless. Americans in the middle and at the bottom are less secure now in a downturn than ever before. Those with defined benefit pensions are a vanishing breed, and the pensions themselves are far less reliable.

That a downturn as severe as this one would lead to a populist outburst was as predictable as thunder following lightning. Adding to this outburst are broader changes in the American economy of which average citizens are more aware than ever before. As charted by Jacon Hacker and Paul Pierson in Winner Take All Politics (2010), while the American economy has grown, sometimes rapidly, during the past forty years, for the first time since the 1920s almost all the income growth has gone to the top tenth. A rising tide isn’t lifting all the boats, just the yachts. In the past, Carnegies and Rockefellers could justify their vast wealth by pointing to obvious evidence of shared prosperity and the permeable nature of the upper class. But as the same authors note, the probability that an American born poor will die poor is now higher than for a similarly situated West European, and the same is true for the rich. The American dream of social mobility and a better life for the next generation mocks the overwhelming majority of Americans today, who have seen the virtual stagnation of their real income (if not necessarily of their living standards) since 1973.

Why, then, did Tea Party populism emerge in a form that advocates policies that would, at best, do nothing about the underlying causes of mass anxiety and anger and, at worst, exacerbate them? Why do so many rage against the “fat cats” in ways that help no one so much as those same fat cats?

One cannot give too much credit for this to Fox News (although none of these authors gives any). Fox did not create the rage, but it gave it an easy narrative. More than any social movement in American history, the Tea Party is a media creation. Consider the earliest FreedomWorks event linked to the Tea Party’s birth, a tiny Florida demonstration outside an appearance by President Obama on February 10, 2009. The organizer of this handful of sign-waving Floridians, Mary Rakovich, was subsequently interviewed on Fox. Rakovich, fresh from a FreedomWorks training seminar, had rocketed from complete obscurity to national news by dint of just a few signs. It was working out just as her trainer had told her: “You only need the two of you and a few signs to make your voices heard.” Oh, yes, that and Fox News.

In truth, no social movement emerges entirely from the bottom up. Rosa Parks, working class seamstress, did not wake up one morning and decide to take a stand against segregation. She was trained by civil rights activists much as Rakovich was trained by FreedomWorks. But Parks did not get on a national news broadcast the very first night of her protest and arrest. Nor were subsequent civil rights rallies promoted the way Fox News trumpeted every Tea Party event. Nor were civil rights demonstrators encouraged to show more enthusiasm for the cameras, as a Fox News producer did in a widely circulated clip.

Finally, while it would be absurd to claim that the national media was, as a group, entirely unbiased in the conflict between freedom-seeking blacks and racist Southern whites, civil rights rallies did not feature journalists giving full-throated support to the movement. Not even Palin, now a paid Fox News personality, gives any credit to her friends at Fox for fostering the Tea Party. Like the absence of the word Koch in the Armey-Kibbe book, this is ingratitude with intent.

Is Dick Armey right when he proclaims the Tea Party “a permanent force in American politics”? Is this a movement comparable to its perceived enemies, the progressives, who over more than half a century of activism successfully altered the nature of American governance? Hardly.

The surge in populism that became the Tea Party was Right-wing almost by chance. By January 21, 2009, the national government was largely in the hands of the Democratic Party. Potential Left-wing populists, furious about financial shenanigans at the top, sat on their hands, waiting to see if the party ostensibly devoted to their interests would address their concerns. If the economy recovers in, say, a year’s time, the Tea Party will rapidly recede into the swamps where the John Birch Society has somehow managed to eke out an existence since its brief heyday in the 1960s. However, should the economy continue to spiral downward, Obama is likely to be a one-term President. A Washington run by Republicans committed to slashing social spending during a double-dip recession may produce a Left-wing populism so powerful as to make the Bonus Army of the Hoover years look like the League of Women Voters.

We may have already seen a hint of this at the state level. When a Tea Party Governor working with a Republican legislature attacked unions’ collective bargaining rights in Wisconsin, tens of thousands descended on the state capitol and literally camped out. Tea Party supporters who counter-demonstrated were dramatically outnumbered. While the subsequent recall election efforts of the labor movement ultimately failed to take the Senate from the Republicans, two incumbents were defeated, and the governor had to face a recall effort. The Wisconsin movement, unlike the Tea Party, more closely resembled classic populism in American history.

Indeed, research based on an impressive panel study by distinguished political scientists David Campbell and Robert Putnam suggests that the Tea Party is little more than the most socially conservative wing of the Republican Party. Further evidence for this is that the greatest electoral successes of the Tea Party have come in intraparty contests. The Tea Party has collected far more scalps of Republican moderates and mild conservatives than it has of Democrats. And its greatest policy success, the remarkable partisan unity of Republicans in opposition to reasonable compromise on the debt-ceiling negotiations, shows the limits of its influence. It scares Republicans and empowers Democrats; it cannot create new policies, it can merely, at the moment, contribute to unprecedented gridlock.

Thus, unlike progressivism, the Tea Party is probably not a political hurricane capable of altering the coastline of national governance for decades into the future. It is more likely akin to a fierce summer storm with tempestuous winds and loud thunder, but with little significance for the long term. That assessment, not surprisingly, is the final no-show in these three books.

____________________________________

Jeremy D. Mayer is an associate professor at the School of Public Policy at George Mason University, and the author of Running on Race (2002) and American Media Politics in Transition (2008).

1 Sarah Palin, “America by Heart: Reflections on Family, Faith, and Flag” (HarperCollins, 2010).

2 Senator Rand Paul with Jack Hunter, “The Tea Party Goes to Washington” (Center Street, 2011).

3 The first quote was written by John Sharp Williams in a 1913 book about Thomas Jefferson; the second was uttered by President Gerald Ford in 1974, according to the Thomas Jefferson Foundation.

4 Dick Armey and Matt Kibbe, “Give Us Liberty: A Tea Party Manifesto” (William Morrow, 2010).

Chapter 6

The Foreign Policy of Plutocracies

James Kurth

The United States and indeed the entire Western world are in the midst of the greatest economic crisis in many decades. The current Great Recession is comparable in depth and gravity to the Great Stagflation of the 1970s, and in some ways it has become similar to the Great Depression of the 1930s or the earlier deep economic crisis of the 1890s, which in its time was also called “The Great Depression.” It seems that major global economic crises come along about every forty years.[1]

Given the depth and gravity of our current crisis, it is not surprising that certain ideas and terms from those earlier eras should now reappear in analyses and discussions about public affairs. One of these terms is plutocracy. How might plutocracy affect U.S. foreign policy and America’s place in world affairs?

In the short run, it is clear enough that the global economic crisis has seriously diminished U.S. leadership in the world and that it has begun to weaken the projection of U.S. military power. Of particular importance, the Chinese political elite appears to have drawn the conclusion that the economic crisis of America and its allies may be producing a tipping point in the distribution of power and leadership in world affairs.[2] As the Chinese see it, the U.S. economic debacle has discredited the “Washington Consensus” and produced extraordinary partisan polarization and policy paralysis in the U.S political system, thus casting useful (from the Chinese perspective) doubts on the American democratic model. Also, from their perspective, it has the potential to force substantial reductions in U.S. defense spending, in turn casting doubt on American military capabilities and credibility. This comes at a time when China is expanding and modernizing its military, particularly its navy, and is pressing claims of sovereignty—and exclusive and exclusionary authority—over its three littoral seas: the Yellow Sea, the East China Sea and the South China Sea.

But it is not the short run that interests us most. The argument here, that a plutocratic system produces a different foreign policy and world role than would a more genuinely democratic system, is proved by its long-term consequences and illustrated by historical examples many decades old. These examples suggest that it is not plutocracy as such that determines long-term, structural outcomes, but rather the particular sectors of the economy that provide the basis for the plutocracy’s wealth and power. As it turns out, it makes a big difference if that wealth is based upon industrial sectors, or upon a financial one.

The first Gilded Age of the 1880s–90s certainly produced a plutocracy, and that plutocracy in due course produced the Great Depression of the 1890s.[3] But of course, the 1890s were also the very decade when the United States dramatically and decisively ascended to the status of a great power. The annexation of Hawaii (1893–98), the successful deterring of Britain in the Venezuelan Crisis (1895), victory in the Spanish-American War (1898), and the subsequent annexation of the Philippines and dominion over the Caribbean provided impressive evidence for that rise. Thereafter, the United States was taken seriously by other great powers, particularly by the greatest power, Great Britain, which then acquiesced to U.S. primacy in the Western Hemisphere. If plutocracy is so bad for America, how could it have presided over this extraordinary rise in American power and influence?

The American plutocracy of the post-Civil War era resulted from the recent and rapid development of a massive American industrial structure. This structure in turn was dominated by such industrial sectors as coal, steel, railroads and oil. These new industries generated great wealth, and by the 1880s they had been organized into great cartels and trusts, which then generated even greater wealth for the men, be they called captains of industry or robber barons, who organized and directed them. In this system, which was democratic in form and plutocratic in content, the industrial sector plutocracy controlled virtually all of the Republican Party and much of the Democratic Party as well.

A more truly democratic system became the goal of the minority Populist Party and then, in 1896 and for a time thereafter, of the populist elements within the Democratic Party (famously represented by William Jennings Bryan). These populist or democratic forces could certainly make a lot of noise, and in the form of the famous Mugwumps, with spokesmen like Mark Twain, they could get a lot of attention. But plutocratic forces had the advantage not only of great wealth, with which they could readily buy politicians and policies, but also great concentration. A perfect example of the logic of collective action, they could readily negotiate decisions among themselves and then persist in seeing them through. Consequently, the plutocratic forces repeatedly prevailed over the democratic ones, at least until Theodore Roosevelt came along, with respect to their preferred public policies in domestic affairs.

It would not be surprising if they also had preferred foreign policies and also got their way with them. This was most obvious with the most economic of foreign policies: those concerning foreign trade. American industries faced formidable competition from their counterparts in Europe, especially Britain and Germany, so the industries wanted a policy of trade barriers, of protectionism. They got it. But these same industries perceived market opportunities in underdeveloped countries where the United States might develop a preponderant political influence: the countries of Latin America, especially the Caribbean Basin and Central America, and in the Western Pacific, especially the emerging market of China. Here the industries wanted a policy of free trade (or even better, trade that would give preference to American products). They got it. This stance was often described as the “Open Door Policy.”

Since other great powers were also interested in these Latin American and Pacific markets, it followed that the United States would need a strong navy to promote and protect its access to them. Of course, a big navy would itself provide a big market for the coal and steel industries, and, on occasion, the preservation of this secure access might require actual military intervention in some countries, usually employing a combination of the Navy and the Marines.

These were the foreign and military policies of the Gilded Age plutocracy, yet they were not spared opposition. Democratic forces specifically contested protectionist trade policies, the construction of a big navy and military interventions overseas. Had these opposition forces gotten their way, they would have prevented, or at least delayed, much of the expansion and projection of U.S. military power into foreign countries. But as in domestic policies, so too in foreign and military policies: Plutocratic forces prevailed. One might therefore conclude that the industrial plutocracy of the late 19th century was necessary for the dramatic and decisive rise of the United States to great power status.

The next era of plutocracy was in the 1920s, the second Gilded Age. Like the earlier era of the 1880s–90s, this plutocracy was largely based upon the vast and diverse American industrial structure, but by now a substantial American financial sector had come into being. This sector provided new members for the plutocracy who had their own distinct economic interests and policy preferences. The American financial sector had been greatly expanded with the profits from World War I and with the rise of the United States to the status of a creditor country. Nevertheless, the character and direction of the American plutocracy as a whole was still set by industry rather than by finance.

Despite the great transformation in the U.S. economy since the 1890s, the foreign policy preferences of the industrial plutocracy remained much the same: a protectionist trade policy toward Europe and a free trade or open door policy toward Latin America and East Asia. Industry for the most part also continued to support a large navy to protect and promote its interests in these regions. The major U.S. diplomatic achievement of the 1920s was the Washington Naval Treaty with Britain and Japan, along with a parallel treaty between all the major powers regarding their interests in China. Together, these produced the “Washington System” that established U.S. leadership in the Pacific. This system for the Pacific and China suited the interests and preferences of much of American industry, and its creation was greatly facilitated by the cohesive plutocracy that supported it. Similarly, the plutocracy supported an active U.S. policy of military intervention in the Caribbean Basin and Central America in order to maintain stability and predictability in that region. With respect to Latin America and East Asia, there certainly was no U.S. policy of isolationism during the 1920s. This was because the plutocracy, both its industrial and financial components, supported active and interventionist policies in those regions.

With respect to Europe, however, the plutocracy was divided. Industry wanted protection from European competitors’ imports. In contrast, finance wanted European borrowers to be able to pay off their loans from American banks, which required that European countries earn money from exports to the United States. This contradiction between industry and finance, and the corresponding division within the plutocracy, meant that U.S. policy toward Europe often lacked coherence and consistency in the 1920s. Since industry dominated the plutocracy and since it preferred protectionism, U.S. policy toward Europe indeed seemed to be isolationist.

The onset of the Great Depression in the 1930s greatly weakened the American plutocracy and significantly pushed U.S. foreign policy to be more broadly isolationist. First, the contraction of markets worldwide made American industry even more insistent on protecting what market remained within the United States. Second, the stock market crash and the ensuing Depression destroyed much of the paper assets of the plutocracy; this loss was confirmed by New Deal legislation that imposed significant limitations upon great fortunes. Third, the destruction of paper assets naturally resulted in even greater losses for the financial component of the plutocracy than for the industrial one. This meant that what was left of the now-diminished plutocracy was more dominated by industry than before.

All of these factors made for an even more isolationist policy toward Europe. However, even U.S. policies toward Latin America and East Asia became less active and interventionist. It was not that the United States adopted a policy of isolationism toward these regions. Rather, it simply became less willing to provide the economic and military resources necessary to sustain the previous policies. The populist and democratic forces in U.S. politics had rarely supported such policies, and now, with the plutocracy weakened and divided, democratic forces could at last get their way. This shift began under a Republican administration but accelerated in the subsequent Democratic one.

What might have happened if somehow plutocratic forces had remained strong and united into the 1930s and the Great Depression? They probably would have produced outcomes similar to those that occurred anyway in policies toward Latin America (where the outcomes were benign) and toward Europe (where the outcomes were malign), but not with respect to the Pacific and China. A plutocratic foreign and military policy would have been much more vigorous and consistent in protecting U.S. interests in China, in building a strong U.S. Navy, and in restraining Japan. In the end, the history of the European war within World War II might have been much the same, but in this counterfactual world the history of the Pacific War would have been very different. Japan might have been deterred; there might not have been a war in the Pacific at all.

During the same half-century (1880s–1930s) that the rising United States experienced two waves of plutocracy, the established power of Great Britain was experiencing its own variations on a plutocratic theme. But in Britain the plutocracy had a very different character from the American one, with very different consequences for foreign policy and for Britain’s place in world affairs. The origins of the British plutocracy’s wealth, like that of the American version, had originated in the Industrial Revolution. But the British plutocracy itself was not really based on industrial sectors; it was instead based on the financial one.

The term plutocracy was little used in Britain during this half-century. Instead, public discussion talked about the aristocracy. By the late Victorian era, the British aristocracy still affected the styles and symbols of a great landed upper class. However, the actual source of much of its wealth was no longer their landed estates, which were ceasing to be profitable; rather, it was now derived from the growing financial sector, especially from investments in the British Empire and in foreign countries—and in rising great powers like the United States and Germany. And so by the late 19th century the British upper class was dominated by an aristocracy in form that was becoming a plutocracy in fact.

The great industrialists of Britain were not drawn from the old aristocracy. They came instead from a middling class of “tradesmen” and “tinkerers”, the most successful of whom rose to create a new capitalist class. British politics and policy were soon defined by the struggle between the old landed aristocracy and the new industrial capitalists, respectively represented by the Conservative Party and the Liberal Party. As long as British wealth was divided into these two economic sectors and these two political parties, no unified and cohesive plutocracy could develop. However, by the early 20th century, much of the capitalist class based on industry had also transformed itself into an upper class based on investments and finance. The earlier conflict between agricultural and industrial interests was transcended by a new convergence around shared financial interests. The earlier partisan conflict between the Conservative Party and the Liberal Party was transcended by a new bipartisan consensus on many issues of public policy, and it is no surprise that the Liberal Party began a long decline into near political irrelevancy.

The convergence of economic interests and the consensus on policy issues allowed the creation of a cohesive and effective plutocracy, but in this case one based upon an immense financial sector. Whereas in America the industrial sectors dominated the economy and produced the plutocracy, with the financial sector playing only a supporting role, in Britain the financial sector dominated the economy and produced the plutocracy, with the industrial sectors playing a supporting role. The formidable Royal Navy protected and promoted the British Empire and the dense network of transportation and communication links between its far-flung parts, as well as the ocean trading links of much of the globe. The Empire was the hegemonic economy within the global economy, and so not surprisingly the ideology of the British Empire became, in effect, the ideology of this first era of globalization. Now, in addition to being the workshop and shipbuilder of the world, Britain also became its banker.

Problems arose, however, when certain developing economies began to build their own industries and their own supporting transportation infrastructures with the aid of British capital. This occurred first in Belgium, then in Germany, and then in the United States. Soon, these new foreign industries began to compete effectively with the original British ones. Britain ceased to be the only workshop of the world with respect to the industries it had pioneered: textiles, coal, steel, railroads and shipbuilding.

The outbreak of World War I dramatically revealed the weakened state of British industry, particularly relative to Germany and the United States. Unable to produce what it needed for the war by its own industry, or even with the resources of the British Empire as a whole, Britain made vast purchases of manufactured products, including armaments, from the United States. In wartime, British leadership in finance proved no substitute for British weakness in industry. The economic costs of the war soon transformed Britain from a creditor country into a debtor one (and conversely, the United States from a debtor country into a creditor one). It turned out that strong industrial sectors provided a nation with great resiliency when it faced existential challenges, and that a seemingly strong financial sector could disappear quickly.

Might Britain have taken an alternative path in the first decade of the 20th century that would have provided a more robust economy and a stronger military, and that would have better preserved Britain’s power and leadership in world affairs? In particular, was there a path that would have preserved and promoted the British industrial structure, using technological innovation to push it into new sectors, as occurred in the United States and Germany? Correspondingly, was there a path that would have constrained and confined the British financial sector so that it would have facilitated the movement of capital into new domestic industries (again, more like the United States) but not become the dominant sector, with its dominance solidified by a politically cohesive aristocracy (read: plutocracy) at its top?

One obvious response to the new competing industrial powers of the early 20th century would have been for Britain to develop new industries to succeed its old ones. In the 1870s–80s, technological innovations in chemistry, electricity and engineering provided the basis for whole new industrial sectors such as chemicals, electric lights and machinery, and automobiles. To a degree Britain did develop these industries. By the 1900s, however, leadership in them had passed either to Germany (chemicals), or to the United States (automobiles), or to both (electrical products). Instead, much of British financial capital continued to flow out of Britain into the Empire or into foreign economies. It continued to build up foreign industries to the point that these were better able to compete with industries in Britain itself. This was because finance generally preferred to invest in old industries located in new countries rather than in new industries located in the old country.

The movement of British financial capital out of British industry matched the movement of British human capital. For several generations, the talented young had gone into business and engineering projects. Now they went instead into financial services and the civil service. By the eve of the World War, this diversion of financial and human capital out of British industry meant that British industrial expansion and innovation had slowed to a rate much lower than that of the now-booming industrial economies and rising great powers, Germany and the United States.

At the beginning of the 20th century, the British elite understood well that their country was too small to provide the requisite market for the industries of the future. The United States had the advantage of a large continental market within its own territory; Germany had a similar advantage with a large continental market within Mitteleuropa (Germany plus the Austro-Hungarian Empire). For Britain to compete effectively, it would need a continental-sized market of its own. Some thinkers and leaders saw this market within a politically reconfigured British Empire, especially in its major dominions (Canada, Australia, New Zealand and South Africa), which were dominated by populations that were British in origins and in culture.

Thus it was that some British thinkers and leaders put forward proposals for a “Greater Britain” or an “Imperial Federation.” However, the British financial sector, the City of London, considered Imperial Federation to be merely a second-best choice that would obviate its first choice, which was, in effect, globalization. With its worldwide power and leadership in financial matters, this sector wanted to operate freely on the widest-possible scale. Particular commitments and concessions to the dominions would have meant particular constraints on the global ambitions the financial sector held at the time. An Imperial Federation might also in due course threaten the global interests of the City of London. Thus it was that after a major political struggle, industry’s Imperial Federation project went down to defeat at the hands of finance’s globalization project.

After World War I, Britain tried to restore its financial sector’s central role in the global economy. The financial leaders thought that the best way to do this was to restore the British pound to the same value it had held before the war. This was done in 1925 by Winston Churchill, who was then Chancellor of the Exchequer and a strong proponent of the City of London’s views. A strong, high-value pound was good for British finance, but it was bad for British industry, since it made its products even less competitive with foreign industries than before (particularly those, once again, of the United States and Germany). This policy quickly produced a serious recession in Britain, which continued into the 1930s, when it deepened into the Great Depression. Thus a recession or depression afflicted British industry years before it did America, lasting for a full decade and a half.

The onset of the Great Depression soon produced a global financial crisis in 1931. Now it was the turn of the British financial sector itself to suffer. The financial panic produced a run on the pound, which then served as the primary global reserve currency. This forced the British government into desperate and unprecedented responses. At the Ottawa Conference of 1932 free trade gave way to imperial preference within the Empire, and at the Westminster Conference that same year Britain’s authority within the Empire shrank relative to that of the dominions in what now was called the British Commonwealth.

As radical as these changes were, the most important consequences of the financial crisis of 1931, and of the demonstrated fragility of the pound, manifested in British military spending. British leaders knew that any significant deficit spending might trigger a new run on the pound. Consequently, they capped government spending, including military spending. This signaled far and wide that Britain chose no longer to afford a “Continental commitment” and, with it, the military capability required to be an effective ally for other European states, particularly France. This economic constraint formed the underlying basis of what would soon become the Appeasement Policy, which British financial and political elites in the 1930s thought was the only policy they could afford.

Instead, British military policy focused on the one area where financial elites still thought that they could receive good returns: the Empire. “Imperial policing” became the military counterpart to imperial preference, particularly with respect to the most profitable parts of the Empire, such as the oil-producing countries of the Middle East. Of course, a military force designed around imperial policing looked very different from one designed around a Continental commitment. The former developed capabilities for counterinsurgency warfare, punitive expeditions and “small wars.” As important as these capabilities may be, they were inadequate for engaging in conventional warfare, armored invasions and big wars against great powers.

It had been Britain’s industrial supremacy that had maintained the British Empire and its role as the leading world power. However, this legacy could not be preserved by a power that was now mainly a financial one. By the end of the 1930s, Britain faced military challenges from three great powers—Germany, Italy and Japan. During World War II each of these powers put the British military to the test. Against Germany, a truly great power with a formidable conventional military supplied by a massive industrial sector, the British military failed the test. Britain, even with the entire British Empire, could never have defeated Germany on its own. It took the massive industrial sectors, and consequent military power, of the United States and the Soviet Union to bring the Germans down and rescue Britain in Europe. Against Japan, also a truly great power, the British military proved unimpressive and inconsequential. Again, Britain, even with the entire British Empire, could not have defeated Japan on its own. It took the United States to defeat the Japanese and to rescue the British Empire in Asia. Only against Italy, always problematic as a great power, did the British military prove effective, as in its campaigns in North Africa and the Mediterranean. Of course, the Mediterranean had always been at the center of British imperial strategy, since it provided the crucial route to the Empire in the Middle East, India and the Far East.

Clearly, the American experience in the first half of the 20th century suggests that a strong industrial sector will tend to think in terms of big wars against great powers, since it has the capacity to produce the weapons to deter or fight such wars (as well as an interest in doing so). Conversely, the British experience in the same era suggests that a strong financial sector will tend to think in terms of small wars and imperial policing, since it calculates that only these wars will provide an acceptable mix of costs and benefits. With little capacity to produce weapons and no particular interests in investing in such capacity, a financial plutocracy will see its most attractive investment prospects in other economic activities in other countries rather than its own, indeed, in countries all over the globe.

The American plutocracy of our time is based on the American financial sector and not on its industrial ones. As such, it has far more in common with the British plutocracy of the early 20th century than with the two previous American ones. The power of the financial sector with respect to financial policy certainly has been demonstrated in the course of the Great Recession. But what about its effect on foreign and military policies and on America’s power and leadership in the world? For this we need to look into the origins of this third American plutocratic era.

After World War II, the U.S. financial sector was even larger than before, and it continued to advance its vision of an open global economy. But several industrial sectors now joined finance in this project. Whereas after World War I European industry had largely remained intact and could quickly field competition for its American counterpart, after World War II much of European industry lay destroyed and most of what remained was obsolescent. As long as European industry was still rebuilding or modernizing (in the late 1940s–50s), American industry retained valuable markets in Europe and therefore could join finance in supporting free trade. And by the time European industry was rebuilt and modernized (the 1960s), several American industrial sectors—particularly the automobile industry—had discovered the cost advantage of directly investing in European countries in order to produce their products there. Thus began the era of the “multinational corporation”, which has continued to expand in both size and scope to the present day.

This movement of American industrial production into foreign countries was facilitated by American banks, which provided all sorts of useful financial services to multinational corporations. Soon the banks became multinational, too. A grand alliance between the biggest and most important corporations in American industry and the biggest and most important banks in American finance now agreed not only on free trade but also on free investment and indeed on the openness of the entire international economy. This grand alliance provided a solid base for what soon became the dominant ideology shaping U.S. foreign policy and America’s place in world affairs: liberal internationalism, which became liberal multinationalism in the 1970s, and which culminated in liberal globalization in the 1990s. However, although there was a grand alliance between finance and industry around an open global economy, there was not yet a full plutocracy. That awaited the 1990s.

Although the consequences of overseas investment for American economic prosperity are complex and debatable, the consequences for American military security are clear and well defined. When the U.S. military needs to procure certain crucial weapons components from overseas sources, this obviously poses the problem that an enemy might disrupt vital supplies in wartime or during a protracted crisis. Even if a shrunken, rump production base remains in the United States, its costs will be higher because its scale will be smaller and therefore less efficient. This problem was first posed in a serious way (in the 1960s) with the shipbuilding industry. It was posed again a generation later (1980s) with the electronics industry. Recently, another generation later (2000s), it has been posed with the computer and software industry. And it has appeared even more recently in terms of space launch capabilities.

The migration of much of these industries overseas (especially to East Asia or South Asia) creates challenges and uncertainties for each of the U.S. military services. The biggest impact, however, has been on the U.S. Navy, which relies on the products of all of these industries. These holes in the Navy’s industrial base make for a more insecure and expensive, as well as smaller and weaker, U.S. Navy than would otherwise be the case. (The U.S. Navy fleet now consists of only 270 ships, fewer than at any time since the 1930s—and those numbers are due to drop even further.) To compound the challenge (and to enhance the historical irony), these three industries (shipbuilding, electronics and software) are now principally located in East Asia, especially within China. China is also rapidly developing its own navy in a way that will soon pose serious challenges to the U.S. Navy in China’s three littoral seas.

It is obvious that the 1990s was a decisive decade in shaping the future course of the United States in world affairs. Several developments came together in that decade to set the United States on this path. First and most obviously, the collapse of the Soviet Union left the United States as “the sole superpower”, even, as some called it, “the American empire” or the “hyperpower.” In this exuberant time, it seemed that the United States could do whatever it wished in the world. Second, the consensus ideology of liberal internationalism, now ripened into liberal globalization, was an ideology that perfectly suited America’s supreme global power. Third, the American financial sector greatly expanded in wealth and power, both in absolute terms and in relation to America’s industrial sectors. Finance became the dominant sector in the economy and also in politics.[4] This is clearly evidenced by the success of America’s finance plutocrats in obtaining congressional legislation and executive decisions that almost completely deregulated the financial sector, destroying the regime established by the New Deal in response to the Great Depression. Finally, the great increase in wealth and income inequality in the United States at last culminated in the creation of a new plutocracy. Having been created by public policies with respect to deregulation and taxation, this plutocracy then set its sights as an even more cohesive and powerful force on locking in even more favorable versions of these policies. These in turn rendered the financial sector and the plutocrats running it even richer and more powerful. From the perspective of the American plutocracy, it was the beneficiary of a virtuous cycle; from the perspective of the American democracy, it was the victim of a vicious cycle.

The first decade of the third American plutocratic era happened to be characterized by continuity with respect to the grand parade of successive industrial sectors, based on new technological innovations that had been going on in America for a century and a half. The 1990s was a time of a spectacular development (and speculative boom) in the computer and telecommunications industries, one centered on the internet and the extraordinary opportunities and services it made available. When the speculative boom in high-tech stocks burst in 2000, it afflicted investors with the usual distress attending the end of a speculative boom in new industries. Its effects, however, should have been short-lived and sectorally limited. Following the pattern of the past, American capital should have shifted into the next new industry in the grand parade after a decent interval of sobering up after the bust. The most promising candidates were perhaps biotechnology and renewable energy.

That shift never happened. At the beginning of the second decade of the third American plutocratic era, finance preferred to invest in old technologies located in new regions rather than in new technologies located in old regions. Finance’s conception of risk management makes it most comfortable with incremental changes within established investment fields (“portfolio diversification”); short-term profit horizons (quarterly or yearly balance sheets); and “financial engineering” thanks to the supposed predictive accuracy of complex computer models based on data drawn from only the past ten to twenty years. Investing in new industrial sectors such as biotechnology and clean energy did not conform to any of these conceptions of good risk management. What did conform, and conformed perfectly, was real estate.

Beginning in the early 2000s, the financial sector thus directed the great majority of its new investments into real estate within what seemed to be areas of rapidly growing demand. This was a perfect case of preferring an old (very old) industry in new regions (or in old regions that appeared to be new in some way). Moreover, real estate was largely a consumption sector; it did not contribute to new production or productivity increases in any significant way. It created construction jobs and jobs in related supplier industries, but in terms of both numbers and innovative potential this did not amount to much.

When the financial crisis hit the U.S. economy in the autumn of 2008, the financial sector was powerful enough to ensure that it received first priority in the government’s response: bailouts on an unprecedented scale of major financial institutions that were deemed “too big to fail.” These bailouts included more than $150 billion to each of four financial corporations: AIG, Citigroup, Fannie Mae and Freddie Mac—the latter two being, of course, government-sponsored institutions. Together, these four bailouts alone amounted to more than the entire annual U.S. defense budget. Each individual $150 billion corporate bailout is sufficient to purchase for the Air Force either all of the F-22s or F-35s it seeks, or to purchase for the Navy either all of the new aircraft carriers or all of the new attack submarines it says it needs.

An alternative course would have been for the U.S. government to liquidate or break up several major financial institutions. This course would have followed successful precedents from the savings-and-loan crisis of the late 1980s and from the paradigmatic banking crisis of the 1930s. This would have had not only the advantage of minimizing financial burdens put upon the Federal budget and the American taxpayer; it also would have reduced the overall financial sector (and the size of the business units within it) to a point at which it would return to being a facilitator of the real, industrial economy instead of being the dominant and distorting economic and political power it has become.

Of course, no such liquidations, reforms or financial sector reconstructions have occurred like those of the 1930s and 1980s. The Dodd-Frank legislation does not even deserve the label “band-aid” in this respect. Unlike the earlier eras of financial reform and reconstruction, the financial sector has retained its status as the largest sector in the American economy. Of even weightier consequence, it is now organized into a cohesive political force by the plutocracy at its top. So instead of the financial crisis reducing the power of these institutions and this plutocracy, it ended up increasing it.

The United States entered the present decade with the financial sector and its plutocracy fully in charge. There is little sign that domestic forces within the United States will replace this regime. The industrial sectors are now either too small or too subordinated to financial interests to be effective counterweights to the financial sector. Democratic forces are now too disorganized (the Tea Party) or too weak (the labor unions) to mount an effective opposition. The domestic power of the contemporary American financial plutocracy exhibits similarities to that of the British financial plutocracy of the 1930s, and the hard times of this era also exhibit striking similarities to the hard times of that one. The most likely economic prospect is that the current Great Recession will continue, or even deepen, for the rest of the 2010s.

It would therefore not be surprising if other similarities between the American condition of the 2010s and the British condition of the 1930s were to manifest, particularly with respect to the growth of foreign threats and especially those posed by rising industrial economies and great powers. We can already see that some kind of challenge will likely come from China.

In the 1930s, the established but weakened British financial sector confronted a large American one distinguished by great financial resources and a strong creditor position. Similarly, today the established but weakened American financial sector confronts a rising Chinese one also distinguished by great financial resources and a strong creditor position. Historically, periods that have been characterized by both a declining global financial power and a rising one have issued in substantial financial instability and even prolonged global recession or depression.[5] The 1930s was one such period, and the 2010s could well be another. Also in the 1930s, an established but weakening British naval power confronted a rising Japanese naval power in the western Pacific. Similarly, today an established but weakening U.S. naval power confronts a rising Chinese naval power in the same region, particularly in China’s three littoral seas.[6]

We have already seen that a financial plutocracy is ill-suited for effective leadership in the global competition between great powers. Its neglect or even disdain for a healthy domestic industrial structure is one factor. Its attachment to a global reserve currency, despite the vulnerability and consequent sensitivity to government deficits this brings, is another. Its preference for small wars or imperial policing rather than for preparing the nation and its military for deterring great powers and large wars is a third. It is very likely, therefore, that we are steadily approaching the day, be it in this decade or the next, when the United States and China will confront one another in the seas that border China. These are seas that the United States considers to be part of the western Pacific but that China considers to be part of its historical patrimony one day to be redeemed.

When the rising industrial and naval power of Japan confronted the British Empire and the Royal Navy in the western Pacific, it was so strong that it easily got its way. It was only because Japan also had to confront the formidable industrial and naval power of the United States that it was defeated, and then only in a long and terrible war. When the new rising industrial and naval power of China confronts the United States and the U.S. Navy in the western Pacific, who will prevail? One can still imagine that the old financial power, with its small-war military (and diminished navy) will do so, and will do so without having to fight a long and terrible war. But to imagine this, one has to believe, as a financial sector on the make so often does, that “this time is different.”[7] A financial power achieving this kind of outcome for itself against this kind of challenge from an industrial power has never before happened in history.

If we cannot prevail, what greater power will save us in, say, the early 2020s, as America saved Britain in the early 1940s?

____________________________________

James Kurth is professor of political science and senior research scholar at Swarthmore College.

1 For comparisons of these economic crises, see Peter Gourevitch, Politics in Hard Times: Comparative Responses to International Economic Crises (Cornell University Press, 1986); and James Kurth, “A Tale of Four Crises: The Politics of Great Depressions and Recessions”, Orbis (Summer 2011).

2 See Michael Auslin, “Tipping Point in the Indo-Pacific”, The American Interest (March/April 2011).

3 Economic historians still debate with some passion the particular nature of this Great Depression, which is dated from the Panic of 1873 to the crisis of the mid-1890s. By many measures before the mid-1890s, this was certainly an odd “Depression” in that industrial growth rose dramatically, unemployment was not high in the context of massive immigration, and also in that context general living standards rose. The problem, insofar as there really was one, was that business profits were plagued by deflation. The money supply did not keep pace with the real growth of the economy, making credit relatively scarce. In this regard, the term “Great Depression” refers to phenomenon unlike those of the late 1920s and today, but if it is taken to refer just to the crisis of the mid-1890s, the parallels hold.

4 Jeff Madrick, Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present (Knopf, 2011).

5 This was the classic thesis of Charles Kindleberger, The World in Depression, 1929–1939 (University of California Press, 1973).

6 Contrasting views of the potential Chinese challenge are given in Auslin, “Tipping Point”; Henry Kissinger, On China (Penguin Press, 2011), chapter 18; and James R. Holmes and Toshi Yoshihara, Red Star over the Pacific: China’s Rise and the Challenge to U.S. Maritime Strategy (Naval Institute Press, 2010).

7 Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009).

Chapter 7

The Inequality That Matters

Tyler Cowen

Does growing wealth and income inequality in the United States presage the downfall of the American republic? Will we evolve into a new Gilded Age plutocracy, irrevocably split between the competing interests of rich and poor? Or is growing inequality a mere bump in the road, a statistical blip along the path to greater wealth for virtually every American? Or is income inequality partially desirable, reflecting the greater productivity of society’s stars?

There is plenty of speculation on these possibilities, but a lot of it has been aimed at elevating one political agenda over another rather than elevating our understanding. As a result, there’s more confusion about this issue than just about any other in contemporary American political discourse. The reality is that most of the worries about income inequality are bogus, but some are probably better grounded and even more serious than even many of their heralds realize. If our economic churn is bound to throw off political sparks, whether alarums about plutocracy or something else, we owe it to ourselves to seek out an accurate picture of what is really going on. Let’s start with the subset of worries about inequality that are significantly overblown.

In terms of immediate political stability, there is less to the income inequality issue than meets the eye. Most analyses of income inequality neglect two major points. First, the inequality of personal well-being is sharply down over the past hundred years and perhaps over the past twenty years as well. Bill Gates is much, much richer than I am, yet it is not obvious that he is much happier if, indeed, he is happier at all. I have access to penicillin, air travel, good cheap food, the internet and virtually all of the technical innovations that Gates does. Like the vast majority of Americans, I have access to some important new pharmaceuticals, such as statins to protect against heart disease. To be sure, Gates receives the very best care from the world’s top doctors, but our health outcomes are in the same ballpark. I don’t have a private jet or take luxury vacations, and—I think it is fair to say—my house is much smaller than his. I can’t meet with the world’s elite on demand. Still, by broad historical standards, what I share with Bill Gates is far more significant than what I don’t share with him.

Compare these circumstances to those of 1912, a century ago. Even in the wealthier countries, the average person had little formal education, worked six days a week or more, often at hard physical labor, never took vacations, and could not access most of the world’s culture. The living standards of Carnegie and Rockefeller towered above those of typical Americans, not just in terms of money but also in terms of comfort. Most people today may not articulate this truth to themselves in so many words, but they sense it keenly enough. So when average people read about or see income inequality, they don’t feel the moral outrage that radiates from the more passionate pro-egalitarian quarters of society. Instead, they think their lives are pretty good and that they either earned through hard work or lucked into a healthy share of the American dream. (The persistently unemployed, of course, are a different matter, and I will return to them later.) It is pretty easy to convince a lot of Americans that unemployment and poverty are social problems because discrete examples of both are visible on the evening news, or maybe even in or at the periphery of one’s own life. It’s much harder to get those same people worked up about generalized measures of inequality.

This is why, for example, large numbers of Americans oppose the idea of an estate tax even though the current form of the tax is very unlikely to affect them or their estates. In narrowly self-interested terms, that view may be irrational, but most Americans are unwilling to frame national issues in terms of rich versus poor. There’s a great deal of hostility toward various government bailouts, but the idea of “undeserving” recipients is the key factor in those feelings. Resentment against Wall Street gamesters hasn’t spilled over much into resentment against the wealthy more generally. The bailout for General Motors’ labor unions wasn’t so popular either—again, obviously not because of any bias against the wealthy but because a basic sense of fairness was violated. As of November 2010, congressional Democrats were of a mixed mind as to whether the Bush tax cuts should expire for those whose annual income exceeds $250,000; that was in large part because their constituents bear no animus toward rich people, only toward undeservedly rich people.

A neglected observation, too, is that envy is usually local. At least in the United States, most economic resentment is not directed toward billionaires or high-roller financiers—not even corrupt ones. It’s directed at the guy down the hall who got a bigger raise. It’s directed at the husband of your wife’s sister, because the brand of beer he stocks costs $3 a case more than yours, and so on. That’s another reason why a lot of people aren’t so bothered by income or wealth inequality at the macro level. Most of us don’t compare ourselves to billionaires. Gore Vidal put it honestly: “Whenever a friend succeeds, a little something in me dies.”

Occasionally the cynic in me wonders why so many relatively well-off intellectuals lead the egalitarian charge against the privileges of the wealthy. One group has the status currency of money and the other has the status currency of intellect, so might they be competing for overall social regard? The high status of the wealthy in America, or for that matter the high status of celebrities, seems to bother our intellectual class most. That class composes a very small group, however, so the upshot is that growing income inequality won’t necessarily have major political implications at the macro level.

All that said, income inequality does matter—for both politics and the economy. To see how, we must distinguish between inequality itself and what causes it. But first let’s review the trends in more detail.

The numbers are clear: Income inequality has been rising in the United States, especially at the very top. The data show a big difference between two quite separate issues, namely income growth at the very top of the distribution and greater inequality throughout the distribution. The first trend is much more pronounced than the second, although the two are often confused.

When it comes to the first trend, the share of pre-tax income earned by the richest 1 percent of earners has increased from about 8 percent in 1974 to more than 18 percent in 2007. Furthermore, the richest 0.01 percent (the 15,000 or so richest families) had a share of less than 1 percent in 1974 but more than 6 percent of national income in 2007. As noted, those figures are from pre-tax income, so don’t look to the George W. Bush tax cuts to explain the pattern. Furthermore, these gains have been sustained and have evolved over many years, rather than coming in one or two small bursts between 1974 and today.[1]

These numbers have been challenged on the grounds that, since various tax reforms have kicked in, individuals now receive their incomes in different and harder to measure ways, namely through corporate forms, stock options and fringe benefits. Caution is in order, but the overall trend seems robust. Similar broad patterns are indicated by different sources, such as studies of executive compensation. Anecdotal observation suggests extreme and unprecedented returns earned by investment bankers, fired CEOs, J.K. Rowling and Tiger Woods.

At the same time, wage growth for the median earner has slowed since 1973. But that slower wage growth has afflicted large numbers of Americans, and it is conceptually distinct from the higher relative share of top income earners. For instance, if you take the 1979–2005 period, the average incomes of the bottom fifth of households increased only 6 percent while the incomes of the middle quintile rose by 21 percent. That’s a widening of the spread of incomes, but it’s not so drastic compared to the explosive gains at the very top.

The broader change in income distribution, the one occurring beneath the very top earners, can be deconstructed in a manner that makes nearly all of it look harmless. For instance, there is usually greater inequality of income among both older people and the more highly educated, if only because there is more time and more room for fortunes to vary. Since America is becoming both older and more highly educated, our measured income inequality will increase pretty much by demographic fiat. Economist Thomas Lemieux at the University of British Columbia estimates that these demographic effects explain three-quarters of the observed rise in income inequality for men, and even more for women.[2]

Attacking the problem from a different angle, other economists are challenging whether there is much growth in inequality at all below the super-rich. For instance, real incomes are measured using a common price index, yet poorer people are more likely to shop at discount outlets like Wal-Mart, which have seen big price drops over the past twenty years.[3] Once we take this behavior into account, it is unclear whether the real income gaps between the poor and middle class have been widening much at all. Robert J. Gordon, an economist from Northwestern University who is hardly known as a Right-wing apologist, wrote that “there was no increase of inequality after 1993 in the bottom 99 percent of the population”, and that whatever overall change there was “can be entirely explained by the behavior of income in the top 1 percent.”[4]

And so we come again to the gains of the top earners, clearly the big story told by the data. It’s worth noting that over this same period of time, inequality of work hours increased too. The top earners worked a lot more and most other Americans worked somewhat less. That’s another reason why high earners don’t occasion more resentment: Many people understand how hard they have to work to get there. It also seems that most of the income gains of the top earners were related to performance pay—bonuses, in other words—and not wildly out-of-whack yearly salaries.[5]

It is also the case that any society with a lot of “threshold earners” is likely to experience growing income inequality. A threshold earner is someone who seeks to earn a certain amount of money and no more. If wages go up, that person will respond by seeking less work or by working less hard or less often. That person simply wants to “get by” in terms of absolute earning power in order to experience other gains in the form of leisure—whether spending time with friends and family, walking in the woods and so on. Luck aside, that person’s income will never rise much above the threshold.

It’s not obvious what causes the percentage of threshold earners to rise or fall, but it seems reasonable to suppose that the more single-occupancy households there are, the more threshold earners there will be, since a major incentive for earning money is to use it to take care of other people with whom one lives. For a variety of reasons, single-occupancy households in the United States are at an all-time high. There are also a growing number of late odyssey years graduate students who try to cover their own expenses but otherwise devote their time to study. If the percentage of threshold earners rises for whatever reasons, however, the aggregate gap between them and the more financially ambitious will widen. There is nothing morally or practically wrong with an increase in inequality from a source such as that.

The funny thing is this: For years, many cultural critics in and of the United States have been telling us that Americans should behave more like threshold earners. We should be less harried, more interested in nurturing friendships, and more interested in the non-commercial sphere of life. That may well be good advice. Many studies suggest that above a certain level more money brings only marginal increments of happiness. What isn’t so widely advertised is that those same critics have basically been telling us, without realizing it, that we should be acting in such a manner as to increase measured income inequality. Not only is high inequality an inevitable concomitant of human diversity, but growing income inequality may be, too, if lots of us take the kind of advice that will make us happier.

Why is the top 1 percent doing so well?

The use of micro-data now makes it possible to trace some high earners by income and thus construct a partial picture of what is going on among the upper echelons of the distribution. Steven N. Kaplan and Joshua Rauh have provided a detailed estimation of particular American incomes.[6] Their data do not comprise the entire U.S. population, but from partial financial records they find a very strong role for the financial sector in driving the trend toward income concentration at the top. For instance, for 2004, nonfinancial executives of publicly traded companies accounted for less than 6 percent of the top 0.01 percent income bracket. In that same year, the top 25 hedge fund managers combined appear to have earned more than all of the CEOs from the entire S&P 500. The number of Wall Street investors earning more than $100 million a year was nine times higher than the public company executives earning that amount. The authors also relate that they shared their estimates with a former U.S. Secretary of the Treasury, one who also has a Wall Street background. He thought their estimates of earnings in the financial sector were, if anything, understated.

Many other high earners are also connected to finance. After Wall Street, Kaplan and Rauh identify the legal sector as a contributor to the growing spread in earnings at the top. Yet many high-earning lawyers are doing financial deals, so a lot of the income generated through legal activity is rooted in finance. Other lawyers are defending corporations against lawsuits, filing lawsuits or helping corporations deal with complex regulations. The returns to these activities are an artifact of the growing complexity of the law and government growth rather than a tale of markets per se. Finance aside, there isn’t much of a story of market failure here, even if we don’t find the results aesthetically appealing.

When it comes to professional athletes and celebrities, there isn’t much of a mystery as to what has happened. Tiger Woods earns much more, even adjusting for inflation, than Arnold Palmer ever did. J.K. Rowling, the first billionaire author, earns much more than did Charles Dickens. These high incomes come, on balance, from the greater reach of modern communications and marketing. Kids all over the world read about Harry Potter. There is more purchasing power to spend on children’s books and, indeed, on culture and celebrities more generally. For high-earning celebrities, hardly anyone finds these earnings so morally objectionable as to suggest that they be politically actionable. Cultural critics can complain that good schoolteachers earn too little, and they may be right, but that does not make celebrities into political targets. They’re too popular. It’s also pretty clear that most of them work hard to earn their money, by persuading fans to buy or otherwise support their product. Most of these individuals do not come from elite or extremely privileged backgrounds, either. They worked their way to the top, and even if Rowling is not an author for the ages, her books tapped into the spirit of their time in a special way. We may or may not wish to tax the wealthy, including wealthy celebrities, at higher rates, but there is no need to “cure” the structural causes of higher celebrity incomes.

If we are looking for objectionable problems in the top 1 percent of income earners, much of it boils down to finance and activities related to financial markets. And to be sure, the high incomes in finance should give us all pause.

The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

To understand how this strategy works, consider an example from sports betting. The NBA’s Washington Wizards are a perennially hapless team that rarely gets beyond the first round of the playoffs, if they make the playoffs at all. This year the odds of the Wizards winning the NBA title will likely clock in at longer than a hundred to one. I could, as a gambling strategy, bet against the Wizards and other low-quality teams each year. Most years I would earn a decent profit, and it would feel like I was earning money for virtually nothing. The Los Angeles Lakers or Boston Celtics or some other quality team would win the title again and I would collect some surplus from my bets. For many years I would earn excess returns relative to the market as a whole.

Yet such bets are not wise over the long run. Every now and then a surprise team does win the title and in those years I would lose a huge amount of money. Even the Washington Wizards (under their previous name, the Capital Bullets) won the title in 1977–78, despite compiling a so-so 44–38 record during the regular season, by marching through the playoffs in spectacular fashion. So if you bet against unlikely events, most of the time you will look smart and have the money to validate the appearance. Periodically, however, you will look very bad. Does that kind of pattern sound familiar? It happens in finance, too. Betting against a big decline in home prices is analogous to betting against the Wizards. Every now and then such a bet will blow up in your face, though in most years that trading activity will generate above-average profits and big bonuses for the traders and CEOs.

To this mix we can add the fact that many money managers are investing other people’s money. If you plan to stay with an investment bank for ten years or less, most of the people playing this investing strategy will make out very well most of the time. Everyone’s time horizon is a bit limited and you will bring in some nice years of extra returns and reap nice bonuses. And let’s say the whole thing does blow up in your face? What’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton. For the people actually investing the money, there’s barely any downside risk other than having to quit the party early. Furthermore, if everyone else made more or less the same mistake (very surprising major events, such as a busted housing market, affect virtually everybody), you’re hardly disgraced. You might even get rehired at another investment bank, or maybe a hedge fund, within months or even weeks.

Moreover, smart shareholders will acquiesce to or even encourage these gambles. They gain on the upside, while the downside, past the point of bankruptcy, is borne by the firm’s creditors. And will the bondholders object? Well, they might have a difficult time monitoring the internal trading operations of financial institutions. Of course, the firm’s trading book cannot be open to competitors, and that means it cannot be open to bondholders (or even most shareholders) either. So what, exactly, will they have in hand to object to?

Perhaps more important, government bailouts minimize the damage to creditors on the downside. Neither the Treasury nor the Fed allowed creditors to take any losses from the collapse of the major banks during the financial crisis. The U.S. government guaranteed these loans, either explicitly or implicitly.

Guaranteeing the debt also encourages equity holders to take more risk. While current bailouts have not in general maintained equity values, and while share prices have often fallen to near zero following the bust of a major bank, the bailouts still give the bank a lifeline. Instead of the bank being destroyed, sometimes those equity prices do climb back out of the hole. This is true of the major surviving banks in the United States, and even AIG is paying back its bailout. For better or worse, we’re handing out free options on recovery, and that encourages banks to take more risk in the first place.

In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good. “Going short on volatility” is a dangerous strategy from a social point of view. For one thing, in so-called normal times, the finance sector attracts a big chunk of the smartest, most hard-working and most talented individuals. That represents a huge human capital opportunity cost to society and the economy at large. But more immediate and more important, it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.

And it’s not just the taxpayer cost of the bailout that stings. The financial disruption ends up throwing a lot of people out of work down the economic food chain, often for long periods. Furthermore, the Federal reserve system has recapitalized major U.S. banks by paying interest on bank reserves and by keeping an unusually high interest rate spread, which allows banks to borrow short from Treasury at near-zero rates and invest in other higher-yielding assets and earn back lots of money rather quickly. In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government. This is rarely called a bailout and it doesn’t count as a normal budget item, but it is a bailout nonetheless. This type of implicit bailout brings high social costs by slowing down economic recovery (the interest rate spreads require tight monetary policy) and by redistributing income from the Treasury to the major banks.

The more one studies financial theory, the more one realizes how many different ways there are to construct a “going short on volatility” investment position. To an outsider, even to seasoned bank regulators, the net position of a bank or hedge fund may well be impossible to discern. It’s not easy to unpack a balance sheet with hundreds of billions of dollars on it and with numerous hedged, offsetting, leveraged or off-balance-sheet positions. Those who pack it usually know what’s inside, but not always. In some cases, traders may not even know they are going short on volatility. They just do what they have seen others do. Their peers who try such strategies very often have Jaguars and homes in the Hamptons. What’s not to like?

The upshot of all this for our purposes is that the “going short on volatility” strategy increases income inequality. In normal years the financial sector is flush with cash and high earnings. In implosion years a lot of the losses are borne by other sectors of society. In other words, financial crisis begets income inequality. Despite being conceptually distinct phenomena, the political economy of income inequality is, in part, the political economy of finance. Simon Johnson tabulates the numbers nicely:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.[7]

If you’re wondering, right before the Great Depression of the 1930s, bank profits and finance-related earnings were also especially high.[8]

There’s a second reason why the financial sector abets income inequality: the “moving first” issue. Let’s say that some news hits the market and that traders interpret this news at different speeds. One trader figures out what the news means in a second, while the other traders require five seconds. Still other traders require an entire day or maybe even a month to figure things out. The early traders earn the extra money. They buy the proper assets early, at the lower prices, and reap most of the gains when the other, later traders pile on. Similarly, if you buy into a successful tech company in the early stages, you are “moving first” in a very effective manner, and you will capture most of the gains if that company hits it big.

The moving-first phenomenon sums to a “winner-take-all” market. Only some relatively small number of traders, sometimes just one trader, can be first. Those who are first will make far more than those who are fourth or fifth. This difference will persist, even if those who are fourth come pretty close to competing with those who are first. In this context, first is first and it doesn’t matter much whether those who come in fourth pile on a month, a minute or a fraction of a second later. Those who bought (or sold, as the case may be) first have captured and locked in most of the available gains. Since gains are concentrated among the early winners, and the closeness of the runner-ups doesn’t so much matter for income distribution, asset-market trading thus encourages the ongoing concentration of wealth. Many investors make lots of mistakes and lose their money, but each year brings a new bunch of projects that can turn the early investors and traders into very wealthy individuals.

These two features of the problem—“going short on volatility” and “getting there first”—are related. Let’s say that Goldman Sachs regularly secures a lot of the best and quickest trades, whether because of its quality analysis, inside connections or high-frequency trading apparatus (it has all three). It builds up a treasure chest of profits and continues to hire very sharp traders and to receive valuable information. Those profits allow it to make “short on volatility” bets faster than anyone else, because if it messes up, it still has a large enough buffer to pad losses. This increases the odds that Goldman will repeatedly pull in spectacular profits.

Still, every now and then Goldman will go bust, or would go bust if not for government bailouts. But the odds are in any given year that it won’t because of the advantages it and other big banks have. It’s as if the major banks have tapped a hole in the social till and they are drinking from it with a straw. In any given year, this practice may seem tolerable—didn’t the bank earn the money fair and square by a series of fairly normal looking trades? Yet over time this situation will corrode productivity, because what the banks do bears almost no resemblance to a process of getting capital into the hands of those who can make most efficient use of it. And it leads to periodic financial explosions. That, in short, is the real problem of income inequality we face today. It’s what causes the inequality at the very top of the earning pyramid that has dangerous implications for the economy as a whole.

A key lesson to take from all of this is that simply railing against income inequality doesn’t get us very far. We have to find a way to prevent or limit major banks from repeatedly going short on volatility at social expense. No one has figured out how to do that yet.

It still remains to be seen whether the new financial regulation bill signed into law the summer of 2010 will help. The bill does have positive features. First, it forces banks to put up more of their own capital, and thus shareholders will have more of their own skin in the game, inducing them to curtail their risky investments. Second, it also limits the trading activities of banks, although to a currently undetermined extent (many key decisions were kicked into the hands of future regulators). Third, the new “resolution authority” allows financial regulators to impose selective losses, for instance, to punish bondholders if they wish.

We’ll see if these reforms constrain excess risk-taking in the long run. There are reasons for skepticism. Most of all, the required capital cushions simply aren’t that high, so a big enough bet against unexpected outcomes still will yield more financial upside than downside. Furthermore, high capital reserve requirements insulate bank managers from the pressures of both shareholders and bondholders. That could encourage risk-taking and make the underlying problem worse. Autonomous managers often push for risk-taking rather than constrain it.

What about controlling bank risk-taking directly with tight government oversight? That is not practical. There are more ways for banks to take risks than even knowledgeable regulators can possibly control; it just isn’t that easy to oversee a balance sheet with hundreds of billions of dollars on it, especially when short-term positions are wound down before quarterly inspections. It’s also not clear how well regulators can identify risky assets. Some of the worst excesses of the financial crisis were grounded in mortgage-backed assets—a very traditional function of banks—not exotic derivatives trading strategies. Virtually any asset position can be used to bet long odds, one way or another. It is naïve to think that underpaid, undertrained regulators can keep up with financial traders, especially when the latter stand to earn billions by circumventing the intent of regulations while remaining within the letter of the law.

It’s a familiar story, repeated many times in the past. If one recalls the Basel I capital agreements for banks, the view was that we would make banks safer by inducing them to hold a lot of AAA-rated mortgage-backed assets. How well did that work out? So, with no disrespect to the regulators or the sponsors of the Dodd Frank bill, it is hardly clear that enhanced regulation will solve the basic problem.

For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism. It’s no longer obvious that the system is stable at a macro level, and extreme income inequality at the top has been one result of that imbalance. Income inequality is a symptom, however, rather than a cause of the real problem. The root cause of income inequality, viewed in the most general terms, is extreme human ingenuity, albeit of a perverse kind. That is why it is so hard to control.

Another root cause of growing inequality is that the modern world, by so limiting our downside risk, makes extreme risk-taking all too comfortable and easy. More risk-taking will mean more inequality, sooner or later, because winners always emerge from risk-taking. Yet bankers who take bad risks (provided those risks are legal) do not end up with bad outcomes in any absolute sense. They still have millions in the bank, lots of human capital and plenty of social status. We’re not going to bring back torture, trial by ordeal or debtors’ prisons, nor should we. Yet the threat of impoverishment and disgrace no longer looms the way it once did, so we no longer can constrain excess financial risk-taking. It’s too soft and cushy a world, at least for bankers.

That’s an underappreciated way to think about our modern, wealthy economy: Smart people have greater reach than ever before, and nothing really very serious can go so wrong for them. As a broad-based portrait of the new world, that sounds pretty good, and usually it is. Just keep in mind that every now and then those smart people will be making—collectively—some pretty big mistakes.

How about a world with no bailouts? Why don’t we simply eliminate the safety net for clueless or unlucky risk-takers so that losses equal gains overall? That’s a good idea in principle, but it is hard to put into practice. Once a financial crisis arrives, politicians will seek to limit the damage, and that means they will bail out major financial institutions. Had we not passed TARP and related policies, the United States probably would have faced unemployment rates of 25 percent or higher, as in the Great Depression. The political consequences would not have been pretty. Bank bailouts may sound quite interventionist, and indeed they are, but in relative terms they probably were the most libertarian policy we had on tap, odd as that may seem. It meant big one-time expense, but, for the most part, it kept government out of the real economy (the General Motors bailout aside).

So what will happen next? One worry is that banks are still undercapitalized and will seek out or create a new bubble within the next few years, again pursuing the upside risk without so much equity to lose. A second perspective is that banks are sufficiently chastened for the time being but that economic turmoil in Europe and China has not yet played itself out, so perhaps we still have seen only the early stages of what will prove to be an even bigger international financial crisis. Adherents of this view often analogize 2009–10 to 1929–32, when many people thought that negative economic shocks had stopped and recovery was underway. In 2006, banks were gambling on the housing market, and maybe today they are, as the result of earlier decisions, gambling on China and Europe staying in one economic piece.

A third view is perhaps most likely: We probably don’t have solutions to the hazards created by our financial sector, not mainly because plutocrats are preventing our political system from adopting appropriate remedies, but because we don’t know what those remedies are. Yet neither is another crisis immediately upon us. The underlying dynamic favors excess risk-taking, but banks at the current moment fear the scrutiny of regulators and the public and so are playing it fairly safe. They are sitting on money rather than lending it out. The biggest risk today is how few parties will take risks, and, in part, the caution of banks is driving our current protracted economic slowdown. According to this view, the long run will bring another financial crisis once moods pick up and external scrutiny weakens, but that day of reckoning is still some ways off.

Is the overall picture a shame? Yes. Is it distorting resource distribution and productivity in the meantime? Yes. Will it again bring our economy to its knees? Probably. Maybe that’s simply the price of modern society. Income inequality will likely continue to rise and we will search in vain for the appropriate political remedies for our underlying problems.

____________________________________

Tyler Cowen is professor of economics at George Mason University and a member of the AI editorial board.

1 See Jacob S. Hacker and Paul Pierson, “Winner-Take-All Politics: Public Policy, Political Organization, and the Precipitous Rise of Top Incomes in the United States”, Politics & Society (June 2010). For one criticism of those numbers, see Scott Winship, “Hacker-mania!”, ScottWinshipWeb, September 19, 2010.

2 Lemieux, “Increasing Residual Wage Inequality: Composition Effects, Noisy Data, or Rising Demand for Skill?” American Economic Review (June 2006).

3 See Christian Broda and John Romalis, “Shattering the Conventional Wisdom on Growing Inequality”, New York Times Freakonomics blog, May 19, 2008.

4 Gordon, “Misperceptions About the Magnitude and Timing of Changes in American Income Inequality”, National Bureau of Economic Research, NBER Working Paper No. 15351 (September 2009).

5 See Thomas Lemieux, W. Bentley Macleod and Daniel Parent, “Performance Pay and Wage Inequality”, Quarterly Journal of Economics (February 2009).

6 Kaplan and Rauh, “Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?” Review of Financial Studies (March 2010).

7 Johnson, “The Quiet Coup”, The Atlantic (May 2009).

8 See Thomas Philippon and Ariell Reshef, “Wages and Human Capital in the U.S. Financial Industry”, National Bureau of Economic Research, NBER Working Paper No. 14644 (January 2009).

Chapter 8

Democracy and Oligarchy

Jeffrey A. Winters

It is a confounding moment in American political history. On the one hand, evidence of democratic possibilities is undeniable. In 2008, millions of Americans helped catapult a man of half-African descent into the White House long before most observers thought the nation was “ready.” Democratic movements have won major victories in recent decades, spreading civil rights, improving the status of women and ending unpopular wars. This is the continuation of a trend with deep roots in American history, reaching back at least to the Jacksonian era, of extending the equality principle into American culture at large.

On the other hand, democracy appears chronically dysfunctional when it comes to policies that impinge on the rich. Despite polls consistently showing that large majorities favor increasing taxes on the wealthiest Americans, policy has been moving for decades in the opposite direction. Reduced taxes on the ultra-rich and the corporations and banks they dominate have shifted fiscal burdens downward even as they have strained the government’s capacity to maintain infrastructure, provide relief to children and the poor, and assist the elderly.

Everyone is by now aware of the staggering shift in fortunes upward favoring the wealthy. Less well understood is that this rising inequality is not the result of something economically rational, such as a surge in productivity or value-added contributions from financiers and hedge-fund CEOs, but is rather a direct reflection of redistributive policies that have helped the richest get richer, and such outcomes are inexplicable on standard, commonly understood democratic grounds. The tiny proportion of wealthy actors among eligible voters cannot account for the immense political firepower needed to keep winning these policy victories. While motivated and mobilized minorities—those organized over issues like gay marriage, for example—can sometimes win legislative victories despite broad opposition from the electorate, America’s ultra-rich all together could barely fill a large sports stadium. They never assemble for rallies or marches, sign petitions, or mount Facebook or Twitter campaigns. So how do they so consistently get their way?

One increasingly popular answer is that America is an oligarchy rather than a democracy.[1] The complex truth, however, is that the American political economy is both an oligarchy and a democracy; the challenge is to understand how these two political forms can coexist in a single system. Sorting out this duality begins with a recognition of the different kinds of power involved in each realm. Oligarchy rests on the concentration of material power, democracy on the dispersion of non-material power. The American system, like many others, pits a few with money power against the many with participation power. The chronic problem is not just that electoral democracy provides few constraints on the power of oligarchs in general, but that American democracy is by design particularly responsive to the power of money.

When democracy combines with oligarchy, the result is a distinctive fusion of equality and inequality. This is what sets the current debate about oligarchs and the power of the rich apart from the debate that erupted in the 1950s over “power elites.” The claim then was that the United States was dominated by a tiny segment of the population that commanded major institutions across society and shared privileges of status, education, access and comfortable living standards. Elite theorists like C. Wright Mills devoted great energy to mapping how the power elite were densely networked, and thus politically suspect.

Pluralists led by Robert Dahl at Yale responded by granting that American democracy had plenty of inequality built into it. Some actors and institutions were unusually powerful, but always in ways that were competitive and crosscutting. Pluralists argued that the linkages mapped by elite theorists did not amount to cohesion. Although various strands of elites constituted influential minorities, no pernicious or consensual political thread could be shown to run through them. There were powerful Republicans with the expected laissez faire proclivities, but there were also influential Democrats who paid homage to or were even evangelizers for the latter-day social gospel agenda. The conclusion was that American democracy had elites, but no coherent elite agenda.

The current focus on oligarchs is different. Unlike elites, who are empowered in diverse ways and are oriented toward diverse ends, oligarchs are defined more uniformly by the power of money. Concentrated wealth serves as both the source of oligarchic power and the motivation to exercise it. Unlike any other power resource, wealth unites oligarchs politically around a core set of shared interests because, throughout human civilization, great riches have always attracted threats. Whatever their political disagreements, oligarchs in America, as elsewhere, are motivated and connected by the desire to deflect threats to their fortunes. Being networked certainly augments the influence of oligarchs, but coordination is not the primary source of their political power.

Oligarchy should therefore be understood as the politics of wealth defense, which has evolved in important ways throughout human civilization. For most of history, this has meant oligarchs were focused on defending their claims to property. They did so by arming themselves or by ruling directly and jointly over armed forces they assembled and funded. Every great increase in wealth required oligarchs to spend additional resources on armaments, castles, militias and other means of defense. The greatest transformation in the politics of wealth defense and thus of oligarchy came with the rise of the modern state. Through its impersonal system of laws, the armed modern state converted individual oligarchic property claims into secure societal property rights. In exchange, oligarchs disarmed and submitted to the same protective legal infrastructure that applied to all citizens (in theory if not always in practice). Property rights offered reliable safeguards not only against potential antagonists without property, but also, no less important, against other oligarchs and the armed state itself that administered the entire arrangement.

This new formula for political economy had several major consequences. One was that it created the mistaken impression that there were no longer any oligarchs, only wealthy people with no shared political motivation; yet this illusion is proved false every time states in the modern era fail to protect property and wealthy people re-arm or hire private militias once again to do the oligarchic job themselves. Another consequence is that the transformation shifted rather than fully solved the broader problem of wealth defense for contemporary oligarchs. The legal state made property inviolable, but in many cases it also aggressively targeted income and, occasionally, wealth via taxation. This was “taking” of a different kind.

Indeed, progressive taxation is the unique challenge to oligarchs in democratic states. Heavier tax burdens on those most able to pay can theoretically retard the pace at which the rich enlarge their estates, and in extreme cases could even redistribute wealth downward. The story of oligarchy in America has unfolded as a titanic battle over wealth defense as oligarchs have sought to deflect tax burdens onto others in society. With tens of billions of dollars at stake annually, the struggle is politically charged for a small number of ultra-wealthy Americans. While its intensity has ebbed and flowed throughout American history, it is a battle oligarchs have been winning handily for the past several decades. Again, the question is why.

There tends to be considerable ideological tension in the United States when the discussion turns to money and power. The “class anonymous” packaging of liberal democracy has been so prevalent that many Americans balk at the mention of oligarchy and the anti-democratic power wielded exclusively by the ultra-rich.[2] The regrettable detour into power-elite theory only muddled the debate further. Yet the basic understanding that concentrated wealth confers concentrated power, whether in dictatorships or democracies, has a pedigree stretching back at least to ancient Greece. James Harrington observed in the 1650s that “where there is inequality of estates, there must be inequality of power.” Much influenced by Harrington, John Adams wrote in 1776 that “the balance of power in a society, accompanies the balance of property in land.”

Riches have always been a source of power, and nothing about modern societies or institutions fundamentally changes that reality. Neither the shift in wealth away from landed estates nor the achievement of universal suffrage has disrupted the fundamental nexus between money and power. The essence of oligarchy within democracy rests on the near-veto power oligarchs retain on threats to concentrated wealth. On all other issues, oligarchs’ views and positions are as disunited and democratically contested as those held by everyone else across the society. Thus, there is no oligarchic stance on abortion, immigration or the rights of women.

A full appreciation of oligarchy in America must begin with an estimate of how much material power is concentrated in the hands of a tiny minority. I call this a Material Power Index (MPI), which can be approximated using both income and wealth data. The MPI assigns a base value of one to the average material power position of Americans across the bottom 90 percent of the population. The MPI of the richest strata in society are a multiple of this base value. The accompanying tables provide a snapshot of MPIs for the United States based on recent income and wealth data. As can readily be seen, measured by income, oligarchs at the very top of American society have an MPI just over 10,000, which happens to approximate the MPI of Roman senators relative to their society of slaves and farmers. When measured by wealth, the MPI for the richest Americans is 30,000 (it jumps to 50,000 if home equity is excluded). The weakest American oligarchs have between 125 and 200 times the material power of an average citizen.

Beyond a certain level, the political meaning of these concentrations of material power becomes too enormous to fathom, for there is no precise algorithm for translating financial power into political power. An oligarch with $1 million to deploy politically for wealth and income defense is dramatically more powerful than someone who has only $100. But an oligarch with a spare $1 billion to deploy may not be a thousand times more powerful than one with $1 million. He may be more or less powerful depending on a host of other contextual factors. It is clear, however, that oligarchs in America, who constitute only a fraction of 1 percent of the population, have at their disposal material “voting” power that is hundreds, and in some cases tens of thousands, of times that of the average citizen. Such inequalities of power do not comport well with garden-variety notions of pluralism and democratic representation.

One might counter that despite these yawning asymmetries at the individual level, average citizens with a modest MPI of one can still muster the overwhelming power of their numbers in a democracy if they band together and pool their material resources, say, to vote for candidates favoring large social welfare programs. But poverty by itself neither motivates nor provides a core set of common interests for the poor the way wealth does for the rich. The presence of wealth focuses the political attention of the rich on wealth defense; its absence has no parallel effect on the poor or those of middling or lower than middling income. Wealth is inherently empowering and motivating; poverty is neither.

Thus, for the many to exercise their collective material power in a manner oligarchs can while operating solo, they must first be actively networked and coordinated and then remain in this state of mobilization over extended periods. This inverts the common argument that oligarchs are only potent politically if they form associations or conspire. In fact, the reverse is true. The vast majority of citizens exert very little concerted material power in politics. But a small number of individuals each have at their disposal the resources it would take tens of thousands of their fellow Americans acting in sustained coordination to match.

A final and daunting aspect of wealth’s power is that it buys armies of skilled professionals, not least lawyers and accountants, to pursue the core political and social interests of the rich. These intermediaries render the political engagement of oligarchs more indirect, obscure their power from view, and shield them from scrutiny and accountability. In democracies no less than in dictatorships, oligarchs experience virtually no disruption of their daily lives as they employ and deploy the best wealth defense money can buy. The duration and intensity of this oligarchic power is limited mainly by the scale of resources the richest Americans have at their disposal.

How has this power been expressed in the United States over the past century? The best window on oligarchy in America is the battle over taxes, which for oligarchs means the politics of income defense. Not surprisingly, this battle has also affected American income inequality writ large.

Over the course of the 20th century, two wrenching things happened within American democracy and oligarchy that together constitute the Great American Inversion. First, early in the century, steep new income taxes were imposed exclusively on the rich. By the end of the century, these same tax burdens had been shifted from the richest Americans to the various strata below them.

Second and related, there was a sharp reversal of economic momentum for average Americans and the rich. The average income of working-class Americans around 1920 doubled in real terms by 1955 and tripled by 1970. A growing American middle class was taking an ever-larger share of an expanding economic pie. Although the chasm separating the rich from the rest remained huge, ordinary citizens were closing the gap at a remarkable pace. But then this process stopped. In the four decades since 1970, there has been almost no improvement on average for the lower 90 percent of American households. Although the U.S. economy continued to grow, income stopped growing very much, and sometimes not at all, for average citizens. Adjusted for inflation, average household incomes in 2010 were almost exactly what they had been forty years earlier. They peaked and stopped in 1970 at “triple 1920.” Growth America became stagnation America.

The story was much different for America’s oligarchs. At first their wealth shot up significantly during the 1920s. They were also busy in that decade trying to roll back or deflect new taxes aimed at them. But then the Crash of 1929 hit them in the solar plexus. It is not that oligarchs went to the poorhouse like almost everyone else. The rich still enjoyed luxurious lives, but their real gains across the next several decades were modest. One instructive thing about this period of history is that oligarchic influence was weaker during deep political-economic crises and wars than it was during the “politics of the ordinary” between crises. It took decades after 1945 to reverse the relative leveling effects of the Crash, the New Deal and the embryonic welfare state of the Great Society.

During the long arc from 1920 to 1970, the top 1 percent of American families moved up at barely half the pace of the average household. The very richest families (the top 0.1 percent and 0.01 percent) were having a hard time grabbing a larger share of the growing income pie for themselves. By 1955, the real incomes of these two top strata were actually 20 percent lower than their 1915–20 level. It was not until 1970 that the ultra-rich were earning roughly the same real incomes they had enjoyed half a century earlier.

And then, as suddenly as the improvements had come for mainstream society, a new bonanza for the ultra-rich commenced. The decade from 1970–80 was the turning point in the Great American Inversion. This is when the boom for the average household turned to bust and the rich soared after decades of treading water. It is as if a big pause button had been hit in 1970 for the bottom 90 percent at the same moment the fast-forward button clicked on for oligarchs. The cumulative effect was breathtaking. By 1990, real incomes for the top 1 percent exceeded the 1920 level threefold and continued to rise thereafter, while those of the majority did not budge. Reversing the pattern of previous decades, the richer you were, the faster gains accrued. It did not matter if Democrats or Republicans were in charge of the White House or Congress. By 2007, the top 1 percent of households had almost five times the real income they had in 1920; the top 0.1 percent had around six times, and the top 0.01 percent were awash in nearly ten times the real income they had enjoyed nine decades earlier. The tables had turned.

Many analysts have pointed out the role of globalization, higher international capital mobility and the related decline of unions in causing this reversal of fortunes. What has gone largely unnoticed is the compounding effect on these trends due to the increasingly aggressive strategies of wealth defense on the part of oligarchs. As the United States was becoming a tiger economy exclusively for the rich, tax burdens on American oligarchs grew lighter by the decade. Meanwhile, tax burdens on the strata below grew more regressive as average Americans went from seeing rapid gains to being mired in economic molasses and rising debt.

It is impossible to make sense of these transformations without understanding how oligarchic power operates within American democracy. A crucial part of the inversion story starts at the end of the 19th century. In an unprecedented blow to an emerging stratum of American industrial oligarchs, Congress passed a new Federal income tax law in 1894 aimed narrowly at the richest fraction of taxpayers. All but 0.1 percent of citizens earning below a threshold of $100,000 in today’s dollars were exempt. Alarmed oligarchs quickly hired teams of lawyers, who took the law to the Supreme Court, which struck it down in a 5-4 decision that referred to the tax as a “communistic threat.” Although oligarchs won this round, the law confirmed their fears about extending democratic voting rights to those too far down the national wealth pyramid.

The high court protected oligarchs for the next 18 years until the Sixteenth Amendment was passed in 1913, after which a Federal income tax was again imposed exclusively on the top 1 percent of earners. Oligarchs immediately began to explore new modes of income defense, particularly after World War I, which caused the highest rate to leap from 7 percent in 1915 to 77 percent in 1918 (the number of brackets went from seven to 56 over the same period). They fought on two fronts.

First, oligarchs pressured legislators to meet the Federal government’s demand for revenue by reducing the number of brackets, lowering the rate of the highest bracket and shifting the entire structure downward to capture more revenue from the merely well-off and less from the ultra-rich. Although the “mass affluent” had much larger numbers (which ought to count for something in a democracy), individually they lacked the financial firepower oligarchs possessed to influence policy outcomes. Unable to band together, the mass affluent saw their tax burdens rise in tandem with tax relief for the very richest Americans.

The second front was a bold tax strike on the part of oligarchs through tax avoidance and outright evasion. Although there were not that many oligarchs for tax collectors to pursue, they each had formidable resources to hire lawyers and other professionals to mount a vigorous defense. If the government wanted their money, they were going to make it costly and politically risky to get it. Between 1916 and 1925, tax filings by the rich dropped by an average of 50 percent. In the worst year, 1921, tax filings plunged to an average of 19 percent of their 1916 level. The richer the oligarch, the lower the compliance rate. Americans making more than $1 million per year in 1921 filed at just 10 percent of the rate they did in 1916. This resistance by the ultra-rich was so pervasive that it prompted Congressman Ogden Mills (R-NY) to complain, “We collected as much at [a tax rate on the rich of] 10 percent in 1916 as we did at 65 percent in 1921.” By contrast, taxpayers in the “mass affluent” category lacked the resources and nerve to defy the Federal government. Cowed into paying, their filing rate actually increased by 32 percent between 1916 and 1925.

The government faced a difficult choice. Basically, it could either beef up law enforcement against oligarchs and design better systems to track and tax their incomes to force them into compliance, or abandon the effort and instead squeeze the same resources from citizens with far less material clout to fight back. Despite the daunting complexities of taxing wider swaths of the population (and the risks of doing so at election time), the government capitulated to the wealthy few. Beginning with deep tax cuts on oligarchs enacted in 1921, 1924 and 1926, the single most progressive economic policy ever enacted in U.S. history—an income tax exclusively on the rich—was slowly inverted into a mass tax that burdens oligarchs at the same effective rate as their office staff and landscapers.

Pleased with how well their exercise of power had worked, oligarchs rewarded the Federal government for the tax cuts by once again agreeing to file tax returns. One analysis of the period notes that the effect of lower taxes on the willingness of the rich to file returns was “more dramatic the higher the net-income tax class.”[3]

It is noteworthy that from 1913 until 1939 the battle over this new income tax unfolded exclusively among the different components of the rich. It was a narrowly oligarchic tax only during the first four years. On average, across these decades the tax fell on just 10 percent of income earners. In no year before 1940 did it ever involve more than 17.3 percent.

This point matters in debates about who gets what in democracy, and whether there are significant forms of power affecting outcomes that have little to do with democratic equality, representation and voting. One key argument about why the bottom strata of American society, despite their large numbers, fare so badly in economic policy struggles is that the poor lack resources, education and political skills. This reasoning, however, collapses when applied to the pitched battle over who would shoulder the Federal income tax burdens between the two world wars. A tiny number of powerful oligarchs succeeded in convincing legislators to shift tax burdens to the affluent strata immediately below them, a group a hundred times as numerous and hardly lacking in education and political skills. Democratic participation theory cannot explain oligarchic success in this case.

A far better explanation lies in the realm of material power. It is the difference in their MPIs that allows a small number of oligarchs to defeat a much larger number of citizens below them. As we’ve seen, Americans just above the 90th income percentile have MPIs ranging from four to seven. Oligarchs in the top 0.1 percent have MPIs starting at 125 and going as high as 10,300. The intensity of this material power amplified oligarchs’ complaints, made them more intimidating politically, and enabled their tax defiance in 1921. Oligarchs succeeded in getting their taxes reduced from the 70 percent range to just 25 percent. The top bracket held at this level until 1931, when a series of crises weakened oligarchs and increased the government’s need for resources. The 1929 Crash, the Great Depression and World War II combined to increase the top bracket to 63 percent in 1932, 81 percent in 1941 and a peak of 94 percent in 1944. Income taxes on the richest Americans remained above 90 percent until 1964—and that includes the two terms of the Republican Eisenhower Administration—and above 70 percent thereafter until 1981.

Although the Depression (thanks to the advent of Social Security and the new infrastructure for collecting payroll taxes) and especially World War II caused Federal income taxes to be imposed at the mass level for the first time, the rising tax rates on oligarchs and the strength of unions combined to help double and then triple average real incomes for the bottom 90 percent of the population, while the richest saw no gains at all. High taxes on what today are often self-interestedly called the “job creators” did not prevent jobs from being created. But they did retard the rate at which the richest could get even richer.

This account of the first half of the 20th century prompts an important question: If oligarchic power works especially well behind the scenes during the “politics of the ordinary”, while crises like war and financial collapses tend to undercut this power, why have oligarchs been able to maintain the Bush tax cuts (which reduced the top rate to 35 percent) and win other battles despite the devastating economic crisis of recent years?

The answer lies in a major innovation in how oligarchs flexed their wealth muscle starting in the 1960s and 1970s. This was when the income defense industry arose in America to fight against taxes and other policies that restrained the ability of oligarchs to increase their share of national income and wealth. This industry is similar to the legal apparatus oligarchs deployed in 1895 to reverse the income tax, and the tax evasion methods employed to get the 1920s tax cuts, but it is now greatly amplified.

The income defense industry is comprised of lawyers, accountants, wealth management consultants, revolving-door lobbyists, think-tank debate framers and key segments of the insurance industry whose sole purpose is income defense for America’s oligarchs. The industry is wholly funded by oligarchs, and it would simply not exist if oligarchs did not have massive fortunes to defend. There is no parallel (much less countervailing) industry serving the material interests of the mass affluent, the middle class or the poor. The activities of the income defense industry extend far beyond mere “interest group” lobbying over policies. Its salaried specialists assist oligarchs in exerting a form of power that is unique to the ultra-rich: the defensive redeployment of their money and income across a global geography of jurisdictions, banks and offshore havens through the use of tailor-made tax instruments, evasive trusts and shell corporations.

The industry operates almost exclusively by referral and serves only high net-worth individuals who have at least $2 million in investable financial assets, and especially ultra high net-worth individuals with holdings of $30 million or more. The industry is global in its spread and integration. Top-tier players like Whithers, Clifford Chance, Linklaters, White & Case, Milbank Tweed Hadley and McCloy, Weil Gotshal and Manges, and Freeman Freeman and Smiley are known in the trade as “magic circle” firms. They help coordinate relationships with accounting firms and other weapons in the wealth defense arsenal.

The most strategic theater is taxes, with combat conducted on two fronts. The first is the effort to lower the published top tax rate as much as possible and also to set the income threshold for the top bracket low enough that large numbers of relatively modest income earners feel the oligarchs’ pain. The second front is making the spread between the published tax rate and actual (or “effective”) taxes paid as wide as possible. This is one of the most important and costly fights the income defense industry wages on behalf of its oligarchic patrons. In the 1970s, oligarchs paid an average effective tax rate of about 55 percent, which was almost 80 percent of the top published rate. By 2007, the top 400 income earners in America paid an effective tax rate of 16.5 percent, which was barely 50 percent of the top published rate. Thus, the industry delivered lower tax rates on which oligarchs paid a lower proportion. The richer the client, the wider the income defense spread achieved.[4]

The income defense industry’s capacities improved throughout the 1970s and 1980s. As it grew stronger, the results the industry achieved for the ultra-rich were spectacular. Navigating through the almost 72,000 incomprehensible pages of tax code they had helped draft, industry specialists today structure complex partnerships and tax shelters that few IRS auditors can disentangle, or in some cases even fully understand. The richest Americans pay fees ranging from $300,000 to $3 million for lawyers to sort through the tax code and produce “tax opinion” letters (an instrument only those who can afford to buy them have ever heard of). Their purpose is to justify enormous non-payments of taxes that straddle the murky (and therefore costly to enforce) line between tax avoidance and tax evasion. These letters are among the most important weapons for pushing down the effective tax rate and increasing the income defense spread.

The U.S. Senate estimates that the income defense industry helps America’s oligarchs avoid paying about $70 billion in taxes a year through what the IRS calls “abusive offshore tax avoidance schemes” alone.[5] This is a sum equal to the boon the Bush tax cuts give to the entire top 2 percent of income earners (a group twenty times as numerous as America’s oligarchs), and it does not include losses from similar schemes employed by corporations.

The income defense industry, attached symbiotically to the nation’s richest citizens, has fortified the material power and influence of oligarchs. It has enabled them to fight much more tenaciously even in the face of deep crises that, in earlier decades, delivered serious setbacks to their broader wealth defense agenda. Although oligarchs still operate mostly atomistically, their common deployment of a highly networked and organized industry lends their actions an unprecedented degree of unity. Combined with weakened unions and considerably less political unity among average citizens, America’s oligarchs are arguably more powerful today even than during the robber baron era at the turn of the 19th century.

“America does not have oligarchs, it has rich people”, declared one of my seminar students at Northwestern University. This could only be true if wealth were somehow stripped of its inherent political potency. Whatever else American democracy has achieved, it has not managed this. Rather, oligarchy and democracy operate within a single system, and American politics is a daily display of their interplay. Indeed, it is a misreading of oligarchic theory dating back to Aristotle to view oligarchy and democracy as mutually exclusive, or to suggest that democracy is a sham if oligarchs exist and exercise their power routinely and effectively. Aristotle called for an ideal political system, the polity, that combines oligarchy and democracy so deftly that “there should appear to be both elements and yet neither.”

Universal suffrage and liberal freedoms empower all citizens in a radically equal manner. But the one-person/one-vote principle does little to prevent oligarchs from exercising the power of money in a manner that is profoundly unequal. Formal juridical equality is essential to human freedom. But full political equality, even in the most liberal democracy, is impossible as long as concentrated wealth places grossly unequal political influence in the hands of a few citizens. Democracy fused with oligarchy is certainly better than no democracy at all. But there should be no illusions that it is anything other than a partial step toward full political equality and representation.

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Jeffrey A. Winters is professor of political science at Northwestern University and author of Oligarchy, (Cambridge University Press, 2011).

1 Simon Johnson, former chief economist of the International Monetary Fund, wrote of the “the reemergence of an American financial oligarchy” in “The Quiet Coup”, The Atlantic (May 2009); Columbia University historian Simon Schama, in Scribble, Scribble, Scribble: Writing on Politics, Ice Cream, Churchill, and My Mother (Ecco, 2011), suggests that “the United States Inc. is currently being run by an oligarchy, conducting its affairs with a plutocratic effrontery which in comparison makes the age of the robber barons . . . seem a model of capitalist rectitude.”

2 This term is from John P. McCormick’s book Machiavellian Democracy (Cambridge University Press, 2011). “Class anonymous” democracy ignores the highly distorting power of the ultra-wealthy. He argues that electoral democracy alone cannot safeguard the economic interests of the many against America’s oligarchs. In reaching this conclusion he echoes, of all people, William Graham Sumner.

3 Gene Smiley and Richard H. Keehn, “Federal Personal Income Tax Policy in the 1920s”, Journal of Economic History (June 1995).

4 See Winters, Oligarchy, figure 5.5.

5 “Tax Haven Banks and U.S. Tax Compliance”, Staff Report, Permanent Subcommittee on Investigations, United States Senate, July 17, 2008. Also see “Closing Tax Loopholes”, levin.senate.gov (2010).

Chapter 9

Measuring Secrecy

John Christensen

The Financial Secrecy Index (FSI), developed by the Tax Justice Network in 2008, ranks jurisdictions based on the opaqueness of their financial markets. Put more crudely, the FSI, designed to complement Transparency International’s Corruption Perceptions Index, ranks the world’s tax havens, or secrecy jurisdictions.

Developed in cooperation with government officials, researchers and civil society organizations from many countries, the FSI uses only publicly verifiable sources. It combines two measures—one qualitative, one quantitative. The qualitative measure is an Opacity Score based on existing laws, regulations and treaty information. The quantitative measure weighs each jurisdiction based on the scale of the offshore financial services it hosts. The Opacity Score is the more important of the two. Using an assessment of how aggressively a jurisdiction provides secrecy facilities, the score highlights specific features likely to attract illicit financial flows.

The degree of opacity is assessed using 12 indicators grouped into three themes: transparency of ownership information, transparency of corporate activity and engagement in international cooperation to combat harmful practices.

Once an individual jurisdiction assessment has been completed, the aggregated results are arithmetically squared to emphasize differences in transparency among jurisdictions. This emphasis is important, since even small differences in the secrecy on offer can facilitate significant volumes of illicit financial flows. Finally, the values are normalized by dividing through by 100, giving an Opacity Score between 0 (absolutely transparent) and 100 (absolutely opaque).

The quantitative data, weighting each secrecy jurisdiction according to the scope of its cross-border financial services activity, uses either IMF data on cross-border trade in financial services or, where that data is unavailable, estimates of holdings of foreign portfolio assets. The quantitative and qualitative datasets are combined arithmetically by simple multiplication.[1]

A jurisdiction with a larger share of the offshore finance market and a moderate degree of opacity might receive the same overall ranking as a smaller but more secretive jurisdiction. The reasons are clear: The index reflects not only secrecy but also scale. In this way, the FSI provides an objective and politically independent assessment of how secrecy jurisdictions facilitate and encourage illicit financial flows.

The results of FSI calculations are somewhat surprising. For decades it has been popularly believed that bank secrecy such as that offered by Austria, Luxembourg and Switzerland is the touchstone of offshore financial skulduggery. But a range of other mechanisms can achieve the same end. Offshore trusts, for example, or certain kinds of anonymous companies offered by places like Delaware in the United States, are used to disguise identities and ownership in far more devious and effective ways than bank secrecy alone.

Assessed on the prevailing combination of Federal and state laws and regulations, the United States receives a 92 percent Opacity Score. Given its huge scale of cross-border financial services transactions, it ranks as the world’s number one secrecy jurisdiction, with Delaware noted in particular for its corporate secrecy and lack of judicial cooperation in information exchange. Luxembourg ranked second, followed by Switzerland, the Cayman Islands and the City of London.[2]

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John Christensen is a development economist. He has researched tax havens and tax policy for many years.

1 A fuller description of the index methodology is available at www.financialsecrecyindex.com/documents/FSI-Methodology.pdf.

2 Despite an Opacity Score of 42 percent, ranking it most transparent overall, London featured high on the index because of its predominant role in global offshore financial services. London sits at the hub of a global network of highly opaque jurisdictions, including the British Virgin Islands, Cayman Islands and Channel Islands—all intricately linked to London through British Empire attachments—which cumulatively account for half of the secrecy jurisdictions assessed by the index.

Chapter 10

Too Big to Fail: The Prequel

H.W. Brands

At the heart of the continuing debate over the efforts of the U.S. government to stabilize the financial system and revive the economy lies the question of when, if ever, a bank or other corporation becomes so large that its failure poses an unacceptable risk to the nation’s well-being. The Bush and Obama Administrations determined that Fannie Mae, Freddie Mac, AIG and General Motors, to cite four of the most conspicuous examples, were “too big to fail” and therefore required Federal rescues, lest the collateral damage of their demise pull down the national economic house upon the innocent.

To read and hear most of the commentary about the “too big to fail” phenomenon, including that by a score or more Senators and Congressmen, one might think the phenomenon and the debate are recent—the result of globalization, perhaps, or of the repeal of the 1933 Glass-Steagall Act a decade ago, or of the folly of credit-default swaps and other examples of what Warren Buffet has called “financial weapons of mass destruction.” In fact, the debate over what constitutes excessive size in corporate entities, and what ought to be done when corporations achieve such size, is more than a century old.

The arguing began with the emergence of the trusts in the late 19th century. These industrial behemoths—railroad companies first, followed by combines in oil, steel, tobacco, sugar, insurance, banking and a dozen other industries—outgrew the institutions of government that had overseen their predecessors in the preindustrial age. In the persistent contest between capitalism and democracy, they tilted the field sharply in capitalism’s direction. Democracy struck back, or tried to, with the Sherman Antitrust Act of 1890, but the courts interpreted the law in such a capitalist-friendly fashion that the only combinations effectively constrained were labor unions. In the early 20th century, the courts became somewhat more sympathetic to Progressive anti-trusters. In 1911, the Supreme Court mandated the breakup of John D. Rockefeller’s Standard Oil. Yet the verdict, while welcome to the foes of big business, left considerable doubt as to what precisely made bigness bad in the corporate world.

The question became a pivot of the 1912 presidential race. Progressivism—modern-day liberalism minus the concern for racial and ethnic equality—was the prevailing motif. The two leading candidates, Woodrow Wilson and Theodore Roosevelt, embraced the progressive idea that democracy needed to seize back some of the territory captured by big capitalism during the previous decades.

Wilson won the Democratic nomination the old-fashioned way, by beating Champ Clark in a marathon convention at Baltimore. The Democrats’ two-thirds rule, dating from the Jacksonian era, was supposed to ensure party unity behind the standard-bearer; in this case it did, but not without also guaranteeing that delegates would be exhausted for weeks afterward and confused as to what they had agreed upon. Roosevelt lost the Republican nomination in novel fashion. Party primaries were just then coming into practice, a sop from the party bosses to the rank and file. The primaries registered preference but carried little weight, as the bosses still controlled the nomination. Thus Roosevelt, despite multiple primary victories over Republican incumbent William Howard Taft (whom TR himself, while President-boss of the GOP, had selected as his successor), got the cold shoulder at the Chicago convention. Roosevelt thereupon bolted the Republicans for the Progressives, who happily accepted the nickname “Bull Moose” when Roosevelt likened his ruddy good health to that of the antlered beast.

The contest between Roosevelt and Wilson—the two quickly left Taft behind—showcased their contrasting personalities and views of great size in the capitalist sector. Roosevelt had tangled with the trusts personally. Upon assuming the presidency in 1901 after the assassination of William McKinley, he announced that he would break up the Northern Securities railroad trust, J. P. Morgan’s latest brainchild. Morgan had dealt with previous Presidents as equals, and he was incensed to be treated as a mere citizen by this unelected cowboy. He traveled in his private rail car to Washington and insisted on an interview with the President. “If we have done something wrong”, he told Roosevelt, “send your man to my man and they can fix it up.”

“That can’t be done”, Roosevelt replied. Philander Knox, a former railroad lawyer and now Roosevelt’s Attorney General, seconded, “We don’t want to fix it up. We want to stop it.”

“Are you going to attack my other interests?” Morgan demanded. “The steel trust and the others?”

“Not unless we find out that in any case they have done something that we regard as wrong”, Roosevelt said.

Roosevelt’s remarks to Morgan summarized his attitude toward the trusts. He had no animus against capitalists as such. “We cordially believe in the rights of property”, he declared in the run-up to the 1912 campaign. “Normally, and in the long run, the rights of humanity, the rights of mankind, coincide with the rights of property.” Nor was Roosevelt intrinsically opposed to corporate bigness, which he considered an integral part of the modernization process. “Combinations in industry are the result of an imperative economic law which cannot be repealed by political legislation”, he said. Bigness could be benign when its economies of scale allowed ordinary men and women to raise their standard of living. “The past century has been one of gigantic material prosperity, of gigantic accumulation of prosperity.” But big businesses weren’t always benign, as Roosevelt saw it, and when they weren’t they had to be chastised, occasionally even dismantled.

Roosevelt’s reputation as a trustbuster was overblown; he employed the breakup option quite selectively, to remind the corporate barons that in the end democracy, not capitalism, set the rules for the American political economy. In the long intervals between the exemplary amputations, he relied on careful regulation of big business. “The effort at prohibiting all combination has substantially failed”, he said. “The way out lies, not in attempting to prevent such combinations, but in completely controlling them in the interest of the public welfare.”

Roosevelt called his approach the “New Nationalism”, and its essence was his desire to employ the power of big government to offset the power of big business. Roosevelt proposed strengthening Federal regulatory agencies and in some cases creating new agencies, like the Food and Drug Administration, in order to ensure that Washington possessed the expertise to understand the machinations of the trusts and the authority to keep them in line. The goal was to harness the efficiency of big business and put it to the service of the national good:

The great captains of industry do well and are entitled to great rewards only in so far as they render great service; they are invaluable as long as they in good faith act as efficient servants of the public; they become intolerable when they behave as masters of the public. The corporation is the creature of the people; and it must not be allowed to become the ruler of the people.

Woodrow Wilson had no such confidence in the ability of government to control big business. He lacked Roosevelt’s taste for power, in part because he himself had never possessed enough of it to matter. His career in academia had culminated in the presidency of Princeton University at a time when university presidents were respected public figures, but he nonetheless understood the basic irrelevance of his experience for the larger world. He was said to have coined the since-ubiquitous observation about campus politics, that the fights are so bitter because the stakes are so small.

Wilson’s upbringing, too, had made him skeptical of power. Born in Staunton, Virigina, he was a boy in Georgia during the Civil War and a young man at the end of Reconstruction. Power to him meant the destructive and coercive capacity of the North. To the extent power could be positive, it ought to be moral power or—a favorite for one who studied history’s great orators—rhetorical power.

Wilson rejected Roosevelt’s formula for enhancing government power to offset corporate power. Instead, he insisted that corporate power be diminished. Where Roosevelt distinguished between good trusts and bad trusts, Wilson believed the trusts were all bad precisely because they were trusts—that is, entities so large that they subverted the rules of the marketplace. “The center of all of our economic difficulties is that there is not freedom of enterprise in the United States”, Wilson declared during the 1912 campaign. The creators of the great trusts—Morgan, Rockefeller and the rest—had strangled the competition that provided capitalism’s principal justification:

The inventive genius and initiative of the American people is being held back by the fact that our industrial field is so controlled that new entries, newcomers, new adventurers, independent men are feared, and if they will not go partners in the game with those already in the control of it, they will be excluded.

Roosevelt was wrong to accept trusts as inevitable, Wilson said. They had emerged not on account of any irresistible technological trends, but because government had been asleep. Awake, government must not cohabit with the trusts; it must dismantle them. Great size in business was inherently dangerous, Wilson believed. The danger would persist until the trusts were eliminated, and their elimination would restore a vital aspect of the American dream:

What I am interested in is laws that will give the little man a start, that will give him a chance to show these fellows that he has brains enough to compete with them and can presently make his local market a national market and his national market a world market, and put them to their mettle to do the business more intelligently and economically and systematically than he can.

Acceptance of bigness was a bargain with the devil, Wilson said. Americans must choose:

Here at the turning of the ways, when we are at last asking ourselves, ‘Can we get a free government that will serve us, and when we get it, will it set us free?’ They say, ‘No, you can’t have a free government, and you ought not to desire to be set free. We know your interests. We will obtain everything you need by beneficent regulation. It isn’t necessary to set you free. It is only necessary to take care of you.’ Ah, that way lies the path of tyranny; that way lies the destruction of independent, free institutions.

The choice for voters in 1912 between two philosophies for dealing with great size in business—between Roosevelt’s confidence that the trusts could be regulated and Wilson’s insistence that they be broken up—would have been clearer in a two-candidate race. But murky or not, Wilson’s comfortable victory over Roosevelt (and Taft) allowed him to claim a mandate to act on his distrust of big business.

In the event, however, he moved slowly, governing in certain respects more like Roosevelt than like the President he had promised to be. Some of his change of heart reflected the ambition-creep that often occurs when outs become ins. Wilson discovered that power wasn’t so scary when he wielded it, and rather than bust up business he decided to bulk up government. The Federal Trade Commission, established in 1914, could have come straight from a Roosevelt blueprint—in fact, it built on TR’s own idea of a Bureau of Corporations. The FTC set rules for fair trade and prescribed penalties for breaking the rules. Rather than restore the competition of the pre-trust era, as Wilson had pledged to do, it regulated the competition of the trust era, as Roosevelt had recommended. Size wasn’t the issue, Wilson belatedly determined; behavior was.

Yet the flip-flop wasn’t Wilson’s doing alone. The world changed dramatically during his first term; the summer that saw passage of the law establishing the FTC also witnessed the descent of Europe into war. One of Roosevelt’s arguments for letting American businesses get big was that American defense required the efficiencies only big industry could deliver. War had been on few voters’ minds in 1912; had it been, Wilson would not have won. But two years later, war was on everyone’s mind, and Wilson decided, quietly to be sure, that the Rough Rider had a point. And after America eventually entered the war in 1917 and Wilson sought to mobilize the American economy for that struggle, he appreciated that directing a few big corporations in a given industry was easier than herding a myriad of smaller firms.

In one crucial respect, though, Wilson delivered on his pledge to disarm the trusts. The most important law passed during his tenure was the Federal Reserve Act of 1913, which essentially resolved the most persistently vexing question of American political economy from independence to the early 20th century. This was the money question, which came in two parts: What was money in America, and who controlled it? Was it gold, silver, greenbacks, bank notes or something else? (At one time or another it had been all of these things.) Did the government control it, or did private bankers? (Both had played a part.) The battle raged for decades, pitting advocates of gold against partisans of silver, national bankers against state bankers, lenders against debtors, capitalists against democrats. And it was understood at the time that this was a battle whose outcome would shift economic advantage to the side that prevailed; huge sums of money, relative to the size of the economy, were at stake.

The fight came to a head near the end of Roosevelt’s presidency. In October 1907, the Knickerbocker Trust Company of New York announced that it couldn’t meet its obligations. The news caused panic on Wall Street and threatened to paralyze credit across the country. The government lacked the tools and authority to stem the crisis. TR for once was at a loss for both words and action. Into the breach stepped the private titan of finance, J. P. Morgan. Morgan summoned the big bankers of New York and lectured them on their duty to themselves and to the solvency of the nation. He extracted sufficient new money from them to stabilize the situation and then proceeded to lecture the American people on what they needed to do. “If people will keep their money in banks”, Morgan said, “everything will be all right.”

Morgan’s intervention bought time, but a fresh threat emerged when the City of New York itself declared that it couldn’t pay its creditors. Morgan promised the needed funds in return for control of the city budget. City officials reluctantly acquiesced.

To complete his rescue package, Morgan called the presidents of the major trust companies to his private library and locked the doors behind them. The air grew foul with their cigar smoke as the tension mounted, but gradually they reached an agreement that let them live to speculate another day. A final holdout, Edward King of Union Trust, balked almost till the end. “Here’s the place, King”, Morgan growled, pointing to the document the others had signed. “Here’s the pen.”

Morgan’s rescue of the financial system won him the gratitude of the nation, but only briefly. Americans learned that Morgan had negotiated some sweetheart deals for himself amid the fright, and in any case most Progressives thought that in a democracy no capitalist should wield the kind of power Morgan did. Congress commenced hearings into the “money trust”, and Morgan was called as a witness. He refused to cooperate, obstinately asserting that his business was his affair alone. The committee compiled a report demonstrating the extraordinary influence Morgan and a handful of other big bankers exerted upon the American economy by means of interlocking directorates, shared ownership and numerous other leveraging devices. The committee declared that the safety of the nation required that the money trust be neutralized. “The peril is manifest.”

The Federal Reserve Act of December 1913 was the Progressives’ response. It wrested control of the nation’s money supply from the hands of the bankers and delivered it to the Fed. The wresting killed off the system Morgan had created—and killed off Morgan, too, according to friends who blamed the congressional inquisitors for breaking the old man’s health and precipitating his sudden and otherwise inexplicable death in March 1913.

The Fed provided the Progressive era’s answer to the question of when big is too big, at least in the critical realm of finance. Strikingly, the answer followed not a failure of the old system but a success—a success, however, that showed a degree of dependence on unelected, private individuals that Americans decided was unacceptable.

Our age is, by most measures, less progressive than that of Roosevelt and Wilson. It is also, at least in some respects, less candid about the differential effects of various ways of organizing the nation’s financial infrastructure. And it is perhaps more resigned to limits on the flexibility of public policy. In 1912, Wilson, at least, believed that a democratic polity could determine the character of its own economic arrangements and that those determinations could be based on political agency in the best sense of the term. Today, however, as the desultory history of 20th-century anti-trust legislation and litigation shows, most American lawmakers act as though their hands are tied in the face of technological inevitability.

This suggests that such radical reform of the financial sector as Congress mandated in 1913 is unlikely. Yet the arguments of the Progressives still resonate, and their boldness in tackling the money trust ought to give courage to those today who confront similar concentrations of power. President Obama has been compared to Franklin Roosevelt; certainly, the situations the two Presidents inherited have often been noted. But perhaps just as useful a comparison is Obama and Wilson—both the ambitious Wilson of the 1912 campaign and the more circumspect Wilson who occupied the White House. Ambition and circumspection combined in Wilson to produce the Fed; what they might yield for Obama remains to be seen.

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H.W. Brands teaches history at the University of Texas at Austin. His latest book is Traitor to His Class, a biography of Franklin D. Roosevelt.

Chapter 11

Hedging Risk

Sebastian Mallaby & Matthew Klein

It has been four years since the demise of Lehman Brothers and the ensuing rescue of incumbents in the U.S. financial sector. Many Americans are still furious that their government helped the rich and politically connected few while leaving the rest hung out to dry. The government bailed out Wall Street financiers who live in the top tenth of the top hundredth of the income distribution. Meanwhile, almost one quarter of families with mortgages remains stuck with negative equity in their homes.

Of course, the bailout was necessary: After Lehman collapsed the world economy quickly buckled, proving that the government would not have done ordinary Americans any favors if it had left other financial institutions to go down as well. But there can be no doubt that welfare for the well-to-do is corrosive to American capitalism and democracy. In an interview on 60 Minutes in December 2011, President Obama protested that he “did not run for office to [bail] out a bunch of fat cat bankers on Wall Street.” Yet bail them out is what he did.

The Treasury likes to say that it has made money on many of its rescues. It points out that its direct injections of equity into financial institutions, conducted under the $700 billion Troubled Asset Relief Program (TARP), will end up costing taxpayers remarkably little—according to Treasury Secretary Tim Geithner, less than $50 billion, although this estimate is contingent on the Treasury’s ability to sell its remaining stakes in AIG, Citigroup and General Motors at valuations that many private sector analysts consider to be wishful. Geithner has called TARP “one of the most effective emergency programs in financial history”, while Steve Rattner, the Wall Streeter who oversaw the Obama Administration’s rescue of the auto sector, affirms that, “without exaggeration, this legislation [establishing TARP] did more to keep America’s financial system—and therefore its economy—functioning than any passed since the 1930s.” The message is that, rather than being denounced as politically corrosive, the bailouts should be celebrated as a bargain—a fantastically cheap victory against the threat of a second Great Depression.

Geithner and Rattner may be partially correct. The government is likely to resell its stake in Citigroup, for example, for more than it paid in the depths of the crisis. But the omens are less good on its other big gambles. AIG has raised nearly $37 billion from selling foreign operations, but that will not be sufficient to repay the more than $180 billion that it received from the American taxpayer. Meanwhile, despite the triumphalism that accompanied the November 2010 IPO of General Motors, the government only sold half its stake. To break even, the remainder would have to be sold at an average price more than 60 percent higher than its November 2010 market valuation.

Even if the government could emerge with a profit from these deals, the “bargain bailout” narrative would still be a false one. For one thing, as Rattner acknowledges, the TARP bailouts should have ended up costing even less than they did. In the heat of the crisis, the government provided capital when nobody else was willing to do so. It therefore had a right—indeed, it had a duty to taxpayers—to impose commensurately tough terms. It did no such thing. Instead, the government often provided its rescue funds at highly concessional rates. Three weeks before Goldman Sachs received $10 billion of TARP money, for example, it raised $5 billion from Warren Buffett on far more expensive terms.

Furthermore, the government has been willing to renegotiate its deals with bailed-out firms at taxpayer expense. As of this writing, it has altered the terms of the AIG bailout three times. All in all, by providing subsidized capital during the crisis, the government was enriching shareholders and protecting incumbent managers in the financial sector. In this sense there is a grain of fairness in the verdict reported by opinion pollsters: 58 percent of Americans deem TARP an “unneeded bailout.”

Moreover, direct capital injections under the TARP program were only the smallest part of the broader government bailout of the American financial sector. The rescue also came via accommodative monetary policy. Low interest rates drove Wall Street’s cost of funds to zero, allowing banks to lock in easy profits. They could borrow from the Federal Reserve at zero percent and buy a Treasury bond yielding 3 percent: Simply by borrowing short-term money from one branch of the government and lending it back as long-term funds to another branch, they could generate profit without incurring any risk.

Meanwhile, even as it pushed short-term interest rates to zero, the Fed purchased trillions of dollars of mortgage securities and Treasury bonds. The stated purpose was to stimulate the broad economy by driving down long-term interest rates. But this policy created a further windfall for anyone who owned mortgages and Treasuries—namely, the banks. Any full accounting of the costs of the bailout must reckon with this part of the policy. After all, zero interest rates come at the expense of ordinary savers.

The government’s rescue of Wall Street also included the extensive use of asset guarantees. These guarantees were extended to more than $5 trillion of debt issued by government-sponsored mortgage insurers Fannie Mae and Freddie Mac, more than $306 billion of Citigroup assets and the nearly $3.5 trillion in the money market funds that provide short-term financing to the country’s major corporations and financial institutions. These guarantees amounted to free, unbudgeted assistance to Wall Street and big business: Holders of impaired bonds were spared losses, and issuers of impaired bonds were saved from being shut out of the market, a calamity that might have forced many of them under. Taxpayers have already paid more than $140 billion to cover losses on the debt of Fannie and Freddie, and Congress has voted to remove the $400 billion cap on taxpayer liability for future losses.

The government’s guarantees were perhaps most controversial in the AIG case. AIG Financial Products had written insurance contracts against the default of more than $100 billion worth of bonds and sold these credit default swaps to large investment banks around the world. Had AIG gone into bankruptcy proceedings, the value of these contracts would have been written down to perhaps 65 percent or so of face value, imposing losses on anyone who owned them. But the government declined to impose any such losses on AIG’s counterparties after it took over the firm, effectively transferring more than $30 billion from taxpayers to the banks in a kind of back-door bailout. The deliberations leading up to this decision have been treated like a state secret.

In sum, the U.S. financial sector received subsidized TARP funds, subsidized financing from rock-bottom interest rates and free credit guarantees from the government. On top of all this, financiers pocketed a huge bonanza from the general rally in financial assets that followed the authorities’ rescue of the system. After the low point of March 2009, stocks gained about 60 percent, industrial commodities more than doubled, and “junk” bonds gained about 55 percent. In these circumstances, it was nearly impossible for the financial sector not to make money. And yet, as if to add insult to injury, the bankers, having pocketed the taxpayer bailout, then rewarded themselves handsomely with huge bonuses. Small wonder that large numbers of Americans regard financiers’ pay packets as undeserved.

The mixed effects of the bailout can be detected in the non-financial economy as well. The corporate credit market has bifurcated into those big businesses able to take advantage of the bailout’s effects on the capital markets and small businesses that rely on financing from their local banks. Big businesses were among the principal beneficiaries of the blanket guarantee of money market funds, since these are their main source of short-term financing. They benefited from the Fed’s determination to pump money into the markets—a policy since become known as quantitative easing—because the resulting low interest rates allow them to borrow longer-term funds more cheaply than ever before. Microsoft, for example, recently issued a three-year bond at a record low interest rate of only 0.875 percent while Johnson & Johnson locked in a ten-year rate of only 3.14 percent. Investment-grade companies as a whole have borrowing costs that are more than one percentage point lower than they were before the crisis. Small businesses, however, which employ nearly three-quarters of all Americans, are still starved of financing despite the bank rescues and the fall in market interest rates. The Federal Reserve’s Senior Loan Officer Opinion Survey reported that, as of October 2010, credit conditions for small businesses were beginning to ease for the first time since the crisis began. However, a survey of small businesses conducted by the New York Fed that same month shows that access to credit was still extremely difficult to come by: Nearly half of all loan applications were rejected. Additionally, according to a survey published in November 2010 by the National Federation of Independent Business, small business owners who are regular borrowers were experiencing tightening credit conditions and were expecting the situation to get worse. From the perspective of small business owners, there has been no recovery.

Ordinary households are out in the cold, too. They could face years of higher taxes as the government struggles to pay off the big jump in the national debt. One-quarter of all homeowners are trapped in homes with negative equity. Many are un- or underemployed. Unable to sell their homes, they cannot readily move to pursue new work opportunities. Those who still have jobs cannot refinance their mortgages at the low rates theoretically available because of much tighter credit standards. Meanwhile, more fortunate Americans are free to move jobs and fully able to take advantage of cheap financing. Again, the pain of the weak economy is unevenly shared, and those on the losing end often cannot help but wonder if the game is somehow fixed against them.

That suspicion is heightened by the fact that the bailouts appear distressingly arbitrary. In the spring of 2008, Bear Stearns was saved from bankruptcy by the Fed, which injected its own money into the firm to induce J.P. Morgan to rescue it. Compare that with the fall of 2008, when Lehman Brothers found itself in a similar predicament and was left to go bankrupt. Or, to cite another contrast: In the aftermath of the Lehman bust, creditors of the Detroit automakers were forced to endure a haircut on their debt even as creditors of Fannie Mae and Freddie Mac, the largest of whom were Middle Eastern sovereign wealth funds and the People’s Bank of China, were protected by the government. If the answer is that some bailouts are essential because certain institutions are “too big to fail”, then why has the government promoted consolidation of the sector into even fewer and bigger institutions?

The regrettable fact is that whenever the government acts to save the system while also trying to teach financiers a few lessons, it will make decisions in the heat of the moment that prove arbitrary in hindsight. This is bound to fuel conspiracy theories that particular institutions were treated better because they pull bigger strings in Washington. It can only reinforce public frustration with the bailouts and deepen suspicions of plutocracy at work, even when those suspicions are not justified by reality.

This thumbnail history of the bailout and both its economic and political consequences suggest that, even if the acute phase of the economic crisis has abated, the crisis of governance has not. As American corporations earn their largest profits ever, the un- and underemployed constitute nearly a fifth of the labor force. Long-term unemployment is at a record high. The spread between the interest rates on mortgage-backed securities and Treasury bonds is lower than it was before the crisis, yet the value of the houses that had served as the principle form of savings for much of the middle class has eroded. Had no public money been spent, had the Federal Reserve not taken unprecedented action, had the national debt not increased so dramatically, this might have been an acceptable, albeit painful outcome. Yet the fact is that these are the disappointing results of a round of government activism in the economy the likes of which haven’t been seen since the 1930s.

Of course, Americans have long tolerated disparities of income and wealth that would be intolerable in other rich nations. Even in the face of a widening income gap since the late-1970s, this tolerance has held up, partly because perception of the gap was obscured by a consumption binge financed by cheap credit. Moreover, even though the widening gap has made it steadily harder for those born into the bottom quintile to vault into the top quintile, most Americans still feel that they live in the land of opportunity. They do not begrudge the outsized success of the whiz kids in Silicon Valley, California, and Redmond, Washington, because they see it as a product of innovation, daring and raw intelligence. Nevertheless, the Wall Street bailouts of 2008–09 have strained this generosity of spirit. They have nourished the suspicion that many of the wealthy—especially those connected with the financial sector—are super-rich not on account of their acumen or enterprise but because of purchased political favors. It’s not hard to take large risks with other people’s money if you know your losses will be backstopped at taxpayer expense.

The crisis of governance in America now consists of finding ways to assuage a growing sense of basic injustice in the system, and to demonstrate that while some level of plutocratic “capture” of political behavior may exist, it is not to blame for the larger and broader problems with which we have been struggling.

One obvious option would be for the government to end the expectation that it will deliver more rescues in the future. It could erase the implicit promise of bailouts with an explicit declaration that financial institutions can fail, even if their failure threatens other institutions. This course of action has some theoretical appeal: There is no better way to ensure that banks behave responsibly than to force them to fend for themselves. In the era of “free banking” before the 1913 establishment of the Federal Reserve, depositors had a healthy fear for the security of their savings while banks had a healthy fear of being victims of a run. The result was that bankers managed their enterprises far more cautiously than they do now. In 1880, the average American bank held enough gold in reserve to repay about one-quarter of its debt at a moment’s notice. For a point of comparison, the new Basel III accord mandates that banks hold equity capital worth only 7 percent of their assets.

Unfortunately, the matter is not so simple. The Federal Reserve System was established for a reason, and the conditions of its creation provide warning to those who would now deprive bankers of their security blanket. One may feel nostalgic about the plush capital cushions held by banks in the pre-Fed era, but capital cushions exist to stabilize banks, and cushions or no, 19th-century banks were not actually very stable at all. To the contrary, they often failed, and with broadly painful consequences. The United States experienced banking panics in 1819, 1837, 1857, 1873, 1884 and 1893. The crisis of 1873 closed the New York Stock Exchange for ten straight days, while the fallout from the crisis led to a depression in the United States that lasted nearly six years, the longest period of contraction on record. The crisis of 1893 forced President Cleveland to appeal personally to J.P. Morgan for a loan of $65 million in gold bullion.

Not only did the 19th-century American financial regime fail to deliver stability; it would have failed even more spectacularly had it been allowed to survive into the modern era. The reason is that the effects of financial crises on the rest of the economy grow as the financial sector itself grows. And, much recent commentary notwithstanding, a dynamic economy requires a robust financial sector to support innovation and growth. As technology advances and firms specialize in ever more abstruse areas of production, the challenge of allocating scarce capital grows harder: Financial institutions are likely to hire more people to do the job. As consumers grow richer and communications grow cheaper, the best companies will realize economies of scale. Big companies need big loans, and it takes big financial institutions to provide them. Like it or not, the growth of the financial sector is inevitable as innovation expands the range of services it can provide. Currency hedges, for example, can usefully insulate manufacturers from foreign-exchange risk and give them the confidence to invest in new factories. Commodity futures allow producers and consumers to shield themselves against price swings. But to have currency or commodity hedges you need financial institutions that trade derivatives.

For all these reasons, the U.S. financial sector is likely to grow even larger as the economy grows more sophisticated. Yes, Wall Street’s exuberant growth over the past quarter of a century accelerated thanks to the easy profits associated with the government’s implicit backstop, but we would be kidding ourselves if we supposed that absent this distortion the financial sector would shrink back to the share of GDP it occupied in the days of free banking. (Those who still doubt this point should note that other high-end service industries also tend to expand as economies grow more complex. Think of corporate law firms or management consultancies.)

The best illustration of why the era of free banking had to end (and why we should not restore it) resides in the episode that did the most to end it: the Panic of 1907. Because it was the last financial crisis to occur in the United States in the absence of a government safety net, the Panic of 1907 provides a window on what a world without such safety nets might look like.[1]

Its first lesson is that dangerous credit cycles can emerge even in the absence of moral hazard. The quarter century before the 1907 panic in some ways resembled the quarter century before the crisis of 2007–09: Strong growth and technology-driven productivity gains gradually reduced the perceived risk of lending capital in the United States, with the result that the conservative reserve ratios of the early 1880s were eroded from about one-quarter of liabilities to about one-sixth. Strong growth plus easier credit drove up asset prices, which in turn drove up collateral values, which in turn encouraged even easier credit. People felt wealthier; consumer spending rose; the result was more business investment and more credit.

Then an earthquake struck San Francisco in April 1906. In addition to the damage caused directly by the quake, ruptured underground gas mains fed a fire that consumed about half the city. The estimated damages amounted to about 1.5 percent of the entire national income of the United States at the time. Like AIG in the credit crisis, the insurance companies that had sold protection for an apocalyptic disaster now became the natural vectors for financial contagion—with the difference that at the dawn of the last century, the Feds were not about to step in and cut the contagion off. To meet the flood of earthquake claims, insurance companies shipped gold from London and New York to San Francisco, draining the financial system of liquidity. Easy money turned so tight that, by the end of March 1907, American stocks had declined about 20 percent from their peak.

The situation deteriorated further in the summer when the Bank of England, which was worried about domestic gold shortages after the earthquake triggered a spike in shipments to the United States, banned all refinancing of American debt. One consequence of this decision was that about a tenth of America’s gold reserves were sent back to the United Kingdom between May and August. Coming on top of the diversion of gold to San Francisco, this draining of liquidity from U.S. debt markets left borrowers scrambling. In June, New York City failed to find sufficient subscribers to a bond issue and nearly defaulted. In October, bank runs threatened several large trust companies, the forerunners of today’s investment banks. One prominent trust, the Knickerbocker, nearly went broke after participating in a failed leveraged buy-out of a copper firm. Another, Moore & Schley, had used its holdings in the Tennessee Coal, Iron and Railroad Company (TC&I) as collateral for loans. As it faced a run by depositors it became a distressed seller of TC&I stock, nearly bankrupting one of America’s largest industrial firms. By late 1907, American equities were worth half as much as they were on the eve of the earthquake. Unemployment jumped from less than 3 percent to more than 8 percent. The crisis in the financial economy was spilling over into the non-financial economy.

In the absence of a TARP-like program, credit guarantees, emergency central bank liquidity and the whole paraphernalia of 21st-century government intervention, no mechanism existed to halt the downward cycle. Each collapse threatened to trigger another, the contagion potentially carrying on indefinitely. And so, in one of the legendary episodes of Wall Street history, a private citizen stepped forward to fill the policy vacuum. J.P. Morgan, the era’s preeminent banker, literally locked the biggest financial players of his day in his library until they agreed to participate in a multipurpose bailout fund. A hybrid between the TARP and the emergency Federal Reserve credit lines, this fund prevented runs on major securities houses and trust companies while also financing the acquisition of TC&I by its rival, U.S. Steel. [2] The government supported this bailout by improvising the sort of intervention that the Federal Reserve would undertake later. The Treasury extended a credit line of $25 million to J.P. Morgan’s consortium and simultaneously issued $40 million in new gold bonds. While ostensibly meant to finance the Panama Canal, the banks could use these bonds as safe collateral for the issuance of new banknotes. Even in the era of the gold standard, there was no alternative to printing money.

The bailout worked; both the real and financial economies recovered quickly. But the shock was sufficiently profound to impel Congress to investigate the causes of the panic so as to devise ways to prevent a recurrence. President William Howard Taft seized on the popular idea of using anti-trust law to break up the financial sector into smaller institutions, and in that effort he launched a series of suits from the Attorney General’s office. Meanwhile, Congressmen inspired by William Jennings Bryan called for a central bank that would be, not a lender of last resort to Wall Street financiers, but a printing press that would help poor farmers. The leaders of the big banks lacked enthusiasm for either course, and in the end they prevailed. The titans of Wall Street and senior representatives from Treasury met in secret to devise an alternative approach, at whose center was a government-backed yet industry-operated National Reserve Bank. In 1913, Wall Street’s preferred plan was realized with the creation of the Federal Reserve System.

The main lesson to be learned from all this is that even at the dawn of the 20th century, when the financial sector was far smaller and the economy less complex and interdependent than today, the United States was unable to bear the pain of a world without safety nets. The notion of returning to the laissez-faire idyll of the 19th century is therefore nothing short of fanciful. And yet its appeal is understandable because, in 1907 just as now, the consequences of financial safety nets are so disturbing. Just as they are today, taxpayers then were caught in a vise. On the one hand, the absence of an official safety net had created a panic so profound that the government felt compelled to intervene, even if on an unofficial, ad hoc basis through the aegis of a private citizen. On the other hand, the response to the panic was to create precisely the sort of safety net that ultimately made the banks larger, more prone to risk-taking and more important to the welfare of the real economy than ever before. Over the course of the ensuing century, financial crises led inexorably to an even bigger safety net and even more risk-taking, producing a vicious cycle of increasing profits for bankers and increasing liabilities for everyone else. We found ourselves damned if we didn’t create a safety net, and damned if we did.

The traditional response to breaking this cycle, especially in the wake of the Great Depression, has been regulation. If the financial system required safety nets, and if the safety nets encouraged greater risk-taking, then the solution was for regulators to impose limits to risk-taking. Reserve capital requirements for banks have been one expression of this logic. Because of the government backstop, banks were taking on excessive leverage; the 25 percent capital ratios of the late 19th century were a quaint memory. So government decreed what the safe level of leverage was and imposed that limit on banks. Having incentivized risk-taking through one intervention (the creation of the Federal Reserve), the government constrained it with a second intervention (the minimum reserve capital ratio).

Yet regulation has proved to be an inadequate tool for breaking the vicious cycle. For one thing, regulations tend to sow the seeds of their own undoing. The better they are at maintaining the stability of the system, the less necessary they appear. The longer markets stay calm and financiers go without suffering the indignity of a sharp loss, the more it becomes tempting to suppose that new financial technologies have enabled investors to tame risk. In these circumstances, calls for reforming seemingly outmoded regulations become common. Surely, it is claimed, limitations on leverage are obsolete in light of new, sophisticated risk modeling? (This argument made possible the Basel II capital accord, which deferred too much to the bankers’ own risk models.) Surely there is no need to supervise new markets in complex securities? (This view caused government to be too slow in driving systemically dangerous over-the-counter transactions onto exchanges.) The problem is compounded when genuinely bad regulations, such as ceilings on interest rates that banks can offer depositors, live among good ones, such as minimum reserve requirements. At some point, the rules are loosened, either by conscious choice or as the enforcers soften supervisory standards bit by bit, perhaps without realizing that they are doing so.

The second problem with regulation is the assumption that regulators are capable of understanding risks at financial institutions better than the risk managers at those same institutions. A financier is paid very well to understand the dangers in his portfolio, has the potential to lose much of that income if he is wrong, and likely has superior information regarding the underlying quality of the assets. A regulator is not likely to be well-compensated compared to someone equally qualified in the private sector, has less at stake if he misses something, and lacks specific information about the assets he has been assigned to assess. No one in government, after all, was fired for failing to foresee the financial crisis. For all these reasons it is naive to expect preventive miracles from regulators.

Moreover, it is not at all surprising that those regulators who did see the crisis coming failed to clamp down on excessive risk-taking. The Monday morning quarterbacks now declare that the disaster was obvious, and that only a blind faith in markets (or plutocratic corruption) prevented government from acting decisively. But it’s just not so. Suppose that, in 2005, a regulator had been concerned about the extent to which the health of the financial system depended on the high performance of mortgage loans. Would that regulator have been willing to assert that AAA-rated mortgage securities were worth far less than their face value, especially when the bankers who held them, the ratings agencies and the government-sponsored mortgage guarantors all seemed confident? Had the regulator originated the securities? Done due diligence on the borrowers? What about the presumably sophisticated investors from all over the world who had purchased trillions of dollars of these securities? What could the regulator possibly know that everyone else, including people with far greater financial incentives, supposedly missed? And why were the bureaucrats so hostile to the ideal of homeownership?

In the wake of the financial crisis, regulators now declare that henceforth they will engage in “macro-prudential surveillance”, using their power over the financial sector to force more conservative behavior when a bubble seems to be building. But bubbles are only obvious in retrospect. Prospectively, all judgments in markets are uncertain. Nobody can have perfect information. It is too much to expect that regulators will face down financial mania when the best and brightest in the private sector are convinced that all is well.

Many argue that a regulatory agency can nonetheless add value by aggregating the information from major institutions that would otherwise lie about in fragments. In principle, this exercise might make it possible to determine risks to the financial system that spring not from weaknesses at one company but rather from the “crowding” of multiple institutions into particular positions. Because individual private institutions are not in a position to collect information from their rivals, this sort of “systemic” analysis might indeed provide regulators with an informational edge over the private sector—and hence with a basis for second-guessing their behavior in the run-up to a crash. That is the rationale for the systemic regulator established by the Dodd-Frank financial reform.

Its theoretical promise notwithstanding, the systemic regulator’s job may turn out to be a mission impossible. Many major market players are foreign and so may not cooperate with U.S. demands for information. Even if the foreign players do cooperate, it is doubtful that a regulator can collect portfolio positions in real time and in detail. A failure on either front will render it impossible to determine the true risks to the financial system.

Moreover, even if the systemic regulator clears these hurdles, it will have a hard time turning information into action. If it determined, for example, that too many leveraged traders had piled into Brazilian stocks, it might fear that a shock to the market might trigger destabilizing fire sales as everyone rushed for the exit. To prevent a crash, it might want to order U.S. institutions to reduce their Brazilian bets. But the U.S. banks might retort that, if they sold positions, Europeans or Asians would pile in instead. If so, the risk of a Brazilian blow up would persist and so would the risk to U.S. banks: If the Europeans and Asians took losses in Brazil, they would dump positions elsewhere, driving down other assets held by U.S. institutions. From the point of view of U.S. banks, therefore, pulling out of Brazil would bring uncertain risk-reduction benefits in the future in exchange for foregone profits in the short-term. So if the systemic regulator wants banks to pull out of Brazil, it must expect resistance. It must be prepared to press its point even in the absence of certainty about Brazil’s prospects, and in the knowledge that, if it is wrong, it will be penalizing its own country’s financial sector and benefiting foreign rivals.

Time will tell whether the Dodd-Frank systemic regulator will have the fortitude required by its mission. And when one also considers that the existence of a systemic regulator could lead market participants to believe that risks are better monitored and controlled than they actually are, the Dodd-Frank innovation may turn out to be a source of harm, not benefit.

If regulatory initiatives such as bank capital standards and systemic regulation are frail, we are back to the vexing question: What happens when we can’t live with government bailouts of the “too big to fail”, and can’t live without them? One partial answer harkens back to one of the paths not taken after the Panic of 1907: Rather than stand by as the financial sector is consolidated into ever larger firms, we should spread the risk of the system across more, smaller institutions that are better at handling it.

There are Taft-like voices in the post-2007 debate similar to those in the aftermath of 1907 that support versions of the small-enough-to-fail doctrine. Some have suggested that institutions that are too big to fail must be deemed too big to exist: They should be broken up in a new round of trust-busting. Although the Dodd-Frank financial reform mainly shrank from this idea, the so-called Volcker rule, which was included in the reform, is intended to force banks to spin out some of their proprietary trading. The UK government and the London School of Economics published a report in August 2010 that argued for far tougher measures.[3] Andrew Haldane of the Bank of England and Simon Johnson, formerly of the IMF, have both taken outspoken positions against the current concentration and size of the banks. Charles Goodhart, formerly of the Bank of England and a professor at the London School of Economics, proposed taxing bank leverage, while Beatrice Weder di Mauro, a prominent economist at the University of Mainz who serves on Germany’s version of the U.S. Council of Economic Advisers, advocated a “systemic risk” tax on banks to discourage consolidation. These proposals are eminently reasonable. The size of a financial institution is like the pollution emitted from a car: It imposes costs on society, so society should tax it.

Unfortunately, for reasons of political correctness, governments are not embracing another possible solution to the too-big-to-fail problem: encouraging hedge funds. To most voters, the very idea sounds outlandish. Aren’t hedge funds the most dangerous part of the financial system, the bit most in need of taming? No, they’re not. Contrary to myth, hedge funds make fewer egregious misjudgments than most other financial institutions. And when they do make mistakes, they require no taxpayer bailouts. Rather than focus energy on the difficult task of regulating the part of the financial sector that has proved itself dysfunctional, policymakers should consider the complementary approach of enabling the part of the sector that navigated the crisis successfully.

Why are hedge funds superior? The short answer is that hedge funds have better incentive structures than other financial vehicles.[4] Because they take a large performance fee, they have a motive to do their own research rather than follow the crowd. This leads them to be more contrarian and more likely to avoid buying into bubbles than their rivals. Likewise, because hedge fund managers often keep their own savings in their funds, they have a powerful reason to avoid crazy risks. Unlike proprietary traders within an investment bank, who take risk in the knowledge that a large failure will be the shareholders’ problem, hedge fund managers take risk in the knowledge that failure will be their problem, too.

Yet far from embracing hedge funds, most governments are inclined to restrain them. In the United States, the Dodd-Frank reform requires even small hedge funds to register with the Securities and Exchange Commission, a burden that will discourage smaller funds—precisely those that are most attractive from the standpoint of avoiding systemically dangerous consolidation. In Europe, France and Germany have opposed hedge funds with the same vigor that they defended their notoriously unhealthy and over-leveraged banks at the Basel negotiations.

Regulators across the developed world have bridled particularly at hedge fund secrecy. Classic hedge fund practices such as algorithmic trading and short-selling have been depicted as hostile to the interests of investors, despite the fact that they increase market liquidity and help dampen excessive swings in asset prices. Even when they admit that they have no evidence to suppose that hedge funds are destabilizing, policymakers still insist that they want to regulate them anyway out of a sense of caution. The problem with this mindset is that it is not cost-free. Already, the Securities and Exchange Commission is set to expand its staff by about one third in order to implement the Dodd-Frank reform. Adding an unproductive mission of hedge fund regulation to the SEC’s overflowing plate only increases the chances that the implementation of reform will fall short of expectations.

The truth is that hedge funds represent an opportunity to maintain the quality of our capital markets while reducing the risk they pose to taxpayers and society. They offer a chance to return to the path not taken after 1907: Rather than responding to a crisis with safety nets from the government plus consolidation on Wall Street, we should prefer safety nets combined with fragmentation. It is almost Orwellian that policymakers everywhere should be lamenting the power of too-big-to-fail financial institutions and yet refusing to celebrate a ready-made alternative. Hedge funds cannot replace all of a bank’s functions. They are not going to issue credit cards or serve retail customers. But when it comes to complex asset management, they can take over from safety-net-distorted rivals, and we would all be better off if they did.

Of course, there is an irony in starting an essay with the problem of rising inequality and ending it with a prescription to embrace those famously rich hedge-fund moguls. But the solution to hedge fund riches is not to rein in hedge-fund trading. Unlike banks, which extract hidden subsidies from government, hedge fund profits are a sign of health. They are a measure of the funds’ success in allocating capital and absorbing risk efficiently. The goal of public policy must be, first, to welcome that efficiency, which has benefits for the wider economy, and second, to tax a larger share of the profits in order to address legitimate concerns about inequality. Embracing small-enough-to-fail hedge funds as a partial alternative to too-big-to-fail banks is not a panacea. We will still have crises and there will still be bailouts. But the tradition of robust, unsubsidized risk management at hedge funds is surely a window into a better financial system than the one we have now. To a surprising and unrecognized degree, the future of finance lies in the history of hedge funds.

____________________________________

Sebastian Mallaby and Matthew Klein are director and research associate, respectively, at the Maurice R. Greenberg Center for Geoeconomic Studies at the Council on Foreign Relations. Sebastian Mallaby is the author of More Money Than God: Hedge Funds and the Making of a New Elite (Penguin Press, 2010).

1 The history that follows is based on Robert F. Bruner and Sean D. Carr’s The Panic of 1907: Lessons Learned from the Market’s Perfect Storm (John Wiley & Sons, 2007).

2 This last act bears striking similarities to the purchase of Bear Stearns by JPMorgan Chase with a $29 billion loan from the Fed in March 2008.

3 Adair Turner et al., The Future of Finance: The LSE Report (August 2010).

4 Readers who seek the long answer can consult Mallaby, More Money Than God (Penguin Press, 2010).

Chapter 12

Risk and Uncertainty

Jessica Einhorn

We are four years out from the 2008 death-spiral of our financial system. In stages, we have gone from shock and fear, to analysis and reform, to revisionism and critique. But the work of establishing a robust and resilient global financial system is surely not complete. Indeed, we have yet to pose the full set of questions, let alone implement the answers.

On a narrow, technical economic level, we have a good idea what went wrong. Within a year of the meltdown, several high-level reports got the basics down pretty well. I refer in particular to the reports of the Bank for International Settlements (BIS), the Financial Stability Forum (headed by Mario Draghi), the Institute of International Finance (chaired by Josef Ackermann of Deutsche Bank), the Group of Thirty and the Corrigan group (CRMPG). As good as these reports are, however, they are limited. As befit the times, they focused most on monetary and banking regulation to strengthen the dikes, but they don’t take us to highlands, above the flood line. To start that ascent, we need a basic understanding of two conditions that our forebears had a better grasp of than we seem to: risk and uncertainty.

We generally speak as if risk and uncertainty were synonyms. They are not, and appreciating the distinction between these two fundamental elements of free markets is critical for knowing what government can and ought to do in its relation to the economy.

Risk and uncertainty are no more similar than a common house cat and a leopard. One can be domesticated, the other merely kept at a safe distance. The main problem of the past few decades is that increasingly we mistook the leopard for a house cat, with catastrophic results.

Risk presumes certain rules to be at work, certain parameters to be in place; uncertainty is about changes in rules and the sundering of parameters. Risk is intrinsic to a set of circumstances; uncertainty applies to the bounding circumstances themselves. By way of example, consider a fisherman who fishes the same river over many years. He takes a kind of risk, makes a certain kind of bet, each time he throws in his line. He will do well if he is familiar with the terrain. But an earthquake or avalanche upstream could change the terrain and the course of the river, leaving the fisherman high, dry and bankrupt.

John Maynard Keynes, Hyman Minsky and others wrestled with these issues in the decades before World War II. Risk can be managed, but uncertainty cannot. Frank Knight, the “grand old man” of Chicago, explained in his 1921 dissertation, Risk, Uncertainty and Profit, that risk is randomness with knowable probabilities, and uncertainty is randomness with unknowable probabilities. Donald Rumsfeld gave the same distinction a modern twist with his “known unknowns” and “unknown unknowns” in the context of the Iraq War.

In the practical terms of finance, the difference is this: When someone buys a collateralized debt obligation (CDO) backed by a thousand mortgages, theoretically that buyer can analyze the borrowers, their income levels, the prepayment terms and so on, or he can depend on ratings agencies to do so—all articles of risk management. But the buyer cannot possibly determine just what might disrupt the structural assumptions behind the entire enterprise of housing finance, such as the possibility that the tools employed to manage risk might themselves generate risk. If I said to the CDO buyer before the crash, “What about the risk of default?” he or she might answer, “Don’t worry, I’ve factored that in.” That’s the voice of risk awareness speaking. But if I say, “These times are good, but they can’t last forever, can they?” and the response is, “I think they will”, then that’s the voice of hubris, which has forgotten uncertainty.

This mistake, thinking that uncertainty, which cannot be tamed, could be transformed into manageable risk, which can be, penetrated our conventional wisdom on the management of free markets before the crash. Conventional wisdom concluded that the dispersion of market risk, with technologically complex instruments and models to manage it, supported by the liquidity of a massive financial system, could manage uncertainty in whatever form it arose. We thought that free markets would handle uncertainty when they managed risk. But they did not, because they cannot. Our financial leadership in both the public and private sectors came to rely on efficient, rational and self-equilibrating markets. We caricatured our models and ignored the excesses that spring from complacency in the face of good times.

What is particularly remarkable about our having forgotten or ignored the distinction between risk and uncertainty is that some of us, at least, should have known better by dint of our own experience. I have been on the playing fields of finance for all the crises from the 1970s through 2000. At the World Bank for more than twenty years, I had a front-row seat to watch the successes and failures in economic development around the world, and I experienced as a player the effects of both on financial markets. These decades were frequently punctuated by crisis. I remember when Mexico defaulted on its sovereign debt in 1982, leaving U.S. financial leaders to tremble in fear that the U.S. banking system would not withstand the shock. That did not happen: Wise Men (there were very few women in upper ranks then) helped the United States recover from that crisis with both an understanding of the need for higher capital adequacy and regulatory attentiveness to international exposures of the banks.

The fix for the Mexico crisis, however, laid the ground for the next crisis. We had the idea that it would be better if risks were diffused by opening securities markets to developing countries. That contributed to subsequent crises, such as again in Mexico and in Russia. Capital markets were opened and liberalized beyond institutional capabilities to manage them, leading to the most remarkable crisis—in Asia. The world’s “miracle continent” stumbled, and for a few weeks the financial officials of the world’s wealthiest countries cowered.

In hindsight, the stunning thing is that every one of these crises seemed to emanate from a period of almost preternatural financial calm and well-being. Indeed, each period of calm seemed even calmer and more prosperous than the one before. Though crises kept happening, more and more people joined the chorus announcing, each time, that we had now figured out how to manage away crises.

We had domestic as well as international troubles, of course, but the same pattern repeated. In the mid- and late 1970s, we experienced a crisis with inflation. In 1981, Paul Volcker at the Fed brought inflation to heel with the support and encouragement of President Ronald Reagan. The solution gave rise to a steep recession, but we rebounded from it, and avidly spent our profits. The 1980s then yielded what seemed at the time like massive budget deficits, but a 1990 budget agreement and later the Clinton-Gingrich unholy alliance on spending controls and relatively sane tax policies yielded a new period of calm and optimism. That optimism, however, ended up generating what seemed the mother of all bubbles: the tech bubble. We managed to ring that one with fences too, thereby setting the stage for the grandmother of all bubbles in the housing and credit bubble.

Up and down this roller coaster we were told that we were experiencing a “Goldilocks” economy—not too hot, not too cold, but just right. We didn’t understand that having confidence that such a thing exists creates its own bubble. The porridge is always either too hot, too cold—or toxic. “The great moderation” has become an ironic tagline, right up there with “Mission Accomplished” and “Dow 36,000.” It has done so because randomness with unknowable properties, “unknown unknowns”, is an endemic, not contingent, feature of market economies, and it will always spite, in due course, the runaway herd. That much about uncertainty is certain.

The fundamental revolution in our thinking that needs to come out of this crisis, therefore, is simple: We must manage modern financial systems with an appreciation of unavoidable uncertainty. That said, it is a challenge to explain how something so solidly a part of human understanding for so long could ever have been ignored so thoroughly by so many thoughtful people. The root of the explanation, however, is that we were not on the lookout for the excesses that spring from the complacency born of good times. Let me offer four examples of this complacency from my own experiences in public finance.

The first example illustrates macroeconomic myopia. We see things happening in the macroeconomic world and routinely fail to apply their implications to whatever we are doing on the microeconomic level. People who have operating jobs on Wall Street find it very difficult to manage against what is potentially unsustainable, so they carry on as though whatever is keeping their balloon up in the air is going to continue.

Consider recent events in this light. When we looked at the global imbalances in credit, currencies and trade, we thought they were largely a balance-of-payments problem. We wondered whether the inevitable adjustment would come about through a gradual re-pricing of the U.S. dollar against the renminbi, or through a foreign exchange crisis. Could we get the Chinese to stoke their own domestic demand while we curbed our fiscal profligacy? Soft landing or hard? Those were the options we entertained. And then, seemingly out of nowhere, came the crisis, which moved European and Asian creditors to question for the first time why they were holding complex securities tied to condos in places they had never even been.

The crisis often arrives not as you expect it might, but in disguise. The global imbalance fed a credit glut in the United States, with interest rates too low for too long, leading many investors to search for higher returns on (supposedly) low-risk assets, as designated by rating agencies. Growing complexities in securitization, financial innovation and global distribution invited belief that the link between risk and return had somehow been suspended. When troubles became apparent, trillions of dollars headed for the exits at the same time. The lesson is that we have to look around the corner, not just at the oncoming traffic.

The second form of complacency concerns the misreading of good news. In June 2008, the annual report of the Bank of International Settlements observed that the biggest policy mistake of the boom period was misreading the positive supply shock of inexpensive manufactured imports. Those imports caused inflation to be artificially depressed, making it possible for monetary policy to loosen up, thus creating a credit bubble. The problem, in retrospect, was that the oil shocks had made us attentive to managing a negative supply shock but not a positive supply shock. The result was that we imported a financial crisis through the trade account via excess credit. Yes, inflation was tamed, but it was too tame in our Goldilocks world. The symptom of the illness came disguised as evidence of a cure.

A third form of complacency is the problem of prudence. We like to pretend that there are bad guys and good guys in this drama, with the good guys always prudent and the bad guys always reckless. It doesn’t work like that. It may sound odd, but sometimes prudence is no friend of stability. Indeed, much of what we take to be prudential behavior in a microeconomic setting can produce massive pro-cyclical feedback at times of stress. This means that rationally hedged behavior on an individual level can add up to collectively unsustainable behavior. In plain English: too much of a good thing.

Let me offer a personal example: During my tenure as Treasurer of the World Bank, derivative transactions were becoming too complex for my tastes, so I decided that we should either make those positions safer or pull out of that market. We accomplished that with what we called “collateralized swaps.” This required more collateral to be posted by a counterparty to a transaction in case of a credit downgrade. We knew this was a prudent move that would reduce our risks of loss. As we initiated this program, however, I thought to myself that this prudent behavior would be strongly pro-cyclical in its effects during a major downturn. Excellent discipline in normal times could, if enforced across the market, cause systemic turmoil in times of generalized trouble through chain effects. One loss triggers another as assets decline in value and each player scrambles for protection by demanding payments from another.

This point, raised to scale, is extremely important. We ask businesses to optimize the use of capital, minimize risks, maintain steady income growth, and so on. Then when they do it, they get clobbered during a period of unwinding caused by our own regulatory inattention to uncertainty. For us to cry foul when the system is in meltdown is the ultimate example of moving the goal posts at the toughest point in the game.

Fourth is the problem of data naivety. This is the problem of believing the numbers too much. Just as the fact that prudence can have a downside is a counterintuitive proposition, this one is too. Empirical work can help us see trends in the past that may shape the future, but no amount of data can remove the gauzy uncertainty that blocks what we cannot see and count. No judgments reside in the data. Yet sometimes we fall so in love with what we can measure that we surrender all common sense about the critical factors we cannot measure. Take the argument for Social Security private accounts: Such accounts look good for a hypothetical perpetual investor who is evenly invested in the market over a span of decades and doesn’t plan to liquidate those investments at any particular time. But that’s not how Americans live, save and retire.

We ignore the microeconomics, misread good news, overlook systemic aspects of prudence and then misinterpret what our economic models tell us—all to wish away an uncertain future. Some of this inheres in human nature, so it constitutes a problem we will never solve once and for all. But can we manage it better?

We are trying to manage it. We have seen a major effort at regulatory reform since 2008 that may help us address some of the blind spots we have created. But our efforts fall far short of adequate, and the reason is that our political economy is unsuited to changing the culture of a sector as complex and well protected as finance. New designs for more government intrusion in the private sector in the United States are certainly not in fashion at this moment in our history. Yet to manage uncertainty, we need to make government a more intrusive player in our market economy than many of us might prefer. Who else can stand outside the market and lean against the wind or arrest the stampeding herd? But it will require a government with a very different mindset than that which it possesses today.

This is a political issue as well as an intellectual one. The first-order tasks are already underway. We are undertaking to increase capital requirements for banks, decrease the use of leverage throughout the financial system, and create special resolution procedures so big banks can be put down, as they say in the medical profession, with grace, love and certainty.

We can do even more, however. Lord Adair Turner, Chairman of the UK Financial Services Authority, has most thoughtfully raised questions about the beliefs, structure and practice that define our modern financial culture. My own suggestions overlap to some degree. Fundamentally, however, he is taking the lead in analyzing how we go about credit creation to support economic growth. When we interfere with markets in the name of stability, we should be clear-eyed about the effects on growth—which means, when you see risks of instability with virtually no payoff in growth, government action should be less contested.

For example, we should dethrone debt. Equity is hopelessly disadvantaged by the tax benefits of debt. Making interest payments deductible expenses distorts behavior ranging from what individuals borrow to buy a home to what corporations borrow to fund acquisitions and operations. This is, to be sure, a big and complex issue, but the principle involved is not in question. As Jack Kemp used to say, if you want less of something, tax it; if you want more of something, don’t. If we want less debt, then the obvious thing to do is tax it. We need to draw public attention to the imbalances that come with that distortion. Debt is so structurally embedded that any transition away from the status quo will need to be carefully managed for a long time. But the journey needs to begin somewhere, and it needs to begin now.

Next on my list is access to credit. The United States grew and prospered as its financial system grew ever more democratic. We became both great and fair by opening up access to credit. It is a source of national pride. But, of course, now things have gone much too far. We tend to treat credit as a right detached from credit worthiness. In the run-up to the crisis, getting a credit card was about as easy as getting a library card. But a credit card is like an automobile: It requires knowledge to operate, and in the wrong hands it can cause lots of damage. Credit cannot be unconditional.

It is worth noting in this regard that the U.S. military has discovered that the indebtedness of its soldiers is a security risk. It can’t mobilize soldiers who are financially prone to blackmail, so the military has won the right to restrict payday loans, usurious interest rates and other abuses of its soldiers. Other major security agencies, including several police forces, are eager to set similar restrictions. There is a lesson here. If credit-at-will is making it harder to defend the nation, then we need to treat it like we treat legal painkillers: Regulate it to protect both the patient and society as a whole.

This is not to say that I support government restrictions of credit for the sake of anyone’s personal virtue. It is not government’s role, per se, to promote virtue on the part of consumers or investors. But credit providers must not be allowed to push credit to those unable to carry it, nor should they be empowered to run roughshod over a financially illiterate public. In addition to consumer protection, we have learned that regulatory oversight of credit has an important place in securing our financial stability.

Lastly, I join with those who question whether the financial sector itself has grown so large that its marginal benefits are outweighed by the costs of the uncertainty it breeds and nurtures. Many have expressed concern about institutions being “too big to fail” (or they mean, rather, too interconnected to fail). I am more concerned about the sector as a whole being so big that it can take us all down when it stumbles.

Of course, the defenders of the status quo preach that they create liquidity by trading amongst themselves and that this enhances efficiency, lowers the cost of capital and boosts prosperity. But our intuition and recent experience tell us otherwise. Certainly, liquidity is important to our modern economy, and no one should pretend otherwise. But neither should anyone pretend that all transactions in finance are welfare-enhancing across society. Our high priests of finance were peddling a theology that any transaction between a buyer and a seller provides a public good, but theology is all that is—and a most self-serving one at that.

No one is proposing fixed controls on the size of the industry. We will never know what is the best size in a dynamic and increasingly complex economy. What we need, rather, are speed bumps, rumble strips, pot holes—anything that inconveniences market magicians as they try to load up on leveraged risk. The most obvious solution would be taxes on intra-industry transactions. That would be a radical step, to be sure. But it is a starting point to discuss how to put brakes on those who have no sense of speed limits.

Can we expect any of these things to come about under the current circumstances of our political economy? On the one hand, we seem hardwired to remain inactive as trouble brews. There is little will within our political class to seriously reconsider the role of government in relation to markets, despite all that has befallen us in recent times. On the other hand, there are the makings of a mob looking to ding the paychecks of bankers, which is a poor foundation for fundamental reform. Perhaps we await the coming generation of Nobel Prize-caliber thinkers to provide us the concepts that will bring government into the void left by the shortcomings of rational expectations and self-equilibrating markets. Clearly, we need new and practical ideas in many areas. If anything is certain, it is that conventional wisdom is in shambles.

But we need more than good ideas; we need a willingness to accept and act on them. On that count I am deeply concerned. Recall our house cat and leopard. We abide a government that steadily creates risks to a greater extent than the private sector did or ever could. We are the producer of the world’s greatest currency, and whatever else that means, it means that we can borrow well beyond our own peril. Certainly, government itself should never increase its own risks while it ignores uncertainty. And yet that is precisely what our fiscal policy has been doing. Look at the biggest measurable risk looming on the horizon: the unsustainable and growing fiscal imbalances that come from overspending, overpromising and undertaxing. If successive officeholders in Congress and the White House cannot even manage mere ordinary risk, then, sure as the sun will rise tomorrow morning, the uncertainty ahead will hit us when we have little or no margin left for action.

A famous maxim traced back to Herbert Stein holds that “if something cannot go on, it will stop.” Our mounting fiscal imbalance will be corrected through a plan to regain sustainability or by a crisis that befalls us because we have no plan. We are a great country with the great luxury of having the wherewithal to recover and learn from our mistakes. But our government is lagging the lesson book. It has not even begun to take stock of the fundamental and decisive role it played in bringing us to this unhappy pass. In the run-up to the housing bubble, there was a party that Congress was more than happy to attend. Bankers, realtors, inspectors and appraisers were having a great time, too. So were the poor-credit homeowners who felt they had finally nabbed a piece of the American dream. Finally, let us not forget all the middle-class homeowners who were using their homes as ATMs.

It couldn’t go on, and so it didn’t. The unsustainable has been unsustained, the party is over, and the populists are rising up in its wake. But they have risen not calling for fundamental reforms of existing entitlement programs. Rather, they want less government, which translates in current circumstances into more risk, more uncertainty—exactly what we don’t need.

Everyone likes a good tea party. But a lot depends on the distinction between what we need to drink for nourishment and what we’re wise to dump over the side. Ideas matter, but political courage and craft matter more. It starts with a narrative that harnesses the well-founded anger of the electorate to a story that opens the possibility of a happy ending.

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Jessica Einhorn is past dean of SAIS, Johns Hopkins University and former Managing Director at the World Bank.

Chapter 13

We the “People” after Citizens United

Robert Reich

Of all the bizarre decisions the U.S. Supreme Court has produced over its long and for the most part distinguished history, its decision in January 2010 in Citizens United v. Federal Election Commission ranks right up there with Bush v. Gore and Dred Scott for lacking any basis in common sense and for making a mockery of democratic ideals. When large corporations wield more political power than at any time since the late 19th century, the decision to treat them as persons with First Amendment free-speech rights in effect creates super-citizens who have at their disposal retained earnings and capacities to borrow against their capital exceeding the resources of almost every real citizen. The decision thereby consigns the rest of us to second-class citizenship.

Some argued at the time that the Court’s decision would not lead to significant increases in corporate spending on political campaigns since there are so many other ways for them to pump money into the political process. That may or may not be so as time passes; the future is stretched out long before us. But as a practical matter, after Citizens United even the mere threat of a giant corporation spending money on this or that candidate may suffice to sway a politician. The rest of us don’t stand a chance of being heard on any but the most salient of issues. Because of this grotesque decision, our First Amendment rights have been diminished to the point where, although we can say whatever we want about a political issue and contribute to the candidate of our choice, we might as well be doing so on a different planet.

While the principle that corporations can be construed as legal persons for business purposes dates at least to the 19th century, the idea that corporations have First Amendment rights to involve themselves in politics is a curious one of comparatively recent vintage. It originated just over three decades ago in a case entitled First National Bank of Boston v. Bellotti. Bellotti was brought by a group of corporations that wanted to spend money publicizing their views on a Massachusetts ballot question about a graduated income tax on individuals. Massachusetts law had barred corporations from buying advocacy ads on such initiatives. Writing for the majority in the 1978 decision, Justice Lewis Powell acknowledged that citizen control over elections was important, but he found that the statute unfairly discriminated against corporate speakers: “The inherent worth of the speech in terms of its capacity for informing the public does not depend upon the identity of its sources, whether corporation, association, union, or individual.”[1]

Citizens United takes Bellotti to its illogical extreme. Justice Anthony Kennedy, writing for the majority—which included the four members of the Court’s conservative wing—concluded that “if the First Amendment has any force, it prohibits Congress from fining or jailing citizens, or associations of citizens, for simply engaging in political speech.” Kennedy and his brethren thereby assumed that a corporation is an “association of citizens.” But it is most certainly not an association of citizens: A corporation is a set of financial agreements. Real people do enter into them but not as “associations of citizens.” They enter them as shareholders, creditors, executives, employees or suppliers. Such people, if they’re American citizens, already have free-speech rights under the U.S. Constitution. Their financial agreements are simply legal contracts, enforceable to the extent they provide some financial benefit—in legal parlance, “consideration”—to other parties. The notion that these contracts themselves have a voice, a will, a capacity for intention or a personality is absurd on its face: The Court’s decisions in effect turn such contracts, and the corporation they constitute, into life forms. It might as well give First Amendment rights to the chairs we sit on or the light bulbs we see by.

Companies should have no rights or responsibilities in a democracy; only people should. Yet the anthropomorphic fallacy—making corporations into people—turns this logic upside down. In fairness, the Court was only mirroring a way of thinking that has become deeply ingrained in American culture. When a disastrous spill occurs on an offshore rig used by the giant oil company BP, politicians and the media accuse BP of being negligent. When a mine owned by Massey Energy Corporation explodes, killing 29 miners, we blame the company for the disaster. When large Wall Street banks bring the national economy to the brink of chaos, we talk as if Goldman Sachs, JPMorgan Chase, Morgan Stanley and Citigroup are responsible. Even the grammatical convention in America of attaching verbs directly to a company—as in “Microsoft is trying to...” or “Wal-Mart wants...”—subtly reinforces the tendency to think about these entities as having independent volition. (The British, with their typical impeccability, use plural verbs to describe corporate conduct, as in, “Rolls Royce are considering...”)

This anthropomorphic fallacy that in effect grants corporations duties, responsibilities and also rights leads to a host of bad public policies. Consider the corporate income tax. The public has the false impression that corporations pay it; and if they pay taxes, why shouldn’t they be entitled to participate in the democratic process? No taxation without representation, as the saying goes. In reality, of course, only people pay taxes. The corporate income tax is actually paid by whomever the corporation can shift its costs to—consumers, shareholders or employees, depending on their respective economic leverage.

A logical tax policy would eliminate the corporate income tax and require shareholders to pay personal taxes on all income earned by the corporation on their behalf—whether retained by the corporation or paid out as dividends. Shareholders need not feel the pinch any more than salary-earners do: As each shareholder’s “corporate” earnings accumulate throughout the year, the company would withhold taxes owed just as do employers on their workers’ salaried earnings.[2] One important byproduct of this reform would be to puncture the false idea that corporations pay taxes and therefore deserve to be represented in the political process.

A similarly bizarre outcome occurs when companies are held criminally liable for the misdeeds of their executives or other employees. Not only does this practice reinforce the anthropomorphic fallacy—after all, criminals have rights under most democratic legal systems—but it ends up hurting innocent people. Consider Arthur Andersen, the former accounting firm convicted of obstruction of justice in the Enron case when, shortly before the SEC began its investigation, certain partners destroyed records of their auditing work just as the energy giant was imploding. When the company was convicted in 2002, its clients abandoned it for other accounting firms. Andersen shrank rapidly from 28,000 employees to a skeleton crew of 200, who attended to the final details of shutting it down. The vast majority of Andersen employees had nothing to do with the Enron account but lost their jobs nonetheless. Some senior partners moved to other accounting or consulting firms. Joseph Berardino, Andersen’s CEO at the time, snagged a lucrative job at a private equity firm. Some other senior partners formed a new accounting firm and were able to maintain their high salary levels. But many lower-level employees were hit hard; three years after the conviction, a large number were still out of work, according to an Andersen associate who ran a website for Andersen alumni. In addition, retired partners and employees lost a substantial portion of their retirement benefits. The Supreme Court eventually reversed the conviction, but by then it was too late—the company was gone. One former employee wrote on the website, “Does this mean we can bring a class action against the DOJ [Department of Justice] for ruining our lives?”[3]

The Arthur Andersen episode illustrates well the moral perversity as well as the illogic of the anthropomorphic fallacy. Companies cannot act with criminal intent because they have no human capacity for intent. Arthur Andersen may sound like a person but it wasn’t; the accounting firm was a legal fiction. The Supreme Court reversed the decision because the trial judge had failed to instruct the jury that it must find proof Andersen knew its actions were wrong. Yet how can any jury, under any circumstances, find that a company “knew” that “its” actions were wrong? A company cannot know right from wrong; a company is incapable of “knowing” anything. Nor does a company itself take action. It is a basic tenet of democracy, after all, that only people know right from wrong, and only people act.

Similarly, it makes no sense for the U.S. government to favor corporations headquartered in the United States on the assumption that American-based companies are somehow more “patriotic” than companies headquartered abroad. This use of the anthropomorphic fallacy confuses the set of contracts that comprise a company with rights and responsibilities of citizenship that only people deemed citizens can exercise. The truth is that under contemporary global capitalism all major companies, wherever they are headquartered, compete against each another for global consumers and investors. They hire executives and employees from all over the world, take in money from investors and lenders who live all over the planet, and conduct business wherever they can make a profit.

Giving First Amendment rights to “American” corporations therefore gives non-Americans the right to finance political elections in America. This problem is not obviated, as the Justices seem to think, on the basis of where a company is incorporated, because the composition of its staff and investment portfolio need bear no likeness to its place of incorporation. Likewise, blaming “American” companies for “outsourcing abroad” and therefore “sacrificing American jobs”—and imposing taxes or other penalties on them for doing so—assumes that an “American” company has a unique competitive advantage doing business in the United States. This is just not so: If an “American” corporation used more higher-priced American labor than its global competitors, with the result that its costs and prices were higher, the vast majority of its American customers and investors would abandon it in favor of other global companies that provided better deals.

It is just as illogical for policymakers to subsidize the U.S.-sited research of American-based companies on the assumption that this will make America more competitive. American-based companies do research and development all over the world. Such subsidies merely underwrite research that would have been undertaken here anyway while freeing up more corporate research money to be spent outside the United States. Nearly every U.S. brand of notebook computer, except Apple, is now designed in Asia. The same is true for most cell phones and many other hand-held electronic devices. IBM has a major research laboratory in Switzerland; the Swiss company Novartis, on the other hand, operates a research lab in Boston.[4] Microsoft has invested $1.7 billion in India, about half that sum in its R&D center in Hyderabad. IBM is opening a software laboratory in Bangalore. Dow Chemical has a research center in Shanghai that employs 600 engineers, as well as a large installation in India. A survey of more than 200 American and European global corporations conducted by the National Academies of Science found that 38 percent are in the process of shifting more of their R&D work to China and India, and decreasing the share of R&D done in the United States and Europe.[5]

The goal of U.S. government policy should be to make Americans more competitive, not to make American companies more competitive. Most corporate executives understand this distinction, although most Americans—and many of the politicians and policymakers who represent them—do not. “For a company, the reality is that we have a lot of options”, says William Banholzer, Dow’s chief technology officer. “But my personal worry is that an innovative science and engineering workforce is vital to the economy. If that slips, it is going to hurt the United States over the long run.”[6] The Federal government should subsidize the basic R&D of any company, regardless of where its headquarters are located, as long as its work develops the on-the-job skills of American-based engineers and scientists.

Nor does it make any sense to treat companies as “persons” with legal rights to challenge the constitutionality of duly enacted laws and regulations. Yet this is occurring all the time. Nine global automakers sued the state of California to block its “clean cars” law, which requires cars sold in California to reduce greenhouse gas emissions 30 percent by model year 2016, on grounds that the legislation amounts to an unconstitutional restraint on interstate commerce. A majority of the shareholders of at least seven of these automakers were not American citizens, yet the court gave them standing to challenge, and potentially overturn, a law enacted by the citizens of California. Real citizenship should be the core criterion for engaging the U.S. legal and political system; only people—actual living, breathing human beings, who are citizens—should be granted standing to challenge Federal or state laws and regulations on constitutional grounds. Any American citizen or group of American citizens claiming they are injured by California’s law should have standing to mount a constitutional challenge to it—including, for example, a class-action suit brought by American investors in Toyota. But non-Americans should not have such a right, including non-American investors in, say, General Motors.

Democracy is for people, not for corporations. Getting our thinking straight about this is a crucial step toward reclaiming our dilapidated democracy. For many years, anti-union lobbyists have pushed what they call “paycheck protection” laws designed to protect union members from being forced, through their dues, to support union political activities they oppose. Under such laws—already in effect in several states—no union dues can be spent for any political purpose, including lobbying, unless union members specifically agree to it. It would be logical to apply the same principle to protect shareholders from being forced through their investments to support political activities they oppose. “Stockholder protection” would require that shareholders specifically agree to any corporate political activity. If a company dedicates, say, $100,000 to political action in a given year—including lobbying, campaign contributions, so-called “issue” advertisements, and gifts or junkets for elected officials—shareholders who do not wish their money to be used this way would get a special dividend or additional shares representing their pro rata share of that expenditure. Mutual funds and pension plans would have to notify their shareholders of such political activity, and seek their agreement or acquiescence. Such political activity would thereby be financed only by shareholders who wish to spend their portion of company profits on it.

We are all consumers and a great many of us are investors, and in those roles we try to get the best deals we can. That is how we participate in a market economy and enjoy the benefits of capitalism. But we are also citizens who have a right and a responsibility to participate in a democracy. Yet we can do this only if we protect our democracy from capitalism for, contrary to comforting myth, the two are not eternally harmonious and mutually reinforcing. A giant first step would be to abandon the anthropomorphic fallacy. Policymakers, including even the Justices of the Supreme Court, eventually will come to understand this basic point—but only if the rest of America understands it, too.

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Robert Reich, former U.S. Secretary of Labor, is professor of public policy at the University of California at Berkeley.

1 Powell in First National Bank of Boston v. Bellotti, 435 U.S. 765 (1978).

2 Modern computer software is easily capable of allocating corporate earnings based on the number and duration of stock holdings.

3 Jonathan Glater and Alexei Barrionuevo, “Decision Rekindles Debate Over Andersen Indictment”, New York Times, June 1, 2005.

4 See G. Pisano and W. Smith, “Restoring American Competitiveness”, Harvard Business Review (July/August 2009).

5 See William Broad, “Advisory Panel Warns of an Erosion of the U.S. Competitive Edge in Science”, New York Times, October 13, 2005.

6 Banholzer quoted in Steve Lohr, “Outsourcing Is Climbing the Skills Ladder”, New York Times, February 16, 2006.

Chapter 14

Courting Plutocracy

Ruth Wedgwood

To the ordinary person, the label “plutocrat” conjures Monopoly’s black-suited banker with mustachio and cigar, puffing his way to success without concern for his struggling neighbors. He has his office, we surely suppose, in a factory belching dark smoke, with exhausted workers engaging in repetitive tasks for a pittance. His worship of wealth and indifference to its victims is antithetical, so critics would claim, to the ideal of equality centering the American republic.

A century ago, the enormous success of entrepreneurs such as John D. Rockefeller assembling Standard Oil and Henry Ford turning out the black Model T might well have fit this caricature. Even caricatures, after all, come from somewhere. Their prowess as businessmen and inventors was offset by the optics of labor conflicts such as the Ludlow Mine massacre and the violent strikebreaking at Ford’s Dearborn factories. Railroad kingpin James J. Hill equally complicated the reputation of entrepreneurs for political chastity. When the Dakota territorial legislature refused to approve his right of way, he led a secessionist movement to create North Dakota and thereby gained a more congenial set of assemblymen.

In the sensibility of the 20th century, the Great Depression added to the worry that capitalism had gone awry, with Dorothea Lange pictures from the Farm Security Administration capturing the distress of migrant families from the Dust Bowl looking for work in California. The New Deal and Great Society programs of Social Security and unemployment insurance, together with the Civil Rights revolution, later mitigated the sense that peonage was still rife in America. But the 1960s still served to romanticize a lukewarm, sentimental socialism in America later ratified by expressions of envy for a maturing European “Third Way.” Pete Seeger and the Weavers picked their way through the banjo and guitar notes of old Wobbly songs to celebrate a bucolic age of labor before bosses became exploiters. And despite the early warnings of Arthur Koestler and George Orwell, it was not until the archives of the Soviet Gulag and KGB were exposed that the perils of a revolutionary workers’ paradise were audibly acknowledged by the American Left.

In the present age, there is more appreciation of what entrepreneurship does for a society, as scores of remarkable drop-outs and undergraduates have created wired businesses worth billions of dollars in word processing, social networking and Internet search engines. This millennial spurt of innovation has yielded a more indulgent view of the rewards due to innovators in a changing economy, not least because of its effect on productivity. The reshaping of commerce, communications and transport has, to be sure, created the daunting challenge of a worldwide labor market, where Malthusian outsourcing seems to have no obvious limit and the sense of unique luck that has accompanied America in its more than two centuries of history has faded a bit. But the power of innovation and entrepreneurship still may help us understand with greater clarity why the Founders of the American Republic, while they worried in undertones about “factions” and their source in property inequality, saw no necessary contradiction between political equality and free enterprise, or indeed, between liberty and wealth.

Looking backward makes the point. The American Revolution was fought, in one view, not so much to shake off British taxes but to gain the right to move west beyond the Appalachian Mountains despite the British imperial prohibition that valued peace with the Indian tribes more than the lure of limitless land. After victory, the constitutional moment of 1787, which followed four months of secret debate in Philadelphia, was protective of the instruments of commerce and acquisition. The new Congress was granted power to regulate interstate and foreign commerce, but this was construed for more than a century as extending only to transactions that involved actual cross-boundary shipments. This construal constrained the power of the Congress to meddle in economic matters, even while the Federal government solicited funds for “internal improvements” such as roads and canals. The sanctity of private contract was celebrated, and beggar-thy-neighbor state judicial decisions thwarted, by Federal court “diversity” jurisdiction over interstate disputes. This displaced any local court that might rule in favor of local parties by applying a “Federal common law” of private contracts.

The obliging nature of private contracts was also championed by a Federal constitutional ban on state “impairment” of contracts. This denied any power over bankruptcy proceedings at the state level. (The early Founders’ personal fever for speculating in land—including Supreme Court Chief Justice John Marshall and Justice James Wilson—makes this intolerance of debt relief all the more remarkable, for it came at a time when debtors in default could be arrested in order to post security for payment. Indeed, Justice Wilson died in disgrace for failing to pay his debts.)

John Marshall’s Supreme Court also actively supported the economic value of corporate charters, with Marshall and Story even supposing that a charter to build the Charles River Bridge silently precluded any second bridge. And even on the frontier, amid a post-revolutionary world of chaotic land claims where elms, maples and oaks marked the boundaries of property, the Marshall Court acted strictly to enforce formal land titles, voiding state-granted rights to land squatters who made improvements on another person’s property. And as an added antidote to state license, Secretary of the Treasury Alexander Hamilton used the founding moment to assume the states’ elephantine debts from the Revolutionary War, understanding that the debtor wields power over creditors.

Yet property and its protection were different from plutocratic privilege. For the generation of the Founders, the freehold of free men in the abundance of a new continent took pride of place over all other considerations. Blame it on the virgin forest, if you will. But as John Locke taught in the Second Treatise on Government, amidst a plenitude of land any man could wield an axe and fell first-growth timber, claiming the land as his own by mixing labor with vacant soil. It was labor, or what we might call today value-added, that defined property. Veterans of the American Revolutionary War and the War of 1812 were given “land warrants” to locate on unclaimed western land, whether in Kentucky, Tennessee or Ohio. The land rush and the Homestead Acts of the later 19th century extended this Edenic promise of abundance farther across the continent, though the grim realities of subsistence farming were not always immediately apparent. Success in farming was limited by the vagaries of weather and difficulties of transporting goods to market, in the slow progress of canals and later railroads. But the ideal of an agrarian America and yeoman farmers persisted for the duration of the 19th century. Despite skepticism about Federal power, even the American South succumbed to the need for “internal improvements” in transportation. There were no plutocrats in sight, and the term, of antique British origins, was not yet heard in the New World.

There was, of course, the quandary of slavery. This inherited curse represented a constant affront to the self-regard of independent farmers of the North, who saw the large-scale use of servile labor in the harsh climate of the South as unfair competition and a bowdlerization of the dignity of honest work. Even some thinkers in the South imagined slavery’s demise, since the plantation agriculture of Maryland, Virginia and the Carolinas faced a diminishing fertility in the early 19th century. But the Louisiana Purchase and the accession of Texas, together with the invention of the cotton gin, renewed the energy of the slave machine and created conspicuous fortunes among rural patricians. At least in slavery’s setting, patrician wealth bore no relationship to honest work. The maritime families of the North also made handsome livings from the triangle trade in slaves, cotton and rum (as students at various eponymous universities have lately noticed). Here, in what some historians have called the Slavocracy of the South, the potential for a kind of plutocracy, at least, arose.

To be sure, even without slavery, it would be a mistake to exaggerate the degree of political equality envisioned in the 1787 Constitution. Until the Civil War, the Constitution allowed the states to determine the qualifications of voters, including in Federal elections. Property-holding requirements for casting a ballot lasted well into the early 19th century. When a dust-up called Dorr’s Rebellion challenged Rhode Island’s restriction of the franchise to a handful of Providence plantation families in the 1830s, the legitimacy of the autocratic state government came before the U.S. Supreme Court. The Justices ran from the question, ruling that the meaning of the Federal constitutional guarantee of a “republican form of government” was not a question given to judges. Not least, this was an indulgence to Southern opinion that feared republicanism might preclude slavery, as well.

So, too, women were deemed unsuited to the franchise in most states until the end of the 19th century. To some, this followed from the fact that married women could not hold property or contract in their separate names under the common law doctrine of “coverture”; economic dependence on a husband was thought to preclude independent political judgment. The intellectual acumen of noted women in the founding such as Mary Warren and Abigail Adams was apparently not sufficient counterexample.

Nonetheless, the widespread availability of property in an agrarian state allowed most white men to vote, and a more radical vision of democracy took root with the triumph of Jacksonianism in the 1830s. Chief Justice Roger Taney is remembered with suitable derision for the Dred Scott decision that denied free blacks any standing to sue in Federal court, even when they were kidnapped into bondage; yet as a legal populist in a white agrarian society, he also inclined to allow local government to handle problems of insolvency and loosened the restrictions of corporate law.

The Civil War, of course, brought the enormous changes of a conflict won largely because of the industrial plant and railroad logistics of the North. The economic devastation of the war destroyed the South’s plutocratic plantation wealth, yet left most blacks tied to the land in the informal servitude of sharecropping and debtors’ prison. In contrast, the North’s burgeoning industrialization assembled fortunes in the late 19th century of a scale that was hard for any antebellum to imagine, assisted as well by America’s commercial expansion abroad. This new concentration of wealth, seasoned with conspicuous consumption, inspired the Progressives to attack the rise of trusts and cartels, arguing that a vigorous antitrust policy was necessary for the restoration of an open economy. The 16th Amendment in 1913 in turn allowed Congress to tax the private income of individuals, without requiring the political feat of apportionment among the states.

Yet strangely enough, some of the court cases that were later assumed to be plutocratic in motive were, at the time, quite arguably protective of an open economy. The Supreme Court struck down state regulation of working hours in non-hazardous industries as a violation of substantive due process in the famous turn-of-the-century decision of Lochner v. New York. Tutored by the Progressives and the New Deal, Lochner has been dismissed in the past fifty years as an antique Court’s misuse of “freedom of contract” to perpetuate the advantages of capital in a landscape hostile to workers’ rights and trade unions. But an alternate reading could see this case as an attempt to protect smaller businesses against larger firms, since a small business could not muster the same surge capacity in busy seasons without requiring longer hours.

So, too, the sanctity of contract was sometimes used to surprising effect, for example, in challenging the lack of regularity in immigration law. Although immigration law was seen as being immune to the claims of equal protection among nationalities, still the written promise made to a Chinese man that he would be readmitted to the United States after a visit home argued to be binding on the basis of the sanctity of contracts (albeit unsuccessfully) in the historic Chinese Exclusion Cases.

Not surprisingly, the Great Crash of 1929 and the seemingly endless economic depression that ensued appeared to shake the ground of American capitalism, destroying any faith in Say’s Law and its claim that industrial production would necessarily generate sufficient consumer demand. But the Supreme Court still acted to preserve a more classical account of free markets, resisting Franklin Roosevelt’s proposal in the early years of the New Deal to reorganize American industry in the quasi-syndicalist structure of the National Recovery Administration. The “switch in time that saved nine” brought the Supreme Court to accept broader Federal regulation of the economy, but not Roosevelt’s more radical proposals for industrial control, which did not return to the debating floor. In a sense, the classical vision was preserved, but with some buffering. FDR’s Wagner Act assisted labor unions in taking root in large-scale industry, and Congress passed a broad portfolio of social guarantees, such as Social Security and Federal unemployment insurance, in large part on the back of trade union activism. Industrial plutocracy might be conspicuous in the assembly of fortunes on Park Avenue and great country estates on Long Island, but a guaranteed social minimum helped to take the edge off any surge of radical resentment.

The Great Society legislative program of Lyndon Baines Johnson was equally transformative as a more deeply institutionalized form of buffering. It added Medicare and Medicaid to the package of social minima for the elderly and children. And the original promise of Fanny Mae and Freddie Mac was framed to make home ownership available to more citizens in a financially responsible way.

With the end of (what we thought was) the high-growth decade of the 1990s, the burgeoning cost of social programs has now begun to test the limits of Federal solvency in a diminished economy. How much taxation can be sustained without dampening creative entrepreneurship or driving investment capital out of the country in a global economy of mobile capital and offshore banking remains anyone’s guess. The World Bank’s “Washington Consensus” on how to sustain long-term development is looking somewhat less attractive to Washington itself, in the sharp contrast between upward-spiraling plutocratic fortunes and the diminution of the prospects of working Americans. The internationalization of the labor market, vividly focused for Americans today in offshore outsourcing and the sharp questioning of immigration, are part of the renewed American debate about whether a robust democracy can retain its social cohesion and ennobling sense of political equality when so many citizens are out of work and the frontier—any frontier—is closed.

Historically, Americans have not minded the accumulation of great wealth so long as they thought that everyone had a fair chance to chase up the hill after it. The burden of U.S. legal history has been to let the chase go on, out of concern that infringing on the pursuit of property would stifle the motors of entrepreneurship and general economic advance, as well as the vitality of a free life. That is still the premise of the American Constitution. But the founding document also aspires to preserve a sociability that distinguishes a republic from a free-for-all. If the social and technological environment surrounding us has undergone qualitative change of a magnitude that throws this definition off its mount, the American republic will have to go back to basics in its self-definition.

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Ruth Wedgwood is Edward B. Burling Professor of International Law at the Johns Hopkins University School of Advanced International Studies.

Chapter 15

Fighting Lobbying, Then and Now

Ellen P. Aprill & Richard L. Hasen

In The Federalist (No. 10), James Madison famously worried about faction. He was most concerned about what would happen if a faction consisted of a majority of the population. In contrast, if the faction were to consist of less than a majority, Madison had faith that majority vote would defeat its “sinister views.”

Today we are perhaps less sanguine about the ability of the majority to block special interest groups. The process of lobbying, whereby organized groups attempt to pass, block or change pending legislation by contacting legislators and staffers and urging the public to do the same, is a multibillion dollar industry ($3.6 billion in 2009), and it appears to yield a very good return on investment.

It is therfore no wonder that reining in some of the excesses of lobbying is one of the few issues on which most Republicans and Democrats agree, at least in principle. As a presidential candidate, Barack Obama declared in 2008, “If you don’t think lobbyists have too much influence in Washington, then I believe you’ve probably been in Washington too long.” He explained his refusal to take campaign contributions from federally registered lobbyists on grounds that lobbyists can “drown out the views of the American people.” As President, he has criticized an “army of lobbyists” who spent millions of dollars in an unsuccessful attempt to block passage of a bill reforming practices in the student loan industry.

Sarah Palin also blames lobbyists for the country’s woes. When Fox News host Sean Hannity asked her if campaign contributions to then-Senator Obama and other members of Congress caused lax congressional oversight over mortgage giants Fannie Mae and Freddie Mac, Palin replied that “the role that the lobbyists play in an issue like this is more significant than the role of contributions” because “the cronyism” is “symptomatic of the greater problem that we see right now in Washington, and that is just that acceptance of the status quo.” In a Facebook post, she explained further that when it comes to financial reform, “the big players who can afford lobbyists work the regulations in their favor, while their smaller competitors are left out in the cold.”

In the face of the financial crisis, partisan recriminations and other problems of contemporary American governance, some have urged limits on lobbying in order to promote the public interest. They fear not only potential lobbyist corruption, but also lobbyists facilitating a raiding of the public fisc. Thus, Kentucky Senator Rand Paul has advocated that any government contractors with contracts worth at least $1 million be barred from lobbying or making campaign contributions. But excessively strict limits on lobbying may actually threaten good public policy. Lobbyists provide legislators and other government officials with crucial information and convey the points of view of important constituencies. A responsive government needs to hear various viewpoints, and in a complex world legislators and staffers need help analyzing, and even writing, important legislation. It is hard to imagine the U.S. government today functioning without lobbying. Moreover, lobbying also enjoys constitutional protections. The First Amendment guarantees both free speech and the right to petition the government.

We as a nation long have struggled with how to strike the proper balance between respecting lobbying as a constitutionally guaranteed and pragmatically useful activity and ensuring that the private interests of the wealthy and well-organized do not manipulate and foil efforts to promote the public good. As elaborated below, Congress has tried limiting tax deductions for lobbying expenditures and mandating disclosure requirements. Neither of these has worked very well, however, and episodic scandals such as the Jack Abramoff/Michael Scanlon affair of 2004 have led to calls for further regulation. For example, the Federal government has turned its focus (by both legislation and Executive Order) to regulating more directly interactions between government officials and lobbyists.

The attempt to turn the screws on lobbying may be met with constitutional skepticism as a result of the Supreme Court’s January 2010 decision in Citizens United v. Federal Election Commission. Citizens United is almost universally thought of as a campaign finance case, not a lobbying case, but its reach is far wider. Lower courts in two cases we describe further below have already struck down some core lobbying regulations for violating the First Amendment as the Supreme Court interpreted it in Citizens United. More cases could well be decided in similar ways. In the end, the reach of Citizens United may be even broader than most of us initially understood; it may influence not only who gets elected but also the ability of interest groups to pressure Federal officials in connection with particular legislative issues.

The Federal government’s first efforts to regulate and limit lobbying came in the form of two sets of tax rules. One set, dating from 1918, just a few years after ratification in 1913 of the 16th Amendment allowing an income tax, denies a business deduction for the costs of lobbying. The other set, dating from 1919, limits the amount of lobbying allowed for organizations exempt under section 501(c)(3), which entitles them to accept tax-deductible charitable contributions (the organizations we typically refer to as “charities”). By denying or limiting the deduction for funds used to lobby, these rules in effect made lobbying more expensive. A series of court cases have found no constitutional barriers to either set of rules, but neither set appears to have limited the steady growth of lobbying activities. The elasticity of demand for lobbying thus appears to be quite small: Clients have been more than willing to pay increased costs for benefits that they judge to be indispensable. Let’s look more closely at the history.

Business Deductions for Lobbying: Treasury Department rules denied business deductions for lobbying expenses on the grounds that they were not ordinary and necessary expenses, as the statute required. This rule stood without challenge for many years, but a 1959 Supreme Court case, Cammarano v. United States, tested it. In the end, the Justices rejected (among other arguments) a First Amendment challenge to non-deductibility rules for business lobbying expenses. The Court decided that the tax treatment was valid based on Congress’s determination that,

since purchased publicity can influence the fate of legislation which will affect, directly or indirectly, all in the community, everyone in the community should stand on the same footing as regards its purchase so far as the Treasury of the United States is concerned.

The taxpayers were “not being denied a tax deduction because they engage in constitutionally protected activities”; instead, they, like everyone else engaged in these activities, must pay for them “entirely out of their own pockets.”

The Supreme Court in Cammarano extolled equal treatment of all taxpayers, but its vision of equality seemed confused at best. It trumpeted this conclusion despite the fact that at the time of the case supporters of charities could, to at least a limited extent, support lobbying with deductible contributions. It assumed, without discussion, that the deduction for business lobbying expenses should be judged against the treatment of lobbying costs by all other persons, whether individuals, tax-exempt organizations or for-profit entities, rather than against the treatment of other business costs by businesses. It ignored the fact that individuals and businesses are not similarly situated for tax purposes. We tax businesses, including sole proprietors, on their net, not their gross, income. Businesses are generally permitted deductions for the costs of producing income while individual deductions fall far short of the cost of personal, living or family expenses.

Congress recognized this justification for business deductions of lobbying expenses in 1962. It enacted a statute that permitted a deduction for direct lobbying expenses—that is, for the expenses of lobbying committees or members of legislatures and their staffs, precisely because such a deduction “is necessary to arrive at a true reflection of [a business’s] real income.” The legislative history of the 1962 provision also illustrates the concern that, under the old rules, the costs of contact with the Executive and Judicial Branches could be deducted, but not the costs of contact with the Legislative Branch, a distinction that did not make a great deal of sense.

For some thirty years, then, the tax code permitted direct lobbying expenses as a business deduction. Expenses for grassroots lobbying—the cost of contacting members of the public to urge them to contact their legislators—continued to be nondeductible. In 1993, however, Congress returned to the structure of the original regulations, amending the provision to deny the deduction for both direct and grassroots lobbying. The legislative history of the 1993 amendments gives little reason for this congressional change of heart. The House Report spoke of revenue concerns: “The Committee has determined that in the context of deficit reduction, it is appropriate to limit the business deduction for lobbying expenses.” Earlier that year, however, Treasury’s explanation of the Clinton Administration’s revenue proposals stated, “The deduction for lobbying expenses inappropriately subsidizes corporations and special interest groups for intervening in the legislative process.”

The 1993 legislation disallowed for the first time a deduction for lobbying top Executive Branch officials. It permitted a deduction for lobbying local government, probably on the grounds that it is often difficult to distinguish between legislative and administrative functions at that level. The same legislation also introduced elaborate rules applicable to non-charitable exempt organizations such as social welfare organizations (section 501(c)(4) organizations), unions and trade associations. These organizations are not themselves limited in the amount of lobbying they can undertake so long as the lobbying is related to their tax-exempt purpose. Under the 1993 provisions, however, they must choose between notifying their members of the percentage of their dues or similar fees that cannot be deducted because they were spent on lobbying or political activities, or they themselves must pay a proxy tax on the amounts spent for such activities. Subsequent administrative rulings exempt certain of these organizations, including labor unions, from these notice or proxy-tax provisions.

The law enacted in 1993 continues unchanged today. The tax code permits no business deduction for expenses related to lobbying the Federal government. Again, however, there is little evidence that increasing the after-tax cost of lobbying as compared to other business expenditures has reduced the amount of lobbying that businesses conduct. That lack of evidence in turn suggests that the law (inadvertently, one presumes) benefits larger and more sophisticated businesses over smaller ones.

Although it is generally difficult to measure the financial benefits of lobbying, one recent study found that companies which lobbied for a provision in the 2004 American Jobs Creation Act permitting tax-free repatriation of foreign earnings benefited from a 220 percent return on their investment. Not bad, especially compared to most other investments.

Charitable Organizations and the Charitable Deduction: Treasury regulations dating before the 1920s specified that the distribution of any “controversial or partisan propaganda” was inherently not educational and disqualified a charitable organization for tax exemption. In an influential 1930 case from the United States Court of Appeal for the Second Circuit Court, Slee v. Commissioner, Judge Learned Hand disallowed deductions for gifts to the American Birth Control League because the League’s charter included lobbying as an independent mission. Judge Hand wrote, “Political agitation as such is outside the statute, however innocent the aim. . . . Controversies of that sort must be conducted without public subvention; the Treasury stands aside from them.”

Much ink has been spilled trying to parse Judge Hand’s words, but he has come to be understood as endorsing a policy of government neutrality in legislative controversies. In 1934, Congress entered the fray. It drew a line through the Internal Revenue Code by requiring that no organization could be a tax-exempt charity if a substantial part of its activities consisted of “carrying on propaganda, or otherwise attempting to influence legislation.” Statements in the Congressional Record speak to a concern that charities in general would use tax-deductible contributions to lobby on behalf of the personal interests of their donors. Permitting some lobbying by organizations eligible to receive tax-deductible contributions, however, undermined the neutrality Judge Hand had endorsed in Slee.

Congress further tightened these limits on charitable lobbying in 1969, at a time when businesses were permitted to deduct lobbying costs. It enacted a provision that, for all practical purposes, imposes an absolute ban on lobbying by one category of section 501(c)(3) organizations, private foundations. Private foundations are charitable organizations that, in general, rely on and are controlled by a single group of donors, often a wealthy individual, family or corporation. Congressional hearings had focused on concentrations of social and economic power by private foundations such as the Ford and Rockefeller Foundations, including use of their wealth to influence legislation. The lobbying prohibition was one of several provisions enacted to regulate private foundations.

While private foundations found themselves forbidden to lobby, other 501(c)(3) organizations subject to the “no substantial part” test struggled to comply and understand its vague and uncertain stricture. There was not then, and there is still not today, any clear guidance as to what “substantial” means. In response to organizations that desired greater certainty and freedom to lobby, Congress in 1976 enacted an elective regime permitting charities that so chose to be subject to a specific dollar limit, on a sliding scale according to their total budgets, for their lobbying expenditures. The maximum amount of lobbying permitted under the elective regime is $1 million, which an organization reaches when it has a budget of at least $17 million.

After first proposing controversial regulations that would have broadly defined what constituted lobbying for the purposes of this elective regime, the Treasury Department issued regulations that defined both direct and grassroots lobbying quite narrowly for charities that make this election. Thus, many issue-related activities conducted by such charities are not considered lobbying and thus are not subject to any limit. Nonetheless, very few charitable organizations—no more than 1 to 2 percent, and very few large charitable organizations in particular—make this election, especially because the dollar limits are not inflation-adjusted.

Not until 1983, however, did the Supreme Court consider a constitutional challenge to the limit on substantial lobbying by 501(c)(3) organizations. Regan v. Taxation with Representation rejected a First Amendment challenge on the grounds that “Congress has merely chosen not to pay for TWR’s lobbying.” Congress, the opinion explained, is not required to subsidize First Amendment activity and can choose to subsidize lobbying less extensively than other activities that 501(c)(3) organizations undertake. The opinion noted that the 501(c)(3) organization could form a 501(c)(4) affiliate that could lobby without limit but would not be eligible to receive tax-deductible contributions.

Thus, while excess lobbying by a 501(c)(3) organization can result in its loss of exemption, the ability to create paired 501(c)(3) and 501(c)(4) organizations avoids such a result, although the two organizations must be separately organized and take care that no tax-deductible funds support lobbying beyond permissible limits. Such a pairing is in fact quite common. The Sierra Club, for example, lost its exemption because of excess lobbying in 1966; today, it is a section 501(c)(4) organization, free to lobby without limit but unable to accept tax-deductible contributions. The Sierra Club Foundation, however, is a section 501(c)(3) organization with a stated mission “to educate, inspire and empower humanity to preserve the nature and human environment.” It can accept tax-deductible contributions. Similarly, the American Civil Liberties Union and the ACLU Foundation are paired 501(c)(4) and 501(c)(3) organizations, as are the National Rifle Association and the NRA Foundation.

With charities as with businesses, the government over time has, with some exceptions, worked to tighten or at least clarify the limits on deducting amounts spent on lobbying. Such efforts, however, seem to have had little impact on the amount of lobbying undertaken by larger and well-advised organizations, although many argue that the uncertain reach of the “no substantial part” test deters smaller, local or less wealthy 501(c)(3) organizations from engaging in any lobbying. As a result, the law as currently written and understood mutes the voice of the poorer non-profits, just as higher costs for business lobbying disadvantages smaller, less well-capitalized businesses.

Aside from a short-lived lobbyist registration requirement that lasted only as long as the 44th Congress, Congress did not pass a non-tax bill addressing lobbying until 1946. The Federal Regulation of Lobbying Act imposed registration requirements for those who lobbied Congress, as well as a requirement of quarterly reports of money spent and received for lobbying activities. The Senate Report described its purpose as promoting publicity, or what we would today call transparency. It saw its efforts as a “mild step forward in protecting government under pressure” from “swarms of lobbyists seeking to protect this or that small segment of the economy or to advance this or that narrow interest”, making it difficult for legislators “to discover the real majority will and to legislate in the public interest.”

The 1946 Act suffered from a number of drafting problems, however, and the Supreme Court in United States v. Harris, faced with a First Amendment challenge, significantly rewrote and narrowed the statute. Although the statute as written applied its disclosure requirements to the raising and spending of funds for the purpose of influencing congressional action “directly or indirectly”, the Court construed this language narrowly to refer only to directly communicating with members of Congress on pending or proposed Federal legislation. It further limited the reach of reporting requirements to those persons who solicited, collected or received contributions of money for such a purpose, and only so long as such lobbying was one of the main purposes of the contributions. It held that the rewritten disclosure statute afforded Congress the power of self-protection without offending the First Amendment. In truth, however, its interpretation made the statute ineffective as a disclosure mechanism.

It took another forty years before Congress imposed new lobbying disclosure requirements. Congress passed the Lobbying Disclosure Act of 1995 (“LDA”) on a unanimous vote of 421–0 in the House and 98–0 in the Senate, but only after overcoming serious opposition from the Republican Party. It passed only after supporters gave their assurance that the bill did not seek to require disclosure by those engaged in “grassroots lobbying”, which Republicans sought to protect both for ideological reasons and likely out of a belief that such activities disproportionately benefit them.

The LDA improved on the 1946 Act in a number of ways. It applies to lobbying not just members of Congress, but their staffs as well. It covers lobbying of the Executive Branch; and it expands the scope of who needs to register as a lobbyist and what information needs to be included in filed reports. Along with other Federal laws, particularly the so-called Byrd Amendment prohibiting the use of funds appropriated by Congress to lobby for any Federal award, it provides the current legal framework for all Federal lobbying regulation.

Although the LDA certainly required more disclosure than the 1946 Act, it still imposed a relatively weak enforcement regime. The required format was difficult to follow and the required disclosures minimal—little more than the stating generally that the lobbying activity contacted the House of Representatives, the Senate or a particular Federal agency, such as the Department of Defense. It did not require naming the specific legislators, committees or Federal employees contacted. Notably, however, the LDA has enabled us to gauge the magnitude and growth of dollars spent on lobbying, providing the basis for the data on the extent of lobbying and lobbyist activities we presented above.

In 2007, Congress again revisited lobbying regulation, prompted in large part by the 2004 Jack Abramoff scandal. Abramoff had arranged lavish trips abroad for members of Congress, including then-House Majority Leader Tom DeLay, and enriched himself at the expense of various Native American tribes that were his clients. He eventually pleaded guilty to charges of fraud, tax evasion and conspiracy to bribe public officials.

A legislative stampede to regulate lobbying soon followed. By the time the dust had settled, Congress had passed the Honest Leadership and Open Government Act (HLOGA). HLOGA strengthened the 1995 LDA through expanded disclosure requirements for lobbying coalitions; it mandated a new reporting system for lobbyist contributions and disbursements to or on behalf of Legislative and Executive Branch officials and candidates for Federal office; and it improved public access to information disclosure under the LDA. HLOGA made reporting more frequent and the reports easier for the public to search, but it did not require more detailed information about the specific members of Congress, staff or Federal agency officials who were lobbied on particular bills or issues.

The one significant new type of data that now must be disclosed is lobbyist “bundling” activity. Bundling occurs when someone solicits others to contribute to a candidate or committee and then delivers a “bundle” of contributions (either physically or virtually) to the campaign. Bundlers get credit for their efforts on behalf of the campaign. Representative Christopher van Hollen (D-MD), one of the co-sponsors of the legislation, explained that the basis for the bundling disclosure provision was to guard against the use of campaign finance bundling by a lobbyist to enhance the lobbyist’s stature and thereby “exert an undue influence over public policy.”

HLOGA also strengthened other lobbying rules imposed earlier by Congress. In 1989, the House and Senate had imposed an “anti-revolving door” provision barring members and their staff from working as lobbyists for one year after leaving office. HLOGA extended that provision for Senators to two years (leading Senate Minority Leader and soon-to-be-lobbyist Trent Lott to resign from the Senate early to avoid the new provision). Similarly, though earlier Congressional rules had limited gifts to members of Congress and their staffers, HLOGA (with limited exceptions) banned outright gifts from lobbyists to members of Congress and staffers and limited the meals and travel that members of Congress could accept from anyone.

While it is too early to tell the effect of HLOGA on the amount and extent of lobbying activity, one early result suggesting that HLOGA has some bite is a sharp increase in the number of former lobbyists who have “deregistered” so as to avoid its new requirements. This suggests that much lobbying activity may be shifting to individuals who need not register as lobbyists as they are defined under HLOGA. Such an unfortunate result was far from the aim of the legislation. Its attempt to regulate lobbying further may have the unintended consequence of deregulating much lobbying. On the other hand, the gift ban and related ethics rules appear to have made it harder for future Abramoffs to curry favor with members of Congress through lavish trips and gifts.

President Obama has imposed new requirements on lobbyists through Executive Orders, memoranda and other devices. One of the Obama Administration’s earliest lobbying-related initiatives, announced as an effort to avoid “improper influence or pressure” from lobbyists, prohibited lobbyists from communicating orally with anyone in the Administration regarding the economic stimulus package. The American Civil Liberties Union, the Citizens for Responsibility and Ethics in Washington and the American League of Lobbyists wrote a joint letter in March 2009 criticizing limitations that applied only to registered lobbyists but not to non-registered lobbyists such as corporate directors. As a result, the Administration in July 2009 changed some aspects of this directive, applying it beyond registered lobbyists but narrowing the time frame to which it applied.

The President also announced that, absent a waiver, lobbyists could not serve as presidential appointees, nor could they be appointed to Federal advisory panels. Waivers allowed a former Raytheon lobbyist to become Deputy Secretary of Defense, as well as a former lobbyist for Goldman Sachs to become Chief of Staff for the Secretary of the Treasury. When these waivers attracted criticism, the Administration resolved to grant fewer of them, even for those who had lobbied for reform on behalf of nonprofit organizations.

In October 2009, 16 chairs of the Industry Trade Advisory Committees wrote a letter to the Secretary of Commerce and the U.S. Trade Representative expressing concern over the policy of prohibiting federally registered lobbyists from serving on Federal advisory committees. A November 2009 memorandum defended the Obama Administration’s rules, stating that the concern prompting the approach was “not about a few corrupt lobbyists or specific abuses by the profession, but rather concerns the system as a whole”, because “[f]or too long lobbyists and those who can afford their services have held disproportionate influence over national policy making.” The policies were geared to “level the playing field” so that all Americans, “and not just those with access to money or power”, could gain Washington’s ear. In November 2010 the Office of Management and Budget proposed implementing guidance and requested comments regarding the Obama Administration’s new policy barring certain lobbyist appointees.

Have the new lobbying restrictions worked as intended? A December 2009 Congressional Research Service study concluded that the Obama Administration’s restrictions had “already changed the relationship between lobbying and covered Executive Branch officials.” Whether it has done so in a significant and lasting manner remains to be seen; so far nothing seems to have changed the general power of lobbyists to influence legislation in Congress.

Our national experience over the past century has shown us that eliminating tax deductions or requiring disclosure does little to curb the ability of wealthy and well-organized special interests to lobby the Legislative or Executive Branches. With every effort to restrict its power, lobbying has become more professionalized and sophisticated, particularly so over the past 25 years. Lobbying firms, which gain influence and prestige by hiring former members of Congress and former Hill staff through salaries that can start at triple a former government salary and sometimes reach in the millions, compete for the enormous and growing sums of lobbying dollars.

In response to such developments, recent efforts to rein in lobbying have turned to provisions that more directly limit interaction between lobbyists and government officials. Yet critics of President Obama’s policies have become more vocal in raising First Amendment concerns, suggesting that they encroach on individuals’ rights to petition the government. The courts now seem more receptive to such voices, prompted by new Supreme Court thinking about the role of money and politics in the Citizens United decision.

Citizens United, beyond approving unlimited independent spending by corporations and unions in election campaigns, includes language that endangers all lobbying regulation going beyond tax and disclosure rules. The Supreme Court thus endorsed a stingy definition of corruption, one that excludes the sale of access and ingratiation, which could be used to justify regulations covering some lobbying practices. It further held that many limits on political activities are subject to the most searching standard of judicial review, strict scrutiny.

Two lower court cases have already relied on Citizens United to strike down state lobbying restrictions. In Green Party of Connecticut v. Garfield, the United States Court of Appeal for the Second Circuit in July 2010 struck down two provisions of Connecticut law related to lobbyists. First, the court struck down as a First Amendment violation a ban, imposed on state-registered lobbyists and their families, on campaign contributions to state elected officials. Relying on Citizens United and its narrow definition of corruption, the court rejected evidence suggesting that the public “generally distrust lobbyists and the ‘special attention’ they are believed to receive from elected officials.” Further, “[i]nfluence and access . . . are not sinister in nature.” The court concluded that a limit, rather than ban, on lobbyist contributions would “adequately address” anticorruption concerns. The court similarly rejected a law banning lobbyists from collecting campaign contributions for elected officials. Again relying on Citizens United, the court rejected the idea that “an individual might secure a political favor by recommending that another person make a campaign contribution.”

In Brinkman v. Budish, a Federal district court in February 2010 struck down on First Amendment grounds a law barring former members of the Ohio state assembly and their staff from lobbying the state assembly. Relying on Citizens United and applying strict scrutiny, the court held that, as applied to lobbying for compensation, the anti-revolving door statute could potentially be justified on anticorruption grounds. The state, however, had failed to present sufficient evidence to demonstrate the basis for a 12-month limitation. Moreover, the statute was too broad in covering matters regardless of whether the former official or staff member has personally participated in formulating policy on this issue and where they had an opportunity to gain “inside” information. Further, the law was declared underinclusive in not restricting “other behaviors and activities that might give rise to actual or perceived corruption, such as the acceptance of gifts or offers for employment unrelated to lobbying.”

These two cases show the difficulty of relying upon the traditional anticorruption interest to justify lobbying regulations that go beyond disclosure or special tax treatment for lobbying. To be sure, not all courts are bound to follow Green Party and Brinkman. Certainly there are ways courts could write reasonable opinions upholding various lobbying regulations on anticorruption grounds. In addition, the Second Circuit in Green Party suggested that more narrowly tailored bundling laws possibly could pass muster, and that laws passed with additional evidence of actual corruption facilitated by lobbyists could justify laws banning lobbyist contributions. But these two post-Citizens United cases should be viewed like canaries in a coal mine, signaling that lobbying laws that were once seen as easily passing constitutional muster now face a difficult path.

Over the past hundred years, attempts to limit lobbying through tax limitations and disclosure provisions have proved inadequate. Recent efforts focused on limiting interactions between government officials and lobbyists may work better, but after Citizens United they may not survive judicial scrutiny. We need to come up with new arguments for regulating lobbyists—arguments that this Supreme Court will accept in spite of its expansive view of the First Amendment. If they don’t, moneyed interests will have increased power not just over who gets elected, but what they do once in office. If that scenario comes to pass, Madison’s smaller factions will have carried the day.

____________________________________

Ellen P. Aprill is the John E. Anderson Professor of Law at Loyola Law School, specializing in Federal taxation and non-profit organizations. Richard L. Hasen is the William H. Hannon Distinguished Professor of Law at Loyola Law School, and Visiting Professor at the U.C. Irvine School of Law. He writes the Election Law Blog (electionlawblog.org).

Chapter 16

Shells, Shams and Corporate Scams

Lucy Komisar

Corporate secrecy, which involves hiding the identities of company owners from tax and other legal authorities, is itself no secret. It is well known that offshore banking centers such as Switzerland, Liechtenstein and the Cayman Islands have for many years enabled fraudsters all over the world to carry out scams, launder illicit profits, stash stolen loot and hide money from tax authorities. The basic method is simple: Shell companies with no real business functions are created for the exclusive purpose of hiding the identities of the owners of valuable assets. The legal fiction works because offshore secrecy jurisdictions, by definition, do not require the real owners to identify themselves to the banks and other financial institutions with which they deal.

That some Americans evade their government’s regulations and taxes by sending money offshore is to some extent common knowledge. What most people do not know, however, is that there is a vast and growing American offshore. Foreign crooks prize states such as Nevada, Wyoming and especially Delaware for state laws that don’t require them to list owners or even company officials when a new company is formed. Martin Woods, a former policeman who follows the paper trails left behind by illicit cash for Hermes Forensic Solutions Ltd. in London, quipped at a 2010 conference, “Internationally, Delaware is an acronym. It stands for Dollars, Euros Laundered And Washed At Reasonable Expense.”[1]

Here’s how the U.S. secrecy system works. Most states collect basic information from anyone seeking to establish a corporation. They allow individuals with ownership interest—including investors who control the corporation or partnership—to remain anonymous to state authorities and the public. However, most require by law the name and address of the company, the name of a registered agent who represents it, and a list of officers or directors. Sometimes that is finessed when lawyers and corporation formation agents list their own staffs as nominees to obfuscate connections to real managers. Adding to the sham, incorporation agents may use “aged shelf companies”, which had been set up years earlier, to make investors, banks and regulatory authorities believe that a company has longevity and hence legitimacy. They get away with it because state officials don’t check the facts. Delaware, Nevada and Wyoming take this all a step further by allowing total anonymity of owners and officers by statute, with no managers or directors to call in case of suspected law-breaking. When prodded by investigating authorities, company formation agents—having dealt with their clients strictly over the internet—say they don’t know how to find them. After creating their corporations in this fashion, crooked corporate officers then open one or more U.S. bank accounts in the corporation’s name. Banks are supposed to verify “beneficial ownership” information on high-risk customers, such as “certain trusts, corporate entities [and] shell entities”, according to U.S. legal guidelines. But American banks routinely ignore the rules and accept without question the passport photos of a shell corporation’s straw-man nominees.

The consequences of all this are not modest. Above all, the system promotes tax evasion. California, in severe budget shock, is losing taxes from residents who set up Nevada shells to “own” businesses that operate in California. On a larger scale, corporations and individuals use a web of shell companies nested within each other to move un-taxed profits out of the country. Aside from the money drained from the economy and Treasury—about $70 billion each year, by most estimates—the anonymous company system facilitates stock market corruption, including insider trading and so-called pump-and-dump scams, in which stock manipulators use shell companies to bid up the prices of mostly over-the-counter stocks, spread phony rumors about the stocks’ value, and then sell out, leaving unwary investors holding the worthless bag. The FBI told the Government Accountability Office (GAO) that it had 103 open cases investigating market manipulation, most of them involving U.S. shell companies.

And yet the damage from permitting shell companies to function reaches even further. The shell company system of anonymous ownership and operation impedes U.S. law enforcement and legal proceedings. The GAO said in a 2006 report on company formations that investigators could not prove who was responsible for $800,000 in damages caused by an environmental spill, “because the suspect had created a complicated corporate structure involving multiple company formations.”[2]

Shells have also facilitated the looting of Russia and other countries. According to the Treasury Department’s 2005 U.S. Monetary Laundering Threat Assessment, the FBI believes that U.S. shell companies have been used to launder as much as $36 billion from the former Soviet Union. An individual working for fifty Moscow brokers beginning in 1991, when the Soviet system collapsed, set up more than 2,000 Delaware shell companies and opened 236 accounts at Citibank, New York, and Commercial Bank, San Francisco. The brokers or their clients moved $1.4 billion from East European banks through the U.S. banks and back to other East European banks. Closely related, Immigration and Customs Enforcement (ICE) officials told the GAO in 2005 that a Nevada-based corporation received more than 3,700 suspicious wire transfers totaling $81 million over two years from locations such as the Bahamas, British Virgin Islands, Latvia and Russia. The case was not prosecuted because ICE was unable to identify the corporation’s owners.

The consequences of a permissive environment for shell companies also extend to global crime, state repression and even terrorism. U.S. shell companies are used by international criminals such as arms trafficker Viktor Bout, the Mexican drug-trafficking Sinaloa Cartel and Russian mobster Semion Mogilevich, considered the “boss of bosses” of most Russian organized crime syndicates. According to 2009 Senate testimony by the Justice Department, a U.S. shell company with anonymous owners figured in a plot to send military cargo, mislabeled as farm equipment, to Iran.[3] The GAO says foreign investigators in 2006 sought information about a shell corporation allegedly used to smuggle a toxic controlled substance between two Eurasian countries.

David S. Cohen, Assistant Secretary of the Treasury for Terrorist Financing, has linked the lax company formation processes in the United States to “[weapons of mass destruction] proliferation, terrorist financing, sanctions evasion, tax evasion, corruption and money laundering.” He noted that the ability to form anonymous incorporations was a “pathway for criminal actors to gain access to the international financial system, and creates significant obstacles in our ability to investigate financial crime.” Foreign investigators have complained about hitting dead ends because they were unable to obtain beneficial ownership information about U.S. companies. American authorities are unfortunately severely limited in the assistance they can provide.

As significant and multifaceted as the problem is, it could easily be fixed. The solution proposed by Senator Carl Levin (D-MI) is the Incorporation Transparency and Law Enforcement Assistance Act, which he co-sponsored with Senators Charles Grassley (R-IA) and Claire McCaskill (D-MO) in March 2009. It requires states to collect the names and addresses of the human owners of most non-public registered companies. Stock companies would be excluded. The target is shell companies with no real business functions.

One purpose of Levin-Grassley-McCaskill is obvious enough: It is very difficult for U.S. officials to make the case against financial chicanery in the Caymans when some U.S. states offer the same kinds of smarmy services to others. It is for this reason that then-Senator Barack Obama co-sponsored similar legislation back in 2008 (S. 2956 introduced on May 1, 2008) to end corporate secrecy by requiring all U.S. states to collect the names of owners of companies they register.

Not surprisingly, corporate and legal lobbyists such as the U.S. Chamber of Commerce, the National Association of Manufacturers and the American Bar Association (ABA) sought to defeat the Levin-Grassley-McCaskill bill, just as they sought to defeat earlier versions supported by Senator Obama. Clearly, their constituents are worried about losing profits gained from setting up or using anonymous firms.

Corporate opponents of the bill in the various forms it has taken since its initial introduction and their lobbying proxies object to making owners’ names public because, they claim, this would expose the strategies of businesses setting up corporations to secretly buy undervalued assets. The U.S. Chamber of Commerce agrees, arguing that the bill “would put the United States at a competitive disadvantage in the international community.” The Chamber wrote to Homeland Security and Government Affairs Committee Chairman Joseph Lieberman and Ranking Member Susan Collins, with copies to all Senators, arguing that the bill would add an unnecessary layer of government, stifle investment and discourage entrepreneurialism.

The American Bar Association, for its part, opposes requiring lawyers to report suspicions that clients are involved in money-laundering or terrorist financing because, it says, this would violate attorney-client privilege. The National Association of Secretaries of State and the ABA argue further that implementation will cost too much and require expensive new hardware and software. Speaking for the ABA at a November 2009 Senate hearing (and in an interview with me), Kevin L. Shepherd of Venable LLP, Baltimore, worried not only that anti-money laundering requirements might compromise attorney-client privilege, but also that the Treasury Department’s invocations of the “no tipping off” rule, which bans lawyers from informing clients that government agents have made inquiries about them, might do much the same.

These sound like legitimate concerns, but they really do little more than run a cover play for real motives. Jack Blum, a former Senate Foreign Relations Committee special counsel and an international expert on offshore corruption, dismisses the negligible cost of adding a line to a form or filling it out and attaching scanned identifications, all of which can be routinely submitted electronically. As he and others see it, it’s about the money:

The sophisticated way of keeping a tax-averse rich guy from being pulled apart in an audit is to have his holdings layered in various corporations which have different status. . . . I might have an LLC showing up on Schedule C and all my income comes from that. It will show consolidated results of other LLCs above it in the chain. What other corporations does this entity own? List two. Those own six more. And some of them are corporations, some are treated as pass-throughs. The tricks you can play are almost endless. The tax lawyers love this system.

One might think that with a lawyer and former supporter of anti-corporate secrecy legislation in the White House, the scales would be tilted toward passage of Levin-Grassley-McCaskill. One would need to think again: The Obama Administration agrees with the opposition to providing owners’ names to state incorporation agencies. Specifically, the Obama Justice and Treasury Departments have criticized “the ambiguity and breadth” of the bill’s definition of beneficial ownership and its “burdensome disclosure requirements.” Treasury, the lead agency in the matter, also opposes the application of anti-money laundering obligations to company formation agents, but neither Justice nor Treasury has provided any substantive analysis supporting these positions.

Senator Levin has agreed to compromises that allow owner information to be held by corporate formation agents in states that have systems for registering the agents, and not to be listed on states’ registries. But the Obama Treasury Department has still refused to endorse the bill and has declined to explain why, leading Levin to cancel a mid-July 2010 mark-up on the bill a day before it was to occur. The Administration has not said whether it will support the bill if further changes are made, nor has it specified which changes would induce it to endorse it.

This is unacceptable. The Levin-Grassley-McCaskill bill sets a national minimum standard for state incorporation practices that requires collection of “beneficial ownership” information, which can be kept confidential and provided to law enforcement upon receipt of a summons or subpoena. The information could be retained by the state or, if the state chooses, by a licensed company-formation agent (one of Levin’s compromises). Agents would have to establish anti-money-laundering procedures to ensure they were not forming U.S. corporate entities for criminals or other suspect persons. Beyond exempting public companies listed on the stock exchange, the bill exempts banks, broker-dealers, insurance companies, registered investment funds and charities, corporations with a substantial U.S. presence and corporations whose ownership information would not benefit the public interest or assist law enforcement. What’s left are shell companies with no legitimate operations.

On the face of it, the proposal seems “a no-brainer”, as then-New York District Attorney Robert Morgenthau called it in testimony delivered at a Senate hearing in June 2009. “Exactly what is needed to address the problems associated with shell companies created to hide criminal activity”, he said.

The issue, however, has to do not only with brains but with interests as well. Those in opposition stand to lose a lot if Levin-Grassley-McCaskill becomes law. Delaware sucks $700 million a year in revenues from incorporation fees and pays only $10 million a year to run the corporation registry. With a population of 885,122, that works out to $780 a person from the fees, which means that Delaware can afford not to have a state income tax. Delaware Democrat Senator Tom Carper complains that the bill would subject small businesses to financial pressure and regulatory burdens. Carper has suggested substitute language that would allow the “owner” to be another shell company, so a fake could own a fake. His proposal, further, would be contingent on other states amending their own laws, a blocking maneuver, since states could decline to act.

If Barack Obama as a U.S. Senator co-sponsored a measure similar to Levin’s, why has his Administration forced a watering down of the bill? Why doesn’t the President want to crack down on a system that helps criminals and terrorists? Why doesn’t he make a connection with Viktor Bout, who used shell companies from Delaware, Texas and Florida to carry out arms trafficking activities for which the U.S. government extradited him from Thailand?

The underlying problem, says Blum, is that

half the Treasury wants to stop hot money, the other half wants it to come in because it helps the banking industry. This is the Robert “Citibank” Rubin view. This is typical of the U.S. government, where different interests outside government are mirrored inside of it.

Even the President of the United States cannot untangle this mess unless he truly sets his mind to it and sees the solution through to the end. The mystery is, what is Barack Obama waiting for?

____________________________________

Lucy Komisar is an investigative journalist who since 1997 has focused on reporting about the offshore bank and corporate secrecy system.

1 “Offshore Alert”, Financial Due Diligence Conference, South Beach, Florida (May 2010).

2 Report to the U.S. Senate Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs, “Company Formations: Minimal Ownership Information Is Collected and Available”, April 2006.

3 Statement of Jennifer Shasky, Senior Counsel to the Deputy Attorney General before the U.S. Senate Committee on Homeland Security and Governmental Affairs, “Business Formation and Financial Crime: Finding a Legislative Solution”, November 5, 2009.

Table of Contents

Editor’s Forward

POLITICAL ASPECTS

1. Terms of Contention - Adam Garfinkle

2. American Dreams, American Resentments - Walter Russell Mead

3. The Weakness of Liberal Populism - Francis Fukuyama

4. Reading America's Tea Leaves - Robert Reich

5. The Tea Party's Unlikely Populists - Jeremy Mayer

6. The Foreign Policy of Plutocracies - James Kurth

SOCIAL ASPECTS

7. The Inequality That Matters - Tyler Cowen

8. Democracy and Oligarchy - Jeffrey A. Winters

9. Measuring Secrecy - John Christensen

ECONOMIC ASPECTS

10. Too Big to Fail: The Prequel - H.W. Brands

11. Hedging Risk - Sebastian Mallaby & Matthew Klein

12. Risk and Uncertainty - Jessica Einhorn

LEGAL ASPECTS

13. We the "People" after Citizens United - Robert Reich

14. Courting Plutocracy - Ruth Wedgwood

15. Fighting Lobbying, Then and Now - Ellen P. Aprill & Richard L. Hasen

16. Shells, Shams and Corporate Scams - Lucy Komisar