How Deregulation Begat Enron et al.





Mr. Rauchway is associate professor of history at the University of California, Davis.

Everybody prefers glamorous fable to dusty fact but some Americans seem to prefer myth even to our own memories when we talk about regulating the financial markets. Watching the marshals haul off the outlaws, we nod as our plain-spoken cowboy president tells us that now a vigilant sheriff will make the frontier safe for innovative husbandmen toiling in the soil of a new economy. This indulgence in bad historical metaphor is downright un-American: we have too much money on the line to believe what we knew, as recently as three years ago, just ain't so.

Whenever the US Congress heeds public outcry and regulates business, captains of industry warn against excessive government intervention in private enterprise. Do not kill the goose that lays the golden eggs, they say. The free market works on the energy of entrepreneurs who compete, innovate and make us all rich. These sentiments ignore an inconvenient historical fact: it took regulation to make national free markets in the first place. The American people wanted them created, even if it took a mighty collective effort - and now we are beginning to realize we want those hard-won competitive markets back, even if it means using government regulation to pry them from private hands whose work is anything but innovative.

The businessman's protest at regulation is as old as objectionable business practice. In the US it goes back to the ancient, lucrative and anti-innovative industry of plantation slavery. While the north adopted modern land-intensive modes of production, the south stuck by a pre-modern system of forced labor. Wishful thinkers believed the south would drop slavery when it noticed the benefits of modernity.

But southern slave-holding businessmen resisted regulation, claiming that the government was pinching their freedom to hold property. They innovated only under governmental intervention, when the US Army destroyed the southern capital base by freeing the slaves - and, for good measure, ripped up the south's railways. It was the first federal railway regulation: southern railways ran on a different gauge from those of the north and required government standardization.

The government then pushed railroads west. Congress gave the railroad companies the public lands - not only for rights of way but also as additional land for speculation and sale.

An entire generation of Americans had no choice but to mortgage themselves to the railroads. They needed the rail network to unify the nation. In return, the railroad magnates looted their public bequest. They overstated private investment by giving their friends shares representing phantom capital. Then they joined in pools, raised rates and paid out the income in dividends to these shareholders - as compensation, they said, for the equity risk run by these daring innovators who staked their fortune funding the national network.

When Congress caught on and proposed an Interstate Commerce Commission to regulate rates, businessmen warned that government was destroying the "legal and beneficial freedom of commercial action." The law was passed anyway.

The squealing from railways facing regulation was not the rage of a race-horse taking the handicapper's weights but the indignation of a well-fed pig losing free access to the community trough. It echoed in subsequent regulatory struggles.

After national banking laws of the early 20th century gave securities firms free rein, they bought banking subsidiaries flush with cash from small investors. The cleverest example, the Goldman Sachs Trading Company - a subsidiary of Goldman Sachs & Company - acted like a mutual fund, managing hundreds of millions of dollars in savings. The subsidiary then put the money where it was most advantageous to the share prices of the parent's clients - not, as Goldman's chairman later admitted, where it was most advantageous for investors. About 90 per cent of the subsidiary's capital vanished.

Prodded by public ire at similar episodes, Congress proposed regulation of securities trading. Richard Whitney, president of the New York Stock Exchange, defended the shares market as a"perfect institution" governed by "principle" - until he was convicted of embezzlement and sent to Sing Sing. Congress strengthened the Federal Reserve Board, created the Securities and Exchange Commission and passed the Glass-Steagall and Investment Company Acts to keep securities firms away from small-time savers.

It turned out that regulation could not save industries from themselves - railroads, like modern telecommunications, suffered from dire overcapacity. But it could prevent big transfers of wealth from the poor to the rich or from public to private hands. The lesson stuck for four decades until, in the 1970s, a nation wheezing from stagflation begged for release. Deregulation offered a way to kick-start the economy.

The myth of the frontier entrepreneur swiftly returned and deregulation became a matter of principle rather than an experiment judged by practical effects. Congress deregulated the Savings and Loan industry, which promptly imploded. Even so, energy deregulation followed, begetting Enron. Legislators likewise freed the telecoms market, yielding WorldCom.

And, last, a Congress exhibiting neither memory nor responsibility fixed its sights on a Glass-Steagall Act already weakened by bureaucratic deregulators, repealing it in 1999. Conservative economists warned that an unregulated and consequently fraudulent capital market could kill the real golden goose: investor confidence. They predicted the repeal would yield new fraud on the old model, as firms made and exploded brief share-price bubbles at long-term investors' expense.

Three years on, we are reaping the predicted returns - but President George W. Bush says enforcement of remaining law and a new ethic of corporate responsibility will save us. We should know better. We can remember what it was like when government regulation safeguarded competitive markets and we should demand that policy back.


This piece first ran in the Financial Times and is reprinted with permission of the author.



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