B005HFI0X2 EBOK (45 page)

The result of airline deregulation has been a chronically sick industry. Other than Southwest, few new entrants to the market have survived the Darwinian struggle. No airline went bankrupt in the era of regulation; since deregulation, more than 160 airlines have gone out of business, including Pan Am, TWA, Braniff, and Eastern. Only one of 58 airline companies created between 1978 and 1990 survived past 2000.
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As a result of mergers and alliances between particular cities and particular airlines that turned airports into “fortress hubs,” competition diminished. By 2000, there were a dozen “dominated” hubs, where one airline had more than 50 percent of local passengers or two airlines had more than 60 percent.
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Evidence of predatory monopoly behavior was abundant. The Government Accounting Office (GAO) found that fares were higher at dominated hubs.
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In 1981, Paul Stephen Dempsey accurately predicted three phases in the future of the US airline industry following deregulation: “In the first, price and service competition are increased, carriers become innovative and imaginative in the types of price and service combinations they offer, and consumers thereby enjoy lower priced transportation.” In the second stage, “the intensive competition they are forced to endure under deregulation will force many carriers to float ‘belly up’ in bankruptcy.”

The final outcome, Dempsey predicted, would be worse than the preregulation system: “Stage three of deregulation will constitute the ultimate transportation system with which the nation is left. A monopolistic or oligopolistic market structure will result in high prices, poor service, and little innovation or efficiency. . . . Small communities will receive poorer service and/or higher rates than they enjoyed under regulation. . . . In the end, the industry structure created by the free market may be much less desirable than that which was established by federal economic regulation.”
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Another deregulatory disaster occurred in the electrical utility business. Because electrical utilities are so widely considered to be natural geographic monopolies, free-market libertarians saw them as the ultimate challenge—if electricity can be deregulated, anything can. Libertarians proposed that power providers other than utilities should be allowed to sell electricity on utility lines.

Allowing wholesale prices to be set by the market while limiting consumer-price increases created opportunities for market manipulation that were quickly exploited by Enron, a Houston-based energy company. A modern-day Samuel Insull, Ken Lay, the CEO of Enron, died in prison after his manipulative energy empire crumbled, exposing a shocking variety of criminal practices. According to one government report, Enron used market-manipulation scams with secret internal names like Black Widow, Get Shorty, Big Foot, Ricochet, and Death Star. The Death Star scam involved tricking state utilities into believing that there was congestion, forcing the state governments to pay “congestion fees” to Enron. The result was a series of “rolling blackouts” in California in 2000 and 2001.
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In testimony to the US Senate in 2002, the chair of the California Power Authority, S. David Freeman, explained: “There is one fundamental lesson we must learn from this experience: electricity is really different from everything else. . . . And a market approach for electricity is inherently gameable.”
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FINANCE AND THE GREAT DISMANTLING

Dismantling New Deal–era regulations had even more dramatic effects in the area of finance. As we have seen, the New Deal regulatory system continued the Jeffersonian tradition of protecting small “country banks,” but it had the beneficial, if incidental, side effect of averting “ruinous competition” among banks and other financial institutions that might lead to reckless practices capable of endangering the economy. Thanks to Glass-Steagall and federal and state restrictions on interstate and intrastate branch banking, the US banking system was dominated by small local and regional banks. Between 1945 and 1970, the number of commercial banks dropped only slightly from 14,126 to 13,690; as late as 1991, there were nearly 12,000 banks.
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From the late 1930s until deregulation began in the 1980s, the failure rate of banks and other financial institutions was extraordinarily low.

In the 1970s, money-market funds began to compete for customers with banks. Between 1977 and 1989, the share of American households with savings accounts shrank from 77 percent to 44 percent, while the bank share of household financial assets dropped from 30 percent in 1989 to only 17 percent in 2004.
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In response, commercial banks panicked by falling profits lobbied Congress to repeal restrictions on their activities. In a short period of time, the walls between commercial banking, investment banking, thrifts and savings and loans, and insurance companies were torn down. In 1978, the Supreme Court in
Marquette National Bank v. First Omaha Service Company
struck down a South Dakota state usury law. Rapidly, limits on interest rates disappeared nationwide.

In 1980, the Depository Institutions Deregulation and Monetary Control Act began the process of elimination of Regulation Q (established by the Glass-Steagall Act; see chapter 13) and state-imposed usury limits. The Garn–St. Germain Depository Institutions Act of 1982 authorized money-market accounts. The Competitive Equality Banking Act of 1987, by limiting the ability of nonbanks to expand, gave them an incentive to become bank holding companies. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 dealt with savings and loans. In 1994, the Riegle-Neal Act repealed the prohibition on interstate banking of the 1927 McFadden Act. Following the technically illegal merger of Citicorp and Travelers Insurance in 1998, the repeal of the Glass-Steagall ban on the combination of investment banks and commercial banks took place in 1999.

The result was a wave of mergers among banks and other financial institutions. Between 1990 and 2007, the number of FDIC-insured commercial banks dropped from more than twelve thousand to around seventy-five hundred. In 2007, the ten largest banks had 51 percent of banking industry assets and 40 percent of US domestic deposits.
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THE VOLCKER RECESSION

In 1943, the Polish economist Michal Kalecki predicted that attempts by governments to promote full employment would lead to inflation and provoke a backlash by business and investors: “The assumption that a government will maintain full employment in a capitalist economy if it knows how to do it is fallacious. . . . The workers would get out of hand and the ‘captains of industry’ would be anxious to ‘teach them a lesson.’ . . . A powerful bloc is likely to be formed between big business and
rentier
interests, and they would probably find more than one economist to declare that the situation was manifestly unsound.”
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Sir Alan Budd, chief economic adviser to British prime minister Margaret Thatcher, wrote: “The Thatcher government never believed for a moment that [monetarism] was the correct way to bring down inflation. They did, however, see that this would be a very good way to raise unemployment. And raising unemployment was an extremely desirable way of reducing the strength of the working classes. . . . What was engineered—in Marxist terms—was a crisis of capitalism which re-created the reserve army of labour, and has allowed the capitalists to make high profits ever since.”
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Three months after Thatcher became prime minister of the United Kingdom, Paul Volcker was appointed as chairman of the Federal Reserve by Carter in 1979 and reappointed by Reagan. He served until 1987. Volcker was a former executive of Chase Manhattan Bank. As Carter’s domestic policy adviser Stuart E. Eizenstat explained, “Volcker was selected because he was the candidate of Wall Street. This was their price, in effect. What was known about him? That he was able and bright and it was also known that he was conservative. What wasn’t known was that he was going to impose some very dramatic changes.”
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Volcker’s Fed raised short-term interest rates 7 percent over the rate of inflation to 19 percent. The result was two sharp recessions in three years. To the surprise of most policymakers, foreign money poured into the United States to take advantage of the high interest rates. The dollar rose 40 percent against other currencies in the four years after 1981. The sharp increase in the value of the dollar against other currencies priced American exporters out of many foreign markets.

America’s manufacturing base was devastated. By late 1982, unemployment reached 10.8 percent. Factories were idle and neighborhoods and cities turned into wastelands. Volcker did more than anyone else to turn America’s manufacturing region into the derelict Rust Belt. The chairman of Atlantic Richfield Oil Company, Robert O. Anderson, a Republican himself, complained about Volcker and Reagan that “they’ve done more to dismantle American industry than any other group in history. And yet they go around saying everything is great. It’s like the Wizard of Oz.”
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By 1984, inflation was no more than 4 percent and remained at low levels thereafter. Was Volcker’s artificial recession really necessary to defeat inflation? Subsequent history suggests that a period of low inflation was about to begin anyway. As a factor in wage-price inflation, the bargaining power of workers was already diminishing rapidly, thanks to dwindling union membership. The contraction of the manufacturing sector as a result of productivity growth and offshoring, and the growth of employment in the nonunion service sector was already under way. Another structural factor might have moderated inflation without an artificial near-depression by the mid-1980s. The oil shocks of the 1970s were followed by an oil glut in the 1980s. The real price of crude fell from its high in 1980 to low levels for a generation. If the structural underpinnings of long-term low inflation were already in place before Paul Volcker took office, the damage that the Volcker recession inflicted on millions of Americans and critical US industries might have been a tragic and avoidable mistake.

THE BIRTH OF THE BUBBLE ECONOMY

Although they had no intention of doing so, Volcker, Reagan, and other policymakers of the 1980s accidentally laid the foundation for the US bubble economy of 1980–2008. What the financier George Soros has called a “super-bubble” created an illusion of prosperity, based on the underpinnings of debt that became unsustainable and led to the collapse of 2008. In the wake of the Volcker recession, policymakers and economists in the United States and other countries learned the wrong lesson. As governments vigilantly focused on the slightest threat of inflation, they pursued policies of low interest rates and credit-market deregulation that spawned the inflation of assets like stocks and real estates. The Volcker recession inspired shocked investors to shift from inflation-proof assets like gold and land to financial assets like stocks and bonds. The bubble economy was born.

The troubles of American manufacturing were compounded by a strong dollar that hurt American exporters even as it helped East Asian mercantilist nations and American consumers. Hoping that a higher yen would reduce Japan’s chronic trade surplus, Reagan’s Treasury secretary, James Baker—a Texan realist in the tradition of Nixon’s Treasury chief, John Connally—in 1985 negotiated a deal with the finance ministers and central-bank heads of the Group of Five or G5 (France, Germany, Japan, the United Kingdom, and the United States). Called the Plaza Accord after the New York hotel where the group met, the agreement devalued the dollar relative to the yen, whose value the Japanese had suppressed to help their exports. The policy failed to balance US-Japanese trade, however, because the Japanese government continued to pursue an export-oriented industrial policy by other methods. One was to lower domestic interest rates. This encouraged Japan’s export industries to invest in even more overcapacity. By making speculation cheap, the low-interest-rate policy also encouraged speculation that led to bubbles in real estate and stocks. The funds from Japan’s enormous trade surpluses permitted easy credit creation by Japanese banks, which led to a real-estate bubble in Japan. Prices rose far out of relation to fundamental values. At one point, the Imperial Palace grounds were said to be worth more than Tokyo. The collapse of the Japanese real-estate and stock-market bubbles produced decades of slow growth in Japan, beginning in the 1990s.

The policy of devaluing the dollar came to an end in 1987 with the Louvre Accord. From that point until the crisis of 2008, the United States followed a strong-dollar policy, to the benefit of Wall Street and to the detriment of productive export industries in the United States.

To the surprise of supply-siders, fiscal conservatives, and Keynesians alike, the Reagan deficits were easy to finance because of the inflow of foreign money, much of it from Japan. Dollars spent on Japanese imports were recycled in Japan to finance America’s public and private deficits.

Unwilling to raise taxes much higher or to engage in painful cuts in military and domestic spending, the Reagan administration learned to live with twin fiscal and trade deficits. According to R. Taggart Murphy, “The real causes of the imbalances were twofold: first, the U.S. federal deficit, which the Reagan administration had structurally embedded into the U.S. body politic, and secondly, the Japanese ‘developmental state’ system of national leverage, centralized credit allocation, and credit risk socialization . . . which required exports to close the economic circle.”
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The paradoxes involved in the interaction of free-market America and mercantilist Japan were marked by observers. The financial analyst David Hale wrote: “Future historians will probably note with more than ironic delight that at the end of the 1980s it was graduates of the Ministry of Tokyo Law School presiding over the Finance Ministry of the industrial world’s least deregulated economy who helped to rescue the Reagan administration and the international economic system from currency misalignments, trade imbalances, and financial crises produced by the fiscal and monetary policies of economics graduates of the University of Chicago.”
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