Bubble Trouble

excerpted from the book

The Great Unraveling

Losing our way in the new century

by Paul Krugman

WW Norton, 2003, hardcover

The comentariat mainly consists of people who live in Washington and go to the same dinner parties. This in itself foments groupthink; at any given moment there is a story line that shapes journalists' perceptions. Until September 11 this story line had it that George W. Bush was dumb but honest; after September 11 the new story was that he was a tough-minded hero, all determination and moral clarity, "Texas Ranger to the world." (Yes, one prominent pundit actually wrote that.) The overwhelming evidence that neither of these pictures bore any resemblance to reality was simply brushed aside.

... The stock in trade of most journalists is inside information-leaks from highly placed sources, up-close-and-personal interviews with the powerful. This leaves them vulnerable: they can be seduced with offers of special access, threatened with the career-destroying prospect that they will be frozen out.


"Nothing is more important in the face of a war than cutting taxes."
House majority leader Tom DeLay

... one should regard America's right-wing movement-which now in effect controls the administration, both houses of Congress, much of the judiciary, and a good slice of the media-as a revolutionary power (in Kissinger's sense) That is, it is a movement whose leaders do not accept the legitimacy of our current political system.

... there's ample evidence that key elements of the coalition that now runs the country believe that some long-established American political and social institutions should not, in principle, exist-and do not accept the rules that the rest of us have taken for granted.

Consider, for example, the welfare state as we know it-New Deal programs like Social Security and unemployment insurance, Great Society programs like Medicare. If you read the literature emanating from the Heritage Foundation, which drives the Bush administration's economic ideology, you discover a very radical agenda: Heritage doesn't just want to scale back New Deal and Great Society programs, it regards the very existence of those programs as a violation of basic principles.

Or consider foreign policy. Since World War lithe United States has built its foreign policy around international institutions, and has tried to make it clear that it is not an old-fashioned imperialist power, which uses military force as it sees fit. But if you follow the foreign policy views of the neoconservative intellectuals who fomented the war with Iraq, you learn that they have contempt for all that-Richard Perle, chairman of a key Pentagon advisory board, dismissed the "liberal conceit of safety through international law administered by international institutions." They aren't hesitant about the use of force; one prominent thinker close to the administration, Michael Ledeen of the American Enterprise Institute, declared that "we are a warlike people and we love war." The idea that war in Iraq is just a pilot project for a series of splendid little wars seemed, at first, a leftist fantasy-but many people close to the administration have made it clear that they regard this war as only a beginning, and a senior State Department official, John Bolton, told Israeli officials that after Iraq the United States would "deal with" Syria, Iran, and North Korea.

Nor is even that the whole story. The separation of church and state is one of the fundamental principles of the U.S. Constitution. But Tom DeLay, the House majority leader, has told constituents that he is in office to promote a "biblical worldview"-and that his relentless pursuit of Bill Clinton was motivated by Clinton's failure to share that view. (DeLay has also denounced the teaching of evolution in schools, going so far as to blame that teaching for the Columbine school shootings.)

There's even some question about whether the people running the country accept the idea that legitimacy flows from the democratic process. Paul Gigot of The Wall Street Journal famously praised the "bourgeois riot" in which violent protestors shut down a vote recount in Miami. (The rioters, it was later revealed, weren't angry citizens; they were paid political operatives.) Meanwhile, according to his close friend Don Evans, now the secretary of commerce, George W. Bush believes that he was called by God to lead the nation. Perhaps this explains why the disputed election of 2000 didn't seem to inspire any caution or humility on the part of the victors. Consider Justice Antonin Scalia's response to a student who asked how he felt making the Supreme Court decision that threw the election to Bush. Was it agonizing? Did Scalia worry about the consequences? No: "It was a wonderful feeling," he declared.

[Henry] Kissinger

Lulled by a period of stability which had seemed permanent, they find it nearly impossible to take at face value the assertion of the revolutionary power that it means to smash the existing framework. The defenders of the status quo therefore tend to begin by treating the revolutionary power as if its protestations were merely tactical; as if it really accepted the existing legitimacy but overstated its case for bargaining purposes; as if it were motivated by specific grievances to be assuaged by limited concessions. Those who warn against the danger in time are considered alarmists; those who counsel adaptation to circumstance are considered balanced and sane .... But it is the essence of a revolutionary power that it possesses the courage of its convictions, that it is willing, indeed eager, to push its principles to their ultimate conclusion.

Dan Altman of The New York Times points out, if you take the administration's tax proposals as a group, they effectively achieve a longstanding goal of the radical right: an end to all taxes on income from capital, moving us to a system in which only wages are taxed-a system, if you like, in which earned income is taxed but unearned income is not.

The young Kissinger had it right: people who have been accustomed to stability can't bring themselves to believe what is happening when faced with a revolutionary power, and are therefore ineffective in opposing it.

... why we are now faced with such a radical challenge to our political and social system. Rich people did very well in the 1990s; why this hatred of anything that looks remotely like income redistribution? Corporations have flourished; why this urge to strip away modest environmental regulation? Churches of all denominations have prospered; why this attack on the separation of church and state? American power and influence have never been greater; why this drive to destroy our alliances and embark on military adventures? Nonetheless, it's increasingly clear that the right wants to do all these things.

Journalists find it very hard to deal with blatantly false arguments; by inclination and training, they always try to see two sides to an issue, and find it hard even to conceive that a major political figure is simply lying about the content of his proposals.

David Wessel of The Wall Street Journal wrote about a White House aide who said one thing on the record and the opposite off the record; when Wessel protested, the aide replied: "Why would I lie? Because that's what I'm supposed to do. Lying to the press doesn't prick anyone's conscience."

When you learn that the architects of the Iraq war have wanted to topple Saddam Hussein for a decade, you can surmise that the war has nothing to do with responding to September 11.

... a revolutionary power, which does not regard the existing system as legitimate, doesn't feel obliged to play by the rules. Are there hints of scandal regarding administration personnel? No matter: Fox News, The Washington Times, and The New York Post won't follow up on the story-instead they'll harass other media outlets if they try to make it an issue. Are there complaints about how homeland security is being handled? A sudden rash of terror alerts will drown out the story. "But they wouldn't do that!" protest reasonable people-and a normal regime wouldn't. But we're not dealing with a normal regime here, we're dealing with a revolutionary power.

A revolutionary power, which doesn't accept the legitimacy of the existing system, also doesn't accept the right of others to criticize its actions. Anyone who raises questions can expect a no-holds-barred counterattack.

... those who question or criticize the administration are demonized, their ethics questioned, their careers destroyed if possible.

[Henry] Kissinger

"The distinguishing feature of a revolutionary power is not that it feels threatened . . . but that nothing can reassure it (Kissinger's emphasis). Only absolute security-the neutralization of the opponent-is considered a sufficient guarantee."

... the administration's real goal ... was to eliminate taxation of capital income and sharply reduce if not eliminate the progressively of the tax system ...

There must be limits somewhere to what the right will actually attempt to accomplish. It may move us to a tax system in which poor people pay a higher share of their income than rich people, but it won't take us to a system where rich people actually pay less than poor people-or will it? It may go on from Iraq to Syria and Iran, but it won't start threatening already democratic countries with military force-or will it? I don't know where the right's agenda stops, but I have learned never to assume that it can be appeased through limited concessions. Pundits who predict moderation on the part of the Bush administration, on any issue, have been consistently wrong. Kissier again: "It is the essence of a revolutionary power that it possesses the courage of its convictions, that it is willing, indeed eager, to push its principles to their ultimate conclusion."

[Henry] Kissinger
"Those who warn against the danger are considered alarmists; those who counsel adaptation to circumstance are considered balanced and sane."



July 7, 2002

On Tuesday, George W. Bush is scheduled to give a speech intended to put him in front of the growing national outrage over corporate malfeasance. He will sternly lecture Wall Street executives about ethics and will doubtless portray himself as a believer in old-fashioned business probity.

Yet this pose is surreal, given the way top officials like Secretary of the Army Thomas White, Dick Cheney and Mr. Bush himself acquired their wealth. As Joshua Green says in The Washington Monthly, in a must-read article written just before the administration suddenly became such an exponent of corporate ethics: "The 'new tone' that George W. Bush brought to Washington isn't one of integrity, but of permissiveness .... In this administration, enriching oneself while one's business goes bust isn't necessarily frowned upon."

Unfortunately, the administration has so far gotten the press to focus on the least important question about Mr. Bush's business dealings: his failure to obey the law by promptly reporting his insider stock sales. It's true that Mr. Bush's story about that failure has suddenly changed, from "the dog ate my homework" to "my lawyer ate my homework-four times." But the administration hopes that a narrow focus on the reporting lapses will divert attention from the larger point: Mr. Bush profited personally from aggressive accounting identical to the recent scams that have shocked the nation.

In 1986, one would have had to consider Mr. Bush a failed businessman. He had run through millions of dollars of other people's money, with nothing to show for it but a company losing money and heavily burdened with debt. But he was rescued from failure when Harken Energy bought his company at an astonishingly high price. There is no question that Harken was basically paying for Mr. Bush's connections.

Despite these connections, Harken did badly. But for a time it concealed its failure-sustaining its stock price, as it turned out, just long enough for Mr. Bush to sell most of his stake at a large profit-with an accounting trick identical to one of the main ploys used by Enron a decade later. (Yes, Arthur Andersen was the accountant.) As I explained in my previous column, the ploy works as follows: corporate insiders create a front organization that seems independent but is really under their control. This front buys some of the firm's assets at unrealistically high prices, creating a phantom profit that inflates the stock price, allowing the executives to cash in their stock.

That's exactly what happened at Harken. A group of insiders, using money borrowed from Harken itself, paid an exorbitant price for a Harken subsidiary, Aloha Petroleum. That created a $10 million phantom profit, which hid three-quarters of the company's losses in 1989. White House aides have played down the significance of this maneuver, saying $10 million isn't much, compared with recent scandals. Indeed, it's a small fraction of the apparent profits Halliburton created through a sudden change in accounting procedures during Dick Cheney's tenure as chief executive. But for Harken's stock price-and hence for Mr. Bush's personal wealth-this accounting trickery made all the difference.

Oh, and Harken's fake profits were several dozen times as large as the Whitewater land deal-though only about one-seventh the cost of the Whitewater investigation.

Mr. Bush was on the company's audit committee, as well as on a special restructuring committee; back in 1994, another member of both committees, E. Stuart Watson, assured reporters that he and Mr. Bush were constantly made aware of the company's finances. If Mr. Bush didn't know about the Aloha maneuver, he was a very negligent director.

In any case, Mr. Bush certainly found out what his company had been up to when the Securities and Exchange Commission ordered it to restate its earnings. So he can't really be shocked over recent corporate scams. His own company pulled exactly the same tricks, to his considerable benefit. Of course, what really made Mr. Bush a rich man was the investment of his proceeds from Harken in the Texas Rangers-a step that is another, equally strange story.

The point is the contrast between image and reality. Mr. Bush portrays himself as a regular guy, someone ordinary Americans can identify with. But his personal fortune was built on privilege and insider dealings-and after his Harken sale, on large-scale corporate welfare. Some people have it easy.


July 12, 2002

The current crisis in American capitalism isn't just about the specific details-about tricky accounting, stock options, loans to executives, and so on. It's about the way the game has been rigged on behalf of insiders.

And the Bush administration is full of such insiders. That's why President Bush cannot get away with merely rhetorical opposition to executive wrongdoers. To give the most extreme example (so far), how can we take his moralizing seriously when Thomas White-whose division of Enron generated $500 million in phony profits, and who sold $12 million in stock just before the company collapsed-is still secretary of the Army?

Yet everything Mr. Bush has said and done lately shows that he doesn't get it. Asked about the Aloha Petroleum deal at his former company Harken Energy-in which big profits were recorded on a sale that was paid for by the company itself, a transaction that obviously had no meaning except as a way to inflate reported earnings-he responded, "There was an honest difference of opinion... sometimes things aren't exactly black-and-white when it comes to accounting procedures."

And he still opposes both reforms that would reduce the incentives for corporate scams, such as requiring companies to count executive stock options against profits, and reforms that would make it harder to carry out such scams, such as not allowing accountants to take consulting fees from the same firms they audit.

The closest thing to a substantive proposal in Mr. Bush's tough-talking, nearly content-free speech on Tuesday was his call for extra punishment for executives convicted of fraud. But that's an empty threat. In reality, top executives rarely get charged with crimes; not a single indictment has yet been brought in the Enron affair, and even "Chainsaw Al" Dunlap, a serial book-cooker, faces only a civil suit. Arid they almost never get convicted. Accounting issues are technical enough to confuse many juries; expensive lawyers make the most of that confusion; and if all else fails, big-name executives have friends in high places who protect them.

In this as in so much of the corporate governance issue, the current wave of scandal is prefigured by President Bush's own history.

An aside: Some pundits have tried to dismiss questions about Mr. Bush's business career as unfair-it was long ago, and hence irrelevant. Yet many of these same pundits thought it was perfectly appropriate to spend seven years and $70 million investigating a failed land deal that was even further in Bill Clinton's past. And if they want something more recent, how about reporting on the story of Mr. Bush's extraordinarily lucrative investment in the Texas Rangers, which became so profitable because of a highly incestuous web of public policy and private deals? As in the case of Harken, no hard work is necessary; Joe Conason laid it all out in Harper's almost two years ago.

But the Harken story still has more to teach us, because the S.E.C. investigation into Mr. Bush's stock sale is a perfect illustration of why his tough talk won't scare well-connected malefactors.

Mr. Bush claims that he was "vetted" by the S.E.C. In fact, the agency's investigation was peculiarly perfunctory. It somehow decided that Mr. Bush's perfectly timed stock sale did not reflect inside information without interviewing him, or any other members of Harken's board. Maybe top officials at the S.E.C. felt they already knew enough about Mr. Bush: his father, the president, had appointed a good friend as S.E.C. chairman. And the general counsel, who would normally make decisions about legal action, had previously been George W. Bush's personal lawyer-he negotiated the purchase of the Texas Rangers. I am not making this up.

Most corporate wrongdoers won't be quite as well connected as the young Mr. Bush; but like him, they will expect, and probably receive, kid-glove treatment. In an interesting parallel, today's S.E.C., which claims to be investigating the highly questionable accounting at Halliburton that turned a loss into a reported profit, has yet to interview the C.E.O. at the time Dick Cheney.

The bottom line is that in the last week any hopes you might have had that Mr. Bush would make a break from his past and champion desperately needed corporate reform have been shed. Mr. Bush is not a real reformer; he just plays one on TV.


August 23, 2002

The high pay of America's C.E.O.'s reflects intense competition among companies for the best managerial talent. Stock options and other typical forms of executive compensation are designed to provide incentives for performance. These incentives align the personal interests of managers with those of shareholders.

Nothing in the preceding paragraph is true. That's the message of an extraordinary research paper circulated by the National Bureau of Economic Research, an economics think tank. The paper is must reading for anyone trying to understand what's really going on in our economy.

I first read this paper, "Executive compensation in America: Optimal contracting or extraction of rents?" by Lucian Bebchuk, Jesse Fried and David Walker (of Harvard, Berkeley and Boston University respectively), last December. It was largely due to their analysis that I concluded, early in the game, that Enron would be only the first of many scandals.

What they show is that the official theory of the corporation, in which the C.E.O. serves at the pleasure of a board that represents shareholder interests, is thoroughly misleading. In practice, modern C.E.O.'s set their own compensation, limited only by the "outrage constraint"-outrage not on the part of the board, whose members depend on the C.E.O.'s good will for many of their perks, but on the part of outside groups that can make trouble. And the true purpose of many features of executive pay packages is not to provide incentives but to provide "camouflage"-to let C.E.O.'s reward themselves lavishly while minimizing the associated outrage.

The most obvious case in point is stock options. There is a good argument for linking an executive's pay to his company's stock price, but a true incentive scheme would have features that one almost never sees in practice. For example, an executive's pay should depend on his company's stock price compared with a benchmark index composed of other, similar companies, so that what he gets reflects the job he is doing, not general market conditions.

In fact, however, a C.E.O. almost always receives stock options at the current market price-end of story. If the stock price goes up, he cashes in. If it goes down, he receives new options at the lower price. There are, to be fair, quirks in the tax law that encourage this practice. But the main reason executives are paid this way is that it gives them an almost sure thing-unless the stock falls steadily, sooner or later an executive who keeps getting options at the current price makes a lot of money-yet does so in a way that camouflages the sweetness of the deal. The options grant often isn't even counted as a corporate expense, and the payoff, when it comes, can always be represented as a reward for achievement.

Thanks to the growing skill of companies at camouflage, and also to a steady erosion of old inhibitions against apparent excess, the average pay of C.E.O.'s at major companies has skyrocketed. It was "only" 40 times that of an average worker a generation ago; it's 500 times as much today. That's a lot of money, but the direct expense is not the main problem. Instead, it's the fact that the tricks used to camouflage exorbitant pay give executives an enormous incentive to get the stock price up in time to cash in their options.

We're only beginning to see the extent to which that incentive distorts corporate behavior. We now know that some companies engaged in grandiose programs of acquisition and expansion that ended in grief-but only after top executives had profited immensely. We also know that companies eager to meet or surpass analysts' expectations engaged in creative accounting on a grand scale: in each of the last few years of the bubble most big companies reported double-digit profit growth, yet national statistics show that true corporate profits were hardly growing at all.

I'm not claiming that C.E.O.'s are conscious villains, twirling their mustaches and chortling over their evil doings. People are very good at rationalizing their actions-even Jeff Skilling reportedly regards himself as a victim-and the great majority of C.E.O.'s surely stayed within the letter of the law.

But the fact is that we have a corporate system that gives huge incentives for bad behavior.


October 22, 2002

The mood among business lobbyists, according to a jubilant official at the Heritage Foundation, is one of "optimism, bordering on giddiness." They expect the elections on Nov. 5 to put Republicans in control of all three branches of government, and have their wish lists ready. "It's the domestic equivalent of planning for postwar Iraq," says the official.

The White House also apparently expects Christmas in November. In fact, it is so confident that it has already given business lobbyists the gift they want most: an end to all this nonsense about corporate reform. Back in July George W. Bush declared, "Corporate misdeeds will be found and will be punished," touting a new law that "authorizes new funding for investigators and technology at the Securities and Exchange Commission to uncover wrongdoing." But that was then; don't you know there's a war on?

The first big step in undermining reform came when Harvey Pitt, chairman of the S.E.C., backtracked on plans to appoint a strong and independent figure to head a new accounting oversight board.

But that was only a prelude. The S.E.C. has been underfunded for years, and most observers-including Richard Breeden, who headed the agency when Mr. Bush's father was president-thought that even the budget Mr. Bush signed back in July was seriously inadequate. But now the administration wants to cancel most of the "new funding" Mr. Bush boasted about.

Administration officials claim that the S.E.C. can still do its job with a much smaller budget. But the S.E.C. is ludicrously underfinanced: staff lawyers and accountants are paid half what they could get in the private sector, usually find themselves heavily outnumbered by the legal departments of the companies they investigate, and often must do their own typing and copying. Officials say there are investigations that they should pursue but can't for lack of resources. And the new law expands the S.E.C.'s responsibilities.

So what's going on? Here's a parallel. Since 1995 Congress has systematically forced the Internal Revenue Service to shrink its operations; the number of auditors has fallen by 28 percent. Yet it's clear that giving the I.R.S. more money would actually reduce the federal budget deficit; the agency estimates that it loses at least $30 billion a year in uncollected taxes, mainly because high-income taxpayers believe they can get away with tax evasion. So starving the I.R.S. isn't about saving money, it's about protecting affluent tax cheats.

Similarly, top officials don't really believe that the S.E.C. can do its job with less money; the whole point is to prevent the agency from doing its job.

In retrospect, it's hard to see why anyone believed that our current leadership was serious about corporate reform. To an extent unprecedented in recent history, this is a government of, by and for corporate insiders. I'm not just talking about influence, I'm talking about personal career experience. The Bush administration contains more former C.E.O.'s than any previous administration, but as James Surowiecki put it in The New Yorker, "Almost none of the C.E.O.'s on the Bush team headed competitive, entrepreneurial businesses." Instead they come out of a world of "crony capitalism, in which whom you know is more important than what you do and how you do it." Why would they turn their backs on that world?

And don't forget the personal incentives. Almost all of those ex-C.E.O.'s in the administration became wealthy thanks to the connections they had acquired in Washington; the exception is Mr. Bush himself, who became wealthy thanks to the connections his father had acquired in Washington. This process continues. Senator Phil Gramm, who pushed through legislation that exempted Enron's trading practices from regulation while his wife sat on the company's board, is retiring and taking a new job: he's going to UBS Warburg, the company that bought Enron's trading operation. Somehow, crusaders against business abuse don't get similar offers.

The bottom line is that you shouldn't worry about those TV images of men in suits doing the perp walk. That was for public consumption; now that the public is focused on other things, it's back to business-insider business-as usual.

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