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On the Record

Freedom, Fairness and American Capitalism

This speech was given at Harvard University’s Kennedy School of Government

President Bush has made the spread of Freedom and Democracy the basic pillar of our foreign policy. As part of this effort he has committed to a vastly enhanced program of Public Diplomacy under the authority of Karen Hughes as Under Secretary of State.

By emphasizing diplomacy over the use of force President Bush did much to eliminate the fear of an American military crusade. But in order to prevail Ms. Hughes will not only have to sell the idea of freedom and democracy to the Arab world, she and the President will have to sell the American version of democracy to much of the rest of the world, including many of our allies.

The late George F. Kennan, who may have been our greatest diplomat, wrote the following in advising on how to fight communism in 1946: “It is not enough to urge people to develop political processes similar to our own. Many foreign peoples are less interested in abstract freedom than in security.”

“Democracy,” like “Rashomon,” has many faces and American democracy, viewed from abroad, has some unique facets. During my four years as U.S. Ambassador to France I saw how fascinated the French are by everything American; I believe that to be true of all Europeans. While they admire much of what we do, there also is much that is contrary to their beliefs and, in some cases, frightening to them. The death penalty, the power of religion in our politics, our opposition to international law, are just some examples of deep differences in values.

There is also a certain historical level of anti-Americanism that reflects these differences, but they are offset by recognition of a broad community of interests. Global economic instability, fear of terrorism and proliferation of nuclear weapons ultimately outweigh everything else. However, the war in Iraq unleashed a level of public hostility to America that was more virulent than anything in memory.

The new tone of the Bush Administration’s dialogue with Europe has softened, which is all to the good. It is also a quite pragmatic recognition of the fact that we need each other. Domestically, just as George W. Bush needs the support of American public opinion to commit the country in a dangerous world, European political leaders need the support of their public opinion to be able to support us. To do so we have to recognize their concerns about our policies.


When President Bush speaks of freedom and democracy, Europeans think of the economic freedom that is fundamental to American capitalism. They are fascinated by its dynamic and by the opportunities it offers. They are, however, troubled by the social objectives imbedded in American capitalism, by the lack of a solid social safety net, by the speculative aspect of our markets, by the growing inequality created by our large differentials of wealth, and by the harsh impact of extensive deregulation.

Today they are also worried about the weakness of the dollar, and about policies that may lead to even greater weakness and the risk this creates to the global financial system. After all Europeans own more than $2 trillion in American securities, including over 15% of all listed stocks here, and over five million Americans work for European companies here. As a result of the depreciation of the dollar, they have suffered capital losses of about $800 billion.

The vision we have of American capitalism is that of a market driven system where government regulation and Protestant ethics help ensure that the public interest is protected. In that vision the Federal Reserve maintains a stable currency while a responsible budgetary policy enables strong investment in technology and innovation by the private sector. A progressive tax system is expected to provide for a fair distribution of benefits to society as a whole.

Seen from abroad, however, the current practice of American capitalism is quite different. Huge government deficits are generated by a rapidly growing military budget; taxes are being cut, instead of being raised to meet these expenses; a weak dollar and burgeoning speculative bubbles in the real estate markets are the present reality and the present risk. And the tax cuts, which strongly favor upper income groups, accelerate the growing inequality in wealth and income that is creating an ever more sharply divided America.

Americans’ antipathy to taxes is not new. In 1782, the French Ambassador to the United States noted, “The Americans suffer the torching of their farms, the loss of their ships, and endure all the trials of war with courage, of which they have not enough to levy taxes, which would prevent the greatest part of their calamities.” The tax increases on upper income Americans by Presidents Carter, Reagan, Bush I, and Clinton, in fact improved the functioning of our economy, but we have not changed our attitude. American capitalism is very different in practice than in theory.

Market-based capitalism requires a platform of political freedom, the creation of wealth and fairness in its distribution. The American economy reflected these values until the 1980s, when American capitalism and European social democracy created reasonably similar economic outcomes. After the New Deal and the Great Society an implicit social contract, among business, labor and government, had maintained economic stability, a strong social safety net, and an increasingly broad distribution of wealth in America. We began to diverge with Europe in the 1980s as a result of higher population growth rates in the U.S. coupled with significantly greater investments in research and technology. And by the 1990s accelerating changes in our corporate culture and in the functioning of our financial markets, together with cheap money and easy speculation, resulted in the creation of astounding levels of wealth. These in turn led to serious legal and ethical abuses in the business world and to a breakdown in the concept of fairness.

On December 2, 1988 Ross Johnson, the then Chairman of RJR Nabisco, appeared on the cover of Time Magazine above the headline “A Game of Greed.” Some time earlier, Ivan Boesky had given a much-applauded speech to the graduates of the University of California, entitled “Greed is Good.” Greed had become one of the main engines of American market capitalism and speculation, and, in some cases, massive fraud was the result.

Greed is a sin, but it is not necessarily a crime. In the case of Ross Johnson, it remained a sin. However, it can lead to crime and, in the case of Michael Milken, Ivan Boesky and others it did just that. In the 1990s criminal behavior extended not only to speculators or insider traders, but also to a number of CEO’s and senior corporate officers who manipulated their financial statements in order to inflate the price of their stock. In doing so they were often aided by their auditors, their bankers and, in some cases, their lawyers. We saw some of the results recently in the criminal conviction of the former CEO of WorldCom, Bernie Ebbers. Other rogue companies, and their former CEO’s such as Enron, Adelphia, and HealthSouth, are presently under indictment or under investigation, and great banks such as Citibank and Morgan Chase were forced to pay billions to settle claims for violations of the security laws. As of now, even Blue Chip companies such as Fannie Mae and AIG and their CEO’s, are under investigation.

In the late 1990s, as ambassador to France, I spent much of my time singing the praises of American capitalism. But back at home these factors were changing the system. A booming stock market sent executive compensation soaring, with very little accountability for performance. At the same time, deregulation, an easy monetary policy, and media-driven hype of new information technologies created essentially “free money” and astronomic stock valuations. Speculation created the bubble and in due course brought about the collapse of much larger companies, with tragic results.

The results were usually the same. Management and directors collected hundreds of millions in bonuses and stock sales while tens of thousands of employees saw their jobs and their savings lost. Hundreds of thousands of stockholders were ruined.

These events strike at the very heart of the most basic requirements of market capitalism: transparency and fairness. In addition, the media, treated finance like show business, creating stars out of executives and touted wealth as the sole standard of success.

While no single event can be pinpointed as the start or the single cause of these corruptions, I believe a great deal began in the 1980s. The road to Enron was long and well traveled.

Until the 1980s overall corporate activity was still consistent with the evolution of a largely industrial economy, while the consolidation of the financial sector, of Wall Street and the rise of institutional investors pointed to a major shift—late 20th Century finance capitalism.

Until then, the top levels of American enterprise, the big industrial companies, the big banks, etc., were dominated by Boards and CEO’s who were traditional, conservative businessmen, with relatively high but not excessive compensation levels, whose fiefdoms were the platform of the American economy.

The advent of the leveraged buyout radically changed the relationship of management to the corporation. As LBO firms such as KKR and Forstmann Little, restructured American companies, they provided management with ownership levels never previously imagined. The 20% ownership stake in RJR Nabisco, demanded by Ross Johnson for his small top management team, possibly worth $2.5 billion, was simply an extreme extension of this new process, and Time Magazine made it the symbol of a new age.

The 1980s also coincided with the adoption of the large scale granting of stock options. I remember sitting on the boards of some large companies at the time, pressured by institutional investors demanding changes in compensation packages, aiming at greater stock interests of management and lower cash payouts. That meant more stock options. Meanwhile, stock prices were shooting upward, with no consistent correlation to the performance of their companies. According to the author Kevin Phillips, the compensation level in 1981 for the top ten American corporate executives had ranged from $2.3 million to $5.7 million, mostly in the form of salary and cash bonuses. Because of the shift to more options, by 1988 the compensation of the top 10 American executives ranged from $11.4 million to $40.1 million. By 2000, the range was $104 million to $290 million. While the levels of executive compensation are back from the stratosphere, they are still lofty. However, during this entire period American workers’ pay increased only by slightly more than the inflation rate.

During these years, the deregulation of the telecommunication industry and the breakup of AT&T, together with dramatic advances in information technology had become a magnet for new investment. WorldCom, Qwest, Global Crossing and others raised tens of billions of dollars from the markets. They used over-inflated stock to acquire older, stronger companies and fed the myth of endless growth.

The glamour of these new entrepreneurs, and their new billions, gave a new political dynamic to the notion of deregulation. The repeal of the Glass-Steagall Act allowed banks to re-enter the securities field from which they had been excluded since the Great Depression. Energy deregulation brought new players into the staid utility field where traders such as Enron hooked up with the Internet to create a new culture of trading instead of investment.

The Federal Reserve kept interest rates low and flooded the markets with money. As it found its way into the stock market, it drove prices higher and higher. The Federal Reserve did nothing to slow this down. It was fearful of bursting the bubble and Alan Greenspan had become a convert to the New Economy.

A financial critical mass had been created which, at first, drove stocks sky-high and ultimately, and inevitably, exploded. In March 2000 the NASDAQ reached 5,100 and the Dow Jones 11,000. They then crashed and wiped out $7 trillion of market value. They wiped out the savings of millions of Americans, triggered the recession of 2000, and brought about the bankruptcies.

The public uproar created by these scandals, finally allowed the passage of the Sarbanes-Oxley bill in July 2001. It required more responsibility from independent directors, certification of company finances by CEO’s and demanded separation between the investment banking and research analysis functions of the banking industry. It is important legislation but, by itself, it will not suffice; it is already under attack.

We still have much to learn from what happened. New private equity funds have surpassed the original LBO investors in their size and ability to generate quick returns. Larger and larger hedge funds are being created and highly leveraged transactions in the tens of billions of dollars each are being considered. The availability of almost unlimited amounts of bank financing is astonishing.

Speculation is back but the biggest speculator of all is now the U.S. government. The Bush administration gave in to the conservative anti-tax revolution of the 1970s and 1980s, and went to war in Iraq while greatly underestimating its $300 billion cost to date. It simultaneously engaged in a policy of massive tax cuts, probably the first time ever that a country cut taxes when going to war. The domestic budget went from surplus to a record deficit, as did our trade balance, and the Federal Reserve pushed interest rates to all-time lows. And neither the Treasury nor the Fed acted to protect the dollar, which has declined by 40% and only drove our foreign deficit still higher. Our foreign debt has reached $4 trillion and China, Japan, South Korea and Taiwan became our largest creditors. We have become the world’s largest debtor; the dollar became one of the world’s weakest currencies; and we are now facing large and increasing deficits for the foreseeable future.

And to add to an already incoherent and radical fiscal policy, President Bush, with the support of Chairman Greenspan, proposed to fix a supposedly “bankrupt” Social Security system by borrowing a further $2-4 trillion to create private investment accounts. This would do nothing for Social Security, but the perspective of such huge borrowings is likely to have a seriously negative impact on the credit markets.

During this period the fairness so vital to a modern democracy, was seriously impaired. As a result of the tax cuts and extraordinary levels of executive compensation, 1% of Americans now own 45% of the nation’s household assets, a level not seen since 1929.

And in the meantime, we continued to starve domestic public investment. Much of our infrastructure is in a state of decay. The state of our public schools in particular, is a disgrace. It would probably require $2 trillion to bring our overall infrastructure up to decent condition, and a decade or more to achieve it, if we tried.

Much of what has gone wrong is due to serious ethical lapses of some business leaders, as well as mistaken policies by the Bush Administration. In the financial services field, however, there is an additional factor involved: the dehumanizing aspect of much of the new business.

Financial services used to be an extremely personal business; the making of loans, the purchase and sale of securities, the giving of financial advice, these were all activities with high levels of personal interplay, where personal character counted. Today, more and more of the financial service business involves capital markets and other trading activity. These consist of individuals, facing computer screens, buying and selling electronic signals with counter parties whom they never see, in locations all over the world. The only measure of performance is the profit or loss for that day. Quality, trust and confidence or any other non-quantitative measures of performance are of ever decreasing importance.

When a group, under the sponsorship of the American Academy of Arts and Sciences, recently suggested the adoption of an Ethics Code by the financial industry, it was immediately met with the Kafkaesque notion that the very existence of such a code might increase legal liability risks. This is, however, an initiative that must be encouraged; corporate compensation committees, as part of their reviews, should specifically take ethical standards into account.

A global financial crisis could well happen as a result of our present fiscal policies. Many experts take the view that this is very unlikely; that foreign central banks will indefinitely support the dollar, and that the global system is self-correcting. Perhaps so. The risk that the experts are wrong may be small, but it is a risk we cannot take since it is a gamble we cannot afford to lose.

Our economy is vastly over leveraged and very vulnerable to a major shock. If a crisis occurs, mainly centered on the dollar, it will require heroic coordinated international efforts to bring it under control, as well as a level of bipartisan efforts unthinkable in the present domestic climate. To avoid the crisis, it is critical to maintain our credibility with our foreign friends as well as with those less friendly to us.

I am a capitalist and believe that market capitalism is the best economic system ever invented; but it must be fair, it must be regulated, and it must be ethical. American capitalism is now driven by the urge to deregulate and to limit the role of government to a minimum. Hence the current attacks of the Sarbanes-Oxley Act, only three years after its enactment. At the end of the 19th Century, Theodore Roosevelt had a different view of the earlier manifestations of American capitalism. He rejected the idea that Washington had no role but to stamp Wall Street’s initiatives. His quarrel was with illegal behavior, with those who exploited their extraordinary advantages to abuse others. He insisted on government’s obligation to regulate the large new business aggregations not so much to address the inequalities of wealth as to police its potentially distorting influence. TR’s war on the trusts was an effort to reinforce the new system, not weaken or attack it. This should be the purpose of regulation in a more and more complicated system.

The stakes are very high. Foreign investors own $5 trillion of our stocks and bonds. It is imperative that those foreign investors maintain their level of ownership and actually increase it by about $2 billion a day. That is the amount required to finance our current account deficit. “Credit” comes from the Latin verb: “to believe.” Belief in our system is critical to maintain a global financial balance.

President Bush’s idea of an “ownership society” is an idea, which is consistent with the objectives of American capitalism. But it is not credible within the context of government fiscal policies that increase our external indebtedness every day to the detriment of our national wealth. These policies cannot be allowed to go on indefinitely. They require difficult and painful actions, which can only come from a multi-year, bi-partisan plan, led by the President, and the Congress, with the support of business and labor. Such a plan will require a fair allocation of sacrifice in the form of budget cuts and tax increases. It must deal with entitlement programs. It must address the problem of alternative sources of energy such as nuclear power. It should aim to rebuild the country’s infrastructure with new investment and new employment. It must stabilize our currency. Like the GI Bill of Rights, it should enhance the creation of American intellectual capital. The President and the Congress have much work to do if we hope to regain the global confidence in American capitalism. This is the challenge they must face which is fundamental to our ability to lead the free world.

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