Alice Rivlin
Professor, Urban Management and Policy, the New School University
"Challenges to Capitalism: The Role of Government”
September 30, 2002

Alice Rivlin: I want to raise a really big subject today our modern free market capitalist system and three challenges it faces. I use the word challenge but maybe dilemmas would be better. A challenge suggests an obstacle that can be overcome by just making a greater effort. A dilemma implies that there is no obvious right answer. A dilemma can be worked through but only with continuous balancing of competing objectives. And dilemma might describe better what I want to discuss. The first challenge or dilemma is illustrated by the widening disparity of incomes and wealth in the United States as well as in the world. How to make the free market capitalist system work better for everyone not just the educated the skilled and the lucky. The second is illustrated well by the series of corporate scandals concerning auditing, executive compensation and inside information it’s how to ensure a culture of integrity one in which people who run companies, especially big ones, strive to merit the trust of employees and investors. The third is exemplified by current battles over the federal budget and similar battles playing out all over the country at the state and local levels. Hoe to ensure that our enthusiasm for harnasing private motives to produce goods and services efficiently doesn’t blind us to the need for public goods and the benefit of communities working together toward shared goals. Before I get into these big questions let me say a word about the current state of the US economy and the outlook for the immediate future. That’s a really tough assignment right now indeed it’s a difficult moment to talk about the future of anything. Because of the huge cloud of uncertainty hanging over our lives with respect to terrorism, the possibility of war and the known and unknown consequences of war and terrorism at home and abroad. These uncertainties are essentially non economic but they could profoundly effect our economy as well as everything else. But for this cloud of uncertainty, I believe the US economic outlook would be quite hopeful right now. We’re in adjustment mode, with every prospect of readjusting very quickly and getting back on the track of healthy growth, rising productivity low unemployment and little danger of serious inflation. Now adjustment is ever painless and the excesses of the late 1990’s were extreme we just overdid it in several dimensions. There was excessive investment, over expansion of capacity, especially in telecommunications based on unrealistic projections of how fast demand could grow. There was something bordering on lunacy in the stock market, people how should have known better convinced themselves that everything they learned in business school or elsewhere about the relationships between stock prices and future earnings could be abandoned with impunity. And worst of all the exuberance and lack of realism opened opportunities for fraud and greed and undermined public confidence in the accuracy of corporate accounting and the integrity of corporate executive. But readjustment is something that the American economy knows how to do. If it were not for the uncertainty of war and terror, I believe we would be getting on with the adjustment process with reasonable expectation of near term success. We’ve learned a lot in the last decade or so about the basic strengths of the American economy and its remarkable resilience in the face of shocks. The 1990’s were an extraordinary period in economic history. For an entire decade, beginning in 1990 we experienced sustained growth, low unemployment, low inflation, rising income, productivity growth which determines real income surged in the second half of the nineties. Economists are not sure of the reason for the pickup although technology was clearly a big part of the story. Monetary and fiscal policy combined to keep interest rates low and made investment attractive. Both policy and economic forces compelled US businesses to be competitive or be wiped out. Freer trade, deregulation and global competition all contributed to greater US competitive. As did more effective management techniques and more flexible compensation and production. Despite the strong dollar, American companies remained competitive in global markets. The restructuring and downsizing that American companies learned how to do so painfully in the 1980’s paid off in the 1990’s. Flexibility and adaptation to change are now pretty much built into normal big business practice. We learned at least two lessons from the economic experience of the last decade. First we learned Low unemployment rates are a powerful positive force with tight labor markets wages move up at the bottom as well as the top. Scarcity of labor provides effective incentives both for individuals as well as for companies to invest in training and education and to use skills and workers effectively. Second we learned that we could have low unemployment and low inflation at the same time if productivity is growing fast enough. The boom of the 1990’s treated the world to a vivid demonstration of how well free market capitalism can work when all the conditions and policies are right especially when rapid technological change is propelling growth and productivity and labor is scarce. That is when flexibility and competitiveness pay off and capital moves quickly into new ventures although not all of them succeed and it is relatively easy for people to move from declining industries into new ones. The timing of this demonstration was fortuitous because it following closely the break up of the Soviet block and contrasted with an equally vivid demonstration that centrally planned economies don’t work. The abilities and motivation central planners are not the issue. Even highly skilled and publicly spirited people can’t make a centrally planned economy operate so as to produce a high standard of living. The problem is just too complicated. It is much more efficient to let private incentives do the job of deciding what to produce and how to produce it.  Free market economies provide far more opportunities for individuals to use their talents and provide less opportunity for corruption since power is more diffused and can be competed away. Now that lesson has been absorbed although the traditions are horrendously difficult as Russia, China and Eastern Europe have all found.  But despite the difficulties the tide does not seem likely to be turning back toward central planning and state ownership. Even the mixed economies of Europe and elsewhere have moved aggressively to privatize their state owned industry and introduced more competition and private incentives into public services such as healthcare. So just about everybody has concluded that a high performance economy has to be one in which the dominant motive behind economic activity is pursuit of personal gain. What is not widely recognized is that the easy part of a free market economy id the market part. The hard is creating a public policy environment in which the market can operate effectively. We don’t stop very often to think about how demanding a task we have given our policymakers. Americans are in almost continuous high dudgeon about the failures of our policymakers. We think we are justifiably disappointed if they spend so much time arguing and never get things right. We shake our heads and mutter that if only we had better people and stronger leadership in Washington or Richmond or somewhere everything would be o.k. Or we blame democracy, which is a best a messy way to get decisions made, without realizing that most of the problem is not the demo process the fact is that making public policy in a free market economy is genuinely hard. Now what makes it so hard? First if markets are to work, there have to be rules of the game about property rights, bankruptcy, contracts, not injuring other in specific ways and the rules have to be enforced. Countries in transition from centralized economies to free market capitalism have found how hard it is to make capitalism work if those rules and the institutions that enforce them don’t exist or don’t have the long and rich history that we have. Second there have to be social environmental and other public policies in place to handle the fact that people and companies operating in their own interest tend to load costs onto others when they can and leave behind all others to fend for themselves. And third there are genuine public goods that private investors operating in their own won’t provide. Now dealing with these questions is the intellectually and morally challenging aspect of a free market system. It requires constantly adjusting incentives and regulations just enough to accomplish a public purpose and to move the activities modestly in one direction or another without impeding the main action of the private sector players and the productivity of their operations. The process is complex and contentious and policy makers never get it quite right. They have to keep tinkering as conditions change. That’s why our tax code is so complicated. That’s why it’s so difficult to “fix” the welfare system or Medicaid or Medicare.  For many decades those dissatisfied with economic outcomes, held out the hope that some other system would work better. Now I think that hope is lost, reformers have turned to the hard task of improving the rules and making free market capitalism work better. This process is hard work and it doesn’t lend itself to slogans and demonstrations. The young demonstrators, who marched in Washington this week, breaking windows and shouting down with capitalism, are responding to real problems but are not contributing to real solutions. They are fundamentally anachronism relics of a day when it was possible to shout down with capitalism because socialism or communism or Daoism or something seemed to be viable alternative systems. Today free market capitalism has won the contest among systems in the fair fight and the job of reformers is to make it work better. But these dilemmas of modern capitalism that I want to talk about have no easy answers because they involve balancing sometimes-conflicting values that are widely and simultaneously held.

First how do we make capitalism work better for people in the bottom quarter or third of the distribution of skill education income and luck? In this regard the worlds biggest problem is in developing countries but I am not going to talk about that today.  we have a big enough dilemma in the United States. In the 1970’s and 1980’s the gap between the top and bottom of the income distribution widened. Both because incomes at the top were moving and because the lower third of the income distribution were seeing their real incomes fall. The 90’s were better at least in the second half of the decade even unskilled workers were scarce so wages started moving up at the bottom. Low unemployment rates meant that more people had jobs at better pay. And meanwhile premiums for skill, education and risk-taking were rising very fast. And people with college and graduate degrees were doing really well. But even in the prosperous 90’s the richest and most productive country in the world had people living on the edge of desperation. Millions of people still work at the minimum wage and or not much above it at hard draining jobs with little security no health insurance and not much future. Many are single moms whose kids are getting a tough start in life. Some are older workers without the skills to make it in a modern economy. A lot of people see this economy generating enormous rewards high salaries, expensive effective medical care, fancy cars, expensive vacations for other people while they are left behind. They don’t feel part of the general prosperity and don’t have much hope for the future. Recession and slower economic growth make things worse for the low-income people. The latest statistics released by the Census Bureau this month show that the poverty rate, which came down steadily from 1993 to 2000, ticked up again in 2001. The income levels that define poverty are pretty stringent, $18,000 for a family of four. By that standard, $33million people live in poverty in the United States in 2001 or 11.7% of the population or 16.3% of children. Even in the prosperous 90’s share of income going to low income people declined slightly about 3.5% of income goes to people in the bottom 20%. While the share going to the top 10% increased quite rapidly, from 8% to 22%. Incomes of really high paid people corporate executives, entertainers, sports stars went off the charts. Now the most urgent problem is making it possible for people who work hard at low wages to share in the benefits of a free market system more fully than they do now and give their children more opportunity for a better life. This problem isn’t insable but it isn’t easy either. No magic solutions exist and no single set of actions weather by federal, state or local officials by corporations small businesses community groups can make it happen. But the combined effects of many actions would make a difference. They must balance the benefit of raising rewards for lower skilled workers against the risk of reducing their incentives to work and the incentives of employers to hire them, a challenging task. There are plenty of useful tools available. At the federal level we can raise the minimum wage, but not too far increase the earned income tax credit or food stamps, provide vouchers to make decent housing more affordable. Welfare reform has worked in the sense that is has moved a lot of low skilled mothers into the workforce, but their jobs are precarious and most do not make enough money to put them on a solid tack to self sufficiently. Actions that would help would be revitalizing schools, mentoring kids, revitalizing neighborhoods, providing more money for student aid for college and technical education but the most obvious way to improve life for low income workers is to improve access to healthcare. It’s unconscionable that more than $40 million Americans don’t have health insurance, most of them in working families. One big thing not to do right now is to reduce tax rates for the top quarter of the income distribution. The benefits of the enacted tax cuts scheduled to take effect later in the decade go entirely o the top quarter and very disproportionately to the top 1% of the income distribution. These are not the people who need tax cuts. There is not convincing economic argument for such cuts

The astonishing string of companies Enron, WorldCom, Tyco and the rest, caught breaking accounting rules to overstate their earnings dramatically illustrates the second dilemma. Engaging in insider deals to enrich executives at the expense of employees and shareholders while their boards and auditors look the other way. This sad story is not a new one there were episodes of greed and excess in the roaring 20’s and others in the Robrebaron era of the 19^th century. But the fact that it has occurred again, seriously undermines trust in free market capitalism and challenges both the corporate community and public policy to write new rules that will help restore that trust. In many ways the story of companies like Enron illustrates the swift justice and self-correcting mechanisms of a free market economy. Getting caught misleading investors is punishable by death and there is no appeal from the court of investor wrath. Enron failed it won’t be reconstructed from bankruptcy and its auditors went down with the ship. Bankruptcies are an effective punishment and something that centrally planned economies do not have. But the story of Enron and too many other companies illustrates that we did not have the rules of the game quite right yet. The essence of free market discipline is that publicly traded companies disclosed their earnings, their assets, their liabilities for all to see and on that basis investors decide weather to invest or not.  Companies have been able to overstate earnings, hide debt off the balance sheet create a rosier picture than reality. And even more dismaying has been insider trading that enriching executives at the expense of shareholders, many of them employees and the spectacle of executives, touting the soundness of company stock while secretly dumping their own and tipping off their friends. Irresponsible behavior and corporate excess abuse trust in a greedious way and not just trust in one company but trust in the whole system. People working hard for low wages may be having a tough time but many still believe that their children have a chance for a better future and to get ahead in a system that rewards work, skill and ingenuity. But if they come to believe that the system is corrupt, that bosses lie and cheat and make out like bandits at the expense of hardworking folks, then something very fundamental is lost and that’s why corporate greed matter so much. It’s why the rules need to be fixed quickly and visibly to reassure investors that what they see on the earnings and balance sheet is really happening. But rewriting the rules is harder than it sounds. Modern transactions are extremely complicated and accounting for them involves complex rules that may have unforeseen and counterproductive consequences. At least three problems are getting attention at the moment. One is how to make sure that independent auditors are really independent. The focus is on making sure that they do not perform other services for the company such as consulting for which they are rewarded. And making sure that they are not chosen by managers but by independent outside directors to whom they also report to and changing them periodically that’s all in the new legislation. A second question is how separate analysis of stocks from investments so that analysts could be believed. Chinese walls are a phrase for erecting a barrier within the same company but they are not likely to work very well. Could we get analysis out of investment banks and brokerage houses all together? Set up some independent agency to give independent and professional advice on which stocks are promising. If you did that, how would you finance it? Major institutional investors like pension funds could get together and finance it jointly.

The third and thorniest problem is how to compensate corporate executives. In the last decade CEO compensation rose astronomically. Enormously increasing the differentials between top corporate salaries and the middle level. That’s not good for the image of corporate America. But that is not a place for government to make rules either. A more serious problem is that the focus on shareholder value has focused so much attention on the short run stock price. It’s not easy to fix any of that but somehow we need to focus attention on the longer run future of companies in deciding corporate executive compensation. But even while the new rules are emerging, the corporate scandals have had very positive effects. Boards, audit committees, auditing firms, corporate executives are examining their policy and bending over backwards to make sure they don’t run the risk of becoming the next major headline. Restoring trust is going to be a major preoccupation of corporate leaders for some time to come. Trust of employees as well as investors and it’s going to take more than scrupulous attention to accounting rules and good governance it going to a willingness to talk more openly about what’s going wrong not just want is going right and what has to be done to fix the problem.

The third and final dilemma facing capitalism is improving public services. Our economic system depends on harnessing private motives to produce the goods and services the public wants as efficiently as possible. And this works well for most of the things we need. But not for some of the most important like national defense, police and fire, roads and bridges, research and education. The danger is that we get so carried away with free market rhetoric that we forget how imp public services are and how important it is to attract able people to the public services. Americans have a long tradition, back to the American Revolution, of rejecting authority. In recent years, it has again become popular to rail against the government as if it belonged to some foreign power not to us. We’ve been treated with a comic spectacle of politicians who have worked for the government most of their careers campaigning against the government and its bureaucrats as if they were talking about a foreign enemy. And then something brings us up short. In 1995 when I was budget director, congress voted to close the federal government rather than compromise with president Clinton over budget matters. The congressional leadership thought that the closure would be popular and that it would show people it could get along with less government. To the Legislature’s surprise citizens were outraged they could not go to national parks, get passports renewed, get housing loans approved or get their student aid applications processed they found out suddenly that government did very useful things that they were taking for granted. And we found out again on September 11 when policemen and firemen and soldiers and airman were suddenly transformed into heroes we were all depending on to save our lives and way of life. A free market system, because it is so productive and efficient can actually afford better public services. Better schools and universities, better healthcare, better transportation systems than a centrally planned one. Some of these services should be provided by private philanthropy and citizen volunteers, a strength of our system but sometimes out commitment to private decisions and the profit motive gets in the way of recognizing that there are things we really need government to do or at least to organize. I believe we are foolishly and shortsightedly under funding some of our essential government services. We don’t pay enough to attract the most qualified and ingenious teachers to that demanding profession that effects young peoples lives so directly, we aren’t investing enough in the modern sewer and waste treatment systems that could give us cleaners and more beautiful rivers. We aren’t spending enough to ensure that everyone in society has health insurance and good quality health care when they need it. We are not adequately funding the social security that will come under increasing strains, as the population gets older. The problem is not that we can’t afford to do these things; it’s more that our free market rhetoric gets in our way. One legacy of the old systems is that those committed to the free market economy think they need to starve public services because they that might lead us to socialism. But that’s silly. No one wants socialism anymore. The right wing worriers are as anachronistic as the left wing demonstrators. The challenge for those who believe in free markets is to keep this great system working and at the same time figure out how to make work pay better for those who do the hardest jobs at the lowest wages how to maintain integrity in our corporate culture and how to use our productivity and wealth to ensure that we have top quality public services as well as private ones.