Jeff Madrick on How Wall Street Won and America Lost

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In the book you say the roots of our economic troubles are in the 1970s. What happened in those years?

The American people turned against government, and the catalyst was the confusing and painful period of high unemployment and high inflation that struck harshly in 1973 and didn't really subside until 1980-81.

And right-wing politicians and economists blamed government.

The right wing claimed the government had become too big, that deficits caused the problem, and that the Federal Reserve had allowed the money supply to run amok. And this idea got ingrained in the public imagination and in the media. America began to doubt government, and that opened the door for business to abuse regulation and change regulation, a chance for right-wing politicians to get more power.

But you point out in the book that government wasn’t all that large at the time.

Government wasn’t very big, and federal budget deficits were much smaller, as a proportion of GDP, under Carter than they were under Ronald Reagan, when inflation was falling.

But the idea took hold anyway that government was the problem and deregulated markets the solution.  And Milton Friedman was the big intellectual force behind this view.

Yes. He started out as something of a New Dealer but became a right-wing advocate of the idea that the free market will solve almost all social problems. He thought all you had to do was control money, and there was no way you could really affect the unemployment rate. He was very articulate, especially in journalism and in debates, and his simplistic way of thinking captured minds and hearts at a time of enormous confusion, in the 1970s.

And meanwhile, the financial industry was starting to develop new kinds of securities, derivatives and so on, that would change the nature of investing.

Right. And nobody in Washington started talking about regulating these derivatives. On the contrary, Jimmy Carter - the first really conservative Democrat in economic matters - was very much in favor of deregulation.

Reagan and Bush continued the trend toward deregulation, obviously, but so did Clinton.

Clinton played the game and made matters even worse. His treasury secretaries, Lloyd Bentsen and then Robert Rubin, really believed that Wall Street had the answers – that if we give them their head they will create prosperity in America. They also knew that Wall Street is a place Democrats can get campaign financing. Republicans had lots of other areas of business sewn up, and the Democrats went for entertainment, Silicon Valley, and finance.

So let's turn to the consequences.

The consequence was a misallocation of capital for 40 years. In the 1980s, the S&Ls were deregulated. They made absurd investments for which they had to be bailed out. That's when the corporate takeover movement got crazy, financed by banks and junk bonds, which in turn received tax benefits because the interest was deductible. I think the evidence shows the takeovers mostly wasted money. And then the high-tech fantasies of the 1990s, the WorldComs and Enrons, the enormous accounting frauds, and finally all that wasted money in housing.

Wouldn't free-market types say you have to allow finance to make these mistakes in order to get the benefits of their good investments and of overall growth?

Well, but what happened over this period? There were only a few years here and there where productivity grew rapidly. Capital investment was weak as a proportion of GDP for the most part, except for a few years here and there. And wages as we know basically stagnated. So no, the benefits did not outweigh the costs; we've had enormous waste and then a failure of public investment because taxes have been so absurdly low.

What do you have in mind when you say "failure of public investment"?

A lack of investment across the board – in energy, in new kinds of R&D, new kinds of manufacturing, general public investments in health care and transportation infrastructure, broadband and so forth. I think we're going to see America have a very hard time climbing back to serious prosperity in the future because of this lack of investment.

You call this period an "age of greed" but couldn't you as easily call it an "age of ideology" – of true believers?

Well, you always have to worry when ideology somehow lines your pockets. And I supposed some of them truly believed and some of them still truly believe, but clearly these were large-scale rationalizations, and as greed went unchecked, a climate of greed grew. And greed received approbation. Nobody began to question if you had gigantic houses anymore - once upon a time, people used to be a little bit embarrassed. Now, nobody was embarrassed.

What's your take on the Dodd-Frank financial reforms?

I think Dodd-Frank has some good points, but it's not going to be enforced well, and anyway they're still writing the rules. I think there's been way too much emphasis on "too big to fail." That's really not the issue; the issue is too much speculation, too much leverage and too much incentive to promote investment.

What would you like to see, regulation-wise?

I think we need seriously higher capital requirements, we have to prohibit certain kinds of securities that cannot be truly understood or are very easily given to speculation, like collateralized debt obligations. I think we probably have to limit what big institutions can do – not because of size but because of conflict of interest. And then I think we have to do something which is a no-no in America: We have to recognize that Wall Street is a monopoly, or at least an oligopoly. They get away with charging ridiculous fees – 7 percent for an IPO! – because there's no real competition.

Lastly, what do you make of the deficit fight in Washington?

I think austerity economics now are a disaster in Washington, because we may be facing another recession. We're going to get a very slow recovery – because of private debt, not so much public debt. And I think this argument about balancing the budget right away, right now, will prove to be one of the great follies of American history.

Related: How Alan Greenspan Helped Wreck the Economy (Book Excerpt: Age of Greed)