From Commercial Republic to Plutocracy
Among modern political forms, America is unique in a number of ways; most of all, perhaps, she is unique for the embrace of the commercial interest into the very constitutional structure of the state. This is the famous inversion of the conventional understanding of political philosophy laid out in The Federalist, where the factionalism of a large commercial republic, far from driving it into anarchy and despotism, is proposed as the remedy against despotism.
“Large populations, vast territories: There you have the first and foremost reason for the misfortunes of mankind, above all the countless calamities that weaken and destroy polite peoples.” With this characteristically vivid statement, Jean-Jacques Rousseau summarizes that conventional understanding. Liberty—especially understood as what we would call “independence” or “self-determination”—can only flourish in small republics.
The territorially extensive modern nation-state, meanwhile, is subject to the enervating depredations of individual avarice, interest, and passion: each man, guided by that spirit of acquisitiveness which is the mark of modernity, races off to fulfill his own petty material ambition—this one desiring celebrity, this one wealth, the next luxury—and the state perishes in chaos and degradation.
In the American constitutional order, particularly as molded by the teaching of Hamilton, Madison and Jay in their famed collaborative work under the pseudonym Publius, this conventional understanding is set aside. Indeed, as has often been remarked, it is turned on its head. The commercial republic is refashioned as federal structure and presides over a welter of private interests emanating from the natural passions; despotism is checked by the very factionalism which previous writers had imagined were productive of those “countless calamities” that beggar modern states. Liberty is secured, not by those constitutional “parchment barriers,” about which Publius is generally scornful, but by the rough and tumble of private enterprise engaged in by men pursuing their own interests and desires.
Publius is not insensate to the dangers of interest and faction; his great innovation is to envisage the interplay of private interest informing the republic’s legislation by a process of deliberation and consensus. Instead of Rousseau’s General Will, with all its tyrannical potential, in The Federalist the sovereign authority of the republic is lodged in “the deliberate sense of the community.” Will is softened into deliberation. This rhetorical abridgement of the democratic sovereign lies at the very heart of American constitutionalism. The factions of self-interest remain; there is no attempt to extirpate them from the hearts of the citizens; but their hazards are mitigated by deliberation, which in turn is facilitated by all the constitutional apparatus indicated by the common phrase “checks and balances.”
The unique place reserved for free enterprise in America, in other words, acquires constitutional significance in The Federalist; and it cannot be doubted that this work, above all others, provides the interpretative key for our constitutional order.
The novelty of this idea is difficult to perceive nowadays. Not a few Americans, even those of high intellect and learning, have simply mistaken it for the way the world works, as it were. Yet free enterprise of this sort, bound up not merely in the incidental facts of a certain place and time, but established as a feature of the fundamental ordering of society, is the very farthest thing from the natural way of the world. Any modern political philosopher, active before or during that great creative age from which the American Republic emerged, could have perceived this in an instant. Countless contemporary statesmen and writers, all through the early decades of the Republic, confidently awaited her imminent doom. It is to be doubted, for example, whether even so shrewd a thinker as Rousseau could have believed possible the commercial republic of American provenance as an enduring form. His mind in his later years was bent over the idea of the great Lawgiver of antiquity, like Lycurgus of Sparta, who “fixed upon them a yoke of iron, the like of which no other people has ever born.” The work of the great Lawgiver is to remove this problem of interest and passion, to reform the hearts of men and their institutions, before the state is even made.
Much more could be said about this; much more has been said and will be said. What interests me here is how this unique feature of the American political tradition, which is bound up in our unique political economy, has been caught up in the wreck of high finance which exploded into public view in the autumn of 2008 and has since roiled our politics, shaken our assumptions, and generally reconfigured the public landscape of America.
For what was disclosed back then, in late 2008, when the upheavals of the financial world crashed into every living room, was nothing less than the transformation of the American political economy, and with it the American constitutional order. The commercial interest, with its constitutional role as an inadvertent bulwark against majoritarian or factional despotism, was captured by a particular faction of it—namely the financial interest. And the wreck of finance capitalism presaged the crumbling of that bulwark and, thus unfettered, the ascendance of that despotism.
In a word, the American Republic would no longer be that; it would be, instead, something closer to a plutocracy.
The story of the rise, collapse and rescue of finance capitalism is a long and intricate one. I have written in some detail about it elsewhere (see “The Financial Crisis and the Scientific Mindset,” The New Atlantis, Fall 2009-Winter 2010), but the lineaments can be sketched briefly.
Beginning in the late 1970s, a revolution was made in the securities trade, which transformed it from a staid and even stuffy business of asset management and client service, led by closed partnerships fundamentally conservative in character, into a riot of high-tech gambling, abetted by an infusion of talent from the highest orders of mathematical expertise. The innovations came rapidly, and were rarely considered with any philosophical care. The old private partnerships went public, selling shares like industrial corporations. Computing power, growing more sophisticated by the year, facilitated an abstraction of capital and property into ever more exotic financial “products.” PhD mathematicians from Harvard and MIT brought their subtleties to the trade, and in time had constructed a vast infrastructure of speculative debt so sophisticated as to beggar the imagination. Industrial corporations, getting wind of the riches available in the trade in financial products, entered the business in force; eventually such titans of American industry as General Electric Co. and American International Group had so altered the structure of their enterprises that it is not too much to say that they had become enormous unregulated banks with auxiliary industrial arms.
The opacity of these securities markets acquired an almost hierophantic character. Initiates into the rapidly proliferating engineered abstractions appeared as wizards or gurus, encircled by a powerful mystique, communicating in a peculiar argot, and attended by a host of lesser acolytes. The prestige attached to finance capitalism grew enormously. It was obscured for a time by the dotcom enthusiasm of the late 1990s (which of course had its own prestigious financial arm: namely the floating of IPO stock for start-up technology companies at grossly inflated values); but the collapse of that technology bubble accelerated the trend toward ever more exotic, and ever more exalted finance.
Globalization proved integral to the ascendance of finance capitalism. From all around the world, wherever surplus capital sat, quiescent, in bank accounts, investors and asset managers began to perceive the returns available in Western securities markets. Pension funds, university endowments, private hedge funds, boutique investment firms—all set to work lending their capital, at high rates of interest, to the funding of American and European consumers: their homes above all, but also their credit cards, their cars, their renovations, their children’s education. Globalization may be understood as simply the integration of world capital markets. One actor in China or Japan or Australia has a surplus of capital, with a desire to lend at interest (perhaps he is a retiree with a pension, or a frugal worker with a pool of savings, or a construction bank turning big profits) and another actor, across the globe, has a desire to borrow (perhaps an American family looking to upgrade their residence, or a small businessman looking to expand): who will bring these two actors together? This business of credit intermediation is the essence of high finance.
It is also the basic business model of any bank: to bring borrowers and lenders together. But commercial banking—the familiar business where a firm borrows from depositors, paying out a small interest, and lends out long-term, in mortgages, car loans, and small business loans, at a higher rate of interest, taking its profit in the difference or “spread” between the two rates—is a heavily regulated business, at both the state and federal levels. Globalization required freer actors, institutions emancipated from such onerous restrictions. Thus was born “shadow banking.” AIG, for instance, became a colossal shadow bank. It wrote massive insurance contracts on securities confected out of thousands of mortgages, many of them subprime mortgages. These contracts, known as credit-default swaps, lowered borrowing costs for everyone involved: the mortgagees themselves, the brokers, the banks that packaged the mortgages into securities, and the investors who purchased the securities. In effect, AIG was taking hefty fees to swallow the risk of default on millions of mortgages around America. This business was pristinely unregulated. AIG was under no obligation to hold capital against these swaps; it could write them at will, gobble up the fees, and feel great. A single AIG office in London employing some 300 men exposed itself to losses in excess of a large US state’s annual budget. One AIG counterparty alone—Goldman Sachs, which held huge pools of the mortgage-backed securities insured by AIG—was paid out close to $20 billion on these swaps, much of it, after AIG’s chaotic rescue in September 2008, taxpayer capital.
Inside this stupendous architecture of debt finance, this intricate web of counterparty obligations, engineered abstraction, and computerized abbreviation, the opportunities for chicanery were almost limitless. The differences in interest rates, on Wall Street, are usually calculated in “basis points”—hundredths of a percentage point. On a wild trading day, the yield on a particular bond might be said to move 40 basis points, less than half a percent. In mid-February, 2010, the financial press was full of reports like this: “Five-year credit default swaps (CDS) on Greek government debt climbed to 352.0 basis points from 332.5 bps earlier in the session” and “Greek CDS spreads widened to a record 426 bps today.” Such tiny fractional differences may seem inconsequential to the non-financial mind, but the wagers of the financiers are measured in hundreds of millions when they are not measured in billions of dollars. Hundredths of a percentage point on such sums still comprises a fortune.
An amalgam of supererogatory mathematical sophistication, infinitesimal variation, and massive capital, all shifting around the world moment to moment on supercomputers, presented the speculators with irresistible opportunities.
There is an important division of finance known as arbitrage, which works by, as it were, testing and exploring this infrastructure with meticulous care with an eye toward exploiting its irrationalities. Perhaps the most famous example of bond arbitrage involves the 30-year Treasury bond, which usually trades at an inflated premium on its newest issue, as against its “off the run” old issue. Roger Lowenstein describes the trade in his excellent book When Genius Failed (now over ten years old but still one of the best introductions to the world of high finance):
Treasurys (of all duration) are, of course, issued by the U.S. government to finance the federal budget. [Hundreds of billions of dollars] of them trade each day, and they are considered the least risky investments in the world. But a funny thing happens to thirty-year Treasurys six months or so after they are issued: investors stuff them into safes and drawers for long-term keeping. With fewer left in circulation, the bonds become harder to trade. Meanwhile, the Treasury issues a new thirty-year bond, which now has its day in the sun. On Wall Street, the old bond, which has about 29 ½ years left to mature, is known as off the run; the shiny new model is on the run. Being less liquid, the off-the-run bond is considered less desirable. It begins to trade at a slight discount (that is, you can purchase it for less, or at what amounts to a slightly higher interest yield). As arbitrageurs would say, a spread opens.
The point for arbitrage purposes is that there is no rational reason for this discount. It cannot possibly be based on a serious conjecture of default risk—it is absurd to expect that the US Treasury will be less likely to pay back a bond in 29 ½ years than in 30 years. The arbitrageur, very sensibly, can count on this spread between the two bonds narrowing. Thus he can turn a profit on both sides of the trade: he can short-sell the more expensive, on-the-run bond, profiting on its decline; and he can buy the cheaper, off-the-run bond. This is known as a “convergence” trade.
But observe Lowenstein as he continues the description of this trade, perfected by John Meriwether, first at Salomon Brothers and then at his own hedge fund, Long-Term Capital:
In 1994, Long-Term noticed that this spread was unusually wide. The February 1993 issue was trading at a yield of 7.36 percent. The bond issued six months later, in August, was yielding only 7.24 percent, or 12 basis points, less…. [S]ome institutions were so timid, so bureaucratic, that they refused to own anything but the most liquid paper. Long-Term believed that many opportunities arose from market distortions created by the sometimes arbitrary demands of institutions. The latter were willing to pay a premium for on-the-run paper, and Long-Term’s partners, who had often done this trade at Salomon, happily collected it…. Twelve basis points is a tiny spread; ordinarily, it wouldn’t be worth the trouble. The price difference was only $15.80 for each pair of $1,000 bonds. Even if the spread narrowed two thirds of the way, say in a few months’ time, Long-Term would earn only $10, or 1 percent, on those $1000 bonds. But what if, using leverage [borrowing from banks and other firms], that tiny spread could be multiplied? What if, indeed! With such a strategy in mind, Long-Term bought $1 billion of the cheaper, off-the-run Treasurys. It also sold $1 billion of the more expensive, on-the-run Treasurys. This was a staggering sum.
So a $15.80 profit on a $1000 bond becomes, on a $1 billion bond, a profit of $15,800,000, minus the borrowing costs of the leverage.
Now this is only one of the simplest of all arbitrage trades; but it works well as an example. We see clearly how the gigantic volume of capital deployed magnifies even tiny profits on microscopic variations in price. We see how even fractional increments, deriving from mere peculiarities in investor preferences, can take on great importance.
These are strategies now nearly 20 years old. Ancient stuff, compared to the “high-frequency” trading operations that Wall Street now conducts, much of which is so fully computerized that the market discrepancies are detected and exploited with no human input at all. Long-Term Capital is, nonetheless, a central chapter in the narrative of finance capitalism because it was the first successful and independent firm to really incorporate the PhD mathematicians into the compass of day-to-day trading. Before it collapsed, Long-Term had taken the abstraction of capital and property to new levels of sophistication. It had opened new fields of arbitrage, and suggested to investors new prospects for the fusion of mathematical engineering and debt finance.
The broad consequence of all this was nothing less than the transformation of the American political economy. The financial sector accumulated enormous unaccountable power, in time becoming the dominant commercial faction in the country, if not the world. Much of its power was undergirded by the expectation (which proved perfectly accurate, in most cases) of rescue in the event of a panic or crash. Firms could deploy statutorily-insured deposits as capital in their exotic trades. They could underprice risk, anticipating government support in a pinch. They could exploit the extensive government support for the housing market, expanding credit to consumers recklessly, and then securitizing those debt assets for trade around the world. A great web of obligations and shifting payment streams, of mind-boggling complexity, became the most stylish and prestigious line of work for ambitious minds. Esteemed universities churned out bright-eyed employees in the financial sector for decades.
Meanwhile, in a remarkable irony, the interdependence of globalization had produced a condition of extreme fragility, even as its promoters touted its stability: ever more financial actors established themselves as integral to the functioning of global finance, until at last, when the chips were down and panic threatened the whole edifice, agencies of the government, deploying the public credit of taxpayers, were forced to guarantee the whole system. The point is worth underscoring: All my adult life, globalization has been sedulously commended for the firmness of its foundation. It was said to accomplish a “great moderation” in economic conditions. For a time it seemed to; but that was a perilous illusion. Frailty, not firmness, is what truly marked it. Finance capitalism swelled with wealth and esteem, but its infrastructure grew increasingly brittle.
As a share of US Gross Domestic Product, a basic measure of a country’s economic output, the financial sector rose from around 10% in 1950 to over 20% in 2005. The transformation appears even starker as a measure of earnings: In 1950, finance accounted for some 10% of American business profits; by 2005 that number had quadrupled. So not only has finance capitalism gained as a share of total economic output; it has gained even more dramatically as a share of profits. Furthermore, the turmoil that 2007-08 unleashed in finance capitalism, culminating in a succession of bailouts and rescues of unparalleled complexity and scope, ultimately produced an extraordinary concentration of the financial sector.
Ancient firms like Lehman Brothers, which had maintained a presence on Wall Street dating back to before the Civil war, were laid to waste; others were ruthlessly absorbed into larger banks. The Federal Reserve and Treasury (like their foreign counterparts) engineered a number of “shotgun marriage” mergers so messy they may have included outright securities fraud enjoined on the participants by the Secretary of the Treasury. In consequence of all this, financial might, on Wall Street and in other banking centers, emerged in a condition of unprecedented concentration. The survivors watched competitors vanish from the earth, and happily gathered up market share for themselves. Through 2009, the top ten US financial institutions held more than 60% of financial assets, up from just 10% twenty years ago.
This history may be reasonably described as dégringolade: a precipitous decline from commercial republic to plutocracy. A particular faction within the commercial interest gained power and prestige far beyond what it deserved, ultimately bending the whole political economy to its needs.
Alexander Hamilton is warmly celebrated for his superlative work to establish America on a solid financial footing. His system of political economy, broadly conceived, was mercantilism: the government would actively support the merchants of the Republic, and America would grow by productive manufacturing. Undergirding this was a dazzling design to regularize US credit which, when he arrived at the newly-formed Treasury, was comprised of all the heavily-discounted remnants of debt accumulated by the Continental Congress, the Confederation, and the several States. As Hamilton saw it, even a nearly worthless “continental”—the IOUs the Continental Congress issued once hard currency ran out—was a property interest in the American state; and few things were in his mind more pressing than that the United States establish the security of property. Without this no state can prosper. Since contracts form the legal basis for property, debt must be honored. Public credit is simply a measure of the security of property in society. “In nothing,” he wrote, “are appearances of greater moment than in whatever regards credit. Opinion is the soul of it and this is affected by appearances as well as realities.”
His project to regularize this national debt, set it on firm and trusted credit, and fund it with steady revenues—here would be the repose of American prosperity. Many in Congress were agitating for shirking this debt, or dismembering its payment structure according to various schemes designed to favor certain classes of creditor over others. With careful, patient arguments, Hamilton rejected these ideas; the priority must be to restore American credit by holding to the contracts by which it was extended. The national debt, he admonished, “was the price of liberty. The faith of America has been repeatedly pledged for it, and with solemnities that give peculiar force to the obligation.” Nor was it only a matter of national honor. His perspicacious arguments drove hard at the vital importance to American prosperity of establishing security of property. The temptation of the statesman pressed by debt obligations is toward the apparent convenience of defaulting. Hamilton discerned how insidious this could be, how it would bleed away precious capital by increasing the burden of private debts and debasing the value of money. As he puts it:
It involves a question immediately interesting to every part of the community; which is no other than this—Whether the public debt, by a provision for it on true principles, shall be rendered a substitute for money; or whether, by being left as it is, or by being provided for in such a manner as will wound those principles and destroy confidence, it shall be suffered to continue, as it is, a pernicious drain of our cash from the channels of productive industry.
To press these principles in a climate of such uncertainty, lacking applicable precedents and possessed of only the barest beginnings of the outline of the modern capitalist economy, makes the success all the more remarkable.
It is, indeed, widely acknowledged even by his numerous critics that only a man of Hamilton’s superior intellect and energy could have brought some order to the chaotic public credit condition of the infant Republic. That the assumption of all this diverse debt into the compass of the new federal government was among the most decisive and irrevocable steps toward a true federal union, is also well understood. That his masterly negotiations, bringing into concert with him for the last time both Jefferson and Madison, were among the earliest examples of that government by consensus, by deliberation, which would in time become the signal achievement of the American political tradition, is perhaps less fully grasped. But it cannot be doubted that history affords few parallels of so brilliant a feat, of fixing a new country on a firm financial foundation in the security of property, much less a new country populated by men jealous of their local liberty, suspicious of financiers, and only barely held together in a federal union. It was, in a word, a work for the ages; and Hamilton may justly lay claim to the title Acton gave to Burke: “teacher of mankind.”
Hard on the heels of his Report on Public Credit, Hamilton delivered to the Congress several other reports, equally prescient, thorough and skillfully-composed: one concerning the establishment of a central bank, another concerning a national mint, and still another concerning the encouragement of US manufacturing. Alexander Hamilton, more than any single man, founded America as a commercial republic. It was he who took the theoretical framework laid out in The Federalist, according to which commercial factions and diverse private interests might be embraced unofficially into the constitutional machinery of the state as the infrastructure of liberty over a vast territory, and put it into practice. The federal framework produces, as James MacGregor Burns put it, a republican people that “embodies its own safeguards” against despotism, “in the great variety of sections and groups and classes and opinions stitched into the fabric of society and thus into the majority’s coalition.”
Hamilton was harried all his public life by the calumny that he was the instrument of Yankee and European financiers. In truth, as his biographer Ron Chernow puts it:
He was never the hireling of moneyed interests; rather, he wanted to attach them to the new country’s interests. Like many thinkers of his day, he thought that property conferred independent judgment on people and hoped that creditors would bring an enlightened, disinterested point of view to government. But what if they succumbed to speculation and disrupted the system they were supposed to stabilize? What if they engaged in destructive short-term behavior instead of being long-term custodians of the nation’s interest?
What if indeed? What if, for example, the financiers, intoxicated with their own cleverness, alienated from the true sources of property and prosperity, commence to erect vast conduits of financial infrastructure by which capital from all around the world, all chasing fractionally higher yield, might come pouring into various American debt markets? What if this adventure in abstractions ultimately disrupts the equipoise of the US economy so severely that the natural market correction cannot be endured, because for policymakers to approach it according to a principle of laissez faire would be to risk total ruin? What if, faced with so awful a choice—ruin or socialism—policymakers were obliged to replace the private capital that long had fueled this riot of speculation, which by late 2008 lay in smoldering ruins—what if, I say, they were obliged by prudence to substitute for this private capital the public capital of the commonwealth?
We have at least the outline of an answer to these hard questions, and it ain’t pretty. Free enterprise has been dealt a series of savage blows, many of them self-inflicted. A broader swath of the American economy was absorbed into the machinations of the state over the course of the grueling days of fall 2008 than perhaps in all of prior US history. Taxpayer capital was staked to support a dizzying array of markets. Ruined firms were saved, and then, after the panic, turned loose to carry on with their speculations. Finance capitalism was further concentrated; few actors among it felt the bite of market discipline. Risk was socialized at the highest levels of sophistication by instruments and maneuvers so arcane that to describe them requires almost another language. Meanwhile, small enterprise was left to wither and perish. For a year and more now, finance firms have been making a killing by borrowing money short-term from the Federal Reserve at near-zero interest rates and lending it long-term to the Treasury at 2 or 3%. That’s a trade a child could get rich on.
In a word, the answer to the hard questions may be that we have had the misfortune to witness the degradation of Hamilton’s noble work, his painstaking formation of a commercial republic characterized by liberty, into a much baser form of political arrangement: plutocracy, an aristocracy of alienated wealth, characterized by insolent speculative gain. Instead of patriotic statesmanship grounding prosperity in the security of property, we shall have idle elitism, grounding narrow interest in sophistication and the abstraction of property. I leave it to the reader to judge whether such an environment is conducive to liberty.
In any case, free enterprise has received blows from which it may never really recover; and we are left to observe the dégringolade.