In his latest book, investor Ruchir Sharma takes a hard look at who's getting left out of the American dream and why.
The U.S. economy is kind of a strange beast. It’s a mix of free market, government regulation, individual entrepreneurship, and corporate governance that has evolved and grown over the last 240 years. And while there are plenty of benefits to that system, it hasn’t worked for everyone.
In his latest book, “What Went Wrong with Capitalism,” author Ruchir Sharma, who is also the chairman of Rockefeller International, attempts to look at who’s getting left out of American capitalism and why. The following is an excerpt from Sharma’s book, looking at how the government’s relationship to corporate bailouts has evolved over the last century.
In the United States, direct corporate bailouts started out as one-off and highly controversial rescues. A hint of what was to come surfaced during the 1930s and 1940s, when the new Reconstruction Finance Corporation became a kind of back channel for relief spending of all kinds, including cheap but often inadequate emergency loans for distressed banks and businesses. Banks still failed by the hundreds. Railroads that got RFC loans were still more likely to go bankrupt than rivals. As prosperity returned in the 1950s, the idea of “reconstruction” seemed out of date, and the RFC was shut down.
The first postwar bailouts emerged from the suffocating regulatory environment of the 1960s, which was strangling America’s oldest and sixth-largest company, Penn Central railroad. Regulations demanded that the railroad keep running trains even if the cars were empty; union contracts demanded it pay workers who were not on the job. Desperate to make up for mounting losses, Penn Central managers began borrowing in European markets, which were less heavily regulated than U.S. markets. They used these loans to invest in property, buying swaths of the land under Lexington, Park, and Madison Avenues in New York. America’s leading railroad had quietly become its largest real estate company.
When recession hit in early 1970, Penn Central could no longer service its loans. Its bosses had powerful friends, and they went to the White House to ask for loan guarantees. The Nixon administration found a way to say yes, using an obscure rule that would allow the Pentagon to bail out the railroad on “national security” grounds, in exchange for an ownership stake. The leading liberal economist of the era, John Kenneth Galbraith, praised the bailout of Penn Central and predicted it would lead to further nationalization of troubled giants. He delighted in chiding conservative Republicans for leading this campaign, in a piece titled “Richard Nixon and the Great Socialist Revival.”
Galbraith spoke too soon. The country wasn’t ready. Congressional leaders blocked the deal, asking why they should bail out corporate giants rather than small businesses or homeowners. Instead, Nixon’s friend at the Fed, Arthur Burns, stepped in, opening a new “discount window” that eased fears of a broader seizure in the credit markets. Penn Central was forced into a reorganization that ultimately cost taxpayers some $4 billion, securing a place in the early history of corporate bailouts.
Soon America’s twentieth-largest bank, Franklin National on Long Island, was going the way of Penn Central, getting into trouble on heavy borrowing in Europe. Again Congress would not help. Again the Fed would, reassuring Franklin’s investors in 1974 that the bank would get financial support—even after the bank’s chief shareholder tried to escape accountability by faking his own kidnapping. The stress in the markets melted away. “The entire financial world can breathe more easily, not only in this country but abroad,” said Burns.
That was it, outside of a few midsize banks and a relatively small loan guarantee for Lockheed Martin, for bailouts in the early 1970s. The rescue response was not yet automatic. In 1975 New York City, then awash in street crime, found its coffers depleted by an exodus to the suburbs and pleaded for federal help to stave off default. President Gerald Ford’s abrupt refusal inspired the legendary tabloid headline: “Ford to City: Drop Dead.”
A turning point came in 1984, with the first financially costly bailout of a major bank, Continental Illinois. The nation’s largest commercial and industrial lender, Continental had gotten involved with a small Oklahoma bank run by Bill “Beep” Jennings, who was, according to Christopher Leonard, “the sort of person who drank beer out of a cowboy boot to impress clients.” Jennings was also an early pioneer in financial securitization, the same repackaging of risky loans into supposedly secure assets that would come back to haunt America in the 2000s.
Amid the oil boom of the 1970s, Jennings sold investors on packages of loans to oil companies that he called “participating loans,” which were premised on the faith that oil prices could only go up, and aided by stratagems that allowed him to dodge limits on how much he could lend to any one customer. When oil prices started to drop in the early eighties, the government allowed Jennings’s little bank to fail.
But soon it emerged that his biggest customer was Continental Illinois, which had a complex string of loans and connections to more than two thousand other banks. Spooked customers were withdrawing cash by the millions. Concerned that the run on Continental would lead to a broader stampede, and accepting collateral “no private actor would accept,” the government extended emergency credit along with a promise of unlimited protection for depositors. Greeted at the time as an “extraordinary” departure from past practice, the bailout would establish “one of the most important legacies” of the 1980s, with Continental becoming the first bank that the United States declared “too big to fail.” The total cost to taxpayers came to $11 billion.
The first sweeping industry bailout came in the late 1980s and early 1990s, in the savings and loan crisis. Like others before them, S&Ls got caught up in dubious foreign borrowing, and their troubles grew as the easy money era got rolling. Ultimately, the taxpayer bill for folding roughly 750 S&Ls and shoring up the many hundreds of faltering survivors would come to around $125 billion, many times the record set in the Continental Illinois bailout.
With global markets growing rapidly, and more interconnected, the Fed was ever more watchful of worldwide contagion effects, which rose high on the radar during the crises in Asia and Russia of the late 1990s. In September 1998, the hedge fund Long-Term Capital Management was getting into very short-term trouble, having borrowed heavily to make bets across many asset classes. Managing as much as $100 billion for fewer than a hundred clients, including foreign countries, LTCM had about $30 in debt for every $1 of capital. And its creditors included most major Wall Street firms.
Fed officials feared markets might panic and “cease to function” if even an investment house like LTCM, which was led by Nobel laureates in economics, could not find buyers for its more exotic assets. First Greenspan cut the Fed funds rate to ease fear in the markets, and a week later the chair of the New York Fed brought together nearly a dozen of Wall Street’s largest banks to defend themselves from contagion by financing a private $5.6 billion infusion for LTCM. This was another first, establishing the habit of bailouts to preempt rather than respond to recessions. Saving LTCM ushered “in an era of extreme moral hazard that continues to this day,” wrote economist Jim Reid of Deutsche Bank Research. “Pure capitalism that has been the catalyst for over two centuries of economic growth was being replaced by an increasingly state-managed capitalism that involved larger and larger bailouts.”
The next industry bailout was for the airlines after the 9/11 terror attacks, at a relatively low cost of $25 billion, but all previous rescues would be outdone by the government response to the financial crisis of 2008.
Excerpted from WHAT WENT WRONG WITH CAPITALISM by Ruchir Sharma. Copyright 2024 © by Ruchir Sharma. Reprinted by permission of Simon & Schuster, an Imprint of Simon & Schuster, LLC
