4 America’s Exhausted Paradigm Macroeconomic Causes of the Crisis
The current financial crisis is widely recognized as being tied to the bursting of the housing price bubble and the debts accumulated in financing that bubble. Most commentary has therefore focused on market failure in the housing and credit markets. But what if the housing price bubble developed because the economy needed a bubble to ensure continued growth? In that case, the real cause of the crisis would be the economy’s underlying macroeconomic structure. A focus on the housing and credit markets would miss that.
Despite the relevance of macroeconomic factors for explaining the financial crisis, there is resistance to such an explanation. In part, this is because such factors operate indirectly and gradually, whereas microeconomic explanations that emphasize regulatory failure and flawed incentives within financial markets operate directly. Regulatory and incentive failures are specific, easy to understand, and offer a concrete “fixit” agenda that appeals to politicians who want to show they are doing something. They also tend to be associated with tales of villainy that attract media interest (such as Bernie Madoff’s massive Ponzi scheme, or the bonus scandals at AIG and Merrill Lynch). Finally, and perhaps most importantly, a microeconomic focus does not challenge the larger structure of economic arrangements, whereas a macroeconomic focus invites controversy by placing these matters squarely on the table.
However, an economic crisis of the current magnitude does not occur without macroeconomic forces. That means the macroeconomic arrangements that have governed the U.S. economy for the past twenty-five years are critical for explaining the crisis. As illustrated in Figure 4.1, two factors in particular have been important. The first concerns the U.S. economic growth model and its impact on the pattern of income distribution and demand generation. The second concerns the U.S. model of global economic engagement and its impact on the structure of U.S. economic relations within the global economy.
Figure 4.1. Macroeconomic causes of the economic crisis.
The macroeconomic forces unleashed by these twin factors have accumulated gradually and made for an increasingly fragile and unstable macroeconomic environment. The brewing instability over the past two decades was visible in successive asset bubbles, rising indebtedness, rising trade deficits, and business cycles marked by initial weakness (so-called jobless recovery) followed by febrile booms. However, investors, policy makers, and economists chose to ignore these danger signs and resolutely refused to examine the flawed macroeconomic arrangements that led to the cliff’s edge.
The Flawed U.S. Growth Model
Economic crises should be understood as a combination of proximate and ultimate factors. The proximate factors represent the triggering events, whereas the ultimate factors represent the deep causes. The meltdown of the subprime mortgage market in August 2007 triggered the current crisis, which was amplified by policy failures such as the decision to allow the collapse of Lehman Brothers. However, a crisis of the magnitude now being experienced requires a facilitating macroeconomic environment. That macroeconomic environment has been a long time in the making and can be traced back to the election of Ronald Reagan in 1980, which symbolized the inauguration of the era of neoliberal economics.
The Post-1980 Neoliberal Growth Model
The impact of the neoliberal economic growth model is apparent in the changed character of the U.S. business cycle.1 Before 1980, economic policy was designed to achieve full employment, and the economy was characterized by a system in which wages grew with productivity. This configuration created a virtuous circle of growth. Rising wages meant robust aggregate demand, which contributed to full employment. Full employment in turn provided an incentive to invest, which raised productivity, thereby supporting higher wages.
After 1980, with the advent of the new growth model, the commitment to full employment was abandoned as inflationary, with the result that the link between productivity growth and wages was severed. In place of wage growth as the engine of demand growth, the new model substituted borrowing and asset price inflation. Adherents of the new orthodoxy made controlling inflation their primary policy concern, and set about attacking unions, the minimum wage, and other worker protections. Meanwhile, globalization brought increased foreign competition from lower-wage economies and the prospect of offshoring of employment.
The new neoliberal model was built on financial booms and cheap imports. Financial booms provide consumers and firms with collateral to support debt-financed spending. Borrowing is also sustained by financial innovation and deregulation that ensures a flow of new financial products, allowing increased leverage and widening the range of assets that can be collateralized. Meanwhile, cheap imports ameliorate the impact of wage stagnation, thereby maintaining political support for the model. Additionally, rising wealth and income inequality makes high-end consumption a larger and more important component of economic activity, leading to the development of what Ajay Kapur, a former global strategist for Citigroup, termed a “plutonomy.”
These features have been visible in every U.S. business cycle since 1980, and the business cycles under presidents Reagan, Bush père, Clinton, and Bush fils have robust commonalities that reveal their shared economic paradigm. Those features include asset price inflation (equities and housing); widening income inequality; detachment of worker wages from productivity growth; rising household and corporate leverage ratios measured respectively as debt/income and debt/equity ratios; a strong dollar; trade deficits; disinflation or low inflation; and manufacturing-sector job loss.
The changes brought about by the post-1980 economic paradigm are especially evident in manufacturing-sector employment (see Tables 4.1 and 4.2). Before 1980, manufacturing-sector employment rose in expansions and fell in recessions, and each expansion tended to push manufacturing-sector employment above its previous peak.2 After 1980, the pattern changes abruptly. In the first two business cycles (between July 1980 and July 1990), manufacturing-sector employment rises in the expansions but does not recover its previous peak. In the two most recent business cycles (between March 1991 and December 2007), employment in this sector not only fails to recover its previous peak, but actually falls over the entirety of the expansions.3
Table 4.1. Manufacturing Employment by Business Cycle, October 1945–January 1980
Table 4.2. Manufacturing Employment by Business Cycle, July 1980–December 2007
Accompanying this dramatic change in the pattern of real economic activity was a change in policy attitudes, perhaps most clearly illustrated by the attitude toward the trade deficit. Under the earlier economic model, policy makers viewed trade deficits as cause for concern because they represented a leakage of aggregate demand that undermined the virtuous circle of growth. However, under the new model, trade deficits came to be viewed as semi-virtuous because they helped control inflation and because they reflected the choices of consumers and business in the marketplace. According to neoliberal economic theory, those choices represent the self-interest of economic agents, the pursuit of which is good for the economy. As a result, the trade deficit was allowed to grow steadily, hitting new peaks as a share of GDP in each business cycle after 1980. This changed pattern is illustrated in Table 4.3, which shows the trade deficit as a share of GDP at each business cycle peak.
Table 4.3. The U.S. Goods Trade Deficit by Business Cycle Peaks, 1960–2007
The effect of the changed growth model is also evident in the detachment of wages from productivity growth, as shown in Table 4.4, and in rising income inequality, as shown in Table 4.5. Between 1979 and 2006, the income share of the bottom 40 percent of U.S. households decreased significantly, while the income share of the top 20 percent increased dramatically. Moreover, a disproportionate part of that increase went to the 5 percent of families at the very top of income-distribution rankings.
Table 4.4. Hourly Wage and Productivity Growth, 1967–2006 (2007 Dollars)
Table 4.5. Distribution of Family Income by Household Income Rank, 1947–2006
Sources: Mishel et al. (Reference Mishel, Bernstein and Allegreto2009) and author’s calculations.
The Role of Economic Policy
Economic policy played a critical role in generating and shaping the new growth model, and the effects of that policy boxed in workers.4The new model can be described in terms of a neoliberal policy box (see Figure 4.2), the four sides of which are globalization, small government, labor market flexibility, and retreat from full employment. Workers are pressured on all four sides, and it is this pressure that has led to the severing of the wage/productivity growth link.5
Figure 4.2. The neoliberal policy box.
Globalization, in part spurred by policies encouraging free trade and capital mobility, means that American workers are increasingly competing with lower-paid foreign workers. That pressure is further increased by the fact that foreign workers are themselves under pressure owing to the so-called Washington Consensus development policy, sponsored by the International Monetary Fund (IMF) and the World Bank, which forces them into the same box as American workers. Thus, not only do these policies undermine demand in advanced countries; they also put pressure on demand in developing countries by pressuring workers there too. This is clearly evident in China, which has been marked by rising income inequality and a sharp decline in the consumption-to-GDP ratio.6 The net result of global implementation of neoliberal orthodoxy is the promotion of deflationary global economic conditions.
Small-government policies undermine the legitimacy of government and push privatization, deregulation, and light-touch regulation. Although couched in terms of liberating the economy from detrimental governmental interference, small-government policies have resulted in the erosion of popular economic rights and protections. This is exemplified by the 1996 reform of U.S. welfare rights. Moreover, the government’s administrative capacity and ability to provide services have been seriously eroded, with many government functions being outsourced to corporations. This has led to the creation of what the economist James Galbraith (2008) terms the “predator state,” in which corporations enrich themselves on government contracts while the outsourced workers employed by these corporations confront a tougher work environment.
Labor market flexibility involves attacking unions, the minimum wage, unemployment benefits, employment protections, and employee rights. This is justified in the name of creating labor market flexibility, including downward wage flexibility, which, according to orthodox economic theory, is supposed to generate full employment. Instead, it has led to wage stagnation and widening income inequality.
Abandonment of full employment means having the Federal Reserve emphasize the importance of keeping inflation low over maintaining full employment. This switch was promoted by the economics profession’s adoption of Milton Friedman’s (1968) notion of a natural rate of unemployment.7 The theoretical claim is that monetary policy cannot affect long-run equilibrium employment and unemployment, so it should instead aim for a low and stable inflation rate. In recent years, that argument has been used to push the adoption of formal inflation targets. However, the key real-world effect of the natural-rate theory has been to provide the Federal Reserve and policy makers with political cover for higher actual unemployment, which has undermined workers’ bargaining power regarding wages.8
The Neoliberal Bubble Economy
The implementation of neoliberal economic policies destroyed the stable virtuous-circle growth model based on full employment and wages tied to productivity growth, replacing it with the current growth model based on rising indebtedness and asset price inflation. Since 1980, each U.S. business cycle has seen successively higher debt-to-income ratios at the end of expansions, and the economy has become increasingly dependent on asset price inflation to spur the growth of aggregate demand.
Table 4.6 shows the rising household-debt-to-GDP ratio and rising nonfinancial business-debt-to-GDP ratio under the new growth model. Compared to the period between 1960 and 1981, the period between 1981 and 2007 saw enormous increases in the debt-to-GDP ratios of both the household and nonfinancial corporate sectors.
Table 4.6. Household Debt-To-GDP and Nonfinancial Corporation Debt-To-GDP Ratios by Business Cycle Peaks, 1960–2007
Table 4.7 shows the rising household debt service ratio, measured as a ratio of debt service and financial obligations to disposable personal income. That this ratio trended upward despite declining nominal interest rates is evidence of the massively increased reliance on debt by households.
Table 4.7. Household Debt Service and Financial Obligations Ratio (DSR)
Table 4.8 shows the pattern of house price inflation over the past twenty years.9 This table is revealing in two ways. First, it shows the extraordinary scale of the 2001–06 housing price bubble. Second, it reveals the systemic role of house price inflation in driving economic expansions. Over the last twenty years, the economy has tended to expand when house price inflation has exceeded consumer price index (CPI) inflation. This was true for the last three years of the Reagan expansion. It was true for the Clinton expansion. And it was true for the Bush Sr. expansion. The one period of sustained housing price stagnation was between 1990 and 1995, which was a period of recession and extended jobless recovery. This is indicative of the significance of asset price inflation in driving demand under the neoliberal model.
Table 4.8. CPI Inflation and Home Price Inflation Based on the S&P/Case-Shiller National Home Price Values Index
Along with rising debt ratios, households progressively cut back on their savings rates, as shown in Table 4.9. This reduction provided another source of demand.
Table 4.9. Personal Savings Rate (PSR)
Lastly, disinflation and the space it created for lower nominal interest rates were also critical for the new paradigm. In recessions and financial upheavals, U.S. economic policy makers were quickly able to restore growth by lowering interest rates and opening the spigot of credit. This pattern is captured in Table 4.10, which shows three long cycles governing the Federal Reserve’s federal funds interest rate over the period between 1981 and 2010.
Table 4.10. Brief History of The Federal Funds Interest Rate, June 1981–January 2010
Given the initial high interest rates in 1981, the Federal Reserve had enormous space to lower rates each recession, and in recovery, rates were raised but by not as much. It was this process that lay behind the so-called Great Moderation and the perceived success of monetary policy. However, the reality was that the Federal Reserve was consuming the disinflation dividend (i.e., the Fed was using up the policy space provided by lower inflation to lower interest rates). That could not last forever, and in the Great Recession it has finally hit the zero lower bound to nominal interest rates.
In sum, the new growth paradigm put in place after 1980 involved squeezing worker incomes, squeezing household saving rates, raising debt levels, persistent asset price inflation in excess of CPI inflation, and reliance on ever lower nominal interest rates. This logic made it economically unsustainable. That is because the economy was eventually going to hit constraints imposed by debt ceilings, pushing the saving rate to zero, inflating asset prices to bubble levels, and hitting the nominal interest rate floor.
Although intrinsically unsustainable, the paradigm lasted far longer than expected because of the ability to raise debt limits, and squeeze saving rates lower and push asset prices higher than imagined. That is the real significance of financial innovation and deregulation that contributed to these extension mechanisms.
Viewed from this angle, financial innovation and deregulation did not cause the crisis. The neoliberal paradigm was always going to fail owing to its internal contradiction, but financial innovation and deregulation kept the model going longer. However, the sting in the tail is that rather than simply grinding to a slow stop, this extension resulted in the accumulation of large financial imbalances. Consequently, when these extension mechanisms eventually exhausted themselves, the result was an implosion that took the form of a financial crisis capable of producing a far bigger and more dangerous collapse.10
The Flawed Model of Global Economic Engagement
Although prone to instability (i.e., to boom and bust), the neoliberal growth model might have operated successfully for quite a while longer were it not for a U.S. economic policy that created a flawed engagement with the global economy. This flawed engagement undermined the economy in two ways. First, it accelerated the erosion of household incomes. Second, it accelerated the accumulation of unproductive debt – that is, debt that generates economic activity elsewhere rather than in the United States.
The most visible manifestation of this flawed engagement is the goods trade deficit, which hit a record 6.4 percent of GDP in 2006. This deficit was the inevitable product of the structure of global economic engagement put in place over the past two decades, with the most critical elements being implemented by the Clinton administration under the guidance of Treasury secretaries Robert Rubin and Lawrence Summers. That eight-year period saw the implementation of the North American Free Trade Agreement (NAFTA), the adoption after the East Asian financial crisis of 1997 of the “strong dollar” policy, and the establishment of permanent normal trade relations (PNTR) with China in 2000.
These measures cemented the model of globalization that had been lobbied for by corporations and their Washington think tank allies. The irony is that giving corporations what they wanted undermined the new model by surfacing its contradictions. The model would likely have eventually slumped because of its own internal dynamic, but the policy triumph of corporate globalization accelerated this process and transformed it into a financial crash.
The Triple Hemorrhage
Flawed global economic engagement created a “triple hemorrhage” within the U.S. economy. The first economic hemorrhage, long emphasized by Keynesian economists, was the leakage out of the economy of spending on imports. Household income and borrowing was significantly spent on imports, creating incomes offshore rather than in the United States. Consequently, borrowing left behind a debt footprint but did not create sustainable jobs and incomes at home.
The second hemorrhage was the leakage of jobs from the U.S. economy as a result of offshore outsourcing, made possible by corporate globalization. Such offshoring directly reduced the number of higher-paying manufacturing jobs, cutting into household income. Moreover, even when jobs did not move offshore, the threat of offshoring could be used to secure lower wages, thereby dampening wage growth and helping sever wages from productivity growth.11
The third hemorrhage concerned new investment. Not only were corporations incentivized by low foreign wages, foreign subsidies, and undervalued exchange rates to close existing plants and shift their production offshore; they were also incentivized to shift new investment offshore. That did double damage. First, it reduced domestic investment spending, hurting the capital-goods sector and employment therein. Second, it stripped the U.S. economy of modern industrial capacity, disadvantaging U.S. competitiveness and reducing employment that would have been generated to operate that capacity.
A further unanticipated economic leakage from the flawed model of global engagement concerns energy prices. Offshoring of U.S. manufacturing capacity has often involved the closing of relatively energy-efficient and environmentally cleaner production and its replacement with less efficient and dirtier foreign production. In addition, the shipping of goods from around the world to the U.S. market has compounded these effects.12 These developments added to energy demand and contributed to the 2005–08 increase in oil prices, which added to the U.S. trade deficit and effectively imposed a huge tax (paid to OPEC) on U.S. consumers. Additionally, 2008 saw a bubble in oil prices as speculative excess migrated from financial markets to commodity markets.13
The flawed model of global economic engagement broke with the old model of international trade in two ways. First, instead of having roughly balanced trade, the United States has run persistent large trade deficits. Second, instead of aiming to create a global marketplace in which U.S. companies could sell their products, its purpose was to create a global production zone in which U.S. companies could operate. In other words, the main purpose of international economic engagement was not to increase U.S. exports by creating a global market place. Rather, it was to create a global production zone from which U.S.-owned production platforms in developing countries could supply the American market, or from which U.S. corporations could purchase cheaper imported inputs.
As a result, at the bidding of corporate interests, the United States joined itself at the hip to the global economy, opening its borders to an inflow of goods and exposing its manufacturing base. This was done without safeguards to address the problems of exchange rate misalignment, systemic trade deficits, or the mercantilist policies of trading partners.
NAFTA
The creation of the new system took off in 1989 with the implementation of the Canada-U.S. Free Trade Agreement that established an integrated production zone between the two countries. The 1994 implementation of NAFTA (North American Free Trade Agreement) was the decisive next step. First, it fused Canada, the United States, and Mexico into a unified North American production zone. Second, and more importantly, it joined developed and developing economies, thereby establishing the template U.S. corporations wanted.
NAFTA also dramatically changed the significance of exchange rates. Before, exchange rates mattered for trade and the exchange of goods. Now, they mattered for the location of production. That, in turn, changed the attitude of large U.S. multinational corporations (MNCs) toward the dollar. When U.S. companies produced domestically and looked to export, a weaker dollar was in their commercial interest, and they lobbied against dollar overvaluation. However, under the new model, U.S. corporations looked to produce offshore and import into the United States. This reversed their commercial interest, making them proponents of a strong dollar. That is because a strong dollar reduces the dollar costs of foreign production, raising the profit margins on their foreign production sold in the United States at U.S. prices.
NAFTA soon highlighted this new dynamic, because Mexico was hit by a financial crisis in January 1994, immediately after the implementation of the free-trade agreement. To U.S. corporations, which had invested in Mexico and planned to invest more, the peso’s collapse versus the dollar was a boon as it made it even more profitable to produce in Mexico and reexport to the United States. With corporate interests driving U.S. economic policy, the peso devaluation problem went unattended – and in doing so it also created a critical precedent.
The effects of NAFTA and the peso devaluation were immediately felt in the U.S. manufacturing sector in the form of job loss, diversion of investment, firms using the threat of relocation to repress wages, and an explosion in the goods trade deficit with Mexico, as shown in Table 4.11. Whereas prior to the implementation of the NAFTA agreement, the United States was running a goods trade surplus with Mexico, immediately afterward, the balance turned massively negative and kept growing more negative up to 2007.
Table 4.11. U.S. Goods Trade Balance with Mexico before and after NAFTA ($Billions)
These features helped contribute to the jobless recovery of 1993–96, although the economy was eventually able to overcome this with the stock market bubble that launched in 1996, the emergence of the Internet investment boom that morphed into the dot-com bubble, and the tentative beginnings of the housing price bubble, which can be traced back to 1997. Together, these developments spurred a consumption and investment boom that masked the adverse structural effects of NAFTA.
The Response to the East Asian Financial Crisis
The next fateful step in the flawed engagement with the global economy came with the East Asian financial crisis of 1997, which was followed by a series of rolling financial crises in Russia (1998), Brazil (1999), Turkey (2000), Argentina (2000), and Brazil (2000). In response to these crises, Treasury Secretaries Rubin and Summers adopted the same policy that was used to deal with the 1994 peso crisis, thereby creating a new global system that replicated the pattern of economic integration established with Mexico.14
Large dollar loans were made to the countries in crisis to stabilize their economies. At the same time, the collapse of their exchange rates and the appreciation of the dollar was accepted and institutionalized in the form of a “strong dollar” policy.15 This increased the buying power of U.S. consumers, which was critical because the U.S. consumer was now the lynchpin of the global economy, becoming the buyer of first and last resort.16
The new global economic architecture involved developing countries exporting their production to the United States. Developing countries embraced this export-led growth solution to their development problem and were encouraged to do so by the IMF and the World Bank. For developing countries, the new system had a number of advantages, including the ability to run trade surpluses that allowed them to build up foreign exchange holdings to defend against capital flight; providing demand for their output, which led to job creation; and providing access to U.S. markets that encouraged MNCs to redirect investment spending toward them. The latter was especially important as it transferred technology, created jobs, and built up developing countries’ manufacturing capacity.
U.S. multinationals were also highly supportive of the new arrangement as they now gained global access to low-cost export production platforms. Not only did this mean access to cheap foreign labor, but the overvalued dollar lowered their foreign production costs, thereby further increasing profit margins. Large importers, like Wal-Mart, also supported this arrangement. Furthermore, many foreign governments offered subsidies as an incentive to attract foreign direct investment (FDI).
In effect, the pattern of incentives established by the response to the East Asian financial crisis encouraged U.S. corporations to persistently downsize their U.S. capacity and shift production offshore for import back to the United States. This created a dynamic for progressively eroding U.S. national industrial capacity, while foreign economies were encouraged to steadily expand their capacity and export their way out of economic difficulties.
As with NAFTA, the adverse effects of this policy were visible almost immediately. As shown in Table 4.12, the goods trade deficit took a further leap forward, surging from $198.4 billion in 1997 to $248.2 billion in 1998, and rising to $454.7 billion in 2000. In addition, as shown in Table 4.13, there was a surge in imports from Pacific Rim countries. Part of the surge in the trade deficit was due to the boom conditions sparked by stock market euphoria, the dot-com bubble, and housing price inflation, but the scale of the trade deficit surge also reflects the flawed character of U.S. engagement with the global economy.
Table 4.12. U.S. Goods Trade Balance ($Billions)
Table 4.13. U.S. Goods Trade Balance with Pacific Rim Countries ($ Billions)
The proof of this claim is that manufacturing employment started falling despite boom conditions in the U.S. economy. Having finally started to grow in 1996, manufacturing employment peaked in March 1998 and started declining three full years before the economy went into recession in March 2001. That explains why manufacturing job growth was negative over the entirety of the Clinton expansion – a first in U.S. business cycle history.
As with NAFTA, these adverse effects were once again obscured by positive business cycle conditions. Consequently, the Clinton administration dismissed concerns about the long-term dangers of manufacturing job loss. Instead, the official interpretation was that the U.S. economy was experiencing – in the words of senior Clinton economic policy advisers Alan Blinder and Janet Yellen – a “fabulous decade” significantly driven by policy.17 According to the ideology of the decade, manufacturing was in secular decline and destined for the dustbin of history. The old manufacturing economy was to be replaced by a “new economy” driven by computers, the Internet, and information technology.
China and Permanent Normal Trading Relations (PNTR)
Although disastrous for the long-run health of the U.S. economy, NAFTA-style corporate globalization plus the strong-dollar policy was extremely profitable for corporations. Additionally, the ultimate costs to households were still obscured by the ability of the U.S. economy to generate cyclical booms based on asset price inflation and debt. That provided political space for a continued deepening of the global engagement model, the final step of which was to incorporate China as a full-fledged participant.
Thus, corporations now pushed for the establishment of permanent normal trading relations with China, which Congress enacted in 2000. That legislation in turn enabled China to join the World Trade Organization (WTO), which had been established in 1996.
The significance of PNTR was not about trade, but rather about making China a full-fledged part of global production arrangements. China had enjoyed access to the U.S. market for years, and its entry into the WTO did generate some further tariff reductions. However, the real significance was that China became a fully legitimate destination for foreign direct investment. That is because production from China was now guaranteed permanent access to the U.S. market, and corporations were also given internationally recognized protections of property and investor rights.
Once again the results were predictable and similar to the pattern established by NAFTA, although the scale was far larger. Aided by a strong dollar, the trade deficit with China increased dramatically after 2001, growing at a rate of 25 percent per annum and jumping from $83.1 billion in 2001 to $201.5 billion in 2005 (see Table 4.14). Moreover, there was also massive inflow of foreign direct investment into China so that it became the world’s largest recipient of FDI in 2002 – a stunning achievement for a developing country.18 So strong was China’s attractiveness as an FDI destination that it not only displaced production and investment in the United States, but also displaced production and investment in Mexico.19
Table 4.14. U.S. Goods Trade Balance with China before and after PNTR ($ Billions)
According to academic and Washington policy orthodoxy, the new global system was supposed to launch a new era of popular shared prosperity. Demand was to be provided by U.S. consumers. Their spending was to be financed by the “new economy” based on information technology and the globalization of manufacturing, which would drive higher productivity and income. Additionally, consumer spending could be financed by borrowing and asset price inflation, which was sustainable because higher asset prices were justified by increased productivity.
This new orthodoxy was enshrined in what was termed the “New Bretton Woods Hypothesis,” according to which the global economy had entered a new golden age of global development, reminiscent of the postwar era.20 The United States would import from East Asian and other developing economies, provide FDI to those economies, and run large trade deficits that would provide the demand for the new supply. In return, developing countries would accumulate financial obligations against the United States, principally in the form of Treasury securities. This would provide them with foreign exchange reserves and collateral that was supposed to make investors feel secure. China was to epitomize the new arrangement.21
The reality is that the structure of U.S. international engagement, with its lack of attention to the trade deficit and manufacturing, contributed to a disastrous acceleration of the contradictions inherent in the neoliberal growth model. That model always had a problem regarding sustainable generation of demand because of its imposition of wage stagnation and high income inequality. Flawed international economic engagement aggravated this problem by creating a triple hemorrhage that drained consumer spending, manufacturing jobs, and investment and industrial capacity. This, in turn, compelled even deeper reliance on the unsustainable stopgaps of borrowing and asset price inflation to compensate.
As for developing economies, they embraced the post-1997 international economic order. However, in doing so they tied their fate to the U.S. economy, creating a situation in which the global economy was flying on one engine that was bound to fail. Consequently, far from creating a decoupled global economy, it created a linked economy characterized by a concertina effect: When the U.S. economy crashed in 2008, other economies began weakening in its wake.
America’s Exhausted Macroeconomic Paradigm
The twin macroeconomics factors of an unstable growth model and of flawed global economic engagement were put in place during the 1980s and 1990s. However, their full adverse effects took time to build, and the chickens only came home to roost in the 2001–07 expansion. From that standpoint, the Bush administration is not responsible for the financial crisis. Its economic policies can be criticized for mean-spiritedness and a greater proclivity for corporate favoritism, but they represented a continuation of the policy paradigm already in place. The financial crisis, therefore, represents the exhaustion of that paradigm rather than being the result of specific policy failures on the part of the Bush administration.
In a nutshell, the U.S. implemented a new growth model that relied on debt and asset price inflation. As the new model slowly cannibalized itself and became weaker, the economy needed larger speculative bubbles to grow. The flawed model of global engagement accelerated the cannibalization process, thereby creating the need for a huge bubble that only housing could provide. However, when that bubble burst, it pulled down the entire economy because of the bubble’s massive dependence on debt.
In many regards, the neoliberal paradigm was already showing its limits in the 1990s. An extended jobless recovery marked the business cycle of the 1990s when the term was coined, and the subsequent 1990s boom was accompanied by a stock market bubble and the beginnings of significant house price inflation.
The recession of 2001 saw the bursting of the stock market and dot-com bubbles. However, although investment spending was hit hard, consumer spending was largely untouched, owing to continued household borrowing and continued moderate increases in home prices. Additionally, the financial system was largely unscathed, because the stock market bubble involved limited reliance on debt financing.
Yet, despite the relative shallowness of the 2001 recession and aggressive monetary and fiscal stimulus, the economy languished in a second extended bout of jobless recovery. The critical factor was the trade deficit and offshoring of jobs resulting from the model of globalization that had been decisively implemented in the 1990s. This drained spending, jobs, and investment from the economy, and also damped down wages by creating job insecurity.
The effects are clearly visible in the data for manufacturing employment. As noted earlier, manufacturing employment peaked in March 1998, shortly after the East Asian financial crisis and three years before the economy went into recession. Thereafter, manufacturing never really recovered from this shock and continued losing jobs throughout the most recent expansion (see Table 4.15).
Table 4.15. U.S. Manufacturing-Sector Employment (Millions)
The sustained weakness of manufacturing effectively undermined economic recovery, despite expansionary macroeconomic policy. According to the National Bureau of Economic Research, the recession ended in November 2001, when employment was 130.9 million. Two years later (November 2003), total employment was 130.1 million – a decrease of 800,000 jobs. Over this period, manufacturing lost 1.5 million jobs, and total manufacturing employment fell from 15.83 million to 14.32 million.
Failure to develop a robust recovery, combined with persistent fears that the economy was about to slip back into recession, prompted the Federal Reserve to lower interest rates. Beginning in November 2000, the Fed cut its federal funds rates significantly, lowering it from 6.5 to 2.1 percent in November 2001. However, the weakness of the recovery drove the Fed to cut the rate still further, pushing it to 1 percent in July 2003, where it was held until June 2004.
Ultimately, the Federal Reserve’s low-interest-rate policy succeeded in jump-starting the economy by spurring a housing price boom, which in turn sparked a construction boom. That boom became a bubble, which burst in the summer of 2007. What is important about this history is that the economy needed an asset price bubble to restore full employment, just as it had needed the stock market and dot-com bubbles to restore full employment in the 1990s.
Given the underlying structural weakness of the demand-generating process, which had been further aggravated by flawed globalization, a bubble was the only way back to full employment. Higher asset prices were needed to provide collateral to support borrowing that could then finance spending.
A housing bubble was particularly economically effective for two reasons. First, housing ownership is widespread so the consumption wealth effects of the bubble were also widespread. Second, higher house prices stimulated domestic construction employment by raising prices above the cost of construction. Moreover, the housing bubble was a form of “house price populism” that benefitted incumbent politicians who could claim credit for the fictitious wealth created by the bubble.
The Federal Reserve is now being blamed by many for the bubble,22 but the reality is that it felt compelled to lower interest rates for fear of the economy falling back into recession. Additionally, inflation – which is the signaling mechanism the Federal Reserve relies on to assess whether monetary policy is too loose – showed no indication of excess demand in the economy. Indeed, all the indications were of profound economic weakness and demand shortage. Finally, when the Federal Reserve started raising the federal funds interest rates in mid-2004, the long-term rate that influences mortgages changed little. In part this may have been because of recycling of foreign country trade surpluses back to the United States, but the real cause likely was expectations of weak future economic conditions that kept the lid on long-term interest rates.
This reality is confirmed by a look back at the expansion of 2001–07 compared to other expansions. By almost all measures it ranks as the weakest business cycle since World War II. Table 4.16 shows “trough to peak” and “peak to peak” measures of GDP growth, consumption growth, investment spending growth, employment growth, manufacturing employment growth, profit growth, compensation growth, wage and salary growth, change in the unemployment rate, and change in the employment/population ratio of this business cycle relative to other postwar cycles. The 2001–07 cycle ranks worst in seven of the ten measures and second-worst in two other measures. If the comparison is restricted to the four cycles lasting twenty-seven quarters or more, the 2001–07 cycle is worst in nine of ten measures and best in one measure – profit growth. This weak performance occurred despite a housing price and credit bubble of historic proportions. That is the clearest evidence possible of the structural weakness of the U.S. macroeconomic model and why a bubble was needed to sustain growth.
Table 4.16. Rank of Last Business Cycle Relative to Cycles since World War II (1 = Best; 10 = Worst)
This structural weakness is the heart of the matter, but as yet, policy makers and the economics profession are unwilling to acknowledge it. The refusal to change paradigms means the economy will likely be unable to escape the pull of stagnation. That is because stagnation is the logical next stage of the model.
This chapter (Palley, Reference Palley2009a) was originally commissioned by the New America Foundations’ Economic Growth Program whose permission to use it is gratefully acknowledged. The original report is available at http://www.newamerica.net/ publications/policy/america_s_exhausted_paradigm_macroeconomic_causes_ financial_crisis_and_great_recession. An abbreviated version of that paper was published in Empirica, 38 (1), 2011.
1 See Palley, T.I. [2005a], “The Questionable Legacy of Alan Greenspan,” Challenge 48 (November–December): 17–31.
2 The 1950s are an exception because of the Korean War (June 1950–July 1953), which ratcheted up manufacturing employment and distorted manufacturing employment patterns.
3 Defenders of the neoliberal paradigm argue that manufacturing has prospered, and the decline in manufacturing employment reflects healthy productivity trends. As evidence, they argue that real manufacturing output has increased and remained fairly steady as a share of real GDP. This reflects the fact that manufacturing prices have fallen faster than other prices. However, this is owing in part to hedonic “quality adjustment” statistical procedures that count improved information technology embodied in manufactured goods as increased manufacturing output. It is also due to increased use of cheap imported components that are not subject to the same hedonic statistical adjustments. As a result, the real cost of imported inputs is understated, and that has the effect of making it look as if real manufacturing output is higher. The stark reality is that the nominal value of manufacturing output has fallen dramatically as a share of nominal GDP. The United States has also become more dependent on imported manufactured goods, with imported manufactured goods making up a significantly increased share of total manufactured goods purchased. Moreover, U.S. purchases of manufactured goods have risen as a share of total U.S. demand, indicating that the failure lies in U.S. production of manufactured goods, which has lost out to imports. See Bivens, J. [2004], “Shifting Blame for Manufacturing Job Loss: Effect of Rising Trade Deficit Shouldn’t Be Ignored,” EPI Briefing Paper No. 149, Washington, DC: Economic Policy Institute.
4 In an earlier book, I analyzed in detail how economic policy has impacted income distribution, unemployment, and growth (Plenty of Nothing: The Downsizing of the American Dream and the Case for Structural Keynesianism [Princeton, NJ: Princeton University Press, 1998a]). The metaphor of a box is attributable to Ron Blackwell of the AFL-CIO.
5 There is a deeper political economy behind the neoliberal box, which has been termed “financialization.” See Epstein, G. [Reference Epstein2001], “Financialization, Rentier Interests, and Central Bank Policy,” unpublished manuscript, Department of Economics, University of Massachusetts, Amherst, MA, December; and Palley, T.I. [Reference Palley2008b], “Financialization: What It Is and Why It Matters,” in Finance-led Capitalism: Macroeconomic Effects of Changes in the Financial Sector, ed. Eckhard Hein, Torsten Niechoj, Peter Spahn, and Achim Truger (Marburg, Germany: Metroplis-Verlag). The policy agenda embedded in the box is driven by financial markets and corporations who are now joined at the hip, with corporations pursuing a narrow financial agenda aimed at benefiting top management and financial elites.
6 See International Monetary Fund [2006], “People’s Republic of China: Staff Report for the 2006 Article IV Consultation,” Washington, DC.
7 The natural rate of unemployment is also referred to as the NAIRU or nonaccelerating inflation rate of unemployment.
8 See Palley, T.I. [2007a], “Seeking Full Employment Again: Challenging the Wall Street Paradigm,” Challenge, 50 (November–December), 14–50.
9 S&P/Case-Shiller index data is only available from 1987.
10 This means the crisis is not a pure “Minsky” crisis. Hyman Minsky (Reference Minsky1992, 1993) saw crises as the result of endogenous financial instability that developed over time. However, the current crisis is a crisis of the neoliberal paradigm. That paradigm fostered financial instability as a way of sustaining itself. Consequently, when the crisis hit, it took on the appearance of a classic Minsky crisis, but its real roots lie in the neoliberal model. For a more extensive discussion of this issue, see Palley, T.I. [Reference Palley2010a], “The Limits of Minsky’s Financial Instability Hypothesis as an Explanation of the Crisis,” Monthly Review (April), 28–43.
11 See Bronfenbrenner, K. [Reference Bronfenbrenner2000],Uneasy Terrain: The Impact of Capital Mobility on Workers, Wages, and Union Organizing, Report prepared for the United States Trade Deficit Review Commission, Washington, DC, September; and Bronfenbrenner, K. and S. Luce[Reference Bronfenbrenner and Luce2004], The Changing Nature of Corporate Global Restructuring: The Impact of Production Shifts on Jobs in the U.S., China, and Around the Globe, Report prepared for the U.S.-China Economic and Security Review Commission, Washington, DC, October.
12 See Peters, G.P., J.C. Minx, C.L. Weber, and O. Edenhofer [2011], “Growth in Emission Transfers Via International Trade from 1990 to 2008,” Center for International Climate and Environmental Research, Oslo, Norway, March 29.
13 See Masters, M.W. and A.K. White [2008], “The Accidental Hunt Brothers: How Institutional Investors are Driving up Food and Energy Prices,” Special Report, July 31, http://www.accidentalhuntbrothers.com.
14 It cannot be overemphasized that the policies adopted by Treasury Secretaries Robert Rubin and Lawrence Summers reflected the dominant economic paradigm. As such, Rubin and Summers had the support of the majority of the U.S. political establishment, the IMF and the World Bank, Washington’s premier think tanks, and the economics profession.
15 China had already gone this route with a large exchange rate devaluation in 1994. Indeed, there is reason to believe that this devaluation contributed to hatching the East Asian financial crisis by putting other East Asian economies under undue competitive pressures and diverting foreign investment from them to China.
16 The strong-dollar policy was also politically popular, constituting a form of exchange rate populism. Boosting the value of the dollar increased the purchasing power of U.S. consumers at a time when their wages were under downward pressure due to the neoliberal model. Households were under pressure from globalization, yet at the same time they were being given incentives to embrace it. This is why neoliberalism has been so hard to tackle politically.
17 See Blinder, A.S. and J.L. Yellen [2001], The Fabulous Decade: Macroeconomic Lessons from the 1990s, New York: Century Foundation Press. To the extent there was concern in the Clinton administration about manufacturing, it was about the hardships for workers regarding job dislocations. Additionally, there was political concern that produced some sweet talk (i.e., invitations to policy consultations) aimed at placating trade unions. However, there was no concern that these outcomes were due to flawed international economic policy. Not only did this policy failure contribute to eventual disastrous economic outcomes, it may well have cost Vice President Al Gore the 2000 presidential election. The Clinton administration’s economic advisers may have downplayed the significance of manufacturing-sector job loss, but blue-collar voters in Ohio did not.
18 “China Ahead in Foreign Direct Investment” [2003], OECD Observer, No. 237, May.
19 See Greider, W. [2001], “A New Giant Sucking Sound,” The Nation, December 13.
20 See Dooley, M.P., D. Folkerts-Landau, and P. Garber [Reference Dooley, Folkerts-Landau and Garber2003], “An Essay on the Revised Bretton Woods System,” Working Paper 9971, Cambridge, MA: National Bureau of Economic Research, September; and Dooley, Folkerts-Landau, and Garber [Reference Dooley, Folkerts-Landau and Garber2004], “The US Current Account Deficit and Economic Development: Collateral for a Total Return Swap,” Working Paper 10727, Cambridge, MA: National Bureau of Economic Research, August.
21 For a critique of the New Bretton Woods hypothesis, which explains why it was unsustainable, see Palley, T.I. [Reference Palley2006c], “The Fallacy of the Revised Bretton Woods Hypothesis: Why Today’s System Is Unsustainable and Suggestions for a Replacement,” Public Policy Brief No. 85, The Levy Economics Institute of Bard College.
22 See Taylor, J.B. [Reference Taylor2009], “How Government Created the Financial Crisis,” Wall Street Journal, February 9.
