The first half of this book has been backward looking, analyzing the causes of the financial crash of 2008 and the Great Recession. It is now time to look forward, and unfortunately the prognosis is not good.

The reason for this gloomy outlook is that the U.S. and global economies are beset by weakness and contradiction resulting from thirty years of neoliberal economic policy domination. However, the economy is not preordained, so that it is possible to change the outlook. The underlying problem is the neoliberal paradigm that has ruled policy making for the past three decades. The challenge is to replace that paradigm with a structural Keynesian paradigm that rebuilds a stable income- and demand-generating process that restores shared prosperity.

Economic policy is going to be absolutely critical. If policy makers get policy right, it will be possible to construct a prosperous future. If they get it wrong, there is a high likelihood the Great Recession will be followed by the Great Stagnation.

That leads to politics – the politics of policy and the politics of ideas. Getting it right will require change, but there are plenty of vested interests that will look to block change. That includes blocking policy change at the political level, and also blocking policy change by ignoring competing ideas regarding economics and economic policy.

The Danger of Stagnation

In the wake of the Great Recession, the global economy confronts a dangerous and challenging future. Immediately following the financial crisis of 2008, policy makers succeeded in stabilizing the economic system and checking a free fall. However, it has now become evident the global economy is beset by generalized demand shortage. In the industrialized countries, the demand shortage is explicit; in the EM economies, it is implicit in their reliance on exports to maintain employment. That makes for an outlook of global economic stagnation.

The core problem is that the forces that drove global growth over the past three decades are exhausted and existing policy is not up to producing shared prosperity. That means there is a need for a new approach to growth. However, so far there has been little progress in creating the political and intellectual space for a change of economic paradigm.

Given these conditions, in the industrialized North, two scenarios deserve special consideration. The first is labeled the “new normal.” In this high-probability scenario, the existing orthodox economic paradigm remains policy dominant; policy makers accept a “new normal” marked by high unemployment that is justified on grounds it is structural. Wage stagnation and an attack on the welfare state are also justified on grounds of affordability.

The second scenario is labeled the “Weimar scenario.” In this political scenario, extended stagnation and prolonged mass unemployment create conditions in which the forces of intolerance and hate are released. Both scenarios are profoundly disturbing.

Among EM economies, the outlook is more fractured. Some larger EM economies (China, India, Brazil) may be able to pursue “go it alone” development strategies owing to the size of their internal markets. However, smaller export-led economies are likely to be infected by the North’s “new normal” economic malaise.

The Economic Outlook

It is now clear that the United States is experiencing a third episode of “jobless recovery” and slow growth that parallels the previous episodes in the business cycle recoveries of 1991–95 and 2001–04. Together, these three episodes provide firm evidence that today’s U.S. business cycle is fundamentally different from that which held sway for thirty-five years after World War II. Moreover, the current episode of jobless recovery comes after an economic expansion that was the weakest since World War II.¹

The difficulties confronting the U.S. economy have enormous negative implications for the global economy. That is because the global economy has relied on the U.S. economy to fuel global demand. Furthermore, Europe and Japan are both suffering on their own account from weak-demand conditions. Europe was hit hard by the U.S. financial crisis, whereas Japan languishes from problems related to its aging population and residual effects from its financial crisis of twenty years ago.

In the United States and Europe, all sectors of the economy (business, household, financial, and government) face strong headwinds, some of which are temporary and some of which are more permanent. A list of factors affecting most economies in varying degrees might include:

1. The weakening of confidence and investor “animal spirits” in the wake of the financial crisis.

2. The waning of inventory rebuilding that underpinned initial economic rebound after the financial crash.

3. A weak investment spending outlook due to global excess capacity.

4. In the United States, the construction sector remains depressed owing to overbuilding from the last boom and continued foreclosures.

5. Waning fiscal stimulus and emerging fiscal austerity. In Europe, this is being driven by rolling public-sector financial crises. In the United States, it is being driven by politics at the federal level and budget balance requirements at the state and local government levels.

6. In the international economy, there has been a fundamental failure to rebalance the U.S. trade deficit with China. Moreover, the U.S. trade deficit is increasing again – a problem that could be compounded by any weaknesses affecting the euro.

7. The global trade imbalance problem is further exacerbated by the fact that almost all countries (including the United States) are looking to adopt export-led growth. This is impossible because of a fundamental fallacy of composition (some country has to import). Increased emphasis on exports also promises to aggravate exchange rate conflict and global deflationary tendencies.

8. The global exchange rate problem remains unresolved and could get worse. There has been no resolution of the China currency problem, and to this has been added the problem of the euro. Exchange rate instability is bad for business confidence and complicates planning of investment spending.

9. Global consumer spending stands to be weak owing to the destruction of housing and stock market wealth, destruction of jobs, wage stagnation, and reduced consumer confidence.

10. U.S. consumption spending stands to be especially weak relative to historical patterns, because households are debt burdened and must restore their saving rate. Households will be additionally constrained by damage to credit histories that will limit access to credit.

11. Banks everywhere are still grappling with commercial property losses, and U.S. banks face continuing difficulties related to their prior reckless residential mortgage lending.

12. As banks remedy their past failings, they are likely to maintain tightened credit standards, and this will be exacerbated by financial reforms that raise capital standards and limit leverage ratios.

13. In financial markets, there is the perennial problem of “bond market vigilantism” that could spike interest rates. Thus, interest rates could rise in response to phantom fears of inflation, and there is the persistent danger of speculative attacks on individual country bond markets that produce financial turmoil.

14. Lastly, there is a danger of commodity market speculation that triggers temporary cost inflation, which lowers industrial-sector profits and real wages, thereby adversely impacting investment and consumer spending.

Why this Recession Really is Different

The fact that the economic outlook is so gloomy, despite extraordinary expansionary monetary and fiscal policy, speaks to the fact that the Great Recession is fundamentally different from the recessions of the past thirty years. Understanding the nature of this difference makes clear the danger of the Great Stagnation.

As briefly discussed in Chapter 4, in past recessions and financial upheavals, U.S. economic policy makers were quickly able to restore growth by stepping on the financial accelerator and opening the spigot of credit. This pattern of monetary policy was captured in Table 4.10 (reproduced as Table 8.1 here), which showed the evolution of the Federal Reserve’s federal funds interest rate over the three long cycles during the period between 1981 and 2010.

Table 8.1. Brief History of the Federal Funds Interest Rate, June 1981–January 2010

Source: Board of Governors of the Federal Reserve.

The federal funds rate is the overnight interest rate for loans between commercial banks, and it is the interest rate the Federal Reserve targets in its attempt to guide the macro economy. The federal funds rate peaked in June 1981 at 19.1 percent, almost two years after Federal Reserve Chairman Paul Volcker launched the Fed’s war against inflation. Over the next eleven years, with modest ups and downs in between, it gradually fell to 2.92 percent in December 1992. The reduction to 2.92 percent helped the economy escape the recession of the early 1990s, and it also helped save the banking system, which was suffering from major loan losses. The mechanism was to lower the short-term cost of funds to banks (i.e., the federal funds rate) and thereby increase the spread between banks’ cost of funds and banks’ loan rate.

Over the 1990s, the federal funds rate again trended upward, hitting 6.51 percent in November 2000, which was shortly before the economy went into recession. Thereafter, the federal funds rate was progressively lowered, hitting 1 percent in May 2004. That helped restart the economy once again. It also accelerated the house price bubble that had begun in the late 1990s.

Following the May 2004 low, the federal funds rate reversed on an upward course, hitting 5.27 percent in July 2007. In August 2007, the subprime mortgage market detonator went off, and the Fed started reversing course again, pushing the federal funds to 0.16 percent in December 2008.

The important feature is that every time the economy got into trouble, the Federal Reserve was able to jump-start the economy by lowering interest rates. It did this not only for recessions as shown in Table 8.1, but also for major financial storms. Thus, when the stock market crashed in October 1987, the Federal Reserve lowered the federal funds rate from 7.22 percent in October 1987 to 6.58 percent in March 1988. Another episode was the Russian financial crisis of August 1998 that hit Wall Street and the U.S. financial system via the speculative activities of Long Term Capital Management. The Federal Reserve responded by lowering the federal funds rate from 5.55 percent in August 1998 to 4.74 percent in April 1999.

The twenty-five years from 1981 to 2006 marked a period during which the Federal Reserve was able to jump-start the economy in recessions and inoculate it against financial disturbances by adjusting the federal funds rate. Most economists labeled this period of apparent success the “Great Moderation,” and the reputations of central bankers soared. The smoothing of the business cycle, the lengthening of expansions, the shortening of recessions, and the lowering of inflation were all attributed to improved central bank monetary policy, hence the boom in central banker reputations.

This explanation has been popular with economists because it implicitly applauds the economics profession. After all, improved policy was attributable to advances in economics and increased influence of economists within central banks. For instance, the Fed’s current Chairman is a former academic economist, as are many of the Fed’s board of governors and many presidents of the regional Federal Reserve banks.

However, there was always another, less celebratory explanation of what was going on, but it got little play time as the winners write history. That less celebratory account explains the Great Moderation as a transitional phenomenon, and one that has ultimately come at a high cost.² This alternative account emphasizes the changed economic environment that followed with the retreat from policy commitment to full employment.

The great Polish economist Michal Kalecki observed that full employment would likely cause inflation because job security would prompt workers to demand higher wages. That is what happened in the 1960s and 1970s. The problem was exacerbated by the oil price shocks of the 1970s, which created further cause for conflict between capital and labor over whether wages or profits would bear the hit. However, rather than solving this political problem, economic policy retreated from full employment and assisted in the evisceration of unions. That lowered inflation, but it came at the high cost of rupturing of the link between wage and productivity growth and almost three decades of wage stagnation.

Persistent disinflation in turn lowered nominal interest rates, particularly during downturns, and provided the economy with a cushion of support. In particular, falling interest rates facilitated successive waves of mortgage refinancing that lowered interest burdens on borrowers and reduced cash outflows on new mortgages.³ This improved household finances and supported consumer spending, thereby keeping recessions short and shallow.

With regard to lengthened economic expansions, the Great Moderation was driven by asset price inflation and financial innovation, which also financed consumer spending. Higher asset prices (especially house prices) provided collateral to borrow against, whereas financial innovation increased the volume and ease of access to credit. Together, that created a dynamic in which rising asset prices supported increased debt-financed spending, thereby making for longer expansions. This dynamic was exemplified by the housing bubble that began in 1996 and ran until mid-2006.

The important implication is that the Great Moderation was the result of a retreat from full employment combined with the transitional factors of disinflation, asset price inflation, and increased consumer borrowing. An essential factor was the Federal Reserve’s ability to lower interest rates in step-like fashion each recession.

All of these factors have now disappeared, which is why the system is in true crisis. The factors needed for the system to work are no longer there. The federal funds rate is near zero, so that there is no further room for reduction. Further disinflation will produce disruptive deflation that increases debt burdens. That will increase defaults and further weaken an already weak banking system.

Households are heavily indebted and no longer want or are able to take on debt. The decline in asset prices (especially housing prices) has destroyed financial wealth so that households lack collateral to back borrowing. Twenty years ago, households had relatively low debt burdens and therefore had unused borrowing capacity. That borrowing capacity was an unrecorded asset (a kind of off-balance-sheet asset) that could be called on to jump-start consumer spending, but now it is used up. Additionally, many households have seen their credit histories damaged by bankruptcy and default. Taken together, it means increased consumer credit cannot jump-start recovery as it did in the past.

Not only are many households not borrowing more, many are paying back debt – a process known as deleveraging. That process involves households increasing their saving rate and reducing consumption spending. Consequently, deleveraging further aggravates the underlying structural weaknesses in the demand-generating process.

Moreover, this time, lowering the federal funds rate to near-zero seems to have had a smaller positive effect on the economy. One reason is the stock of high-interest-rate loans has already been significantly refinanced in past recessions, leaving less benefit from another round of refinancing. Another reason is that many households who could have benefited from refinancing have not been able to. This is because housing prices have fallen so much that many owners are “under water” (i.e., have negative equity), and banks will not refinance loans. A corollary of this is that those who can refinance tend to be wealthier, higher-income households and these households tend to save most of the refinancing windfall rather than spend it. Consequently, the effect of lower interest rates on consumer spending has been far more modest than in the past.

Moreover, many households who have been able to refinance are choosing to refinance into shorter mortgages, such as fifteen-year mortgages instead of thirty-year mortgages. The saving on interest payments is therefore often outweighed by the increase in principal payments resulting from a shorter payback period. In the past, households used their interest saving from refinancing to increase consumption. This time, many are choosing to use interest payment reductions to increase their saving rate.

A third reason why the economic effect of lower interest rates has been muted is that asset prices were initially significantly overvalued. Thus, rather than increasing asset prices and generating a positive wealth effect on consumption as in the past, this time lower interest rates diminished the decline in asset prices that would otherwise have occurred. That mitigated the negative effect of falling wealth on consumer spending, but it did not increase spending.

These multiple factors and their effect on the economy can be understood through the metaphor of a car that symbolizes the economy. Demand (i.e., spending) is the gas that fuels the car (i.e., the economy). The problem is that the fuel line has been gradually getting clogged because of wage stagnation, rising income inequality, and the trade deficit that have together undermined the demand- generating process.

In prior recessions, these underlying structural effects could be overcome by increased household borrowing, which was like stepping on the gas, and that accelerated economic activity as consumers spent their borrowings. Every time there was economic trouble, the Federal Reserve took measures to encourage borrowing (i.e., stepped on the pedal), which got the car moving again.

This time, households have run out of borrowing capacity. Consequently, measures by the Federal Reserve to stimulate borrowing are not working. The mere stop in borrowing is like taking the foot off the pedal and causes the car to slow. However, now there are additional effects from the stock of debt accumulated from past borrowing, which is like a weight in the car’s trunk that causes the car to slow even more. Furthermore, deleveraging means households are increasing their saving to repay debt, and that is like pressing on the brake, which further compounds the slowdown. Putting the pieces together, it is small wonder the car (i.e., the economy) is stuck.

Why U.S. Economic Policy is Failing

The car metaphor helps explain why U.S. economic policy is failing. Much attention is being devoted to the problems of deleveraging and the blockage of borrowing. However, that ignores the more fundamental problem, namely that the fuel line is clogged (i.e., the underlying demand-generating process is failing because of problems concerning wage stagnation, the trade deficit, and globalization). Even if the Fed could restart borrowing, it would be a short-term fix that does not remedy these deeper problems. Moreover, any short-term fix comes back to haunt the economy in the form of increased debt burdens and financial fragility. That is the lesson of the past thirty years and the financial crash of 2008.

U.S. policy makers have failed to come to grips with the fact that this recession is different and have not learned its lessons. Instead, they are still trying to resuscitate the old model. This is reflected in the current policy mix of conventional stimulus plus some financial reform. The hope is to revive a marginally less speculative version of the existing neoliberal model.

Current policy is not going to work because the existing paradigm is completely exhausted. It is futile to think it possible to revive the debt-fueled growth model of the past thirty years because U.S. households are debt saturated.

Following the Great Crash of 2008, policy makers confronted a threefold task:

1. 1. Stop the economic free fall.

2. 2. Jump-start the economy.

3. 3. Ensure sustainable growth with shared prosperity.

In the United States, after much delay and indecision, policy makers succeeded in stopping the free fall. The U.S. Treasury’s Troubled Asset Relief Program, combined with myriad of special lending and liquidity programs established by the Federal Reserve, stabilized financial markets and put an end to the liquidation trap that gripped financial markets in 2008 and early 2009. Although belated, the moves were effective.

However, with regard to jump-starting the economy and creating sustainable growth, policy has failed. At best, the economy confronts jobless recovery and subpar growth that will leave the unemployment rate high and wages stagnant for years to come.

The reason for this policy failure is refusal to confront the fundamentally flawed nature of the neoliberal paradigm, abandon it, and reconstruct economic policy along new lines. This failure is symbolized in President Obama’s choice of economic policy team, headed by Larry Summers and filled with other personnel connected to the 1990s Clinton administration. Yet, as shown in Chapter 4, the Clinton administration was instrumental in putting in place so many of the policies that have proven so disastrous.

Instead of change, economic policy has opted for conventional measures of fiscal and monetary stimulus – albeit budget deficits have been larger and the Federal Reserve’s interest rate is at record lows. Additionally, the Federal Reserve has pursued policies of quantitative easing whereby it has directly lent money to financial institutions, purchased private-sector mortgage-backed securities, and purchased U.S. Treasury bonds. The hope is that pumping extraordinary amounts of stimulus into the economy via budget deficits and monetary policy will jump-start private-sector demand and job creation.

The current policy mix fails to address the fundamental problem, which is that the existing paradigm has undermined the demand-generating process. The most immediate policy failure concerns the failure to plug the trade deficit, which undercuts the effectiveness of fiscal and monetary stimulus. The trade deficit’s impact can be understood through the metaphor of a bathtub, with the tub representing the economy and the volume of water in the tub representing the level of total demand. Monetary and fiscal policy stimulus have opened the tap and poured demand into the bathtub, but it has then leaked out of the tub through the plug hole, which symbolizes the trade deficit.

Plugging the trade deficit leakage is therefore critical. But plugging the trade deficit alone is not enough. There is also a deeper need to rebuild a stable demand-generating process that does not rely on excessive debt and asset price bubbles. That requires improving income distribution and reconnecting wages to productivity growth. Plugging the trade deficit will give a boost to demand, creating breathing room to make further policy adjustments. But it does not remedy the deeper underlying problem in the U.S. economy, which is the reliance on debt and asset bubbles to fuel demand.

The failure of policy to jump-start growth has meant continuing job losses, continuing housing price weakness, and continuing home foreclosures. These developments create facts that make recovery even harder. For instance, when a factory closes and jobs are lost, the collection of skills and capital that comprise the business is disbanded, and it is difficult to reassemble them. Once a house enters the foreclosure process, it is hard to reverse, putting more pressure on housing prices and construction. And once a consumer or business files for bankruptcy, their credit record is tainted, making it harder to get future credit to finance consumption or investment. Such factors mean the longer it takes to jump-start recovery and growth, the more difficult it becomes for policy to succeed because stagnation sets in. In the current situation, delay is costly, which is why it is so urgent that policy change.

Even the Best Mainstream Economists do not Understand the Problem

The Obama administration has pursued an entirely mainstream policy, navigating between those economists calling for less economic stimulus and those calling for more. The problem is that stimulus is only part of the solution, and so far it has been impossible to get a hearing for the full solution.

The economy needs a policy cocktail. In terms of the car metaphor, it needs more gas (i.e., stimulus) but it also needs repairs that unclog the fuel line (i.e., policies that rebuild the demand-generating process). Calls for more economic stimulus are fully appropriate, but stimulus alone is insufficient and stimulus alone also poses dangers.

First, stimulus alone will likely fail, and at the end of the day that could leave the economy worse off by creating more debt without resolving the problem. Second, policy failure risks exhausting the public’s appetite for real policy change. Third, exclusive focus on stimulus crowds out space for debate of other needed policies.

Large-scale stimulus is undoubtedly needed but it will only generate sustainable recovery if accompanied by other reforms. Absent those reforms, large budget deficits will ratchet up the debt without jump-starting sustainable growth. At some stage this risks creating a political demand for fiscal austerity, and it also burdens the federal government with massive debt obligations that create budget problems down the road.

A similar misunderstanding applies to monetary policy. The Federal Reserve has already lowered the federal funds rate to near-zero and it can effectively go no lower because of the zero lower bound. Liberal economist and Nobel Prize winner Paul Krugman (2010b) argues this is the fundamental problem:

However, being stuck at the zero bound is merely a symptom. The real underlying problem is told in Table 8.1. Since 1981, the economic system has relied on ever-falling interest rates to escape the contradictions caused by hollowing out of the demand-generating process inflicted by the neoliberal paradigm. In past recessions, the Fed had room to lower rates, but this time it has hit the zero lower bound to nominal interest rates. The proximate cause of the problem is the zero bound, but the ultimate cause is the Federal Reserve needed to keep lowering interest rates to stave off stagnation.

Some economists (DeLong, 2009; Farmer, 2009) have argued that the Federal Reserve should start buying private-sector assets, including corporate bonds and equities. The claim is this would drive up asset prices, thereby implicitly reducing the cost of capital and stimulating business investment. It would also increase wealth and encourage consumption.

Harvard economist Gregory Mankiw (2009) argues the Fed can circumvent the zero nominal interest rate bound by simply charging a negative interest rate on loans and paying banks to borrow from the Fed. With a lower cost of funds, banks might lend more.

Undoubtedly, there is some truth in these claims. Buying assets and subsidizing lending would juice asset markets a bit and have some expansionary impact. Buying equities would surely also be welcomed by the country’s richest segment that owns the bulk of privately held equities. Likewise, banks would rejoice at being paid to borrow from the Fed, which would be akin to giving them a printing press for profits.

The problem is that although these schemes might help ameliorate some of the problems caused by the zero lower bound to nominal interest rates, they would not resolve the underlying problem. The real story is that the neoliberal economic paradigm is exhausted and offers only stagnation: Hitting the zero bound on nominal interest rates is simply the manifestation of that fact.

Moreover, not only does the strategy not address the fundamental problem; it is also risky and embodies a contradiction. The risk is another asset bubble that imposes further collateral damage effects when it bursts. The contradiction is if the economy begins to revive, higher interest rates are likely to bring asset prices crashing back down and create fresh difficulties.

The Farmer-DeLong-Mankiw remedy is to blow harder when a bubble goes disastrously flat. From a political angle, it represents a fresh twist to the economics of plutonomy and trickle-down economics. The Republican approach to trickle-down economics has been to cut taxes on the rich. The claim is this will induce the rich to work harder and save more, some of which will trickle down to the rest. The New Democrat Wall Street version is to buy assets and subsidize capital, which will increase wealth and juice financial markets, and some of that will trickle down. Both are versions of the late John Kenneth Galbraith’s “horse and sparrow” economics: Feed enough oats to the horse and some will pass through onto the road to feed the sparrow.

The Risk of Further Policy Failures

Not only is existing policy likely to fail, there also exist significant dangers that policy could actually worsen conditions. Danger I, which is the most immediate, is the revived push for fiscal austerity. Austerity has always been part of the neoliberal mental framework, being a complement to the small-government agenda. Now, Europe’s sovereign debt woes (afflicting Greece, Italy, Spain, Portugal, Ireland and the United Kingdom) are adding strength to that push. Moreover, once one country implements fiscal austerity, there appears to be an austerity domino effect, as countries try to outdo each other in an attempt to appease bond markets.

Budget deficit reduction will eventually be required to avoid inflationary pressures once recovery is in place. However, premature deficit reduction and spending cuts will only deepen stagnation. That in turn will aggravate budget difficulties by reducing tax revenues, and it will also cause private-sector bankruptcies that further weaken an already weakened banking sector.

Danger II is that many central bankers are still obsessed with inflation and have itchy anti-inflation trigger fingers. That risks central banks mistakenly raising rates and truncating any recovery, which at best already promises to be anemic. In the United States, this threat has been on display in comments from the “inflation hawk” presidents of the Federal Reserve Banks of Kansas City, Philadelphia, and Richmond.

Danger III is that policy makers try to double down on the existing neoliberal policy mix that has already caused such damage. This danger is especially acute in Europe, but it is present everywhere. Moreover, it is likely to grow stronger if politics turns in a reactionary direction in response to extended high unemployment and economic stagnation.

The doubling-down tendency is evident in the continued push for new free-trade agreements modeled on an unchanged template. It is also evident in the widespread calls for more labor market flexibility and wage cuts in the wake of the Europe’s sovereign debt crisis. Such policies stand to amplify the problem of wage stagnation and deteriorated income distribution and risk releasing the evil genie of deflation. Most worryingly, calls for such policies are coming from across the spectrum of mainstream opinion. For instance, conservative economist Laurence Kotlikoff (2010) writes:

The slightly less conservative economist Barry Eichengreen (2010) writes:

Perhaps the clearest statement comes from Jeffrey Miron (2010), director of undergraduate studies at Harvard University, who writes:

These recommendations come straight out of conventional economic theory that dominates the academy and is widely taught in undergraduate economics. That gives a clue to the source of the policy problem.

Danger IV is the loss of Keynesian policy credibility. Even if policy makers avoid the previously described pitfalls, existing policy is not going to revive shared prosperity. Because existing policy is being sold as “Keynesian,” this creates a danger that when these policies fail to deliver, true structural Keynesian policies will be politically discredited without ever having been tried.