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.

Crisis is a word that is widely bandied about, perhaps so much so that it may have lost some of its impact. However, in social science theory, crisis has a very particular meaning – a situation in which a system is unable to replicate itself. Viewed from that standpoint, the financial crash of 2008 and the Great Recession can be viewed as a real crisis, fundamentally different from the financial upheavals and recessions of the past twenty years. The important policy implication is that if the system can no longer reproduce itself, it must be refashioned. That creates a historic opportunity for change.

The Failure of Neoliberalism

Chapter 8 analyzed the economic forces making for the Great Stagnation and the failure of current policy to address the underlying problem. That problem is a broken demand-generating process that has resulted in global demand shortage and financial fragility.

This condition has been slowly brewing for twenty-five years. Increased financial fragility has been apparent in the lengthening string of financial crises that have hit both developed and developing economies. Examples include the European currency and banking crises of the early 1990s; the Mexican financial crisis of 1994; the East Asian financial crisis of 1997; the Russian debt and Long Term Capital Management crisis of 1998; the financial crises afflicting Brazil, Argentina, and Turkey between 1999 and 2001; the global stock market crash of 2001; and of course the financial crash of 2008.

The weakening of the demand-generating process has also been long detectable.¹ However, in developed economies, it was obscured by asset bubbles and increased indebtedness that kept the problem temporarily at bay – albeit at the cost of a larger ultimate financial crash and deeper recession. Simultaneously, developing economies appeared healthier because of their reliance on export-led growth, which had them piggy-backing on consumer demand in developed countries.

Behind these economic conditions lies the failed neoliberal economic paradigm widely referred to as the Washington Consensus, which undermined and destabilized the global demand-generating process. As described in Chapter 4, the main features of the Washington Consensus are

1. retreat from commitment to full employment and a shift to obsessive concern with very low inflation;

2. promotion of flexible labor markets in which unions are weakened and minimum wages and worker protections are eroded;

3. support for a corporate version of globalization based on free-trade agreements and capital account liberalization that promotes industrial offshoring, limits possibilities for industrial policy, and limits macroeconomic policy options;

4. attacking government via deregulation, privatization, and shrinking public investment.

Chapter 4 described this neoliberal paradigm in terms of a policy box that is shown again in Figure 9.1. Its effect is to put workers under siege from all sides, thereby contributing to income inequality and wage stagnation by severing the link between wages and productivity growth.

Figure 9.1. The neoliberal policy box.

The neoliberal policy mix would have done great damage if implemented in just the U.S. economy. However, over the past thirty years, it was implemented in both the developed North and the emerging South, with the IMF and World Bank playing a crucial role in forcing implementation in the South. This global implementation multiplied its impact by creating an international “race to the bottom.”

The engine of this race to the bottom is international mobility of jobs and investment, global production sourcing, and unrestricted movement of financial capital. That cocktail has pressured workers and facilitated wage repression; pushed governments to shift tax burdens away from capital on to labor; and pressured governments to lower standards regarding corporate governance, labor markets, social protection, and the environment.

Initially, the main direction of competition was between North and South. However, South-South competition has become increasingly apparent, making the problem truly global. The entry of China into the global economy has been very important for this latest development, as exemplified by China’s impact on Central America.² Chinese wage and employment conditions have exerted downward competitive pressures throughout the South via competition for exports, jobs, and foreign direct investment (FDI).³

The metaphor of a policy box captures the existing policy configuration and its effects. However, a real box has six sides and those extra sides give strength to the box. This logic also holds for the neoliberal box and this is where corporations and financial markets enter into the picture.

The enduring strength of the neoliberal policy box derives from a new relationship between corporations and financial markets that is illustrated in Figure 9.2. This new relationship has been termed “financialization,” and the box would collapse absent these side supports.⁴

Figure 9.2. Side supports of the neoliberal policy box.

The basic logic of financialization is that financial markets have captured control of corporations and economic policy, both of which now serve financial market interests along with the interests of top management. That capture has changed corporate behavior, while the political power of corporations and finance ensures political control that enforces the policies described by the economic policy box.

Six sides are more complicated than four. However, the extra complication is essential for providing a full understanding of the political economy of neoliberalism. The economic and political power of corporations is central in shaping policy. Financial markets also have a critical double role. One role, discussed in Chapters 4 and 5, is to fuel demand growth by financing borrowing and spurring asset price inflation. A second role is to change corporate behavior, forcing corporations to adopt a short-term focus on profit maximization and shareholder value extraction.

The financial crisis has focused attention on the problem of financial instability. However, the deeper problem of financial markets capturing and transforming the behavior of corporations has received no attention.

Viewed from this perspective, refashioning the system requires changing the four sides of the policy box shown in Figure 9.1, but it also requires a policy agenda addressing financial markets and corporations. That agenda must change the behaviors of financial markets and corporations so that they serve better the public interest.

Repacking the Box: A Structural Keynesian Model

The blowup of the orthodox paradigm and the threat of the Great Stagnation create an opportunity for a new structural Keynesian policy paradigm that rebuilds the demand-generating process. The most critical need is to restore the link between wages and productivity growth that drove the 1945–80 virtuous circle model of growth. That model is illustrated in Figure 9.3. It rested on a simple logic whereby wage growth fueled demand growth, which created full employment. Full employment then spurred investment, which increased productivity and supported further wage growth.

Figure 9.3. The 1945–1980 virtuous circle growth model.

The key to recreating this virtuous circle model is to repack the policy box along structural Keynesian lines. That involves taking workers out of the box and putting corporations and financial markets in the box, as shown in Figure 9.4.

Figure 9.4. The structural Keynesian policy box.

A structural Keynesian box would reconfigure policy as follows:

1. Corporate globalization is replaced with “managed globalization” that embeds global labor and environmental standards that promote upward harmonization across countries instead of a race to the bottom.

Additionally, international economic governance arrangements must be strengthened, especially as regards exchange rates so as to unwind and then prevent a repeat of the huge trade imbalances of recent years. That requires a system of managed exchange rates whereby countries set exchange rates on the basis of predetermined criteria and rules.

Capital controls must also be made a legitimate part of the policy tool kit to prevent boom-bust cycles driven by capital flows. Such controls can also help deter capital markets from striking against governments that want to improve income distribution and limit corporate power.

2. The antigovernment agenda is replaced with a balanced government agenda that balances the standing of markets and government. One part of this balanced government approach is ensuring that the government efficiently provides public goods (including law and order), health insurance, social insurance, education, and needed infrastructure.

Public investment has a critical role to play in creating jobs and helping restore full employment, enhancing private-sector productivity growth, and meeting the environmental challenges associated with global warming (Heintz et al. 2009; Pollin and Baker, 2010). There is an established economic literature (Aschauer, 1989a, 1989b; Munnell, 1990, 1992; Heintz, 2010) that documents how public infrastructure investment enhances the productivity of private capital. Over the last thirty years, such investment has fallen as a share of U.S. GDP, and reversing that decline can contribute to restoring growth with full employment.

A second part of a balanced government agenda is restoring the standing of regulation. This includes financial market regulation that limits speculation, increases transparency, and provides central banks with policy tools to address asset price bubbles and preserve financial stability. Those tools include adjustable balance sheet requirements such as liquidity requirements, capital requirements, reserve requirements, and leverage restrictions. Financial transactions taxes also have a place, both as a means of limiting destabilizing speculation and for raising revenue.⁶

Along with improved financial market regulation, there is a need for a new regulatory agenda for corporations. That agenda would restrict managerial power by enhancing shareholder control; use the tax system to discourage excessive managerial pay and short-term incentive pay that promotes speculation and myopic business management; limit unproductive corporate financial engineering (particularly stock buybacks); and provide representation for other stakeholders in corporations.

With regard to taxes, policy should restore tax progressivity, which has been eroded over the last three decades. A second reform theme should be to eliminate the preferential treatment given to capital income (dividends and capital gains) relative to labor income (wages and salaries). A third reform theme should be to abolish “job taxes” that link taxes to jobs. This means funding social security and unemployment insurance via general tax revenues rather than via payroll taxes. Health care financing also needs to be changed given that it is job cost, albeit privately paid for under the current system. A fourth reform should reduce the huge tax expenditures that give away tax revenue in the form of deductions. In particular, the mortgage interest deduction, which distorts property prices, should be phased out. A fifth reform could be abolition of corporate income taxes, but only as part of a package that increased tax progressivity and eliminated tax favoritism for capital income. Taxing corporations gives them an incentive to move: instead, governments should tax the owners who receive the profits.

3. A third pillar of the structural Keynesian box is the restoration of full employment as a policy priority. The past thirty years have seen central bankers elevate the significance of anti-inflation policy while lowering their concern with full employment.⁷ That tilt in priorities needs to be reversed, as weak employment conditions undermine the link between wages and productivity growth, and they may also lower productivity growth. Moreover, modest inflation lowers the rate of unemployment by greasing the wheels of labor market adjustment. Effectively, it lets wages in tight labor markets rise relative to wages in weaker labor markets, thereby encouraging job formation in markets where there is unemployment.

4. The fourth pillar of the structural Keynesian box is the promotion of “solidarity” labor markets that encourage creation of high-quality jobs that pay fair wages that grow with productivity.⁸ This requires reviving unions so that workers can bargain effectively for a share of productivity gains; implementing a minimum wage that increases with market wages to provide a true wage floor; and increasing worker protections and unemployment insurance support so that workers have the confidence to press their wage claims and exercise their rights as workers.

Unions are especially important, and in hindsight it is clear that the spurt in union density between 1935 and 1945 was critical in bringing shared prosperity to the U.S. economy after World War II. Table 9.1 shows data on union density (defined as the percent of nonagricultural employees who are union members) and the share of income (including capital gains) going to the top 10 percent of income earners.⁹ During the 1920s, union density declined and income inequality jumped. In the late 1930s and early 1940s, union density spurted and income inequality declined substantially to levels it was to hold until the early 1980s. Table 9.2 shows what happened after 1980 with the full implementation of the neoliberal program. Union density declined precipitously and income inequality spiked, reaching levels not seen since the end of the Roaring Twenties.¹⁰

Table 9.1. Union Density and Income Share of the Top 10 Percent, 1925–1955

Sources: Freeman (1998) and Piketty and Saez (2004).

Table 9.2. Union Density and Income Share of the Top 10 Percent, 1973–2000

Sources: Hirsch and Macpherson (2003) and Piketty and Saez (2004).

The significance of unions for wages and income distribution is widely recognized. Although benefitting union members most immediately, unions also benefit nonmembers by setting wage norms and inducing employers to raise wages to avoid unionization.

Less recognized is the fact that unions have a deeper role to play in balancing the economy and society. One role is as political counterweight to the political influence of corporations and financial markets. A second role is to restrain excessive managerial pay that now resembles looting. Thus, there is empirical evidence that a union presence lowers total CEO pay and lowers the stock option component of pay (see Tzioumis and Gomez, 2007). From this standpoint, unions are an important and valuable component of governance of modern capitalist economies.

In addition to conventional labor market interventions such as unions, minimum wages, unemployment insurance, and employee protections, there is also a need for social policies focusing on race and gender discrimination and family well-being (see Elson and Cagatay, 2000; Folbre, 2001). Such policies have a clear ethical justification, but more than that, they have a powerful economic justification.

Race and gender discrimination contribute to wage inequality and undermine wages, and thereby undermine the income- and demand-generating process. Policies reducing discrimination can therefore remedy that damage. Policies supportive of families and caregiving can yield similar benefits. First, channeling resources to households puts workers in a better bargaining position and may also reduce labor supply, both of which increase wages. Second, assisting households with the task of caring labor is a form of long-term human capital investment that increases adult productivity. All of these policies also have application in developing economies (see Seguino and Grown, 2006).

5. The fifth pillar of the structural Keynesian approach is that the whole is greater than the sum of the parts. The structural Keynesian policy box constitutes a system in which the parts are mutually reinforcing, which means policies must be implemented together to be fully effective. For instance, the benefits of unions and solidaristic labor market institutions will be undermined absent full employment or appropriately designed globalization and international economic engagement. Similarly, flawed international economic engagement will undermine policies aimed at full employment, while an antigovernment agenda will undermine the beneficial effects of good labor market arrangements.

The Great Recession signals the implosion of the neoliberal growth model that was implemented some thirty years ago. This makes the recession fundamentally different and it means there is a need for a new growth model.

In past recessions, policy makers merely had to jump-start the economy because the income- and demand-generating process remained sufficiently intact. The Great Recession has shown that this is no longer the case. Consequently, measures that stimulate demand, such as monetary and fiscal stimulus, cannot generate sustained growth with shared prosperity. That requires repairing the income- and demand-generating process.

Escaping the pull of stagnation requires that policy makers simultaneously jump-start the economy and rebuild the system. One without the other will fail. Stimulus without structural rebuilding will mean recovery is muted, whereas structural rebuilding without stimulus will leave the economy trapped in stagnation and unable to achieve recovery velocity.

U.S. policy makers have failed to recognize this imperative. Having successfully stabilized the economy after the financial crisis, policy makers implemented inadequate stimulus and failed to initiate structural rebuilding. Consequently, the recovery has been weak and risks stalling, while a return to full employment is not even on the horizon.

Escaping the Great Recession requires jump-starting the economy by increasing demand. Preventing the economy from getting stuck in stagnation requires a new growth model that rebuilds the income- and demand-generating process. Success requires the full policy package of stimulus and structural rebuilding. However, such policy holism is politically challenging. All the pieces should be implemented together and that is a more difficult political sell than simplistic silver-bullet policy.

Budget Deficits during the Transition to a New Paradigm

The structural Keynesian box provides a road map for repairing the demand-generating process. However, the global economy currently faces a severe demand shortage, and repairing the system will take time. That means traditional textbook Keynesian policies that stimulate demand will be vital during this interlude. Moreover, the period of need will be longer than usual, because the demand gap is not temporary. This poses a political problem because of widespread misunderstanding about budget deficits.¹¹

One reason for large budget deficits is to fill the gap in demand caused by decline of business and consumer spending. A second reason, related to the current recession, is private-sector deleveraging. The private sector is trying to save and pay back debts, but the laws of economics require that for every saver there must be a borrower. That means if the private sector wants to save more than it invests, someone must take that saving and spend it. Otherwise, income will fail to reduce saving and bring it into alignment with investment. That someone is government, which must borrow and spend the private sector’s excess saving (i.e., run budget deficits) to prevent a further fall in demand and income. Because deleveraging can be a lengthy process, this means large budget deficits may be needed for an extended period.

A third reason for budget deficits is to finance public investment in infrastructure, education, and public goods. Such investment increases the productivity of private capital, and it is appropriate that it be financed with borrowing because it is long-lived. That way, future generations who will benefit from the investment also pay part of the cost.

Over the last thirty years, the share of U.S. national income devoted to public investment has fallen, creating a backlog of needs and opportunities. This combination of need for deficit spending and need for public investment creates a win-win policy opportunity. Large-scale deficit-financed public investment can spur economic activity during a period of rebuilding the demand-generating process.

Unfortunately, fiscal policy confronts a number of myths. One myth is that government spending crowds out private investment. The reality is that it crowds in private investment by increasing demand, which increases the need for productive capacity. The one time government spending can crowd out private-sector activity is when an economy is at full employment. In that special situation, resources are scarce, and government use of resources reduces the resources available to the private sector. However, the United States is far away from that situation.

Another related myth is that government absorbs saving, making less available to the private sector. In fact, in times of deep recession, government spending creates saving by preventing further declines in income that would reduce saving. The extra saving shows up in accumulation of government bonds that increase household wealth.

A final myth concerns claims that government is like a household and should therefore balance its budget like a household. The reality is that the household sector in aggregate has historically had rising debt. Today, the household sector owes more than it did 100 years ago, which is reasonable because it is larger and financial markets are more sophisticated. By that same logic, it is reasonable that government owe more, which means deficits can be legitimate.

Moreover, unlike individual households, government is an issuer of money via central banks. That means government can always repay its debt. The one danger is that paying debt by creating money may cause inflation, but that is an unlikely scenario in an economy with massive excess capacity and short of demand.

For all these reasons, large budget deficits are both feasible and needed to ward off stagnation. To minimize the interest burden of debt and to maximize the expansionary effect, the Federal Reserve should help finance the deficit by buying part of new Treasury bond issues. That way monetary policy and fiscal policy will be working in tandem.

The danger is that deficit myths, combined with animus to government, will prevail politically and prevent needed budget deficits. Worse yet, there is a risk that the politics of fiscal austerity will prevail, forcing a withdrawal of fiscal stimulus. That would worsen the problem of demand shortage and deepen the recession, thereby aggravating budget difficulties by lowering tax revenues. Such an outcome risks a repeat of the events of 1937 when, under pressure from fiscal conservatives, the Roosevelt administration cut back on public spending, thereby contributing to a second recession in the middle of the Great Depression.

Making the case for extraordinary large budget deficits now does not mean large deficits can continue forever. Over a longer time horizon, there is a need to implement fiscal consolidation as current budget deficits are likely unsustainable. However, the key to resolving this problem is the restoration of growth and not fiscal austerity that deepens stagnation. Much of the needed deficit reduction will come automatically with increased employment, but getting there requires abandoning the neoliberal paradigm and replacing it with structural Keynesianism.

Political Obstacles to Paradigm Change

The economic policies needed to avoid the Great Stagnation and restore shared prosperity are not difficult to understand. However, there are massive political obstacles to change.

The Third Way and the Split among Social Democrats

The greatest single obstacle is the capture of social democratic political parties by so-called Third Way thinking. In the United States, the Third Way is represented by the New Democrat wing of the Democratic Party. Its dominance is reflected in the ease with which former Clinton administration officials gained absolute control of the Obama administration’s economic policy without significant debate.

Analytically, Third Way New Democrats accept the core beliefs of neoliberal economics. Thus, they reject the structural Keynesian view that organizing an adequate level of aggregate demand is a permanent part of the economic problem. Instead, they accept the view that laissez-faire economies largely solve the demand problem, except for occasional recessions where a temporary textbook Keynesian fix may be needed. Demand is therefore not a lasting problem, and the real problem is supply.

Consequently, Third Way Democrats focus on traditional microeconomic concerns about incentives and market failures such as monopoly, externalities, and provision of public goods. Unions and labor market protections are characterized as market failures rather than part of the structures needed for organizing demand and income distribution. As for macroeconomic policy, all that is needed is monetary policy that controls inflation and inflation expectations.

Third Way proponents are distinguished from hard-core neoliberals by their belief that market failures are more common, government can successfully address market failures, and government also has a role providing “helping hand” programs that soften the blows of the “invisible hand.” In terms of the academia, hard-core neoliberals identify with the Chicago School of economics, whereas soft-core Third Way proponents identify with the MIT School.

The Third Way’s capture of social democratic parties – New Democrats in the United States, New Labor in the United Kingdom, and New Social Democrats in Germany – creates a fundamental political problem because it splits social democrats. This split is illustrated in Figure 9.5. At the most basic level, there is a divide between those who see the neoliberal economic paradigm as sound and those who see it as fundamentally flawed. Both hard-core neoliberals and Third Way social democrats see market fundamentalism as sound, while traditional social democrats see it as fundamentally flawed. The political problem is this splits social democrats, making it harder to dislodge the paradigm.

Figure 9.5. The political dilemma of neoliberalism.

This division within social democrats creates a major political conundrum. On one hand, if traditional social democrats split from Third Way social democrats, they risk a full-blown triumph of market fundamentalism. On the other hand, sticking in fractious union with Third Way social democrats risks the gradual entrenchment of market fundamentalism.

Worse yet, this entrenchment is done with appeals to “bipartisanship.” The Third Way therefore triangulates the economic policy debate, and in doing so it de facto legitimizes market fundamentalism and delegitimizes alternatives. This was the pattern in the United States during the Clinton presidency, and a similar pattern is discernible in Britain under Prime Minister Blair and in Germany under Chancellor Schroder.

A second political problem is the Third Way approach to economic policy risks discrediting structural Keynesian policy by association. Instead of offering a clear choice between neoliberalism and structural Keynesianism, the current political setup offers a choice between “neoliberalism” and “neoliberalism lite” – a choice between Coke and Pepsi. However, the Coke-versus-Pepsi choice is portrayed publicly as a choice between fundamentally different economic philosophies.

Should Third Way attempts (i.e., the Obama administration’s policies) to deal with the crisis fail, there is a danger that failure will be interpreted as a failure of Keynesianism. In that event, structural Keynesianism will be labeled a failure and rejected without being given a chance.

Conclusion: Politics and Paradigms

In the late 1970s, British Prime Minister Margaret Thatcher coined the acronym TINA – “There Is No Alternative.” By this she meant there is no alternative to neoliberal market fundamentalism. Mrs. Thatcher and Ronald Reagan succeeded in tainting the Keynesian social democratic approach to economics and economic policy. The result was a rejection of demand-management policies, a retreat from commitment to full employment policies, and abandonment of concern with the wage and income distribution generation process.

Mrs. Thatcher’s TINA doctrine has ruled the roost politically and intellectually for thirty years. The financial crisis of 2008 and the Great Recession have tarnished market fundamentalism but they have not done away with the TINA myth. Instead, society has entered an intellectual vacuum in which market fundamentalism is tarnished but the taint on Keynesian social democracy remains.

The challenge is to persuade the public that there is an alternative. Neoliberals try to scare people by framing the debate as a choice between capitalism and authoritarian socialism, which is a tactic that has worked well for fifty years. The reality is that it is a debate about what type of capitalism we have.

The grave danger now is that market fundamentalism survives, policy dominant but unworkable. In that event, a “new normal” of permanent high unemployment and wage stagnation will become a near certainty in the United States and other Northern economies, and the Weimar political scenario of intolerance also becomes more likely. For emerging market economies, lack of adequate engines of demand growth of their own means they too will likely get caught up in the economic malaise caused by stagnation in the North.

Globalization has been a central development of the past twenty-five years. Not only did it play a critical role in creating the conditions that led to the financial crisis; it is now a key factor driving the prospect of a long stagnation. Reforming globalization and reining in the existing model is therefore vital.

The Special Significance of Globalization

Chapter 4 showed how the flawed U.S. model of global economic engagement contributed to undermining the economy. This model can be termed corporate globalization as it was designed and sponsored by corporate interests.

Globalization represents one side of the neoliberal policy box discussed in Chapters 4 and 9. However, it has claims to be primus inter pares – the most important of the four sides. This special standing is because globalization negatively implicates all dimensions of the economy and economic policy.

There are two critical features to globalization. First, it has undermined the internal demand-generating process by fostering wage stagnation via international labor competition, expanding the leakage of spending via imports, and offshoring jobs and investment. Second, it provided a new architecture binding economies together.

One part of the new architecture involved reconfiguring global production by transferring manufacturing from the United States and (to a lesser degree) Europe to emerging market (EM) economies. This new global division of labor was then supported by having U.S. consumers serve as the global economy’s buyer of first and last resort, which explains the U.S. trade deficit and the global imbalances problem.

The other part of the new architecture was financial and involved recycling of foreign country trade surpluses back to the United States, which had two effects. First, it abetted financial excess in the United States as foreign investors channeled funds into mortgage-backed securities. Second, the recycling process tied other economies to the U.S. property bubble so that when it burst, there was a massive spillover that damaged financial systems elsewhere, particularly in Europe.

The economic policy challenge of escaping the Great Recession and restoring shared prosperity is illustrated in Figure 10.1. Policy makers face a threefold challenge. First, policy must rebuild financial stability in light of the financial excess and fragility revealed by the financial crisis. Second, it must stimulate and revive demand so that the private sector increases output and employment. Third, it must rebuild the income-generating process so that the economy permanently generates a stable level of demand consistent with full employment and shared prosperity.

Figure 10.1. The Great Recession policy challenge.

Globalization adversely implicates all three policy challenges. With regard to financial reform, attempts to regulate banks and financial markets risk triggering jurisdictional shopping whereby financial capital leaves countries that impose tough regulations and migrates to countries with lax regulation.

With regard to stimulating demand, globalization weakens policy because of increased trade openness. Thus, stimulus may leak out of the economy via spending on imports rather than domestically produced goods so that it creates jobs offshore rather than at home. Additionally, financial markets tend to dislike budget deficits, and they may try to punish governments that pursue stimulus policies. The classic example of this is France in 1983, where President Mitterandwas forced to abandon his Keynesian policy aimed at restoring full employment under pressure from international markets.

Finally, globalization hampers rebuilding the demand-generating process. Chapter 9 framed the rebuilding challenge in terms of repacking the neoliberal policy box. In the pre-globalization era (1945–80), countries would have had more policy space to pursue a national strategy to repack the box. However, in the era of corporate globalization, “go it alone” national strategies are far more difficult because globalization imposes powerful constraints that restrict policy. Developing countries, including large EM economies like Brazil, have long complained about this aspect of globalization. Today, the United States is feeling some of the same policy space limits, albeit still on a much smaller scale.¹ For instance, attempts to change labor market institutions so as to raise wages and improve income distribution may be met by offshoring production and investment to countries with worker- unfriendly laws and institutions.

Figure 10.2 provides a heuristic map (think of it like a subway map) of the global economy, which consists of four parts. The global economic core consists of North America, Europe, and the export-oriented emerging economies. The resource-based economies and less-developed countries are placed outside of the core. That is because the less-developed economies are substantially disengaged from the core, whereas the resource-based economies conform to traditional periphery status in terms of center-periphery economic relations.²

Figure 10.2. A map of the global economy.

The map helps understand how globalization complicates the policy problem. First, the countries and regions of the global economy are linked together by an international economic system, represented by the solid triangle in Figure 10.2. That system concerns arrangements governing trade, international financial markets, and global policy coordination. The system is part of the problem and has contributed to the undermining of the demand-generating process, within both the U.S. economy and the rest of the global economy. Additionally, the system undermines policy effectiveness and limits space for “go it alone” national policy. That is why reform of globalization is so important.

Second, because countries are linked to each other, successful policy requires policy coordination. If country policies are working against each other, their effects will be correspondingly diminished.

Worse yet, countries may have an incentive to free-ride and take no action, hoping to be pulled along by the coattails of others while avoiding bearing any costs of action. Viewed from a global perspective, there is a need for policy coordination, yet viewed from the individual-country perspective, there can be incentives to evade and shirk such cooperation.

Third, the global economy consists of different regions with different conditions. There are many similarities across regions, but there are also differences. Regions vary in their stage of development, have different internal economics problems, and some are running trade surpluses whereas others are running deficits. That means there is no one-size-fits-all policy. Countries and regions need to take different actions, but those different actions must fit into a coordinated framework. In particular, all countries should work to increase demand because the global economy is short of demand, and all should also aim to build a stable sustainable demand-generating process within countries and in the global economy.

Fourth, reform of corporate globalization is critical. However, because globalization concerns the international system, reform requires international agreement, which makes the political process of reform even more difficult.

Fifth, one-third of humanity lives in resource-exporting countries and less-developed countries that are outside of the global core. Those countries have qualitatively different development problems that are not directly addressed in this book. However, it is ethically clear that their development needs to be a priority. Those needs should be promoted in ways that add to global demand (i.e., they should benefit by receiving resources) and support the underlying global demand-generating process in financially and environmentally sustainable fashion.

In sum, the global economic architecture is of profound importance. It shapes the dynamic of the global economy by shaping the way that countries and regions interact, and by determining what countries can do on their own and what they are willing to do together. The current architecture is flawed, which means there is a need to change the rules governing international trade, capital flows, and exchange rates. However, changing the architecture will require changing the architects, illustrating once again the importance of ideas and politics.

The Economics of Globalization

Globalization refers to the process of international integration of national goods, financial, and labor markets. It is a process that is being driven by technology, businesses’ quest for profits, and policy.

Globalization changes the structure of economies and creates three forms of economic leaks. The first is macroeconomic leakiness, whereby there is a tendency for demand to leak out of the national economy owing to an increased propensity to import goods. The second is microeconomic leakiness, whereby there is a tendency for jobs to leak out of an economy if wages and other employment costs are not sufficiently low, labor markets are not sufficiently flexible, or taxes are relatively unfavorable compared to conditions elsewhere. The third is financial leakiness, whereby finance is free to flow across borders.³

All three types of leakiness matter and they promote and amplify each other. Thus, increased trade increases macroeconomic leakiness, whereas increased financial leakiness promotes trade and foreign direct investment, which increases microeconomic leakiness.

All three types of leakiness also make national economic policy more difficult. Increased macroeconomic leakiness means more spending leaks out of the economy. That makes it harder to use traditional Keynesian stimulus measures to increase domestic demand as stimulus leaks out. Increased financial leakiness makes it hard to adopt policies that regulate finance as financiers will sell domestic financial assets, driving up interest rates. Increased microeconomic leakiness makes it harder to promote decent working conditions, promote a fair distribution of income, and protect the environment, because corporations will offshore jobs and investment.

The critical new feature of globalization is international mobility of the means of production (capital and technology). Trade has existed throughout human history and has yielded enormous economic benefits, as well as occasionally imposing costs on specific regions and industries. The game changer in globalization is the ability to move and coordinate production between countries at low cost. This has fundamentally changed the character of global competition, undermined the demand-generating process, and undermined governments’ ability to conduct national economic policy.

Free trade created a “global marketplace.” Globalization has created a “global production zone.” The new reality was captured in the late 1990s by Jack Welch, then CEO of General Electric, who talked of ideally having “every plant you own on a barge.” The economic logic was that factories should float between countries to take advantage of lowest costs, be they a result of undervalued exchange rates, low taxes, subsidies, or a surfeit of cheap labor.

Globalization has made Welch’s barge a reality, giving rise to “barge economics” that has replaced the old economics of trade based on the theory of comparative advantage. In the old era of classical trade, countries competed regarding the most efficient production of goods. That competition lowered prices and also caused some dislocation as some industries closed. In the new era of globalization, the competition is for jobs. Before, companies wooed customers with cheaper goods: now, workers and governments kowtow to companies to retain jobs and attract investment.

From a Structural Keynesian perspective, the shift from free trade to globalization has numerous adverse consequences. First, it undermines the income- and demand-generating process by undermining worker bargaining power. The result is continuous downward pressure on wages and an increase in the profit share as workers settle for less to hold on to jobs. Globalization also pressures institutional arrangements (such as employment protections, minimum wages, and rights to unionize) supporting the income-generating process, again in the name of staying attractive to business. Furthermore, the income- generating process is also weakened at the after-tax level as governments are pressured to shift the tax burden from profits to wage income to increase their relative attractiveness to business.

Second, globalization undermines the effectiveness of standard Keynesian demand-management policy by increasing macroeconomic leakiness. Increased reliance on imports means fiscal and monetary stimulus tends to leak out of the economy as spending on imports rather than spending on domestically produced goods and services. Reduced policy effectiveness in turn discourages government from adopting such policies.

Not only is the effectiveness of Keynesian policy undermined; governments are also discouraged from pursuing either demand-management policies or structural policies that strengthen the demand-generating process. One reason is the free-rider problem. For instance, fiscal stimulus is costly as it increases the national debt. Governments may therefore prefer other countries stimulate demand so that they can piggyback for free on the induced economic expansion.

A second reason is the prisoner’s dilemma, whereby globalization establishes a pattern of incentives that encourages noncooperative behavior. Every country believes it can do better going it alone, which results in all doing worse than if they cooperated. The prisoner’s dilemma is illustrated in Figure 10.3, which shows the hypothetical payoffs to a policy game. There are two countries, A and B. Each country has two policy options: cooperate or cheat. The payoff to a country is highest (= 10) if it cheats and the other country cooperates, and lowest (= −10) if it cooperates and the other country cheats. For the system as a whole, the payoff is lowest if both countries cheat (−5, −5) and highest if both cooperate (5, 5).

Figure 10.3. The prisoner’s dilemma and international economic cooperation.

The problem is each country has an incentive to cheat to try and get the highest payoff (10), but when both cheat, they actually get the lowest payoff (−5). What is needed is cooperative behavior, but the incentives are not there. The only way to get the cooperative outcome is some form of international coordination, perhaps backed up by sanctions disciplining countries that renege. That is why the design of the correct international architecture is so important.

Worse than that, corporate globalization aggravates these problems by design. A fundamental goal of neoliberalism is to weaken government restraints over markets and expand the power of capital. Putting governments in competition with one another accomplishes that. Corporate globalization does exactly that by increasing economic leakiness, which puts governments in competition, and that worsens the global economy’s generic prisoner’s dilemma problem.

One example concerns labor market protection, the minimum wage, and rights to join unions. Each country may feel it can do better by having weak labor market protections, thereby making itself more attractive to business. However, if all pursue that strategy, none is relatively more attractive to business. Instead, the net result is to weaken the global demand-generating process by lowering wages and the wage share, making all worse off.

A second example concerns fiscal stimulus, and it is exemplified by the situation in European economies like Portugal, Italy, Ireland, Greece, and Spain – the so-called PIIGS economies. Financial markets dislike budget deficits. Financial capital therefore tends to migrate to countries with lower deficits, increasing interest rates in large-deficit countries and lowering rates in small-deficit countries. Given this, governments have an incentive to pursue fiscal austerity to make themselves relatively more attractive to financial markets. However, none gain when all do this, and the only effect is to impose fiscal austerity that reduces demand and worsens recession.

A third example concerns exchange rates. Globalization and increased economic leakiness gives countries an incentive to depreciate their exchange rate to increase their competitiveness and also to make themselves more attractive to foreign investment. However, when all do this, exchange rates are unchanged, and the only effect is to create financial turmoil that may undermine business planning and investment.

In sum, corporate globalization is extremely problematic. The neoliberal policy box shows how corporate globalization contributes to undermining the demand-generating process. When the box is simultaneously implemented in other countries in the context of a neoliberal international architecture, its impact is multiplicative across countries. Thus, it undermines the effectiveness of structural Keynesian policies within each country, and it also undermines the willingness of governments to pursue such policies. The net result is a profound deflationary bias in the global economy.

Mending Globalization

Escaping the Great Recession and the pull of the Great Stagnation requires stimulating demand and rebuilding the income- and demand-generating process. Corporate globalization discourages both, which is why it must be radically reformed. The existing system imposes a global deflationary bias. The goal of reform should be to replace that bias with an expansionary bias.

Lessons from History

The global economy is beset by recession and contradiction. Escape from recession is blocked by shortage of demand. The contradiction is that neoliberal corporate globalization promotes a pattern of development that increases global supply while simultaneously undermining global demand. This problem was hidden for twenty years by asset price inflation and borrowing that filled the demand gap, but the economic crisis has exposed it. The implication is that the global economy needs a new model of development that attends to domestic demand, and U.S. economic history offers powerful salient lessons.

Globalization represents the international integration of goods, labor, and financial markets. In the late nineteenth and early twentieth centuries, the U.S. economy underwent a similar process of integration. The U.S. economy was continental in scope, and the creation of a successful national economy required new laws and institutions governing labor markets, financial markets, and business. This is the history of the antitrust movement of the Progressive era and the history of the New Deal that created Social Security, the Securities and Exchange Commission, and labor laws protecting workers.

These institutional innovations solved the structural problems that caused the Great Depression and they generated America’s famed blue-collar middle class. Today, the challenge is global institutional innovation that will create shared global prosperity. Meeting that challenge means profoundly reforming corporate globalization.

The Problem of Lock-in

Reason and evidence point to the need to reform corporate globalization, but that is easier said than done because of the problem of “lock-in.” Lock-in is a concept developed by economic historians to describe how economies get stuck using inefficient technologies. It also applies to institutions because economies and societies can get locked into suboptimal institutional arrangements. This has relevance for globalization where the arrangements governing the global economy are suboptimal, which poses problems of how to change them. The economics of lock-in helps understand the problem and suggests how to solve it.

Lock-in arises because a technology adopted first may gain a competitive advantage that encourages others to adopt it, even though other technologies are superior and would be chosen if all were at the same starting point. An example of lock-in is a narrow-gauge railroad that is less efficient than broad gauge on which railcars are more stable and can carry greater loads. However, once a stretch of narrow gauge has been laid, there is an incentive for additions to be narrow gauge to fit the existing track. Moreover, the incentive increases as the size of the rail network grows.

Lock-in has enormous relevance for globalization, which has seen the creation of new institutions and patterns of economic activity. Trade agreements and financial market opening have created new rules, fostering new patterns of global production and setting the basis for future trade and investment negotiations.

Globalization lock-in matters because today’s global economy has been designed with little attention to income distribution and labor, social, and environmental issues. This is because the system was largely stitched together in the last quarter of the twentieth century, a period of neoliberal laissez-faire intellectual dominance. This design was locked in through a steady flow of corporate-sponsored trade agreements, both multilateral and bilateral.

The economics of lock-in helps understand what is going on and it also suggests an escape from the problem. Recalling the example of narrow-gauge railroads, the market can produce a gradual escape by cherry-picking the most profitable parts of the existing network, causing it to gradually implode. Thus, a parallel wide-gauge track may be built on the most profitable segments of the existing narrow-gauge network, draining the latter’s profitability while promoting the gradual buildup of a wide-gauge network.

This provides a metaphor for globalization. The modern global economy has been built on a narrow-gauge rail, and countries now need to find a way to build a broad-gauge replacement. That points to several policy measures. First, countries should stop building more narrow-gauge track, which means no more trade agreements without high-quality labor and environmental standard; commitment to a global minimum-wage system; exchange rate provisions guarding against currency manipulation and unfair competition based on undervalued exchange rates; acceptance of capital controls; and changed intellectual property and investor rights.

Second, developed democratic economies should start cherry- picking the existing “narrow-gauge” trade system and promote “broad-gauge” trade agreements. For instance, the United States and Europe could negotiate a Trans-Atlantic Free Trade Agreement (TAFTA) that includes proper labor and environmental standards, commitment to a common minimum-wage system, and a managed exchange rate agreement. Similar agreements could be negotiated with Canada, Japan, and South Korea. All of these countries would have little difficulty complying with standards, and together they comprise approximately 75 percent of the global economy. Such a trading bloc would quickly become a “broad-gauge” magnet for other countries.

Third, multilateral institutions, such as the IMF and World Bank, must be thoroughly house-cleaned. These institutions must be made to promote labor and environmental standards, legitimacy of capital controls, and legitimacy of managed exchange rates. Under pressure of events, there has been some movement in this direction, but that movement is half-hearted and easily reversible given the deep neoliberal convictions of the staff appointed over the past thirty years. A thorough remake will require not just policy change, but also personnel change. Absent that, policy change will not stick.

The bottom line is it is still possible to escape corporate globalization lock-in. The key is creating a new dynamic in which forces of competition promote progressive upward harmonization in place of the existing dynamic that promotes a race to the bottom.

Conclusion: Mend it or End it

The phenomenon of lock-in means there will be costs to escaping the current mode of corporate globalization. If all goes well and a cooperative spirit prevails, those costs can be small. However, that is unlikely. Corporations that have benefitted from corporate globalization will fight tooth and nail against change. Likewise, countries that are exploiting the system will also fight to keep it. This explains the political alliance between autocratic China and large U.S. multinationals like Caterpillar and Boeing.

The tragedy of the current era is that the acceleration of global economic integration triggered by changing technologies occurred at a time of dominance by neoliberal economics. That resulted in the creation of a form of globalization that blocks shared prosperity.

It could have been done differently by expanding a social democratic globalization built on the post–World War II model of social and economic inclusion. In that alternative world, NAFTA would have stood for North Atlantic Free Trade Agreement. However, the opportunity was missed.

At this stage, there are two possible responses to corporate globalization: mend it or end it. Mend it means putting in place the policy recommendations discussed previously, which will shift globalization onto a path that promotes shared prosperity rather than a race to the bottom. This corresponds to a structural Keynesian model of globalization that bolsters the global demand-generating process by shifting countries away from export-led growth and attending to the deficiencies of global governance and repeated instances of prisoner’s dilemma.

End it means rolling back many of the agreements put in place over the past two decades and restarting the process. Under this latter scenario, the global economy will revert to a regionalist system organized around economic blocs that share common goals and a common state of development, with tariffs and capital controls between blocs. Thereafter, the gradual process of integrating blocs can begin again, this time getting it right.

There will be significant costs to an “end it” strategy. Many corporations will face significant losses as they have invested in global production networks, or even abandoned production and transformed themselves into marketing agencies (like Nike or Gap) that source globally from low-cost, exploited workers. This will produce temporary price increases, but it will also produce large numbers of jobs as production is brought back.

Most importantly, the costs are worth it if the system defies reform. Staying the current course entails a future of wage stagnation, massive inequality, and continuous economic insecurity. It is better to pay the up-front costs of change, even if large, to rescue a prosperous future, rather than bear the costs of a flawed globalization that permanently renders shared prosperity a thing of the past.

Chapter 2 addressed the tragedy of bad ideas and noted how bad ideas are often behind the most destructive of man-made disasters. That connects with the central thesis of this book, which is that the financial crisis and the Great Recession can ultimately be traced to bad ideas in economics which have driven bad policy.

In the social sciences, history is the data-generating process that tests grand ideas and theories. The second half of the twentieth century tested the ideas of authoritarian communism and showed them to be horribly flawed. Now, history is exposing the flawed reasoning behind market fundamentalism that dominates current economic thinking.

However, being proved wrong by history does not mean ideas fade away. In the former Soviet Union, authoritarian communism was proved odious and flawed fifty years before it finally passed away. This slow demise reflects the fact that the process of historical proof is messy and controversial in unfolding. It also reflects the existence of powerful political and sociological obstacles to change.

Political and sociological obstacles resisted the abandonment of authoritarian communism, and political and sociological obstacles (albeit very different ones) now resist turning away from neoliberalism. Chapter 9 identified and discussed political obstacles to change. Another obstacle to change is the economics profession which is intellectually dominated by neoliberal market fundamentalism.

In the 1930s and 1940s, there was similar academic resistance to Keynesian economics, and the history of that resistance recently surfaced at a memorial service for the late Paul Samuelson, held on April 10, 2010 in Cambridge, Massachusetts. At that service, Professor Jim Poterba, a colleague of Samuelson’s at MIT, recounted how the MIT economics visiting committee tried to force Samuelson to call off the publication of his path-breaking 1948 economics textbook on grounds that Keynesian economics was too left-wing.¹ Similar resistance exists today and it may be worse in that it is more camouflaged and more sophisticated.

Whereas the connection between politics and policy is linear and direct, it is less easy to see the connection between academic economists and economic policy. The metaphor of a restaurant can help. There are two waiters (Republicans and New Democrats) but only one chef (mainstream economists) who is trained exclusively in the neoliberal school of cooking. The challenge is to get one of the waiters (New Democrats) to carry the cooking of another chef (a structural Keynesian economist).

Naturally enough, the existing chef is opposed to introducing a rival. That opposition fits with a basic principle of economics, subscribed to by right and left, that people are self-interested. Ironically, whereas mainstream economists are willing to apply that principle to understand the behavior of others, they are reluctant to apply it to understand their own behavior as economists.

The Crisis, the Destruction of Shared Prosperity and the Role of Economists

In many ways, economists can be viewed as the high priests of neoliberalism. Scratch any side of the neoliberal policy box, and you find a justification that comes straight from mainstream economics.

1. Corporate globalization has been justified by an appeal to the theory of free trade based on comparative advantage, and by an appeal to neoclassical arguments for deregulating financial markets and allowing uncontrolled international capital flows. The party line on globalization was succinctly summarized by Stanley Fischer (1997), a liberal former professor of macroeconomics at MIT and former managing director of the IMF:

2. The small-government agenda comes straight from Milton Friedman’s (1962) arguments for a minimalist or “night watchman” state. Friedman’s support for a minimalist government was driven by political concerns about freedom and concerns that government was doing things for which there was no economic justification. However, he accepted a role for government to remedy market failure.

Subsequent adherents of Chicago School economics have recommended that even market failures be ignored because government interventions to fix them can give rise to more costly government failures via regulatory capture, bureaucratic incompetence, and political self-dealing.² That argument has been used to justify the rollback of antitrust regulation even in situations where markets are failing, and to justify cutbacks in the provision of public goods and public investment. It is epitomized by the paradigm of self-regulation that argued (with such disastrous consequences) the financial sector could be charged to regulate itself with regard to risk taking.³

3. The influence of Milton Friedman is also present in the retreat from full-employment policy. Friedman (1968) proposed the theory of a “natural” rate of unemployment that was adopted and endorsed by almost the entire economics profession. The theory maintains that monetary policy cannot affect the long-run rate of unemployment, and it abandons the earlier Keynesian notion of a trade-off between inflation and unemployment, whereby a society can have lower unemployment if it is prepared to accept slightly higher inflation.

The important policy consequence of the natural rate theory was that it provided justification for the Federal Reserve’s abandonment of concern with unemployment and shift to a focus on inflation. According to natural rate theory, monetary policy can have no lasting impact on employment, so policy should instead minimize inflation as inflation is undesirable and it is the only thing monetary policy can permanently affect. The determination of employment should be left to market forces and the claim is that the economy will gravitate quickly to full employment.

4. The “flexible” labor markets agenda has also been driven by neoclassical economics and its view of labor markets. The argument is that competitive markets ensure workers are paid their contribution to value of production – a corollary of which is that managers and CEOs are paid their contribution. This theory, which is found in all conventional textbooks, has fueled an attack on unions, minimum wages, and employment protections, all of which are characterized as unnecessary labor market “distortions” that lower employment.

Friedman’s (1968) theory of the natural rate of unemployment also endorsed this thinking, maintaining that such institutions raised the natural rate of unemployment:

Mainstream micro economists have always pushed the labor market flexibility agenda as they deny income distribution affects employment. Friedman’s natural rate approach joined macro economists with micro economists in support of the labor market flexibility agenda. The result was the entire mainstream economics profession supported the agenda.

5. Increased corporate power has been justified by the shareholder value model of corporations, which claims wealth and income is maximized if corporations maximize shareholder value without regard to interests of other stakeholders. To the extent that there is a principal-agent problem that causes managers not to maximize shareholder value, this can be solved by using bonus payments and stock options to align managers’ interests with shareholder interests.

6. Lastly, expansion of financial markets has been promoted by appeal to the theory of efficient markets and claims that speculation is stabilizing.⁴ Additionally, the theory of a market for corporate control asserts that corporations are disciplined by shareholders and act in a way that promotes shareholder interests, which in turn is good for broader economic interest.⁵

Arrow-Debreu competitive general equilibrium theory and Markowitz-Tobin portfolio theory have been invoked to justify exotic financial innovation in the name of risk spreading and portfolio diversification.⁶ The argument was that slicing and dicing of assets into different income tranches created new assets (e.g., collateralized debt obligations) with different risk – return properties that expanded the portfolio opportunity space by covering more states of world. Those newly created assets could then be recombined to enhance investor returns with lower risk. Bundling mortgages as mortgage-backed securities (MBS) also increased liquidity by increasing saleability. The claim was that such financial engineering effectively created additional wealth and made everyone better off. Meanwhile, portfolio diversification would render a collapse near impossible.

The combination of the efficient market hypothesis and the theory that stock markets drive real investment was used to justify the claim that “wild west” financial markets do a good job directing investment and the accumulation of real capital.⁷ Lastly, the Sharpe-Merton-Black-Scholes models of risky asset pricing gave mathematically precise ways of pricing risky assets.⁸ This gave confidence to take massive risks that were supposedly immune from meltdown because the pricing formulas and assumptions about probability distributions said so.

Putting the pieces together, modern economics played a critical role in the making of the financial crisis and Great Recession. The fingerprints of economists and modern economic theory are all over the neoliberal policy box, which undermined the demand-generating process and now threatens the Great Stagnation. Modern finance theory drove attitudes about shareholder value maximization and corporate governance. It also justified the piling up of leverage and risk in the financial sector, which produced the financial crash of 2008. In the media, charlatan quants are widely blamed for the excesses of financial risk taking. Those quants were let loose and guided by the ideas contained in neoliberal economic theory.

The Vulnerability of Orthodox Economics

The ideas of economists have played a critical role in creating the conditions that gave rise to the financial crisis and the Great Recession, and the economics profession has played a double role in propagating those ideas. First, it provided justification for the policies adopted. Second, it has blocked alternative ideas from making it to the policy table. In effect, the economics profession acts a screen through which ideas must pass. Some are labeled as true and given the seal of approval. Others are labeled as wrong and are consigned to exclusion.

The economics profession and the dominant ideas are part of an intellectual establishment that serves particular interests. That establishment is clad in a powerful armor that damps criticism and blocks change. Just as there are political obstacles to policy change, so too there are obstacles to change in economic thinking. The challenge is to find chinks in the armor through which an opening for change can be forged.

One such opening is crisis, the importance of which was recognized by Milton Friedman (2002): “Only a crisis – actual or perceived – produces real change” (p. xiv). Crisis opens the public to change, and this is a real crisis and therefore a real opportunity for change.

A second opening is the abject failure of the economics profession to anticipate the crisis, a failure that has left the profession vulnerable. Economics may not be able to predict daily events but it should at least anticipate seismic shifts.

This vulnerability of the profession was inadvertently exposed by Queen Elizabeth II. On a visit to the London School of Economics in November 2008, the queen politely asked why no one had predicted the crisis. Her question stumped her distinguished hosts. In fact, not only did economists miss the crisis, but large numbers of them predicted a continuing boom.⁹

In a strange way, history has repeated itself with the profession’s re-embrace of pre-Keynesian economics. In 1929, Irving Fisher, then the greatest of all American economists, confidently predicted the stock market would soon reach new record highs and there was no end in sight to the Roaring Twenties expansion of economic prosperity. Two months later, Wall Street experienced the Great Crash and the economy entered what was to become the Great Depression.

The scale of economists’ miss is easily illustrated. In testimony to the Joint Economic Committee of the U.S. Congress on March 28, 2007, Ben Bernanke, Chairman of the Federal Reserve declared: “At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” Adam Posen (2007a), who currently serves on the Bank of England’s Monetary Policy committee, declared in an April 2007 op-ed titled “Don’t Worry About U.S. Mortgages”: In summary, there will be no large negative impact on growth from the current real estate bust in the United States, though some individual homeowners and communities are suffering. Five months later he (Posen, 2007b) doubled down in a September op-ed titled “A Drag, Not a Crisis”:

As the crisis was gaining strength, the International Monetary Fund (IMF), which is charged with monitoring the world economy and serving as early warning system, declared in its World Economic Outlook Update of July 2007:

The IMF’s misreading of economic conditions was then trumped by Ken Rogoff, Harvard professor and former IMF Chief Economist. In an op-ed published in July 2008, Rogoff (2008a) advocated raising interest rates just as the crisis was accelerating:

Two months later, Rogoff (2008b) trumped himself with a Washington Post op-ed celebrating the Federal Reserve’s decision to let Lehman Brothers fail, a decision now widely recognized as having catastrophic consequences:

The general state of unawareness in the economic profession is captured by Olivier Blanchard (2008), MIT professor and IMF Chief Economist, in an August 2008 paper celebrating the state of macroeconomics:

This celebratory attitude was shared by Marvin Goodfriend (2007), Carnegie-Mellon Professor of economics and former chief monetary policy advisor at the Richmond Federal Reserve, in a 2007 article titled “How the World Achieved Consensus on Monetary Policy”:

The blindness to realities is spread throughout the branches of mainstream macroeconomics. With regard to the international economy, Michael Dooley, David Folkerts-Landau, and Peter Garber, of the University of California, Deutsche Bank, and Brown University, respectively, wrote a widely cited paper, titled “An Essay on the Revised Bretton Woods System,” that predicted an era of stability:

A similarly complacent view of the state of the international economy was expressed by Ricardo Hausmann, Harvard University professor and former Chief Economist of the Inter-American Development Bank, in a December 2005 Financial Times op-ed “Dark Matter Makes the US Deficit Disappear,” coauthored with Federico Sturzenegger:

The idea of the “Great Moderation” that had tamed the business cycle, which is now so decisively discredited, was openly endorsed in 2004 by Federal Reserve Chairman Bernanke (2004):

Endorsement of the conduct of monetary policy and the broad macroeconomic policy regime also came from Alan Blinder, Princeton University professor, former Vice-Chairman of the Board of Governors of the Federal Reserve System, and a leading economic policy advisor to the Democratic Party. In a 2005 paper coauthored with Ricardo Reis, Blinder eulogized Greenspan at his retirement as Federal Reserve Chairman as the greatest central banker ever:

The one mainstream economist who predicted accurately the financial crash and its aftermath is Nouriel Roubini, former assistant secretary in the Treasury Department under Larry Summers in the late 1990s. For that Roubini deserves credit, but it is also noteworthy that Roubini got the economics completely wrong. Thus, his explanation of how a crash would develop ran as follows:

In fact this “dollar collapse” view about how a possible financial crisis might develop was widely held by many mainstream economists, including Fred Bergsten (2005) of the Peterson Institute, Barry Eichengreen (2004) of Berkley, and Maurice Obstfeld of Berkley and Ken Rogoff of Harvard (2007). All were wrong, but only Roubini made the astutely accurate and well-timed call of a catastrophe.¹⁴

In sum, this record is a damning indictment. It is not an isolated failure, but a widespread and comprehensive failure of understanding at the top of the profession by economists holding the highest policy positions and teaching at the most elite universities.

Obstacles to Change

The link between economics and the economic policies that created the crisis, combined with the scale and scope of failure within the economics profession, makes a case for major change in economics. Yet, that does not appear to be happening.

The balance of this chapter explains why this is so. Just as there are political obstacles to policy change (discussed in Chapter 9), so too there are obstacles to intellectual change. The myth is that ideas compete on a level playing field. The reality is much more complex.

The Neoclassical Monopoly: Coke versus Pepsi

One major obstacle to change is the absolute dominance of neoclassical economics that claims to be the only true economics and, in the name of truth, blocks other points of views. However, a major difficulty exposing this narrowness is that it is obscured by a family split among neoclassical economists that makes it look as if economics is far more pluralistic than it is.

The split is between hard-core neoliberals who believe that real-world market economies approximate perfect competition and soft-core neoliberals who do not. Hard-core believers are identified with the Chicago School, whose leading exponents include Milton Friedman and George Stigler. Soft-core believers are identified with the MIT School associated with Paul Samuelson. The soft-core MIT School includes well-known liberals such as Paul Krugman, Brad DeLong, Dani Rodrik, and Larry Summers. It also includes Joseph Stiglitz who, although more radical at the policy level, shares the same overarching economic theory.

This hard-core versus soft-core split obscures the underlying uniformity of thought. Hard-core and soft-core economists go after each other tooth and nail, creating an illusion of deep intellectual difference, but the reality is that they share a common analytical perspective. In effect, the debate in mainstream economics resembles competition between Coke and Pepsi. They too go after each other tooth and nail, claiming huge differences in taste, but the reality is that they are both colas.

Figure 11.1 provides a description of modern economics. The discipline is divided into neoclassical economists (probably more than 95 percent) and heterodox economists, which includes Keynesians, Marxists, and institutionalists. Hard-core Chicago School economists claim real-world market economies produce roughly efficient (so-called Pareto optimal) outcomes on which public policy cannot improve. Thus, any state intervention in the economy must make someone worse off.

Figure 11.1. The makeup of modern economics.

The soft-core MIT School, by contrast, argues that real-world economies are afflicted by pervasive market failures, including imperfect competition and monopoly, externalities associated with problems like pollution, and an inability to supply public goods such as street lighting or national defense. Market failures also include information failures, which is why economists like Joe Stiglitz and George Akerlof are part of the MIT School. For MIT economists, policy interventions that address market failures – including widespread information imperfections and the nonexistence of many needed markets – can make everyone better off.

None of this debate between Chicago and MIT is about fairness, which is a separate issue. Indeed, neither the Chicago School nor the MIT School say market outcomes are always fair, because actual market outcomes depend on the initial distribution of resources. If that distribution was unfair, current and future outcomes will be unfair, too.

That said, Chicago economists seem to believe real-world outcomes are acceptably unfair and, more importantly, that attempts to remedy unfairness are too costly because tampering with markets causes economic inefficiency. Moreover, they believe that government intervention tends to generate its own costly failures because of bureaucratic incompetence and rent seeking, whereby private interests try to steer policy to their own advantage. MIT economists tend to espouse the opposite: fairness is important, the real world is unacceptably unfair, and government failure can be prevented by good institutional design, including democracy.

These differences between Chicago and MIT reflect the intellectual richness of neoclassical economics. However, that richness provides no justification for a neoclassical monopoly that asserts and permits only one economics. That is the essential point.

This reality of economics is difficult to convey and therefore difficult to challenge. One reason is that soft-core MIT economists like Paul Krugman and Joseph Stiglitz share values with heterodox economists, and shared values are easily conflated with shared analysis. A second reason is that heterodox and soft-core MIT School economists also often agree on policy, even if their reasoning is different. A third reason is the tendency of the profession to hype the scope of its internal divisions in terms of a battle between “freshwater” (Chicago School) and “saltwater” (MIT School) economics, thereby making the profession look more pluralistic. A fourth reason is that most people are incredulous that economists could be so audacious as to enforce one view of economics.

However, the evidence is there. For instance, Notre Dame University recently closed it economics department, which was heterodox, and replaced it with a neoclassical department. The claim was that the heterodox department lacked standing and publication success, but that was inevitable given the neoclassical monopoly that made that type of success impossible.¹⁵

Another example is provided by Professor Dani Rodrik of Harvard University who recently published a book titled One Economics, Many Recipes: Globalization, Institutions, and Economic Growth. Rodrik is one of the most enlightened neoclassical economists, yet the title of his book inadvertently spotlights all the obstructions to creating an open-minded economics. At one and the same time, he criticizes the hard-core neoliberal Washington Consensus while also arguing there is only “one economics.” Thus, Rodrik criticizes the hard-core neoliberal policies that heterodox economists have long criticized, yet implicitly denies the legitimacy of heterodox analysis.

To lay readers this may seem like a storm in a teacup, but it is not. Heterodox economics includes core theoretical concepts that are fundamentally incompatible with neoclassical economics in either of its two contemporary forms. These concepts result in significantly different explanations of the real world, including income distribution and the determinants of economic activity and growth. Moreover, they often result in different policy prescriptions.

Those theoretical differences explain why neoliberal policy rooted in neoliberal economics has proved so disastrous, and the different policy prescriptions are critical for escaping the looming great stagnation and creating shared prosperity. They are especially critical for understanding the phenomenon of globalization. Absent an opening of economics that makes space for heterodox thinking, it is going to be difficult to get policies for shared prosperity on the political table and keep them there.

Power and Ideas

Ironically, the notion of a capture theory of economics, in which self-interest drives the capture of economics by business interests, links neoclassical economic logic with Marxist analysis. Control of ideas is valuable because it bolsters power and wealth, and power and wealth are therefore directed to controlling ideas. Keynes recognized the power of ideas, writing in his General Theory (1936):

[T]he ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slave of some defunct economist.

But Keynes’s analysis is thin on why particular ideas triumph. For that, we must look to the ideas of Karl Marx in The German Ideology (1845):

The ideas of the ruling class are in every epoch the ruling ideas, i.e. the class which is the ruling material force of society, is at the same time its ruling intellectual force. The class which has the means of material production at its disposal, has control at the same time over the mental means of production, so that thereby, generally speaking, those who lack the means of mental production are subject to it.

This logic makes much sense with regard to economics. In the Marxian schema, shown in Figure 11.2, power and wealth are applied to influence (+) ideas, and ideas then support (+) the existing structure of power and distribution of wealth.

Figure 11.2. The Marxian construction of the relation between power, wealth, and ideas.

That power and wealth influence ideas should come as no surprise. Americans would have no problem with that claim applied to the former Soviet Union. However, the psychological longing for truth makes it hard to admit the claim also holds in every society, including democratic societies such as the United States. This conflict of reality and psychological longing generates cognitive dissonance, and that dissonance is contained by denial.

A society in which the distribution of power is at odds with ideas will be marked by social discord. Over time, one or other must give until some reconciliation is achieved. If that does not happen, discord can be profound and extended.

The question now is: Has the financial crisis and the Great Recession changed the distribution power, which includes awakening political awareness? If not at all, economics will likely remain essentially unchanged.

One place where change may have occurred is U.S. domestic politics, where free-market rhetoric may have worn thin. This creates political space, which could usher in a new politics that drives change in economics. However, judging by the Obama administration’s agenda, initial indications of change are not strong, and the politics of “Coke versus Pepsi” look set to continue.

A second place is the redistribution of power from the United States to China, which could also drive change in economics. How that works out depends on the evolution of the U.S.-China relationship and the evolution of internal Chinese politics. If the relationship turns more contentious, that could drive a rewriting of international economics – particularly the theory of trade. If China continues to be successful with its market-state Keynesianism, that too could drive change. However, if Chinese elites join the existing global ruling class, that would reinforce the existing paradigm.

Expert Opinion and Open Society

Democracies and autocracies tend over long periods to grow at roughly the same rate. The big difference is that democracies tend to grow smoothly whereas autocracies are characterized by growth spurts followed by long periods of stagnation and even calamity. This pattern of feast and famine is costly.

One explanation for the superior growth pattern of democracies is that they are societies open to criticism and alternative ideas. When something goes wrong, the democratic process enables them to change policies and make course corrections. Autocracies have no equivalent mechanism. Consequently, when things go wrong, they cannot change course and thus hit the wall of stagnation.¹⁷

The critical feature of open societies is that they are open to alternative ideas. Above all, that requires being open to the fact that one can never be certain of having the truth. The scientific methodology only allows disproof of hypotheses. It is impossible to prove something as true because tomorrow it might be falsified and we cannot know the future with certainty.

The U.S. economy is now paying the price of closed-mindedness in economic policy. It has been through a financial crisis and now faces an era of stagnation. This outcome is the product of thirty years of policy dominated by one set of ideas and closed to alternatives and warnings of looming problems.

In a sense, the United States has fallen into an analogue of the closed-society trap of autocracies. For autocracies, the trap is rooted in a monopoly of the political process. The economic crisis has revealed that democracies face an analogue trap rooted in a monopoly on expert opinion. Expert opinion often guides political policy makers. When expert opinion becomes monopolized and closed-minded, as has happened in economics, it can create a policy trap.

Democracies still have the great advantage over autocracies in that they have the freedom to change policy course when they hit stagnation. But how soon they do so and how extensively they do it depends on the extent that monopoly expert opinion can be overcome and new ideas introduced.

Vested interests ensure that expert opinion will not simply roll over, no matter how catastrophic the situation. Indeed, catastrophe can invite “staying the course” on grounds that “rocking boat” with change is dangerous and risky.

Finally, even if today’s neoclassical monopoly in economics were dismantled, the crisis holds a valuable long-term lesson for democratic societies. That lesson is that political openness is insufficient. Society must also have openness of expert opinion and openness of thought in the academia. That requires full representation of thought, not lip service to representation, as is currently the case.

The central theme of this book has been the role of neoliberal economic policy in creating an economy that was destined to hit the wall of stagnation. However, as discussed in Chapter 2, neoliberalism is more than just an economic theory. It is also a philosophy of how society should be organized based on beliefs about the relation between economic organization and freedom.

Beginning with Hayek, and carried forward in more extreme form by Milton Friedman and his Chicago School colleagues, neoliberals argued for a radical reshaping of society that elevated markets and diminished government and other collective institutions. The ethical justification for this reshaping was the advancement and protection of freedom, and the case was further bolstered by claims about the benefits of economic efficiency that would follow.

This logic was most clearly captured by British Prime Minister Margaret Thatcher. With regard to the economy, it was captured in the Thatcherite slogan, “There is no alternative (TINA),” to market fundamentalism. With regard to society it was captured in Mrs. Thatcher’s comment that “[t]here is no such thing” as society. Instead, “[t]here are individual men and woman and families, and no government can do anything except through people and people look to themselves first.”¹

Neoliberalism has ruled the intellectual and policy roost for the past thirty years, but the financial crash of 2008 and the Great Recession have opened the door to reversing that dominance. At the economic level, the crisis overtly challenges orthodox economic theory, its description of the workings of market economies, and its claims about the efficiency of market outcomes. Less overtly, but no less importantly, the crisis also challenges the neoliberal view of social relations. That view emphasizes extreme individualism, which in practical terms translates into shifting the balance of power in favor of markets and against government and collective institutions such as trade unions.

Thirty years of widening income inequality, followed by the deepest economic crisis since the Great Depression of the 1930s, now speak to need for rebalancing the relation between markets and other elements of society. That rebalancing is warranted on both economic efficiency grounds and larger societal concerns about the common good.

The Fallacy of the Philosophy of Greed is Good

The neoliberal case for tilting society so heavily in favor of markets rests on views about individuals and their relation to each other. In one sense, Mrs. Thatcher was right: Individuals and the choices they make are the raw input into the process determining outcomes.

Neoliberalism takes individuals as formed and works from there. Given well-formed individuals, it argues that the pursuit of self- interest leads to good social and economic outcomes. This view of society finds its rawest expression in Gordon Gecko, the hero of the 1987 movie Wall Street, whose philosophy was that greed is good.

Orthodox economists, wanting a more academic justification of the philosophy of greed-is-good, appeal to the famous passage from Adam Smith’s Wealth of Nations: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages” (1976a [1784], p. 27). In Smith, the concepts of self-interest and greed are described as self-love.

The unseen sleight of hand in modern economics is the assumption of well-formed moral individuals. That assumption is critical to the neoliberal argument. However, Adam Smith, the misappropriated patron of neoliberal economics, made no such assumption.

For Smith, individuals were socially formed in particular ways and absent that formation, the pursuit of self-love could be disastrous. These thoughts are developed in his Theory of Moral Sentiments, published in 1759, twenty-five years before the Wealth of Nations. Smith’s Theory of Moral Sentiments is overlooked and ignored by orthodox economists who appeal exclusively to his Wealth of Nations. The reality is that it is the foundation-stone on which rest the conclusions of The Wealth of Nations. Without that foundation-stone concerning the moral development of individuals, the conclusions about the benefits of exchange based on the pursuit of self-love implode.

For Smith, justice is the pillar that makes the system work: “Justice, on the contrary, is the main pillar that upholds the whole edifice” (1976b [1790], p. 86). Justice and social order in turn derive from a sense of duty and good conduct that is both natural and socially developed:

Social conditioning and education then reinforce this process:

Smith’s Theory of Moral Sentiments rounds out the critique that neoliberalism rests on a collection of fallacies. Earlier, Chapter 2 described the Keynesian critique of the claim that laissez-faire market economies generate economically efficient outcomes. Keynes explained why monetary credit-based market economies can generate persistent large-scale unemployment that the market mechanism is unable to solve.

Chapter 2 also explained why market economies do not unambiguously advance freedom. That is because they create “unfreedoms” for some persons at the same time that they advance the freedoms of others. Put bluntly, the freedom to starve is not freedom. Furthermore, income and wealth inequality also create political inequality, which undermines political freedom, and that political inequality can then undermine market efficiency by enabling the wealthy to politically rig market rules in their favor. Indeed, this political rigging of markets was an important factor in the financial crisis of 2008, explaining the excessive deregulation of financial markets and the refusal to implement new regulations that addressed financial innovation.

Smith’s analysis of the necessity of moral sentiments completes the critique. Well-formed individuals are essential to the working of the market system, but well-formed individuals are socially produced. Therein is the fallacy of worship of self-interest and animus to government. This combination is toxic for liberal society because worship of self-interest destroys the moral sentiments needed by liberal society, whereas animus to government blocks the reproduction of those moral sentiments.

Chicago School economists advocate a minimalist “night watchman” state in which the role of government is restricted to policeman, judge, and jailer – provider of national defense, protector of person and property, and enforcer of contracts. Their MIT siblings see an additional role for the state to remedy microeconomic problems of commercial monopoly, natural monopoly, public goods, externalities, and information failures. But from Adam Smith’s perspective, the night-watchman state needs essential ingredients to be successful. In particular, Smith believed it needs a sense of justice among the citizenry toward each other:

Society can exist without goodwill among citizens (which Smith terms beneficence), but it cannot exist without a sense of justice among its citizenry. That sense of justice ensures laws are obeyed so that property rights and contracts are essentially self-enforced.² That is a fundamentally different perspective from the orthodox position that holds that individuals, in the name of self-interest, should try and get away with whatever they can.

Without self-enforcement, the system becomes prohibitively expensive and inefficient. First, there are formal enforcement costs associated with increased policing and litigation, private expenses to secure person and property, and costs of an expanded judiciary and correctional system. Second, and even more costly, are the tremendous losses of potential economic gain that follow from withdrawal from commercial contracting because of fear that contracts will be unenforced or prove hugely costly to enforce.

The critical feature about Smith’s moral sentiments is that they are not automatically reproduced. Reproduction needs the right conditions. This includes a sense of identity with society that comes with sharing in the benefits and limited inequality. If people do not feel the system values them, they will not value the system. Reproduction of moral sentiments also requires appropriate socialization and investment via activities like education, which is why education is a fundamental obligation of the state.

When these conditions are present, there exists a virtuous circle between individuals’ moral sentiments, markets, and society, as shown in Figure 12.1. Market outcomes produce benefits that strengthen (+) individual’s moral sentiments, which strengthens social bonds and increases (+) the benefits from market activity.

Figure 12.1. The virtuous circle of moral sentiments.

Appropriate moral sentiments for liberal society have existed because of what was done in the past. The neoliberal fallacy is to assume that existence is natural and permanent. This assumption leads to policy recommendations that end up deconstructing the citizenry that the night-watchman state needs for its own success. This deconstruction is illustrated in Figure 12.2, which shows the neoliberal vicious circle of moral sentiments. Now, socially sanctioned exclusive pursuit of self-interest results in market outcomes that erode (−) individuals’ moral sentiments, contributing to erosion of social bonds and a worsening (−) of market outcomes, which further erodes moral sentiments. In effect, the creed of greed is good results in behaviors that deconstruct the foundations the night-watchman state needs to function. That, in a nutshell, is the Smithian critique of Milton Friedman, Ayn Rand, Margaret Thatcher, and Gordon Gecko.

Figure 12.2. The neoliberal vicious circle of moral sentiments.

Smith’s analytical insights about the formation of moral sentiments are supported by experimental evidence that confirms the socially corrosive properties of the neoliberal creed. Thus, Frank et al. (1993) report that studying neoclassical economics, with its belief that greed is good, can create bad citizens. In controlled surveys of U.S. college students, they found that exposure to neoclassical economics inhibits cooperative behavior and reduces honesty.

These findings have direct and profound economic implications. To the extent that neoliberalism has made pursuit of narrow self-interest the cultural and behavioral norm, it has likely impacted individuals’ behavior. For instance, if managers take self-interest as their guiding principle, that will worsen principal-agent problems by diminishing managers’ sense of responsibility to shareholders and their sense of the obligations of stewardship. This can explain the explosion of managerial pay and pay practices that can degenerate into corporate looting.

Another example concerns the U.S. mortgage crisis where massive lending fraud has become evident. The pursuit of self-interest likely encouraged some explicit borrower fraud, but more importantly it encouraged fraud-like behaviors all down the transaction chain, beginning with realtors and moving on through valuation assessors, mortgage brokers, mortgage insurers, mortgage lenders, mortgage securitizers, and rating agencies. Everyone had a self-interest to get the deal done to earn commissions and profit bonuses, which encouraged loan pushing rather than responsible lending. This role of fraud repeats the findings of William Black (2005) in his analysis of the late 1980s financial crisis in the Savings and Loan industry.

The lesson is solid ethics among individuals is an important ingredient of efficient financial systems, and undermining those ethics produces major efficiency losses. As recognized long ago by Adam Smith, healthy moral sentiments are indeed critical for market economies.

The Liberal Ethical Critique

Adam Smith’s moral sentiments critique, John Maynard Keynes’s economic efficiency critique, and Amartya Sen’s unfreedom critique constitute a pragmatic realist critique of neoliberalism. Together they show that neoliberal claims about markets, economic efficiency, and freedom do not stack up.

To this realist critique can then be added the liberal ethical critique espoused by John Rawls (1971) in his Theory of Justice. Rawls asks that you imagine a veil of ignorance is placed over you so that you do not know your identity, your economic and social status, your intelligence and abilities. In that case, given you might be anyone – a homeless person or a multimillionaire – would you support current economic and social arrangements? Or would you choose an alternative, more egalitarian arrangement? If people respond that current outcomes of wealth, income, and power are grossly unequal and unacceptable, Rawls’s ethical logic concludes the current system is unjust and should be changed on ethical grounds.

This liberal ethical critique is fully compatible with the realist critique, and it lends additional weight to the case for reversing neoliberal dominance. However, politically, concerns with fairness and equity appear to be second order and trumped by concerns with jobs and economic efficiency. This means that in terms of winning the political argument for change, the realist critique is likely to prove more decisive.

Time for a Great Rebalancing

The last thirty years have been marked by the comprehensive dominance of market fundamentalism and could be labeled the era of Milton Friedman. That dominance shaped globalization and national economic policy and destroyed shared prosperity in the process.

The financial crash and the Great Recession have revealed the disastrous flaws in the market fundamentalist paradigm, and the global economy now confronts the prospect of the Great Stagnation. With hindsight, we can see that when implemented, the neoliberal paradigm undermined the economy’s structural balance, producing a range of outcome imbalances that now weigh heavily on the economy.

Escaping the prospect of the Great Stagnation necessitates a great rebalancing. This requires a new set of economic ideas. It is difficult to complete a long journey without a map, and ideas are the map needed for restoring shared prosperity. That is why ideas are so important, and winning the war of ideas is essential. In the words of the Old Testament, “Where there is no vision, the people perish.”

The needed rebalancing should begin with the new ideal of a “balanced market economy.” Like freedom, balance is something widely valued, and the Great Recession has revealed the huge costs of an unbalanced world. A balanced market economy can be the shorthand counter to neoliberalism’s free-market economy.

A first major outcome imbalance concerns wealth and income distribution, which has shifted in favor of society’s top echelons. This shift is a bedrock cause of the Great Recession as it forced reliance on debt to sustain aggregate demand and meet living standard expectations. That economic process is unsustainable, meaning income distribution must be rebalanced to ensure demand adequate for full employment.

A second outcome imbalance is the global financial imbalance, exemplified by the U.S.-China trade deficit. Over the last fifteen years, many emerging market economies shifted to export-led growth, which generated large trade surpluses. The United States pursued debt- fueled consumerism that created matching deficits. This configuration is exhausted, requiring a major rebalancing of the global economy based on new modalities of growth. Emerging market economies must shift away from export-led growth to domestic demand-led growth, whereas the United States must switch spending away from imports toward domestic production.

A third outcome imbalance is the worrying long-term budget outlook that confronts the United States and many other countries. Now is not the time for fiscal austerity as it could deepen the slump. However, when the time for rebalancing the fiscal outlook comes, it must be done in a way that contributes to rebalancing society, and not by aggravating existing imbalances. Much of the budget deficit will disappear automatically with economic recovery. Where health care costs are the source of the problem, the production of health care should be reformed. To the extent any remaining deficit is unsustainable, it should be addressed by progressive tax reform that increases the efficiency of the tax system and reverses the neoliberal tilt that has persistently twisted the tax structure in favor of the affluent over the past thirty years.

A fourth imbalance concerns the dominance of speculation over enterprise, which has been repeatedly visible in the Internet stock bubble of the late 1990s, the oil and commodity price bubble of 2008, and the housing price bubble that triggered the Great Recession. Keynes (1936) wrote of this conflict in The General Theory: “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirl-pool of speculation” (p. 159).

A fifth outcome imbalance concerns the relation between the economy and the environment. The problems of pollution and global climate change pose grave dangers and the costs of global warming have been clearly documented in the Stern (2006) report. Moreover, in the United States, there are additional economic and national security costs that come from reliance on imported oil.

These outcome imbalances are the product of fundamental structural imbalances. Behind the worsening of wealth and income distribution lies a shift in the balance of power between capital and labor. Rebalancing income distribution therefore requires rebalancing economic, social, and political power, which has swung in favor of corporations and the wealthy and against workers. That reveals a fundamental conundrum and the depth of the challenge: Rebalancing economic power is the key to rebalancing political power, but rebalancing political power is the key to rebalancing economic power.

The triumph of speculation over enterprise reflects the dominance of finance capital. That dominance extends over both government and nonfinancial corporations. The dominance of finance over government reflects the power of money in the political process, while the dominance of finance over industry reflects the economic ideology embedded in the shareholder value maximization paradigm. The dominance of finance also reflects an ideological imbalance between markets and government that fostered antipathy to government and regulation, one result of which was disastrous excess in financial markets.

Antipathy to government, which is a collective action, is paralleled by abuse of the environment, which is a form of property that is collectively owned within generations and across generations. Overcoming the antipathy to government requires correcting the ideological imbalance between markets and government. Environmental rebalancing requires rebalancing private consumption and private production with the collectively owned environment. Not only are market-government rebalancing and environmental rebalancing needed for sustainable and shared prosperity; they can also spur growth during a period of economic reconstruction via a green public investment agenda that meets important needs.

The preceding list of economic imbalances reveals both the extreme character of the neoliberal era and the momentous challenges it has created. Absent a great rebalancing, shared prosperity will become a relic of the past and the Great Recession will likely evolve into the Great Stagnation. If that happens, it is also easy to imagine a Weimar-style political scenario in which prolonged mass unemployment and economic hardship release the genie of intolerance and hate.

For these reasons a great rebalancing is essential and urgent, but escaping the pull of neoliberalism will not be easy. There exist major political obstacles associated with vested interests and the capture of political parties. Orthodox economists dominate thinking about economics and economic policy, and market fundamentalism has a deep hold on the public’s imagination. In part, this hold is because of its rhetoric about freedom and individualism, which resonates especially strongly with U.S. cultural images and values. But it is also because extremes are attractive, offering simple but false certainties.

In contrast, economic perspectives that recognize the need for balance also require judgment, and the exercise of judgment is difficult and challenging, being the ultimate expression of individual responsibility. Ironically, neoliberalism, which touts individualism, avoids that responsibility by its embrace of the extreme. That makes it both dangerous and difficult to dislodge, but, to borrow from Mrs. Thatcher, if we want shared prosperity, there is no alternative.