Keynesianism and the Great Recession

An Interview with Walden Bello

Keynesianism offered important tools for overcoming the economic crisis, but its application by Obama’s government was too half-hearted and misdirected (going to banks rather than households) to effectively reduce the recession. Clinton paid the price.

This interview with Walden Bello is based on the paper “Keynesianism in the Great Recession:
Right Diagnosis, Wrong Cure,” available here from the Transnational Institute.

Q: What were the main ways in which neoliberalism created the Great Recession?

A: Neoliberalism sought to remove the regulatory constraints that the state was forced to impose on capitalist profitability owing to the pressure of the working class movement.

But it had to legitimize this ideologically. Thus it came out with two very influential theories, the so-called efficient market hypothesis (EMH) and rational expectations hypothesis (REH). EMH held that without government-induced distortions, financial markets are efficient because they reflect all the available information available to all market participants at any given time. In essence, EMH said, it is best to leave financial markets alone since they are self-regulating. REH provided the theoretical basis for EMH with its assumption that individuals operate on the basis of rational assessments of economic trends.

These theories provided the ideological cover for the deregulation or “light touch” regulation of the financial sector that took place in the 1980s and 1990s. Due to a common neoliberal education and close interaction, bankers and regulators shared the assumptions of this ideology. This resulted in the loosening of regulation of the banks and the absence of any regulation and very limited monitoring of the so-called “shadow banking” sector where all sorts of financial instruments were created and traded among parties.

With so little regulation, there was nothing to check the creation and trading of questionable securities like subprime mortgage-based securities. And with no effective monitoring, there were no constraints on banks’ build-up of unsustainable balance sheets with a high debt to equity ratios.

Without adult supervision, as it were, a financial sector that was already inherently unstable went wild. When the subprime assets were found to be toxic since they were based on mortgages on which borrowers had defaulted, highly indebted or leveraged banks that had bought these now valueless securities had little equity to repay their creditors or depositors who now came after them. This quickly led to their bankruptcy, as in the case of Lehman Brothers, or to their being bailed out by government, as was the case with most of the biggest banks. The finance sector froze up, resulting in a recession—a big one—in the real economy.

Q: So how did these banks get to be so big and powerful? What drove the “financialization boom” that triggered the recession?

A: Financialization or an increasing preference for speculative activity instead of production as a source of profit was driven by four developments. The first was the abolition, during the Clinton Administration, of the Glass-Steagall Act that had served as a Chinese Wall between commercial or retail banking and investment banking, as a result of tremendous pressure from the big banks felt left out of the boom in trading. The second was the expansive monetary policy promoted by the Federal Reserve to counter the downturn following the piercing of the dot.com bubble in the first years of the new century. Third was the government and business’ move to shore up effective demand by substituting household indebtedness for real wage increases. Fourth was the lifting of capital controls on the international flow of finance capital, following the era of financial repression during the post-war period. These developments acted in synergy, first to produce a speculative boom in the housing and stock markets, then feeding on one another to accelerate an economic nose-dive during the bust.

Q: What was the worst impact of the crisis, and upon whom?

A: With unemployment hitting 10 per cent in 2010, working people suffered the most. Although the unemployment rate is now down to five per cent, that fall has been driven less by improved labor market conditions than a falling rate of participation, as discouraged workers withdrew from the labor force. More than 4 million homes were foreclosed. Lower income households, the main victims of aggressive loan sharks, suffered most.

As far as growth was concerned, the recovery was tepid, with average GDP growth barely 2 per cent per annum between 2011 and 2013, less than half the pace of the typical post-World War II expansion. In terms of inequality, the statistics were clear: 95% of income gains from 2009 to 2012 went to the top 1%; median income was $4,000 lower in 2014 than in 2000; concentration of financial assets increased after 2009, with the four largest banks owning assets that came to nearly 50% of GDP.

An Economic Policy Institute study summed up the trends: “[T]he gains of the top 1 percent have vastly outpaced the gains for the bottom 99 percent as the economy has recovered.”
At the individual and household level, the economic consequences of being laid off were devastating; with one study finding that workers laid off during recessions “lose on average three full years of lifetime income potential.” One estimate showed that the income of the United States would have been $2 trillion higher had there been no crisis, or $17,000 per household.

Q: What did Keynesianism offer as a way of responding to the crisis?

A: Keynesianism offered two major weapons for overcoming the crisis. The first and most important was a fiscal stimulus, or deficit spending by government. The second was monetary expansion. Essentially, these were forms of government intervention designed to revive the economy after a collapse of investment on the part of the private sector. They are called “countercyclical” since they are designed to counter the recessionary pressures brought about by the crisis of the private sector.

Q: How were Keynesian policies and strategies applied in the wake of the onset of the recession?

A: The Keynesian interventions were in the right direction. Unfortunately, they were applied half-heartedly by the Obama administration. For instance, the size of the fiscal stimulus $787 billion might have been enough to prevent the recession from getting worse, but it was not enough to trigger an early recovery, which would have demanded at least $1.8 trillion, according to Cristina Romer, the head of Obama’s Council of Economic Advisers.

Expansive monetary policy was always a second best solution and was not as effective as a fiscal stimulus. Yes, cutting interests to zero and quantitative easing—or providing banks with infusions of money—did have some impact, but this was rather small since, for the most part, individuals and corporations did not want to go further into debt but wanted to focus on lessening their debt.

Q: What three things could have been done, “truer” to the spirit of Keynesianism, that would have reduced the recession?

A: First of all, there should have been a much bigger stimulus, one along the lines of Cristina Romer’s proposal of $1.8 trillion. Second, instead of focusing on saving the banks, the government should have devoted resources to assisting the millions of troubled homeowners, a move which would have raised effective demand. Third, the insolvent banks should have been taken over or nationalized and the billions spent on recapitalizing them or guaranteeing their borrowing should have been devoted to creating jobs to absorb the unemployed.

Q: Is financialization still a threat?

A: Yes, even conservative analysts say that the so-called Dodd-Frank reform encourages moral hazard or reckless behavior by banks owing to their belief that when they get into trouble, the government will bail them out.

Derivatives—which Warren Buffet called “weapons of mass destruction”—are still virtually unregulated. And so is the shadow banking sector. The non-transparent derivatives market is now estimated to total US$707 trillion, or significantly higher than the US$548 billion in 2008.

As one analyst puts it, “The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour. Its size and potential influence are difficult just to comprehend, let alone assess.” Former U.S. Securities and Exchange Commission Chairman Arthur Levitt, the former chairman of the SEC, says that none of the post-2008 reforms has “significantly diminished the likelihood of financial crises.”

Q: What has been the legacy of the crisis on U.S. politics?

A: One can say that the Obama administration’s failure to reinvigorate the economy after eight years and to reform the banks was the central factor that lost the elections for Hillary Clinton. If there’s one certainty that emerged in the 2016 elections, it was that Clinton’s unexpected defeat stemmed from her loss of four so-called “Rust Belt” states: Wisconsin, Michigan, and Pennsylvania, which had previously been Democratic strongholds, and Ohio, a swing state that had twice supported Barack Obama.

The 64 Electoral College votes of those states, most of which hadn’t even been considered battlegrounds, put Donald Trump over the top. Trump’s numbers, it is now clear, were produced by a combination of an enthusiastic turnout of the Republican base, his picking up significant numbers of traditionally Democratic voters, and large numbers of Democrats staying home.
But this wasn’t a defeat by default. On the economic issues that motivate many of these voters, Trump had a message: The economic recovery was a mirage, people were hurt by the Democrats’ policies, and they had more pain to look forward to should the Democrats retain control of the White House.

The problem for Clinton was that the opportunistic message of this demagogue rang true to the middle class and working class voters in these states, even if the messenger himself was quite flawed. These four states reflected, on the ground, the worst consequences of the interlocking problems of high unemployment and deindustrialization that had stalked the whole country for over two decades owing to the flight of industrial corporations to Asia and elsewhere. Combined with the financial collapse of 2007-2008 and the widespread foreclosure of the homes of millions of middle class and poor people who’d been enticed by the banks to go into massive indebtedness, the region was becoming a powder keg of resentment.

True, these working class voters going over to Trump or boycotting the polls were mainly white. But then these were the same people that placed their faith in Obama in 2008, when they favored him by large margin over John McCain. And they stuck with him in 2012, though his margins of victory were for the most part narrower. By 2016, however, they’d had enough, and they would no longer buy the Democrats’ blaming George W. Bush for the continuing stagnation of the economy.
Clinton bore the brunt of their backlash, since she made the strategic mistake of running on Obama’s legacy—which, to the voters, was one of failing to deliver the economic relief and return to prosperity that he had promised eight years earlier.

Q: In what ways do we need to go beyond Keynesianism to address current economic and ecological problems?

A: I think Keynesianism has valuable insights into how a capitalist economy operates and can be steadied so its inherent instability and contradictions can be mitigated. But, as Minsky says, these solutions do not address the inherent instability of the system. A new equilibrium contains the seeds of disequilibrium. With its focus on growth propelled by effective demand, Keynesianism also has problems addressing the problem of ecological disequilibrium brought about by growth.
The real issue is capitalism’s incessant search for profit that severely destabilizes both society and the environment. I think there is no longer any illusion, even among its defenders, that capitalism is prone to crises, and these days, these are crises that not only stem from the dynamics of production but from the dynamics of finance.

We need to work towards a post-capitalist system that aims at promoting equality, enhances instead of destroys the environment, is based on cooperation, and is engaged in planning to achieve short term, medium term, and long-term goals. In this scheme, finance would function to link savings to investment and savers to investors, instead of becoming an autonomous force whose dynamics destabilizes the real economy. A post-capitalist society does not mean the elimination of the market. But it does mean making use of the market to achieve democratically decided social goals rather than having the market drive society in an anarchic fashion.

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