From Financial Crisis to Stagnation: The Destruction of Shared Prosperity and the Role of Economics

Thomas Palley, Guest Blogger

Many countries are now debating the causes of the global economic crisis and what should be done. That debate is critical for how we explain the crisis will influence what we do.

Broadly speaking, there exist three different perspectives. Perspective # 1 is the hardcore neoliberal position, which can be labeled the “government failure hypothesis”. In the U.S. it is identified with the Republican Party and Chicago school economics. Perspective # 2 is the softcore neoliberal position, which can be labeled the “market failure hypothesis”. It is identified with the Obama administration and MIT economics.

Perspective # 3 is the progressive position which can be labeled the “destruction of shared prosperity hypothesis”. It is identified with the New Deal wing of the Democratic Party and labor movement, but it has no standing within major economics departments, owing to their suppression of alternatives to orthodox theory.

The government failure argument holds the crisis is rooted in the U.S. housing bubble and bust which was due to failure of monetary policy and government intervention in the housing market. With regard to monetary policy, the Federal Reserve pushed interest rates too low for too long in the prior recession. With regard to the housing market, government intervention drove up house prices by encouraging homeownership beyond peoples’ means. The hardcore perspective therefore characterizes the crisis as essentially a U.S. phenomenon.

The softcore neoliberal market failure argument holds the crisis is due to inadequate financial regulation. First, regulators allowed excessive risk-taking by banks. Second, regulators allowed perverse incentive pay structures within banks that encouraged management to engage in “loan pushing” rather than “good lending.” Third, regulators pushed both deregulation and self-regulation too far. Together, these failures contributed to financial misallocation, including misallocation of foreign saving provided through the trade deficit. The softcore perspective is therefore more global but it views the crisis as essentially a financial phenomenon.

The progressive “destruction of shared prosperity” argument holds the crisis is rooted in the neoliberal economic paradigm that has guided economic policy for the past thirty years. Though the U.S. is the epicenter of the crisis, all countries are implicated as they all adopted the paradigm. That paradigm infected finance via inadequate regulation and via faulty incentive pay arrangements, but financial market regulatory failure was just one element.

The neoliberal economic paradigm was adopted in the late 1970s and early 1980s. From 1945 – 1975 the U.S. economy was characterized by a “virtuous circle” Keynesian model built on full employment and wage growth tied to productivity growth. Productivity growth drove wage growth, which fuelled demand growth and full employment. That provided an incentive for investment, which drove further productivity growth and higher wages. This model held in the U.S. and, subject to local modifications, it also held throughout the global economy – in Western Europe, Canada, Japan, Mexico, Brazil and Argentina.

After 1980 the virtuous circle Keynesian model was replaced by a neoliberal growth model that severed the link between wages and productivity growth and created a new economic dynamic. Before 1980, wages were the engine of U.S. demand growth. After 1980, debt and asset price inflation became the engine.

The new model was rooted in neoliberal economics and can be described as a neoliberal policy box that pressures workers from all sides. Corporate globalization put workers in international competition via global production networks supported by free trade agreements and capital mobility.

The “small” government agenda attacked the legitimacy of government and pushed deregulation regardless of dangers. The labor market flexibility agenda attacked unions and labor market supports and protections such as the minimum wage. Finally, the abandonment of full employment created employment insecurity and weakened worker bargaining power.

This model was implemented globally, in North and South, which multiplied its impact. That explains the significance of the Washington Consensus which was enforced in developing economies by the International Monetary Fund and World Bank by making financial assistance conditional on adopting neoliberal policies.

The new model created a growing “demand gap” by gradually undermining the income and demand generation process. The role of finance was to fill that gap. Within the U.S., deregulation, financial innovation, and speculation enabled finance to fill the gap by lending to consumers and spurring asset inflation. U.S. consumers in turn filled the global demand gap.

These three different perspectives make clear what is at stake as each recommends its own different policy response. For hardcore neoliberal government failure proponents the recommended policy response is to double-down on neoliberal policies by further deregulating financial and labor markets; deepening central bank independence and the commitment to low inflation; and further limiting government via fiscal austerity.

For softcore neoliberal market failure proponents, the response is tighten financial regulation but continue with the rest of the existing neoliberal policy paradigm. That means continued support for corporate globalization, labor market flexibility, low inflation targeting, and fiscal austerity.

For proponents of the destruction of shared prosperity hypothesis the challenge is to replace the neoliberal paradigm with a “structural Keynesian” paradigm that repacks the policy box and restores the link between wage and productivity growth. The goal is to take workers out of the box and put corporations and financial markets in so that they serve the broader public interest.

That requires replacing corporate globalization with managed globalization; restoring commitment to full employment; replacing the anti-government agenda with a social democratic government agenda; and replacing labor market flexibility with solidarity based labor markets.

The critical insight is each perspective carries its own policy prescriptions. Consequently, the explanation which prevails will strongly impact the course of policy. That places economics at the center of the political struggle as it influences which explanation prevails, and it explains why powerful elites and orthodox economists have an interest in blocking other perspectives.

This article is based on my recent book of the same title from Cambridge University Press which has been released as a paperback.

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