Lance Taylor, Guest Blogger
The only way to understand the Great Crisis and how to deal with it is through the economics of John Maynard Keynes and his closest followers. For the details see my new book, Maynard’s Revenge: The Collapse of Free Market Macroeconomics (Harvard University Press). Three ideas emphasized by Keynes 75 years ago are crucial for understanding the contemporary situation.
The first is that economic actors operate under fundamental uncertainty — at times they cannot predict or even imagine the nature of future developments. In the mid-2000s Federal Reserve Governor Ben Bernanke extolled a “Great Moderation” in macroeconomics. He did not, and probably could not, think about the tsunami that was about to strike. Rather, he accepted widespread market conventions that all was well. Keynes thought that such conventions might persist for a time, but then could rapidly break down.
One key set of conventions revolves around prices of assets, with dynamics independent of prices of goods and services. For example, into 2006 many market actors thought that prices of residential housing would continue to trend upward. But then they collapsed with disastrous consequences.
Finally, the level of economic activity is set by spending, or effective demand. When the crisis hit in 2007 consumers cut back on purchases, and firms invested less. Output and employment fell sharply. The mainstream economics postulate that there is ever full employment (“Say’s Law” in Keynes’s terminology) was decisively falsified.
Ideas raised by Keynes’s followers are also important.
Charles Kindleberger and Hyman Minsky explained that a price bubble like the one for housing and associated “derivative” financial instruments is often accompanied by increasing “leverage” or accumulation of debt to buy the assets in question. When asset prices start to fall (as they always do), many actors are driven into bankruptcy as their levels of debt exceed the plummeting values of their assets. An immediate consequence is a collapse in effective demand.
Wynne Godley and Josef Steindl showed how in the national income accounting invented by Keynes that levels of “net borrowing” or spending minus income for groups of economic actors – say households, business, the government, and the “rest of the world” — must sum to zero. An upward move in any borrowing flow has to be accompanied by downward shifts in the others.
Michal Kalecki, Nicholas Kaldor, and Richard Goodwin argued that distributive and productivity shifts help determine effective demand and cycles in economic growth. In a stylized version of Goodwin’s cycle, employment growth lags output when the economy emerges from a slump. Measured labor productivity and profits rise, stimulating investment demand. Rising wages ultimately cut into profits at the top of the cycle, provoking a downturn. Keynes and Minsky stressed how changing rates of interest and household borrowing have similar effects.
From a Keynesian perspective there were six fundamental causes of the crisis:
1. Around 1980 there was a major shift in the political economic environment, heralded by a move beginning in the 1940s of the economics mainstream against Keynes. Practical effects included dismantling financial regulation after the 1960s and successful attacks on labor’s bargaining power. A new “finance theory” based on “stochastic perfect foresight” supplanted Keynes’s conventions and gave intellectual support to deregulation
2. The American business cycle continued, with changes in the real interest rate, the profit rate, the labor share of GDP, and household net borrowing driving fluctuations in output. But all four variables began to trend after 1980, weakening their cyclical role and generating effects that spilled over into asset prices and the balance of payments.
3. The ratio of household net borrowing to GDP increased by around 10 percentage points between the early 1980s and the mid-2000s. The household debt to income ratio roughly doubled. These trends were accompanied by a sharp decrease in the labor share and an increase in profits. Inequality in the size distribution of income rose markedly.
4. Much of the higher household borrowing was collateralized by rising prices of equity and housing. Real housing prices roughly doubled over 25 years. The obvious interpretation is that households took advantage of the opportunity that capital gains on equity (before 2000) and housing provided to run up debt and leverage to maintain living standards as their real incomes stagnated or fell.
5. As a share of GDP, foreign net lending to the US increased by around seven percentage points, “twinned” to rising household net borrowing. By the mid-2000s the US deficit for foreign trade and services was around 1.5% of world GDP. The rest of the world provided the finance, with China and other surplus economies “exporting” short term capital to the US.
6. As inflation receded, the Fed let real interest rates fall steadily from high single digit levels to near zero between the early 1980s and mid-2000s. Although prices of goods and services stabilized, falling rates along with deregulation stimulated the booms in equity and housing prices. The ratios of assets and liabilities of the financial sector to national wealth more than doubled between 1980 and 2005, underlying the expansion of destabilizing derivatives and speculation. The market was ripe for a shake-out, and deregulation set the stage for a major crisis. The key question is how it was transmitted to the real side.
The shifts in household behavior noted in points 3 and 4 provided the crucial links among capital gains, debt, and effective demand on the way up. Asset price reductions then forced demand to collapse. The rest of the world underwrote the run up to crisis as the US economy became an international net borrower (point 5) reliant on short-term capital inflows.
These macroeconomic factors acted together. The 25-year trends mentioned in point 2 could not persist. The shift in political economy (point 1) made them possible in the first place. In hindsight, most players can be seen as pursuing their self-interest. Some people (including Godley) came close but no one connected all the dots to foresee how their contradictory interactions would create disaster.
Lance Taylor is the Arnhold Professor of International Cooperation and Development at the New School for Social Research.
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