America's Exhausted Paradigm:: The Financial Crisis
America's Exhausted Paradigm:: The Financial Crisis
America's Exhausted Paradigm:: The Financial Crisis
50
This report traces the roots of the current financial crisis to a faulty U.S. macroeconomic
paradigm. One flaw in this paradigm was the neo-liberal growth model adopted after 1980 that relied on
debt and asset price inflation to drive demand in place of wage growth. A second flaw was the model of
U.S. engagement with the global economy that created a triple economic hemorrhage of spending on
imports, manufacturing job losses, and off-shoring of investment. Deregulation and financial excess are
important parts of the story, but they are not the ultimate cause of the crisis. Instead, they facilitated the
housing bubble and are actually part of the neo-liberal model, their function being to fuel demand growth
based on debt and asset price inflation.
As the neo-liberal model slowly cannibalized itself by undermining income distribution and
accumulating debt, the economy needed larger speculative bubbles to grow. The flawed model of global
engagement accelerated the cannibalization process, thereby creating need for a huge bubble that only
housing could provide. However, when that bubble burst it pulled down the entire economy because of the
bubble’s massive dependence on debt.
The old post–World War II growth model based on rising middle-class incomes has been
dismantled, while the new neo-liberal growth model has imploded. The United States needs a new
economic paradigm and a new growth model, but as yet this challenge has received little attention from
policymakers or economists.
The current financial crisis is widely recognized as being tied to the bursting of the
house price bubble and the debts accumulated in financing that bubble. Most commentary
has therefore focused on market failure in the housing and credit markets. But what if the
house price bubble developed because the economy needed a bubble to ensure continued
growth? In that case the real cause of the crisis would be the economy’s underlying
macroeconomic structure. A focus on the housing and credit markets would miss that.
Despite the relevance of macroeconomic factors for explaining the financial crisis,
there is resistance to such an explanation. In part, this is because such factors operate
indirectly and gradually, while microeconomic explanations that emphasize regulatory failure
and flawed incentives within financial markets operate directly. Regulatory and incentive
failures are specific, easy to understand, and offer a concrete “fixit” agenda that appeals to
politicians who want to show they are doing something. They also tend to be associated with
tales of villainy that attract media interest (such as Bernie Madoff’s massive Ponzi scheme or
the bonus scandals at AIG and Merrill Lynch). Finally, and perhaps most important, a
microeconomic focus does not challenge the larger structure of economic arrangements,
while a macroeconomic focus invites controversy by placing these matters squarely on the
table.
But, an economic crisis of the current magnitude does not occur without
macroeconomic forces. That means the macroeconomic arrangements that have governed
the U.S. economy for the past 25 years are critical for explaining the crisis. Two factors in
1
This paper was commissioned by the New America Foundations’ Economic Growth Program whose
permission to publish is gratefully acknowledged.
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particular have come into play. The first concerns the U.S. economic growth model and the
pattern of income distribution and demand generation within the U.S. economy. The second
concerns the U.S. model of global economic engagement and the structure of U.S. economic
relations within the global economy.
The impact of the neo-liberal economic growth model is apparent in the changed
character of the U.S. business cycle. 2 Before 1980, economic policy was designed to achieve
full employment, and the economy was characterized by a system in which wages grew with
productivity. This configuration created a virtuous circle of growth. Rising wages meant robust
aggregate demand, which contributed to full employment. Full employment in turn provided
an incentive to invest, which raised productivity, thereby supporting higher wages.
After 1980, with the advent of the new growth model, the commitment to full
employment was abandoned as inflationary, with the result that the link between productivity
growth and wages was severed. In place of wage growth as the engine of demand growth,
the new model substituted borrowing and asset price inflation. Adherents of the neo-liberal
orthodoxy made controlling inflation their primary policy concern, and set about attacking
unions, the minimum wage, and other worker protections. Meanwhile, globalization brought
increased foreign competition from lower-wage economies and the prospect of off-shoring of
employment.
The new neo-liberal model was built on financial booms and cheap imports. Financial
booms provide consumers and firms with collateral to support debt-financed spending.
2
Thomas I. Palley, “The Questionable Legacy of Alan Greenspan,” Challenge 48 (November-December
2005): 17–31.
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Borrowing is also sustained by financial innovation and deregulation that ensures a flow of
new financial products, allowing increased leverage and widening the range of assets that
can be collateralized. Meanwhile, cheap imports ameliorate the impact of wage stagnation,
thereby maintaining political support for the model. Additionally, rising wealth and income
inequality makes high-end consumption a larger and more important component of economic
activity, leading to the development of what Ajay Kapur, a former global strategist for
Citigroup, termed a “plutonomy.”
These features have been visible in every U.S. business cycle since 1980, and the
business cycles under presidents Reagan, Bush père, Clinton, and Bush fils have robust
commonalities that reveal their shared economic paradigm. Those features include asset
price inflation (equities and housing); widening income inequality; detachment of worker
wages from productivity growth; rising household and corporate leverage ratios measured
respectively as debt/income and debt/equity ratios; a strong dollar; trade deficits; disinflation
or low inflation; and manufacturing job loss.
The changes brought about by the post-1980 economic paradigm are especially
evident in manufacturing employment (see tables 1 and 2). Before 1980, manufacturing
employment rose in expansions and fell in recessions, and each expansion tended to push
manufacturing employment above its previous peak. 3 After 1980, the pattern changes
abruptly. In the first two business cycles (between July 1980 and July 1990) manufacturing
employment rises in the expansions but does not recover its previous peak. In the two most
recent business cycles (between March 1991 and December 2007), manufacturing
employment not only fails to recover its previous peak but actually falls over the entirety of the
expansions. 4
3
The 1950s are an exception because of the Korean War (June 1950-July 1953), which ratcheted up
manufacturing employment and distorted manufacturing employment patterns.
4
Defenders of the neo-liberal paradigm argue that manufacturing has prospered and the decline in
manufacturing employment reflects healthy productivity trends. As evidence, they argue that real
manufacturing output has increased and remained fairly steady as a share of real GDP. This reflects the
fact that manufacturing prices have fallen faster than other prices. However, this is due in part to
hedonic “quality adjustment” statistical procedures that count improved information technology
embodied in manufactured goods as increased manufacturing output. It is also due to increased use of
cheap imported components that are not subject to the same hedonic statistical adjustments. As a
result, the real cost of imported inputs is understated, and that has the effect of making it look as if real
manufacturing output is higher. The stark reality is that the nominal value of manufacturing output has
fallen dramatically as a share of nominal GDP. The United States has also become more dependent on
imported manufactured goods, with imported manufactured goods making up a significantly increased
share of total manufactured goods purchased. Moreover, U.S. purchases of manufactured goods have
risen as a share of total U.S. demand, indicating that the failure lies in U.S. production of manufactured
goods which has lost out to imports (Josh Bivens, “Shifting Blame for Manufacturing Job Loss: Effect of
Rising Trade Deficit Shouldn’t Be Ignored,” EPI Briefing Paper No. 149 [Washington, DC: Economic
Policy Institute, 2004]).
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Accompanying this dramatic change in the pattern of real economic activity was a
change in policy attitudes, perhaps most clearly illustrated by the attitude toward the trade
deficit. Under the earlier economic model, policymakers viewed trade deficits as cause for
concern because they represented a leakage of aggregate demand that undermined the
virtuous circle of growth. However, under the new model, trade deficits came to be viewed as
semi-virtuous because they helped to control inflation and because they reflected the choices
of consumers and business in the marketplace. According to neo-liberal economic theory,
those choices represent the self-interest of economic agents, the pursuit of which is good for
the economy. As a result, the trade deficit was allowed to grow steadily, hitting new peaks as
a share of GDP in each business cycle after 1980. This changed pattern is illustrated in table
3, which shows the trade deficit as a share of GDP at each business cycle peak.
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The effect of the changed growth model is also evident in the detachment of wages
from productivity growth, as shown in table 4. It is also evident in rising income inequality, as
shown in table 5. Between 1979 and 2006, the income share of the bottom 40 percent of U.S.
households decreased significantly, while the income share of the top 20 percent increased
dramatically. Moreover, a disproportionate part of that increase went to the 5 percent of
families at the very top of income distribution rankings.
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Economic policy played a critical role in generating and shaping the new growth
model, and the effects of that policy boxed in workers. 5 The four sides of the neo-liberal policy
box (see figure 1) are globalization, small government, labor market flexibility, and retreat
from full employment. Workers are pressured on all four sides, and it is this pressure that led
to the severing of the wage/productivity growth link. 6
WORKERS
Globalization Small Government
5
Thomas I. Palley analyzes in detail how economic policy has impacted income distribution,
unemployment, and growth (Plenty of Nothing: The Downsizing of the American Dream and the Case
for Structural Keynesianism [Princeton, NJ: Princeton University Press, 1998]). The metaphor of a box is
attributable to Ron Blackwell of the AFL-CIO.
6
There is a deeper political economy behind the neo-liberal box that has been termed “financialization”
(Gerald Epstein, “Financialization, Rentier Interests, and Central Bank Policy,” unpublished manuscript,
Department of Economics, University of Massachusetts, Amherst, MA, December 2001; and Thomas I.
Palley, “Financialization: What It Is and Why It Matters,” in Finance-led Capitalism: Macroeconomic
Effects of Changes in the Financial Sector, ed. Eckhard Hein, Torsten Niechoj, Peter Spahn, and Achim
Truger [Marburg, Germany: Metroplis-Verlag, 2008]). The policy agenda embedded in the box is driven
by financial markets and corporations who are now joined at the hip, with corporations pursuing a
narrow financial agenda aimed at benefiting top management and financial elites.
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Globalization, in part spurred by policies encouraging free trade and capital mobility,
means that American workers are increasingly competing with lower-paid foreign workers.
That pressure is further increased by the fact that foreign workers are themselves under
pressure owing to the so-called Washington Consensus development policy, sponsored by
the International Monetary Fund (IMF) and the World Bank, which forces them into the same
neo-liberal box as American workers. Thus, neo-liberal policies not only undermine demand in
advanced countries, they fail to compensate for this by creating adequate demand in
developing countries. This is clearly evident in China which has been marked by rising
income inequality and a sharp decline in the consumption to GDP ratio. 7 The net result of
global implementation of neo-liberal orthodoxy is the promotion of deflationary global
economic conditions.
Labor market flexibility involves attacking unions, the minimum wage, unemployment
benefits, employment protections, and employee rights. This is justified in the name of
creating labor market flexibility, including downward wage flexibility, which according to neo-
liberal economic theory is supposed to generate full employment. Instead, it has led to wage
stagnation and widening income inequality.
Abandonment of full employment means having the Federal Reserve emphasize the
importance of keeping inflation low over maintaining full employment. This switch was
promoted by the economics profession’s adoption of Milton Friedman’s notion of a natural
rate of unemployment. 9 The theoretical claim is that monetary policy cannot affect long-run
equilibrium employment and unemployment, so it should instead aim for a low and stable
inflation rate. In recent years, that argument has been used to push the adoption of formal
inflation targets. However, the key real-world effect of natural rate theory has been to provide
the Federal Reserve and policymakers with political cover for higher actual unemployment,
which has undermined workers’ bargaining power regarding wages. 10
7
International Monetary Fund, “People’s Republic of China: Staff Report for the 2006 Article IV
Consultation” (Washington, DC, 2006).
8
James K. Galbraith, The Predator State: How Conservatives Abandoned the Free Market and Why
Liberals Should Too (New York: Free Press, 2008).
9
Milton Friedman, “The Role of Monetary Policy,” American Economic Review 58 (March 1968): 1–17.
The natural rate of unemployment is also referred to as the NAIRU or non-accelerating inflation rate of
unemployment.
10
Thomas I. Palley, “Seeking Full Employment Again: Challenging the Wall Street Paradigm,” Challenge
50 (November/December 2007): 14–50.
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The implementation of neo-liberal economic policies destroyed the stable virtuous circle
growth model based on full employment and wages tied to productivity growth, replacing it
with the current growth model based on rising indebtedness and asset price inflation. Since
1980, each U.S. business cycle has seen successively higher debt/income ratios at end of
expansions, and the economy has become increasingly dependent on asset price inflation to
spur the growth of aggregate demand.
Table 6 shows the rising household debt to GDP ratio and rising nonfinancial
business debt to GDP ratio under the neo-liberal growth model. Compared to the period
1960–81, the period 1981–2007 saw enormous increases in the debt/GDP ratios of both the
household and nonfinancial corporate sectors.
Non-
Household financial
GDP ($
Year debt (H) ($ H/GDP Corp debt C/GDP
billions)
billions) (C) ($
billions)
1960 526.4 215.6 0.41 201.0 0.38
1969 984.6 442.7 0.45 462.0 0.47
1973 1,382.7 624.9 0.45 729.5 0.53
1981 3,128.4 1,507.2 0.48 1662.0 0.53
1990 5,803.1 3,597.8 0.62 3,753.4 0.65
2001 10,128.0 7682.9 0.76 6,954.0 0.69
2007 13,807.5 13,765.1 1.00 10,593.7 0.77
Source: FRB Flow of Funds Accounts and author’s calculations.
Table 7 shows the rising household debt service ratio, measured as the ratio of debt
service and financial obligations to disposable personal income. That this ratio trended
upward despite declining nominal interest rates is evidence of the massively increased
reliance on debt by households.
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Table 8 shows the pattern of house price inflation over the past 20 years. 11 This table
is revealing in two ways. First, it shows the extraordinary scale of the 2001–06 house price
bubble. Second, it reveals the systemic role of house price inflation in driving economic
expansions. Over the last 20 years, the economy has tended to expand when house price
inflation has exceeded CPI (consumer price index) inflation. This was true for the last three
years of the Reagan expansion. It was true for the Clinton expansion. And it was true for the
Bush-Cheney expansion. The one period of sustained house price stagnation was 1990–95,
which was a period of recession and extended jobless recovery. This is indicative of the
significance of asset price inflation in driving demand under the neo-liberal model.
2001.q1
1987.q1 – 1990.q1 – 1995.q1 –
Period –
1990.q1 1995.q1 2001.q1
2006.q1
Average home
6.7 0.6 5.7 10.9
price inflation (%)
Average CPI
4.5 3.5 2.5% 2.5
Inflation (%)
Excess house
inflation (%) 2.2 -2.9 3.2 8.4
Along with rising debt ratios, households progressively cut back on their savings rates, as
shown in table 9. This reduction provided another source of demand.
PSR (%) 7.3 7.8 10.5 10.0 10.9 7.3 1.8 0.6
Source: Economic Report of the President, table B.30 (2009).
The logic of the neo-liberal growth model rests on redirecting income from lower- and
middle-income households to corporate profits and upper-income households. Asset prices
are bid up by a host of measures, including higher profits, savings by the super-rich that are
directed to asset purchases, borrowing to buy assets, and such institutional changes as the
shift from traditional defined benefit pension plans to defined contribution—such as 401(k)—
pension plans. Consumption is maintained by lower household savings rates and by
borrowing that is collateralized by higher asset prices. The reduction in savings rates is partly
a response to squeezed incomes and partly rationalized on the grounds that households are
wealthier because of higher asset prices (including house prices).
11
S&P/Case-Shiller index data is only available from 1987.
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The problem with the model is that it is unsustainable. Maintaining growth of spending
on consumption requires continued excessive borrowing and continued reduction in savings
rates. Continued excessive borrowing requires ever increasing asset prices and debt/income
ratios: hence, the systemic need for bubbles (which eventually burst). Meanwhile, when the
savings rate hits zero, little further reduction is possible. Consequently, both drivers of
demand eventually exhaust themselves.
The current financial crisis is different and deeper from earlier crises in two ways.
First, the impact of earlier burst bubbles—such as the 2001 stock market and dot.com
bubbles—was contained because their debt footprint was not that deep. Though financial
wealth was destroyed and economic activity was temporarily restrained, the financial system
remained intact. However, the housing bubble of 2001–07 was debt financed and massive in
size, and its bursting pulled down the entire financial system. Second, the drivers of
aggregate demand are now exhausted because of the scale debt accumulation and the
rundown of the savings rate. In earlier crises, households still had unused borrowing capacity
they could call upon and room to further reduce their saving. Both of those channels are now
exhausted, making recovery a much more difficult task. Indeed, if households try to rebuild
their financial worth that will increase savings rates, which will further deepen and prolong the
downturn.
The economic growth model adopted after 1980 lasted far longer than it might have
been expected to because of our capacity to expand access to debt and increase leverage.
That is the real significance of deregulation and financial innovation. However, delaying the
day of reckoning also made it more severe when it arrived. When the subprime detonator set
off the financial crisis, the economy’s financial structure—25 years in the making and
integrally linked to the economic logic of the neo-liberal growth model—proved to be
extremely fragile and akin to a house of cards.
Though prone to instability (i.e., to boom and bust), the neo-liberal growth model
might have operated successfully for quite a while longer were it not for a U.S. economic
policy that created a flawed engagement with the global economy. This flawed engagement
undermined the economy in two ways. First, it accelerated the erosion of household incomes.
Second, it accelerated the accumulation of unproductive debt—that is, debt that generates
economic activity elsewhere rather than in the United States.
The most visible manifestation of this flawed engagement is the goods trade deficit,
which hit a record 6.4 percent of GDP in 2006. This deficit was the inevitable product of the
structure of global economic engagement put in place over the past two decades, with the
most critical elements being implemented by the Clinton administration under the guidance of
Treasury secretaries Robert Rubin and Lawrence Summers. That eight-year period saw the
implementation of the North American Free Trade Agreement (NAFTA), the adoption after the
East Asian financial crisis of 1997 of the “strong dollar” policy, and the establishment of
permanent normal trade relations (PNTR) with China in 2000.
These measures cemented the model of globalization that had been lobbied for by
corporations and their Washington think-tank allies. The irony is that giving corporations what
they wanted undermined the neo-liberal model by surfacing its contradictions. The model
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would likely have eventually slumped because of its own internal dynamic, but the policy
triumph of corporate globalization accelerated this process and transformed it into a financial
crash.
Flawed global economic engagement created a “triple hemorrhage” within the U.S.
economy. The first economic hemorrhage, long emphasized by Keynesian economists, was
leakage out of the economy of spending on imports. Household income and borrowing was
significantly spent on imports, creating incomes offshore rather than in the United States.
Consequently, borrowing left behind a debt footprint but did not create sustainable jobs and
incomes at home.
The second hemorrhage was the leakage of jobs from the U.S. economy as a result
of offshore outsourcing, made possible by corporate globalization. Such off-shoring directly
reduced the number of higher-paying manufacturing jobs, cutting into household income.
Moreover, even when jobs did not move offshore, the threat of off-shoring could be used to
secure lower wages, thereby dampening wage growth and helping sever wages from
productivity growth. 12
The third hemorrhage concerned new investment. Not only were corporations
incentivized by low foreign wages, foreign subsidies, and under-valued exchange rates to
close existing plants and shift their production offshore, they were also incentivized to shift
new investment offshore. That did double damage. First, it reduced domestic investment
spending, hurting the capital goods sector and employment therein. Second, it stripped the
U.S. economy of modern industrial capacity, disadvantaging U.S. competitiveness and
reducing employment that would have been generated to operate that capacity.
The flawed model of global economic engagement broke with the old model of
international trade in two ways. First, instead of having roughly balanced trade, the United
States has run persistent large trade deficits. Second, instead of aiming to create a global
marketplace in which U.S. companies could sell their products, its purpose was to create a
global production zone in which U.S. companies could either produce or obtain inputs from. In
other words, the main purpose of international economic engagement was not to increase
U.S. exports, but rather to substitute cheaper imported inputs for US domestic production and
12
Kate Bronfenbrenner, Uneasy Terrain: The Impact of Capital Mobility on Workers, Wages, and Union
Organizing, Report prepared for the United States Trade Deficit Review Commission, Washington, DC,
September 2000; and Kate Bronfenbrenner and Stephanie Luce, The Changing Nature of Corporate
Global Restructuring: The Impact of Production Shifts on Jobs in the U.S., China, and Around the Globe,
Report prepared for the U.S.-China Economic and Security Review Commission, Washington, DC
October 2004.
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As a result, at the bidding of corporate interests, the United States joined itself at the
hip to the global economy, opening its borders to an inflow of goods and exposing its
manufacturing base. This was done without safeguards to address the problems of exchange
rate misalignment and systemic trade deficits, or the mercantilist policies of trading partners.
NAFTA
The creation of the new system took off in 1989 with the implementation of the
Canada-U.S. Free Trade Agreement that established an integrated production zone between
the two countries. The 1994 implementation of NAFTA was the decisive next step. First, it
fused Canada, the United States, and Mexico into a unified North American production zone.
Second, and more importantly, it joined developed and developing economies, thereby
establishing the template U.S. corporations wanted.
NAFTA soon highlighted this new dynamic because Mexico was hit by a financial
crisis in January 1994, immediately after the implementation of the free trade agreement. To
U.S. corporations, which had invested in Mexico and planned to invest more, the peso’s
collapse versus the dollar was a boon as it made it even more profitable to produce in Mexico
and re-export to the United States. With corporate interests driving U.S. economic policy, the
peso devaluation problem went unattended—and in doing so it also created a critical
precedent.
The effects of NAFTA and the peso devaluation were immediately felt in the U.S.
manufacturing sector in the form of job loss; diversion of investment; firms using the threat of
relocation to repress wages; and an explosion in the goods trade deficit with Mexico, as
shown in table 10. Whereas prior to the implementation of the NAFTA agreement the United
States was running a goods trade surplus with Mexico, immediately afterward the balance
turned massively negative and kept growing more negative up to 2007.
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Table 10. US Goods Trade Balance with Mexico Before and After
NAFTA ($ billions)
These features helped contribute to the jobless recovery of 1993–96, though the
economy was eventually able to overcome this with the stock market bubble that launched in
1996; the emergence of the Internet investment boom that morphed into the dot.com bubble;
and the tentative beginnings of the house price bubble, which can be traced back to 1997.
Together, these developments spurred a consumption and investment boom that masked the
adverse structural effects of NAFTA.
The next fateful step in the flawed engagement with the global economy came with
the East Asian financial crisis of 1997, which was followed by a series of rolling financial
crises in Russia (1998), Brazil (1999), Turkey (2000), Argentina (2000), and Brazil (2000). In
response to these crises, Treasury secretaries Rubin and Summers adopted the same policy
that was used to deal with the 1994 peso crisis, thereby creating a new global system that
replicated the pattern of economic integration established with Mexico. 13
Large dollar loans were made to the countries in crisis to stabilize their economies. At
the same time, the collapse of their exchange rates and the appreciation of the dollar was
accepted and institutionalized in the form a “strong dollar” policy. 14 This increased the buying
power of U.S. consumers, which was critical because the U.S. consumer was now the
lynchpin of the global economy, becoming the buyer of first and last resort. 15
The new global economic architecture involved developing countries exporting their
production to the United States. Developing countries embraced this export-led growth
solution to their development problem and were encouraged to do so by the IMF and the
World Bank. For developing countries, the new system had a number of advantages,
including the ability to run trade surpluses that allowed them to build up foreign exchange
holdings to defend against capital flight; providing demand for their output, which led to job
13
It cannot be overemphasized that the policies adopted by Treasury secretaries Robert Rubin and
Lawrence Summers reflected the dominant economic paradigm. As such, Rubin and Summers had the
support of the majority of the U.S. political establishment, the IMF and the World Bank, Washington’s
premier think tanks, and the economics profession.
14
China had already gone this route with a large exchange rate devaluation in 1994. Indeed, there is
reason to believe that that devaluation contributed to hatching the East Asian financial crisis by putting
other East Asian economies under undue competitive pressures and diverting foreign investment from
them to China.
15
The strong dollar policy was also politically popular, constituting a form of exchange rate populism.
Boosting the value of the dollar increased the purchasing power of U.S. consumers at a time when their
wages were under downward pressure due to the neo-liberal model. Households were under pressure
from globalization, yet at the same time they were being given incentives to embrace it. This is why neo-
liberalism has been so hard to tackle politically.
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creation; and providing access to U.S. markets that encouraged MNCs to redirect investment
spending toward them. The latter was especially important as it transferred technology,
created jobs, and built up developing country manufacturing capacity.
U.S. multinationals were also highly supportive of the new arrangement as they now
gained global access to low-cost export production platforms. Not only did this mean access
to cheap foreign labor, but the overvalued dollar lowered their foreign production costs,
thereby further increasing profit margins. Large importers, like Wal-Mart, also supported this
arrangement. Furthermore, many foreign governments offered subsidies as an incentive to
attract foreign direct investment (FDI).
In effect, the pattern of incentives established by the response to the East Asian
financial crisis encouraged U.S. corporations to persistently downsize their U.S. capacity and
shift production offshore for import back to the United States. This created a dynamic for
progressively eroding U.S. national industrial capacity, while foreign economies were
encouraged to steadily expand their capacity and export their way out of economic difficulties.
As with NAFTA, the adverse effects of this policy were visible almost immediately. As
shown in table 11, the goods trade deficit took a further leap forward, surging from $198.4
billion in 1997 to $248.2 billion in 1998, and rising to $454.7 billion in 2000. In addition, as
shown in table 12, there was a surge in imports from Pacific Rim countries. Part of the surge
in the trade deficit was due to the boom conditions sparked by stock market euphoria, the
dot.com bubble, and house price inflation, but the scale of the trade deficit surge also reflects
the flawed character of U.S. engagement with the global economy.
The proof of this claim is that manufacturing employment started falling despite boom
conditions in the U.S. economy. Having finally started to grow in 1996, manufacturing
employment peaked in March 1998 and started declining three full years before the economy
went into recession in March 2001. That explains why manufacturing job growth was negative
over the entirety of the Clinton expansion, a first in U.S. business cycle history.
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As with NAFTA, these adverse effects were once again obscured by positive
business cycle conditions. Consequently, the Clinton administration dismissed concerns
about the long-term dangers of manufacturing job loss. Instead, the official interpretation was
that the U.S. economy was experiencing—in the words of senior Clinton economic policy
advisers Alan Blinder and Janet Yellen—a “fabulous decade” significantly driven by policy. 16
According to the ideology of the decade, manufacturing was in secular decline and destined
for the dustbin of history. The old manufacturing economy was to be replaced by a “new
economy” driven by computers, the Internet, and information technology.
Though disastrous for the long-run health of the U.S. economy, NAFTA-style
corporate globalization, plus the strong dollar policy, was extremely profitable for
corporations. Additionally, the ultimate costs to households were still obscured by the ability of
the U.S. economy to generate cyclical booms based on asset price inflation and debt. That
provided political space for a continued deepening of the model, the final step of which was to
incorporate China as a full-fledged participant. Thus, corporations now pushed for the
establishment of permanent normal trading relations with China, which Congress enacted in
2000. That legislation in turn enabled China to join the World Trade Organization, which had
been established in 1996.
The significance of PNTR was not about trade, but rather about making China a full-
fledged part of global production arrangements. China had enjoyed access to the U.S. market
for years and its entry into the WTO did generate some further tariff reductions. However, the
real significance was that China became a fully legitimate destination for foreign direct
investment. That is because production from China was now guaranteed permanent access
to the U.S. market, and corporations were also given internationally recognized protections of
property and investor rights.
Once again the results were predictable and similar to the pattern established by
NAFTA—though the scale was far larger. Aided by a strong dollar, the trade deficit with China
increased dramatically after 2001, growing at a rate of 25 percent per annum and jumping
from $83.1 billion in 2001 to $201.5 billion in 2005 (see table 13). Moreover, there was also
massive inflow of foreign direct investment into China so that it became the world’s largest
recipient of FDI in 2002—a stunning achievement for a developing country. 17 So strong was
China’s attractiveness as an FDI destination that it not only displaced production and
investment in the United States but also displaced production and investment in Mexico. 18
16
Alan S. Blinder and Janet L. Yellen, The Fabulous Decade: Macroeconomic Lessons from the 1990s
(New York: Century Foundation Press, 2001). To the extent there was concern in the Clinton
administration about manufacturing, it was about the hardships for workers regarding job dislocations.
Additionally, there was political concern that produced some sweet talk (i.e., invitations to policy
consultations) aimed at placating trade unions. However, there was no concern that these outcomes
were due to flawed international economic policy. Not only did this policy failure contribute to eventual
disastrous economic outcomes, it may well have cost Vice President Al Gore the 2000 presidential
election. The Clinton administration’s economic advisers may have downplayed the significance of
manufacturing job loss but blue-collar voters in Ohio did not.
17
“China Ahead in Foreign Direct Investment,” OECD Observer, No. 237, May 2003.
18
William Greider, “Á New Giant Sucking Sound,” The Nation, December 13, 2001.
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Table 13. US Goods Trade Balance with China Before and After PNTR
($ billions)
According to academic and Washington policy orthodoxy, the new global system was
supposed to launch a new era of popular shared prosperity. Demand was to be provided by
U.S. consumers. Their spending was to be financed by the “new economy” based on
information technology and the globalization of manufacturing, which would drive higher
productivity and income. Additionally, consumer spending could be financed by borrowing and
asset price inflation, which was sustainable because higher asset prices were justified by
increased productivity.
This new orthodoxy was enshrined in what was termed the “New Bretton Woods
Hypothesis,” according to which the global economy had entered a new golden age of global
development, reminiscent of the postwar era. 19 The United States would import from East
Asian and other developing economies, provide FDI to those economies, and run large trade
deficits that would provide the demand for the new supply. In return, developing countries
would accumulate financial obligations against the United States, principally in the form of
Treasury securities. This would provide them with foreign exchange reserves and collateral
that was supposed to make investors feel secure. China was to epitomize the new
arrangement. 20
The reality is that the structure of U.S. international engagement, with its lack of
attention to the trade deficit and manufacturing, contributed to a disastrous acceleration of the
contradictions inherent in the neo-liberal growth model. That model always had a problem
regarding sustainable generation of demand because of its imposition of wage stagnation and
high income inequality. Flawed international economic engagement aggravated this problem
by creating a triple hemorrhage that drained consumer spending, manufacturing jobs, and
investment and industrial capacity. This in turn compelled even deeper reliance on the
unsustainable stopgaps of borrowing and asset price inflation to compensate.
19
Michael P. Dooley, David Folkerts-Landau, and Peter Garber, “An Essay on the Revised Bretton
Woods System,” Working Paper 9971 (Cambridge, MA: National Bureau of Economic Research,
September 2003); Dooley, Folkerts-Landau, and Garber, “Direct Investment, Rising Real Wages, and
the Absorption of Excess labor in the Periphery,” Working Paper 10626 (Cambridge, MA: National
Bureau of Economic Research, July 2004); and Dooley, Folkerts-Landau, and Garber, “The US Current
Account Deficit and Economic Development: Collateral for a Total Return Swap,” Working Paper 10727
(Cambridge, MA: National Bureau of Economic Research, August 2004.
20
For a critique of the New Bretton Woods hypothesis that explains why it was unsustainable see
Thomas I. Palley, “The Fallacy of the Revised Bretton Woods Hypothesis: Why Today’s System Is
Unsustainable and Suggestions for a Replacement,” Public Policy Brief No. 85, The Levy Economics
Institute of Bard College, 2006.
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concertina effect: when the U.S. economy crashed, other economies came crashing in
behind. 21
The twin macroeconomics factors of an unstable growth model and of flawed global
economic engagement were put in place during the 1980s and 1990s. However, their full
adverse effects took time to build and the chickens only came home to roost in the 2001–07
expansion. From that standpoint, the Bush-Cheney administration is not responsible for the
financial crisis. Its economic policies can be criticized for mean-spiritedness and a greater
proclivity for corporate favoritism, but they represented a continuation of the policy paradigm
already in place. The financial crisis therefore represents the exhaustion of that paradigm
rather than being the result of specific policy failures on the part of the Bush-Cheney
administration.
In a nutshell, the US implemented a neo-liberal growth model that relied on debt and
asset price inflation. As the neo-liberal model slowly cannibalized itself and became weaker,
the economy needed larger speculative bubbles to grow. The flawed model of global
engagement accelerated the cannibalization process, thereby creating need for a huge
bubble that only housing could provide. However, when that bubble burst it pulled down the
entire economy because of the bubble’s massive dependence on debt.
In many regards the neo-liberal paradigm was already showing its limits in the 1990s.
An extended jobless recovery marked the business cycle of the 1990s when the term was
coined and the boom was accompanied by a stock market bubble and the beginnings of
significant house price inflation.
The recession of 2001 saw the bursting of the stock market and dot.com bubbles.
However, although investment spending was hit hard, consumer spending was largely
untouched, owing to continued household borrowing and continued moderate increases in
home prices. Additionally, the financial system was largely unscathed because the stock
market bubble involved limited reliance on debt financing.
Yet, despite the relative shallowness of the 2001 recession and aggressive monetary
and fiscal stimulus, the economy languished in a second extended bout of jobless recovery.
The critical factor was the trade deficit and off-shoring of jobs resulting from the model of
globalization that had been decisively implemented in the 1990s. This drained spending, jobs,
and investment from the economy, and also damped down wages by creating job insecurity.
The effects are clearly visible in the data for manufacturing employment.
Manufacturing employment peaked in March 1998, shortly after the East Asian financial crisis
and three years before the economy went into recession. Thereafter, manufacturing never
really recovered from this shock and continued losing jobs throughout the most recent
expansion (see table 14).
21
Thomas I. Palley, “The Economic Concertina,” Comment Is Free, September 7, 2008,
http:/www.guardian.co.uk/commentisfree/2008/sep/07/economicgrowth.useeconomicgrowth?gusrc=rss&
feed=worldnews.
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The failure to develop a robust recovery, combined with persistent fears that the
economy was about to slip back into recession, prompted the Federal Reserve to lower
interest rates. Beginning in November 2000, the Fed cut its federal funds rates significantly,
lowering it from 6.50 percent to 2.10 percent in November 2001. However, the weakness of
the recovery drove the Fed to cut the rate still further, pushing it to 1.00 percent in July 2003,
where it was held until June 2004.
A housing bubble was particularly economically effective for two reasons. First,
housing ownership is widespread so the consumption wealth effects of the bubble were also
widespread. Second, higher house prices stimulated domestic construction employment by
raising prices above the cost of construction. Moreover, the housing bubble was a form of
“house price populism” that benefitted incumbent politicians who could claim credit for the
fictitious wealth created by the bubble.
The Federal Reserve is now being blamed by many for the bubble, 22 but the reality is
that it felt compelled to lower interest rates for fear of the economy falling back into recession.
Additionally, inflation—which is the signaling mechanism the Federal Reserve relies on to
assess whether monetary policy is too loose—showed no indication of excess demand in the
economy. Indeed, all the indications were of profound economic weakness. Finally, when the
Federal Reserve started raising the federal funds interest rates in mid-2004, the long-term
rate that influences mortgages changed little. In part this may have been due to recycling of
22
John B. Taylor, “How Government Created the Financial Crisis,” Wall Street Journal, February 9,
2009.
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foreign country trade surpluses back to the United States, but in part it likely reflected
underlying weak economic conditions.
Number of Cycles 10 10 4
RANK OF 2001-07
CYCLE
GDP growth 10 8 4
Consumption growth 9 9 4
Investment growth 10 9 4
Employment growth 10 9 4
Manufacturing
10 10 4
employment growth
Profit growth 4 2 1
Compensation growth 10 9 4
Change in
9 5 4
unemployment rate
Change in
10 10 4
Emp/population ratio
Source: Josh Bivens and John Irons, “A Feeble Recovery: The Fundamental Economic Weaknesses of the 2001–07
Expansion,” EPI Briefing Paper No. 214 (Washington, DC: Economic Policy Institute, December 2008); and author’s
calculations.
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Recognizing the role of macroeconomic factors in the current crisis raises critical questions.
Deregulation and massive unsound lending by financial markets are important parts of the
crisis story, but they were not the ultimate cause of the crisis. Instead, they facilitated the
bubble and are better understood as being part of the neo-liberal model, their function being
to support demand growth based on debt and asset price inflation.
At this stage, repairing regulatory and microeconomic incentive failures can limit
future financial excess. However, it will do nothing to address the problems inherent in the
neo-liberal U.S. growth model and pattern of global economic engagement. Worse, focusing
on regulation diverts attention from the bigger macroeconomic challenges by misleadingly
suggesting that regulatory failure is the principal cause of the crisis.
The case for paradigm change has yet to be taken up politically. Those who built the
neo-liberal system remain in charge of economic policy. Among mainstream economists who
have justified the neo-liberal system, there has been some change in thinking when it comes
to regulation, but there has been no change in thinking regarding the prevailing economic
paradigm. This is starkly illustrated in the debate in the United States over globalization,
where the evidence of failure is compelling. Yet, any suggestion that the United States should
reshape its model of global economic engagement is brushed aside as “protectionism.”, which
avoids the real issue and shuts down debate.
That leaves open the question of what will drive growth once the economy stabilizes.
The postwar growth model based on rising middle-class incomes has been dismantled, while
the neo-liberal growth model has imploded. Moreover, stripping the neo-liberal model of
financial excess by means of regulation and leverage limits will leave it even more impaired.
The U.S. economy needs a new growth model.
The outlines of that new model are easy to see. The most critical need is to restore
the link between wages and productivity growth that drove the 1945–80 virtuous circle model
of growth. This will require creating a new policy box that takes workers out and puts
corporations in.
The outlines of such a box are easy to envisage and involve restoration of worker
bargaining power in labor markets through strengthened unions, a higher minimum wage, and
stronger employee protections; restoration of full employment as a macroeconomic policy
objective; restoration of the legitimacy of regulation and increased government provision of
public goods; a new international economic accord that addresses the triple hemorrhage
problem created by the flawed model of global economic engagement; and reform of financial
markets and corporate governance that ensures markets and corporations work to promote
national economic well-being.
While the economics are clear, the politics are difficult, which partially explains the
resistance to change on the part of policymakers and economists aligned with the neo-liberal
model. The neo-liberal growth model has benefitted the wealthy, while the model of global
economic engagement has benefitted large multinational corporations. That gives these
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powerful political interests, with their money and well-funded captive think tanks, an incentive
to block change. 23
Judging by its top economics personnel, the Obama administration has decided to
maintain the system rather than change it. The administration may yet manage to create
another bubble, this time probably an interest-rate bubble in Treasury bonds that will weakly
jump-start the borrowing cycle one more time. However, that will not fix the underlying
structural problem, and delay may make its resolution more difficult by creating new financial
facts in the form of more debt. Most importantly, even if the neo-liberal model is revved up
one more time, it will not deliver shared prosperity because it was never constructed to do so.
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________________________________
SUGGESTED CITATION:
Thomas I. Palley, “America’s Exhausted Paradigm”, real-world economics review, issue no. 50, 8 September 2009,
pp. 52-74, http://www.paecon.net/PAEReview/issue50/Palley50.pdf
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