A post-Keynesian take on the causes of the crisis, and on hopes for recovery
by Tim Bending, 16 February 2010
The global economic crisis is popularly blamed on the recklessness of bankers, and on the financial de-regulation and loose monetary policy that allowed them to be so reckless. The cause of the crash is found to be human error in medium-term economic management. The characteristic position of the centre-left is therefore to demand tougher controls, to ensure that such an accident doesn't happen again.
If there is a centre-left ideal, in fact, it is perhaps to return to a happier period in Capitalism's history: the postwar years of social-democratic, Keynesian consensus, when unemployment was low and prosperity more widespread. The whole "Anglo-Saxon" model, from Reagan and Thatcher onwards, is seen as an unfortunate deviation from good economic management. We could, and should, just turn back the clock. But could we? And would the re-regulation of finance be enough?
There is a viewpoint that sees the "Golden Age" of capitalism as dependent on a number of conditions that created strong aggregate demand. The origins of the current crisis are seen in the passing of those conditions from the late 1960's to the present, leading to a long period of underlying stagnation, excessive savings and unsustainable bubble economics. Such an interpretation of post-war economic history would lead us to certain conclusions: that re-regulation will not restore demand and is not enough; that the key to restoring demand, and therefore to sustainable recovery, is the creation of an economically fairer society; and that, in the long term, we may face questions about the viability of our current financial system as a tool for managing ageing societies with increasingly saturated consumer markets.
Explaining capitalism's "Golden Age"
This viewpoint is exemplified by a recent book: The Great Financial Crisis: Causes and Consequences by John Bellamy Foster and Fred Magdoff (Monthly Review Press, 2009). It is a collation of articles tracking the latest crisis from 2006 onwards. Their work is based on that of liberal, "post-Keynesian" socialists, Paul Baran, Paul Sweezy and Harry Magdoff, from the 1960's through to the 80's. In 1966, while mainstream economics congratulated itself on having solved the problems of unemployment and instability, Baran and Sweezy argued (in Monopoly Capital) that such periods of relative prosperity are the exception in industrialised capitalist economies, rather than the norm. The "Golden Age" of capitalism – an "Age" that lasted a whole two decades – was created by a conjunction of conditions that sustained strong aggregate demand.
To an extent, these conditions were a hangover from the Great Depression and the Second World War. They sustained both strong state spending, and a what Keynes called a high "propensity to consume", which corresponds to a low relative desire for savings. These conditions included an accumulation of personal savings after the war years, state spending on the cold war, and relative financial security, thanks to economic stability and the welfare state. They also included relatively low income inequality thanks to low unemployment, high relative wages, and welfare state policies. Poor people tend to consume more of their incomes than rich people, so decreasing inequality takes money away from those most likely to save it (the rich) and gives it to those most likely to spend it. The "Golden Age" also followed a long period, since 1929, when consumption had been weak, but in which technology and production techniques advanced considerably. It was a time of lifestyle-changing consumption for ordinary families; a time when they bought their first car, their first suburban house, their first washing machine and television. The big difference people could make to their lives through consumption was arguably an important factor stimulating consumer demand. In Europe and Japan, the postwar years were also a time of massive rebuilding for both firms and households.
The "Golden Age" becomes leaden
In the late 1960's the situation began to deteriorate. The first critical change may have been the gradual saturation of consumer markets. People had their cars and suburban houses. Buying a second car, house, washing machine or television, just doesn't provide the same utility as buying the first one. This is the same reason why rich people tend to save more; the more stuff we have, the less we benefit from buying each new thing. Consumption, as a strategy for achieving happiness, suffers from diminishing returns. Another gradual change, not yet mentioned, is the ageing and increasing life-expectancy of populations in industrialised countries: Saving is encouraged by rising expectations of future retirement and care needs. As the "perfect storm" of demand-stimulating conditions subsided through the 1970's, the leading industrialised economies returned to a state of stagnation, what economist Joan Robinson called the "Leaden Age".
But why should an increasing desire for savings, relative to consumption, lead to lower growth? Foster and Magdoff rather gloss over this, yet it is the key point of contention between Keynes and neo-classical economics. The latter has a habit of assuming that increased savings must be converted into increased productive investment leading to increases in output, employment and demand. But it is not necessary to get into the circular arguments about Say's Law (that "supply creates its own demand") to see that savings can have other places to go, and must not necessarily contribute to growth.
A second possible outlet for savings is hoarding. Stuffing cash under the mattress is more an allegorical problem than a real one, but banks building up reserves is more significant. Theoretically, in the long term, this should have little effect on demand as monetary policy or deflation should be able to restore liquidity, but in the short-term it can hurt demand. Keynes, in fact, really focused on the short-run possibility of excessive savings and falling demand tipping and economy into recession, and the possibility that a market economy may not be able to correct such an imbalance for extended periods of time, as in the Great Depression. Hence he promoted counter-cyclical deficit spending by governments to prevent economies getting too far out of balance in the first place, and to dig them out a of hole when they did. But here we are talking about a long-term decline in the "propensity to consume" which is a different kind of problem. Hoarding does not seem to be the long-term "escape valve" for excessive savings that have built up.
A third possibility is investment that leads to a decline in output. Savings can be invested in increasing productivity to cut costs and protect profits, yet without increasing output. Such investment can absorb savings yet lead to a reduction in employment, demand and even output, fuelling a recessionary spiral.
A fourth is asset price inflation. Savings may be invested speculatively, inflating asset price bubbles (e.g. in real estate or shares). Cash savings are exchanged for a promise of future wealth. This promise turns out to be false for all those holding the assets when the bubble inevitably bursts. Demand can be expected to decline in the future when people find out they are not as rich as they thought they were, and as they increase saving to compensate for the savings they suddenly find they don't have. Asset price inflation thus has the effect of maintaining demand in the present (cash savings are returned into circulation), at the expense of demand in the future.
A fifth is consumer borrowing. This is closely linked to asset price inflation because of the use of assets such as houses as collateral. Lending for consumption converts one person's savings into the disposable income of another. Again, this maintains demand in the present at the expense of demand in the future, and is thus unsustainable. In the future, there must either be a shift from borrowing to debt repayment, impacting future demand, or borrowers must default. Default means that the promises of future wealth bought with cash savings turn out to be false, also impacting future demand.
A last outlet for savings is public borrowing. This is not a direct effect of increasing savings, but a knock-on effect of declining demand. It is almost automatic when tax returns fail to meet expectations, but deliberate when governments attempt to ride-out downturns they hope are merely cyclical. Again, the effect is to bring forward demand from the future.
There is thus no law that more savings will lead to more useful investment and more growth. This attractive scenario is theoretically possible, but arguably increasingly difficult for mature industrialised economies. It depends on growth being consistently high enough to absorb rising savings, irrespective of the rate of technological advance and population growth. There is little room for external shocks like the oil shocks of the 1970's. It also depends on a high degree of business confidence; "entrepreneurs" must play a "prisoner's dilemma" game in which they must base their decisions upon a prediction of what other entrepreneurs will do. In this game, the best outcome for all players occurs when all bet on growing demand, and therefore invest in expanding output. Yet in betting on such growth, players also risk ending up with the worst possible outcome: investing in expansion just before a slump. The outcome all depends on what the other players do. In this context, it is quite rational for all players to bet on decline and invest defensively in cutting costs and protecting profits without expanding output.
Demand is borrowed from the future
So what actually happened? Foster and Magdoff are at their best in tracking the long-term trends that followed, focused on the US. The key trend, taking-off in the 1980's, has been a massive accumulation of debt by households, firms, financial institutions and (in the case of the US) government. Total outstanding debt in the US rose from 154% of GDP in 1970, to 373%, or nearly $53 trillion, at its latest peak in Q1 2009 (http://www.federalreserve.gov/releases/z1/Current/, table L1; http://www.gpoaccess.gov/eop/tables10.html, table B-1).
This trend has been accompanied by the rise of the FIRE sector (Finance, Insurance and Real Estate). In the decade of the 1960's in the US, the financial sector accounted for an average 15% of domestic corporate profits. The 2000-2008 average was 35%, peaking at 43.8% (http://www.gpoaccess.gov/eop/tables10.html, table B-91). This period has also seen massive asset price inflation. The evidence for the systematic, unsustainable over-valuation of assets is the worsening series of crises. We can list the stock market crash of 1987, the US Savings and Loans Crisis (1989-91), the Asian financial crisis (1997-8), the dot.com crash (2000) and, of course, the "sub-prime" crisis. Each time, so far, governments and central banks have been able to play their function as lender of last resort and have re-floated/inflated the markets, principally through a monetary policy of providing ever cheaper credit.
It is clear that the leading industrialised economies have suffered from a persistent, long-term excess of savings over and above the amount that the weakly growing "real economy" has been able to absorb. Instead, these savings have fuelled asset price inflation and consumer borrowing. The effects have been felt differently in different countries. This has probably been partly due to differing and evolving cultural attitudes to saving and indebtedness. In the United States, the UK, and other countries like Spain and Ireland, this flood of excess savings has fuelled a debt-driven consumer boom. The rich in these countries have got a lot richer and have saved like never before, while well-off professionals have saved heavily for retirement. Meanwhile, lower income groups – groups who are still struggling with life-changing consumption milestones like owning your own home – have been encouraged to borrow to an unprecedented degree. Levels of personal debts that would have been culturally unacceptable as recently as the 1970's have become an everyday fact of life.
In Japan, by contrast, inflated markets in real-estate and shares burst terminally in the early 1990's. Since then, Japan has been mired in stagnation, with the state unable to curb savings and stimulate demand. In Germany, bubble markets never really got off the ground. Both Germany and Japan have suffered from persistent high domestic savings and weak domestic demand, and have only achieved moderate growth through export to the consumer-boom countries like the US. China is more paradoxical. Its level of development would suggest unsaturated consumer markets, yet development has been very unequal and its culture, like that of Germany and Japan, seems to promote savings. China, like Germany and Japan, has weak domestic demand, a high savings rate and export-led growth. All three have lent a large proportion of their savings to the US and other trade-deficit countries. The US and UK have seemed obsessed with consumption. Indeed, there was a consumption-led boom. But nonetheless, this consumption has simply been fuelled by the excessive savings of others. Demand has been high, but it has been demand brought forward from the future.
These trends are obviously unsustainable. So far, governments and central banks have always been able to
prevent collapse, but with interest rates at rock-bottom and unprecedented quantitative easing failing to provide much stimulus to the real economy, monetary policy appears to be running out of ammunition. The last remaining option for governments is deficit spending, though some, like Greece, are already facing difficulties financing their deficits. It remains to be seen how long markets will finance the deficits of the major industrial economies.
What is to be done?
If this viewpoint is correct, it will have three main implications:
1. Re-regulation is not enough. The current crisis is not a simple result of policy errors. It was not caused by the behaviour of financial institutions or the de-regulation of what they do. I think it is safe to suppose that this de-regulation took place because it was in the short-term interest of politicians and their backers to facilitate the emerging trends, with little understanding of the long-term consequences. Tighter controls of the financial sector, including measures to curb asset price inflation, would be desirable. They might increase the likelihood that future savings are invested in the real economy by reining in the alternatives posed by speculation. But even this would do nothing to ensure that the real economy offers attractive investment opportunities. Until that happens, non-debt-dependent growth will be elusive.
2. Recovery requires redistribution. An orderly unwinding of today's massive debts and imbalances will only be possible through a recovery of demand, and one that is not fuelled by debt. For three decades, demand has been stimulated by huge transfers of wealth, both from the rich to the poor and from savings-oriented countries to consumption-oriented ones. The problem is that the money must be paid back. But demand can just as well be stimulated by a redistribution of wealth that does not need to be paid back. While we cannot fully re-create the conditions that helped create capitalism's "Golden Age", we could turn back the clock on the growing economic inequality of recent decades. The tools for doing this include legislation (minimum wage, caps on bonuses, etc.) and a more heavily redistributive fiscal system. The latter could also seek to stimulate demand through state spending on infrastructure (e.g. a Green New Deal) and through seeking to create greater financial security in the face of old age, unemployment and ill-health, reducing the desire for personal savings. It needs to be emphasised that such measures cannot be financed by public borrowing, but only by more progressive taxation. We are not talking about a cyclical problem to be addressed by anti-cyclical deficit spending, but a structural problem requiring a structural response.
3. In the face of ageing populations and saturated markets, a more radical rethink may be needed. A fairer version of capitalism might yet breath life into the moribund economies of the West, but for how long? It would begin by helping the poor to catch up on consumption, but would end up making us all richer and all more inclined to save. The problem of ageing societies will not go away. It is not clear that our current financial system is well suited to managing this situation.
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