From Financial Crisis to Stagnation: An Interview with Thomas Palley

Philip Pilkington: At the beginning of your book From Financial Crisis to Stagnation* you refer to the 2008 crisis as a 'crisis of bad ideas'. Could you please briefly explain why you refer to the crisis in this way?

Thomas Palley: A central and critical element of my book is its emphasis on the role of economic ideas in generating the crisis. This feature fundamentally distinguishes it from mainstream explanations that tend to represent the crisis in terms of surprise events and economic shocks (e.g. black swans).

My book starts with the fundamental idea that economies are made, not found. The way economies are organized and function is significantly the product of social choices, not the product of nature. Over the past thirty years we (society) have embraced a set of economic ideas that shaped economic arrangements – including the pattern of income distribution, the power of corporations and finance relative to labor, and the way in which the economy generates demand.

This shaping of economic arrangements was obviously driven by political forces acting on behalf of corporate and financial elite interests, but economic ideas also played a critical role. First, the ideas of mainstream economists provided justification for the re-shaping of the economy in ways that elite interests wanted. Second, mainstream economists put forward additional ideas that were picked up and incorporated into the policy project of corporate and financial elites. Third, the monopoly capture of economic discourse by mainstream economics served to exclude other competing economic ideas from making it on to the policy table, into classrooms, and into the public debate.

The implication of this view is the crisis is at a deep level the product of a flawed economic policy paradigm derived from a set of flawed economic ideas. Escaping the crisis means replacing that policy paradigm and the ideas from which it derives. That is a massive challenge involving both a political contest and an intellectual contest. We need to win both. One without the other will be useless. It is no good winning the political contest if you simply replace Tweedledum (hardcore neoliberals) with Tweedledee (softcore neoliberals). Likewise, it is no good winning the intellectual contest if you do not win the political contest to implement different economic policy ideas.

PP: In the book you distinguish between two sorts of alternative approaches to the crisis. One you term ‘Textbook Keynesianism’ and the other you term ‘Structural Keynesianism’. Could you briefly delineate the differences between the two approaches? Also, should it be understood that the two approaches overlap with different schools of economic thought?

TP: Textbook Keynesianism and structural Keynesianism both emphasize the significance of total (aggregate) demand for the determination of economic activity. That is what makes both of them forms of Keynesianism.

However, textbook Keynesianism sees the microeconomic structure of the economy as intrinsically healthy. If demand falls off, all that is needed is for policy to step in and temporarily fill the demand gap until private sector demand revives. That is the logic behind temporary fiscal stimulus and temporary easy monetary policy.

Structural Keynesianism argues that the economy’s underlying income and demand generating process can be structurally flawed. For instance, income distribution can become badly skewed, creating a permanent shortfall of demand. In that case, private sector demand will not revive and the solution is structural remaking of the economy’s income and demand generating process.

Textbook Keynesianism can be identified with neo-Keynesianism (what Joan Robinson less politely called bastard Keynesianism). It identifies the principal macroeconomic problem as price and wage rigidity. This way of thinking gradually morphed into so-called New Keynesianism, which means textbook Keynesianism and New Keynesianism overlap. However, we should be clear that New Keynesianism has little to do with Keynes’ original logic and it is more a theory of market imperfections in the spirit of Arthur Pigou, Keynes’ great rival.

Structural Keynesianism links with the work of Michal Kalecki who joined Keynes’ insights about aggregate demand with Marx’s insights about class conflict and income distribution. That means structural Keynesianism overlaps with Marxist sociological and economic analysis. However, classical Marxism views capitalist economies as destined to crisis because of a falling rate of profit. Structural Keynesianism does not.

PP: In the book you discuss various mainstream theories of the recent collapse. Without going into too much detail perhaps you could say something about the mainstream explanations of the crisis?

TP: In principle there are two alternative competing mainstream explanations of the crisis. The first is the hardcore neoliberal perspective, which can be labelled the “government failure hypothesis”. In the U.S. it is identified with the Republican Party and with the economics departments of Stanford University, the University of Chicago, and the University of Minnesota. The second is the softcore neoliberal perspective, which can be labelled the “market failure hypothesis”. In the U.S it is identified with the Obama administration and half of the Democratic Party. In Europe it is identified with the Third Way. Among economics departments it is identified with those such as Harvard, Yale and Princeton.

The government failure hypothesis maintains the crisis is rooted in the U.S. housing bubble and its bust. That bubble was due to failures 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 via the Community Reinvestment Act and Fannie Mae and Freddie Mac, drove up house prices and encouraged homeownership beyond peoples’ means. The neoliberal perspective therefore characterizes the crisis as essentially a U.S. based phenomenon.

The market failure hypothesis maintains 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 market failure hypothesis is therefore slightly more global than the government failure hypothesis, but it views the crisis as a purely financial phenomenon.

PP: Your interpretation of the present crisis is a little different, right? Could you explain it briefly please?

TP: Yes, my interpretation is different – very different. I call it the destruction of shared prosperity hypothesis. This view is not represented in mainstream economic discussions because it challenges the fundamental theoretical foundations of mainstream economics which are shared by both hardcore Chicago School (freshwater) and softcore MIT School (saltwater) neoliberal economics.

My argument is that around 1980 the U.S. adopted a fundamentally flawed economic paradigm. From 1945 through to the mid-1970s the U.S. economy was characterized by a “virtuous circle” Keynesian growth model built on full employment and wage growth tied to productivity growth. The political triumph of Ronald Reagan enshrined a new economic paradigm that abandoned full employment and severed the link between wages and productivity growth.

The new paradigm was fundamentally flawed.  One flaw was that it relied on debt and asset price inflation to fuel growth instead of wages. A second flaw was the model of globalization which created an economic gash in the form of leakage of spending on imports (the trade deficit), leakage of investment spending offshore, and leakage of manufacturing jobs offshore. These twin flaws created a growing demand gap.

That is where finance enters the picture as its role was to fill the demand gap. Financial deregulation, regulatory forbearance, financial innovation, financial mania, and plain vanilla financial fraud kept the economy going by making ever more credit available, However, as the economy cannibalized itself by undercutting income distribution and accumulating debt, it needed ever larger speculative bubbles to grow. The house price bubble was simply the last and biggest bubble and was effectively the only way around the stagnation that would otherwise have developed in 2001.

The house price bubble delayed the onset of stagnation but at a cost. When it burst it created a financial crisis because of the scale of financial excess. Moreover, it also makes it harder to escape stagnation now because of the scale of debt burdens and the extent of destruction of credit-worthiness.

PP: Your interpretation seems to make a lot more sense than the competing theories, which appear to me reductionist. Why do you think that your colleagues – especially your left-leaning colleagues – are missing the bigger picture?

TP: Thanks, Philip. That is a very good and difficult question. It is key to understanding why the crisis has so far generated little change in economics and economic policy.
There are many mainstream (orthodox) economists who have progressive values but they miss the big picture because their theory cannot accommodate it. Moreover, they can’t abandon their theory for a host of psychological and sociological reasons. At the psychological level it would involve a devastating admission that they have been wrong; that they’ve been teaching their students a lot of nonsense for thirty years. At the sociological level it would mean giving up the trappings of power and pay that go with their current intellectual monopoly because the paymasters of the system would quickly replace them with others.

That said, many mainstream economists are starting to admit income distribution has played a role in fermenting the crisis (you have to be willfully blind not too see it). Consequently, they are busy trying to incorporate income distribution into their narrative. However, they do so in a way that leaves their core theory about markets and market efficiency unchanged. Unfortunately, journalists and the general public cannot see this and are taken in by this tactic. One of the contributions of the book is it unmasks these obfuscations by showing how these stories don’t stack up and are inconsistent with the evidence.

Finally, this discussion shows why it is very important the general public be capable of distinguishing between “values” and “analysis”. If not, people risk being fooled by the rhetoric of progressive values that provides cover for policies that are actually conservative.

PP: In the book you provide a very clear description of what actually occurred in the financial market in 2008. Reading it I thought that a lot of people – myself included – have never really put the pieces together in their own minds. Maybe you could summarise the key events briefly?

TP: The mechanics of the crisis within the U.S. financial system are actually quite simple and can be understood as a six step process. Step one was the build-up of toxic loans over several years. Step two was when loans eventually started turning sour with the bursting of the house price bubble in 2007, causing loan losses. Step three was the destruction of bank equity caused by mounting loan losses. This process began in the so-called “shadow banking system” and then moved into the Wall Street investment banks and the established commercial banking sector. Step four was the resulting threat of bank defaults triggered by equity destruction. Step five was the rush to cash spurred by the threat of default. That caused a liquidation trap as agents tried to sell financial assets to raise cash, which deepened the extent of asset price declines and caused further equity losses. Step six was the run in the commercial paper market immediately after the collapse of Lehman brothers (September 2008) whereby banks and financial institutions became unwilling to lend to each other. That put every bank (including Goldman Sachs) on the verge of default, prompting the Federal Reserve to step in and de facto take over the commercial paper market by acting as lender of last resort.

PP: In the book you mention the commodities bubble that blew up in the 2008 financial crisis a number of times. Many commodities – oil included – are nearly back at their 2008 levels. Do you think that this could be due to speculation? If so, why on earth are the US government allowing this?

TP: I firmly believe speculation is a significant part of the run up in commodity prices, particularly oil. Over the last decade there has been tremendous change in the character of commodity market participants. In the past, the market consisted of producers, end-users, and traders intermediating between these groups. Now, the market has been invaded by financial investors in the form of pension funds, endowment managers, hedge funds acting on behalf of high net worth individuals, investment bank entities trading on their own account, and exchange traded funds (ETFs) for ordinary punters who want to speculate on commodities. This transformation represents the ‘financialization’ of commodity markets and it has resulted in a tsunami of money chasing commodities as a speculative investment vehicle. After causing a bubble and a bust in 2008, it has again pushed up oil prices.

The fingerprints of speculation are all over the oil market: large one day price spikes and plunges that cannot possibly be explained by changes in economic fundamentals; high prices in the face of large and growing inventories; storage in unconventional forms like idle super-tankers; and investment banks like Goldman Sachs purchasing oil storage capacity in places like Cushing, Oklahoma.

Why have the Federal Government and Congress done little about this? Two reasons. First, Wall Street, the banks, and oil companies are big beneficiaries from these developments and they (as everyone knows) are some of the most powerful vested political interests. Money talks in politics and they have the money. Second, economists have been disastrous on this issue, continuously denying the role of speculation. The depth of this denial is evidenced by the fact that even the often critical and insightful Paul Krugman has consistently denied the role of speculation. This provides yet another example of the role of bad economic ideas in the destruction of shared prosperity.

PP: Many economists and politicians seek to blame the Fed for the housing bubble and the financial crisis. In your book you say that this is misleading. Why do you think this?

TP: In my view the Fed is both to blame and not to blame for the crisis.

The Fed is to blame because it strongly supported the over-arching neoliberal economic program that is the ultimate cause of the crisis. Its support for the neoliberal program is most evident in its support for financial deregulation, support for self-regulation, and opposition to regulation of financial innovations such as derivatives. Had the Fed not held these beliefs and done its job properly, the excesses of the sub-prime market and the house price bubble would likely have been significantly prevented. Alan Greenspan was the booster-in-chief but almost every member of the board of governors and the roster of economists working in the Fed deserve blame. They all sung from the same song book and were deaf to other music saying inflation targeting was not enough and needed to be accompanied by tough oversight and balance sheet regulation.

However, the Fed is not to blame for pushing interest rates too low and holding them there too long, which is the charge levelled by neoliberal economists like John Taylor of Stanford University. After the recession of 2001 the economy was stuck in jobless recovery and showed signs of falling back into recession. This was despite significant stimulus provided via the Bush tax cuts and Iraq war. From the point of view of escaping stagnation, the Fed did the right thing.

Unfortunately, most of the public discussion has focused on the Fed’s interest rate policy after the 2001 recession. It should be focused on the neoliberal economic thinking that still permeates the Fed. Though there has been some change in attitude toward regulation, the Fed’s fundamental thinking about the economy remains unchanged. This failure to go after deep failures of understanding is part of the mechanism that protects the policy establishment, and it explains why the people in charge of the Fed (and other central banks like the Bank of England and European Central Bank) are the same people who failed so disastrously before the crisis.

PP: Regarding the economic thinking about the broader causes of the crisis you are particularly critical of the ‘savings glut hypothesis’ that has become popular, especially with the Federal Reserve Chairman Ben Bernanke. My impression from the book is that you see this as ad hoc economic thinking that seeks to avoid the real issues. Would I be right in saying that and could you briefly outline what is wrong with the savings glut hypothesis – which, in my reading, is as pervasive on the left as it is on the right?

TP: In my view the savings glut hypothesis is nonsense economics. Looking at it from the big picture, you see it is just another in a series of explanations of the US trade deficit by mainstream economists. My book shows clearly how these explanations evolve to fit the political moment rather than to explain the phenomenon. And the enduring common feature of all these explanations is they avoid blaming globalization as the cause of the problem or having any downside.

That is absolutely staggering. Mainstream economists blind themselves to the most obvious explanation, and that is a pattern that repeats over and over again in other areas of economics. And because the explanation is so obvious and simple you can never write about it in journals which are fixated on complexity. The story about the emperor’s new clothes really does apply for much of modern economics.

With regard to the saving glut hypothesis, it ignores the fact that the US trade deficit has been rising for 30 years, long before China emerged on the scene. And there is much other evidence and argument against it – but that is in the book.

PP: The book ends on a slightly pessimistic note. It appears that, given the entrenched dominant policy paradigm governments are likely not to begin the process of economic rebalancing. Do you see any light at the end of the tunnel? Are there any social or political forces you think might move the policy debate forward, both in the US and worldwide?

TP: You are right. I am pessimistic which is why the book predicts stagnation. And by the way that prediction was made in 2010 when the book was written, so it has already been proven right. I had great difficulty finding a publisher because 2010 was the time of “green shoots” and “V-shaped” recovery and there was widespread denial about the systemic nature of the crisis. Princeton University Press who published my prior book turned it down.

I am guided by Gramsci’s aphorism regarding pessimism of the intellect and optimism of the will. My intellect tells me that as of now there is no significant political force for progressive change that moves the political and policy debate in the direction I would like to see it go. At best, we are muddling through in a way that contains the economic crisis at its current level. Moreover, if anything, the risks are to the downside from contraction in Europe, risks of trouble in China, slowing growth in emerging market economies, and the prospect of fiscal drag in the US.

In many ways the economic die have been cast. We are now moving into the stage where political risk starts to assume a bigger role. I begin my book with some comparisons with the 1930s and I believe those comparisons remain valid. Mark Twain talked of history rhyming rather than repeating, and today’s rhyme is clearly with the 1930s.

That said I am an optimist of the will. Why else write a book that contains a map for change of economics, politics and economic policy. One has to be an optimist if one believes in constitutional democracy, and I do.

*Palley’s latest book, From Financial Crisis to Stagnation, was recently published by Cambridge University Press, 2012. A 20% discount is available at: http://www.cambridge.org/us/knowledge/isbn/item6821687/?site_locale=en_US [2]
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