Thomas Palley: "The Debt Delusion"

Economist Thomas Palley has of late been discussing what he believes to be an insufficiently-acknowledged cause of our current financial woes, namely, a shift in government policy away from emphasizing wage growth as a key objective. Another shift was a lack of concern about trade deficits.

Now one can argue that combatting trade deficits means protectionism, but that’s a naive view. Our trading partners do not have open economies; neither do we. China has an openly mercantilist approach, gives substantial subsidies to domestic industries, and maintains a dollar peg (which is admittedly being permitted to slip, but due to high domestic inflation, not to any desire to accommodate the US). We restrict entry of certain high wage professionals like doctors and provide heavy agricultural subsidies. So to act as if the default position is open borders is a gross misunderstanding of how things work. This is a game of who gives what in return for what access. And our negotiating priorities have been skewed in favor of large corporations rather than wage earners.

Palley describes the consequences:

A second big American interest-rate cut in a fortnight, alongside an economic stimulus plan that united Republicans and Democrats, demonstrates that US policymakers are keen to head off a recession that looks like the likely consequence of rising mortgage defaults and falling home prices. But there is a deeper problem that has been overlooked: the US economy relies upon asset price inflation and rising indebtedness to fuel growth.

Therein lies a profound contradiction. On one hand, policy must fuel asset bubbles to keep the economy growing. On the other hand, such bubbles inevitably create financial crises when they eventually implode.

This is a contradiction with global implications. Many countries have relied for growth on US consumer spending and investments in outsourcing to supply those consumers. If America’s bubble economy is now tapped out, global growth will slow sharply. It is not clear that other countries have the will or capacity to develop alternative engines of growth.

America’s economic contradictions are part of a new business cycle that has emerged since 1980. The business cycles of Presidents Ronald Reagan, George H.W. Bush, Bill Clinton, and George W. Bush share strong similarities and are different from pre-1980 cycles. The similarities are large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth.

The new cycle rests on financial booms and cheap imports. Financial booms provide collateral that supports debt-financed spending. Borrowing is also supported by an easing of credit standards and new financial products that increase leverage and widen the range of assets that can be borrowed against. Cheap imports ameliorate the effects of wage stagnation.

This structure contrasts with the pre-1980 business cycle, which rested on wage growth tied to productivity growth and full employment. Wage growth, rather than borrowing and financial booms, fuelled demand growth. That encouraged investment spending, which in turn drove productivity gains and output growth.

The differences between the new and old cycle are starkly revealed in attitudes toward the trade deficit. Previously, trade deficits were viewed as a serious problem, being a leakage of demand that undermined employment and output. Since 1980, trade deficits have been dismissed as the outcome of free-market choices. Moreover, the Federal Reserve has viewed trade deficits as a helpful brake on inflation, while politicians now view them as a way to buy off consumers afflicted by wage stagnation.

The new business cycle also embeds a monetary policy that replaces concern with real wages with a focus on asset prices. Whereas pre-1980 monetary policy tacitly aimed at putting a floor under labor markets to preserve employment and wages, it now tacitly puts a floor under asset prices. This is not a matter of the Fed bailing out investors. Rather, the economy has become so vulnerable to declines in asset prices that the Fed is obliged to intervene to prevent them from inflicting broad damage.

All these features have been present in the current economic expansion. Wages have stagnated despite strong productivity growth, while the trade deficit has set new records. Manufacturing has lost 1.8 million jobs. Prior to 1980, manufacturing employment increased during every expansion and always exceeded the previous peak level. Between 1980 and 2000, manufacturing employment continued to grow in expansions, but each time it failed to recover the previous peak. This time, manufacturing employment has actually fallen during the expansion, something unprecedented in American history.

The essential role of asset inflation has been especially visible as a result of the housing bubble, which also highlights the role of monetary policy. Despite the massive tax cuts of 2001 and the increase in military and security spending, the US experienced a prolonged jobless recovery. That compelled the Fed to keep interest rates at historic lows for an extended period, and rates were raised only gradually because of fears about the recovery’s fragility.

Low interest rates eventually jump-started the expansion through a house price bubble that supported a debt-financed consumer-spending binge and triggered a construction boom. Meanwhile, prolonged low interest rates contributed to a “chase for yield” in the financial sector that resulted in disregard of credit risk.

In this way, the Fed contributed to creating the sub-prime crisis. However, in the Fed’s defense, low interest rates were needed to maintain the expansion. In effect, the new cycle locks the Fed into an unstable stance whereby it must prevent asset price declines to avert recession, yet must also promote asset bubbles to sustain expansions.

So, even if the Fed and US Treasury now manage to stave off recession, what will fuel future growth? With debt burdens elevated and housing prices significantly above levels warranted by their historical relation to income, the business cycle of the last two decades appears exhausted.

It is not enough to deal only with the crisis of the day. Policy must also chart a stable long-term course, which implies the need to reconsider the paradigm of the past 25 years. That means ending trade deficits that drain spending and jobs, and restoring the link between wages and productivity. That way, wage income, not debt and asset price inflation, can again provide the engine of demand growth.

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  1. eh

    But there is a deeper problem that has been overlooked: the US economy relies upon asset price inflation and rising indebtedness to fuel growth.

    The Sudden Debt blog has covered the very same thing quite well in the recent past.


    since every banknote in circulation is backed by an IOU, it is impossible to pay the interests if not piling on debts further. Down the food chain, the low and then middle class in general, are the first victim, gets impoverished. But as the IOU/debt system is exponential, the damages reach out the upper classes eventually. That is what is taking place as I type this.

  3. S

    The US consumer has had to search elsewhere for “wealth” as it is increasingly out of reach. The free agency star system has been taken to an extreme. The dislocations wriought by the mal incentives built into the gorssly disproportionate pay across certain industries is economically inefficient in the long run. We are entering the long run. The trade policies of the past few decades were as much geopolitical as economic. That side of the equation is vastly underfollowed. The peace dividend circa early 90s should have included a radical reassessment of doctrine. Instead we had corporations push the wage arbitrage as their only means to survival, itself a gross exaggeration. So now we have all time high profit margins and gross systemic imbalance that can only be reconciled by painful actions. The collision course is set. Like the Roger clemosn testimony, someone is lying here. The systemic meltdown speaks to who that is.

  4. Mark

    This proposal sounds like class warfare. The rich won’t allow wages to claim a higher percentage of GDP without a fight…

  5. S

    Palley has it dead right on wages. The fed don’t talk about wages they discuss productivity. It is the sanitized and globalized vocabulary of the elite. To begin to discuss this is to call into question the foundation and superstructure that has grown up around it.

    OFHEO moves today to raise portfolio caps and Congressman Franks falling in line with Blinder are just the latest in a series of backward looking action. Triage is one thing, but the forward look is another.

    Bernanke is essentially financing the banks. Look at the results of the Tafy auctions results. The number of bidders and the bid to cover is steadily increasing. The trend is not your friend in this instance.

    All the bailout in the world will only exacerbate the slingshot blowback.

  6. Anonymous

    Please let me know if I have something wrong here: As I understand it, the Fed intently focuses on keeping wage inflation lower than the general inflation rate (which I assume accounts for productivity increases). Doesn’t this mean that wages will increasingly lose ground to inflation over time? In other words, doesn’t Fed policy necessarily imply declining living standards? Or do I have something wrong?

  7. Anonymous

    The other Anon,
    Productivity gains only occur if the quantity of output increases with a given quantity of labor.
    Wages lose ground to inflation over time not because of FED policy, but because of the economic myth that productivity gains are passed on to the worker rather than the shareholders or consumers. If they can keep labor believing they get paid more if they work harder, workers won’t demand a new system.
    That time has come.

  8. Mark

    If Kalecki’s reserve army of the unemployed is big enough, workers may be too scared to demand a bigger piece of the pie…

  9. Juan

    Eyeballing the productivity v. compensation chart (Index 1959 = 100) in Palley’s November 2007 paper Financialization: What it is and Why it Matters, compensation in 1978 was ~140 while productivity was ~160; for 2005, these had become, respectively, ~150 and ~270.

    Somewhat contrary to Palley, though, I would argue that this – and the soon to follow financialization – were driven by firms’ attempts to prevent the steep decline in average rate of profit experienced as the ‘golden age of capitalism’ (1950-1970) came to an end.

    NB that such crisis (which, on a rate rather than mass of profit basis has not been overcome) also promoted a turn towards increasingly speculative activities or, as Patrick Bond put it in 2003:

    …capitalists begin to shift their investable funds out of reinvestment in plant, equipment and labour power, and instead seek refuge in financial assets. To fulfil their new role as not only store of value but as investment outlet for overaccumulated capital, those financial assets must be increasingly capable of generating their own self-expansion, and also be protected (at least temporarily) against devaluation in the form of both financial crashes and inflation. Such emerging needs mean that financiers, who are after all competing against other profit-seeking capitalists for resources, induce a shift in the function of finance away from merely accommodating the circulation of capital through production, and increasingly towards both speculative and control functions. The speculative function attracts further flows of productive capital, and the control function expands to ensure the protection and the reproduction of financial markets. Where inflation may be a threat, the control functions of finance often result in high real interest rates and a reduction in the value of labour- power (and hence lower effective demand). Where bankruptcies threaten to spread as a result of overenthusiastic speculation, the control functions attempt to shift those costs elsewhere.

    So, today we begin to notice that more than inflating asset prices and credit are required and that these increasingly undermine rather than offset but, heck, this has been known for at least 160 years.

  10. Alex

    To get back to the wage growth, lower trade deficit model one would have to get the FED to dramatically change course.

    Since wages represent 80% of the economy, their focus on inflation was an assault on wages.

    The capitalists ended up being the only benficiary from productivity. Now the capitalist have learnt their lesson: the slaves can longer afford to gouge themselves on lower incomes.

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