Thomas Palley: The Implications of Debt-Fueled Business Cycles

A very good Project Syndicate article by Thomas Palley highlights the way a shift in US policy priorities circa the early 1980s has lead to a lasting change in the foundation of economic growth in the US. Prior to that, the emphasis was on increasing incomes of workers and being wary of trade deficits. As worker incomes rose, businesses had a natural incentive to find ways to use less of it, generally via greater investment in equipment, technology, or improved business methods, which fostered business investment and led to productivity gains that were shared between corporations and workers. Rising incomes also supported rising domestic consumption. All in all, a virtuous circle.

That paradigm changed, and while Palley does not name names here (he does in another post, which we intend to highlight tomorrow), the culprit is the Chicago school of economics, whose free market ideology drove Reagan-era policies and has become deeply rooted in the business and increasingly the public psyche. Palley argues persuasively that this is a bankrupt model and ties it directly to our current economic woes: asset bubbles, stagnant wages, high and rising levels of debt. Needless to say, he is also critical of monetary easing and fiscal stimulus, seeing them as continued reliance on unsound and unsustainable practices.

From Palley:

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 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 Bush Sr, Bill Clinton, and George 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 labour 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 1.8m 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 defence, 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. John

    Just looking at the history of the FFR. Greenspan only began to raise rates from one percent in July 2004.

    Over the past few days I’ve read that monetary policy takes about six months to have an effect. So the “effective” rate at the time of the presidential election was STILL one percent, and had been for a year.

    Do you think this is what got Bush re-elected?

    But I thought the Central Bank was independent of politics.

    Such lies, we are told. They never end.

  2. RK

    I saw an inteview with George Soros at the recent Davos summit, where he spoke about our being at the end of a credit “super cycle”. What he meant by that was the last gasp in a series of expansions, each of which are progressively more dependent than the prior one on the expansion of credit. In the past 20+ years, this ratio of the amount of credit creation needed to fuel the next expansion has increased nearly threefold. To quote Ben Stein’s dad Herb, “What cannot go on forever will eventually stop”. The only question is when.
    It is easy to understand why the general public fails to connect the rising asset prices which form the collateral for their increased borrowings, with
    the expansion of credit. The latter is much harder to observe in the aggregate, wheras the rise in values of land, houses and stocks is the stuff of daily headlines. It would take a simple “thought experiment” (what would happen to prices if everything was 100% cash on the spot, no credit)
    to make things crystal clear.

  3. Anonymous

    There seems to be a revisionist conspiracy afoot to negate the entire economic legacy of Ronald Reagan (Paul Krugman has also notoriously written in this vein). And yet Reagan’s economic and foreign policies brought about the peace dividend that Clinton benefited from. If only Dubya and the drunken sailors in Congress had maintained the Clinton-era budget surpluses, we wouldn’t be having this discussion. And if you really want to get revisionist, why not go all the way back and blame FDR for hugely expanding the role and size of the federal government and putting the whole lumbering entitlements machine in motion?

  4. STS

    Reagan’s economic legacy hasn’t really been properly evaluated, so “revisionism” would be the wrong label.

    Certainly Reagan hagiography is working overtime.

    So much so that it has attracted .

    FDR didn’t “cause” the Great Depression because it was in full swing before he took office. His efforts to fix it met with mixed success, but were initially perceived as spectacularly successful — leading to his landslide reelection in 1936.

    Reagan didn’t “cause” the Soviet Union to implode. The gross ineffectiveness of central planning did them in economically, and Gorbachev’s lack of brutal instincts forstalled a political crack down.

    What links Reagan and FDR most is the fact that Reagan’s reputation has been inflated precisely in order to kick FDR out of public memory so the New Deal can be eliminated. The high water mark of this campaign was the move to put “Reagan on the Dime.” It was a pleasant surprise to find Nancy Reagan unwilling to help Ronnie’s “friends” remove one of Reagan’s heroes from our currency.

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