a journal of modern society & culture

2011: Vol.10, Issue 1



Economic Recovery With No Growth Strategy

by Jeff Madrick

I should begin with where we stand with the economy today. Stand is not the right way to put it. We are falling. We are down on our rears and I am not at all optimistic about where we are headed. Perhaps the biggest danger out there is the political danger of ongoing backlash. I think of the tea party’s successful rise as an economic backlash. Worrying and thinking about economics makes me something of an economic determinist, but I do not think I am totally with economics as the main causal principle. I am very worried about what’s going to happen. I am very worried about the Democratic response to the current state of the economy.

I was at a mainstream conference recently, put together by a Nobelist. There was a rather grand UN General Assembly-like setting. They asked me to make a presentation, and I was considerably left of everybody else in the political sense. Robert Rubin was there and he said, point blank, that he is opposed to further fiscal stimulus. He believes increasing the deficit now, increasing the deficit in the future, means higher interest rates in the future. As a journalist since the 70’s, I have known Rubin for many years. He is not an economist. It was disheartening to hear him speak because I sensed it represented the Obama point of view.

The recession was allegedly over in the middle of 2009. In technical terms, I think it was over. We had a huge rescue package in 2008 and 2009.  It was mostly a monetary rescue package. There was the 700 billion dollars from TARP in the fall of 2008, a Treasury policy. But there was a very rapid reduction of interest rates by the Federal Reserve, the federal funds target rate before that. That is what they try to control and Ben Bernanke, chairmen of the Fed, cut that very rapidly. Then there was what was called quantitative easing, i.e., purchases of debt. There were guarantees of debt by the Fed that ran up to two trillion dollars and still remain at two trillion dollars. There were Federal Reserve and Treasury guarantees and Fed guarantees of the commercial paper market and other markets of greater size. A commercial papers market is the financing that corporations and banks do with each other. It is an enormous market to meet daily cash needs and the money market funds were guaranteed.

The total package of guarantees came to 11 or 12 trillion dollars. All of this was necessary, all of this is to be applauded, and all of it kept us out of a much more serious recession, and, probably, a depression. The best model of this was done by Alan Blinder and Mark Zandi. Both are mainstream economists with a mainstream model. They argue that if TARP, the 700 billion dollar plan, (as well as all the other guarantees I’m talking about from the Fed and Treasury, and the 800 billion dollar Obama stimulus package in early 2009, spent over the course of 2009 and into 2010) had not been undertaken, we would still be in recession. Unemployment probably would have gone to 16 ½ percent. It got as high as 10.1 percent. 16 million people would have lost jobs as opposed to 8 million people and the underemployment rate probably would have gone to 25 percent—that is the rate of people who are not only unemployed, but employed part-time who rather have full-time job or are discouraged workers who cannot find anything. One out of four Americans would probably not have a full-time job when they wanted one.

I actually think that model is optimistic. I think there could have been a much lower bar to this recession, but, if that model were correct, 16 ½ percent unemployment is by any informal definition a depression. So, the government did something right. They did rescue us from a much worse state, but now we are sitting here one year after the alleged end of the recession. Unemployment is 9.6 percent. There is no sign of a speed up in the economy as I speak. (In late 2010, there were more optimistic signs of stronger consumer spending, but nothing to approach the pace needed to cut unemployment seriously.  The possibility of a double-dip as it is called, falling into another recession, is now below 50-50. The probability of slow economic growth is more in the neighborhood of 75 percent, for the next two or three years).

 When you consider that the credit system is stretched and we will not generate income, the danger of another credit crisis is high. The danger of failures of banking institutions is very high in this environment. I asked Rubin, for what it is worth, whether he worried about that. Martin Wolfe the columnist of The Financial Times was also there claiming we needed a bigger fiscal stimulus. Rubin said that the bigger risk is to increase budget deficits. This is not remotely the case at the moment. The risk of falling into another recession or ongoing sluggish growth is enormous because of the thinness of the credit system. There are liabilities out there that have not been considered and almost never make it into the press. One of them is the second mortgage. The American mortgage system is peculiar because you can take out a second mortgage without getting permission from the guy who gave you the first mortgage. So there are two mortgages on a lot of these houses. The fact that these are not being accounted for in the stress tests that the government undertook with financial institutions is another example that we just do not know what is happening.

What should be done?  Although there are some more fundamental and ideologically disturbing trends going on, what should be done is more fiscal spending. Instead, what is going to happen is we are going to get more so-called quantitative easing from the Federal Reserve (that is, purchases of long term bonds), which would bring down long term interest rates, help to keep mortgage rates low, help to get business to spend more to borrow more, and help to get banks to lend more. That is what is going to be done. Having been schooled in Keynes, I think that we need both guns working simultaneously. We need fiscal policy, we need spending, and we need monetary policy, the so-called quantitative-easing. The cannon of reducing rates has already been shot by Bernanke, so we know we have quantitative-easing. However, businesses are not going to lend unless there is demand for goods and services out there. There is not going to be demand for goods and services out there unless we get another fiscal stimulus to try to get the economy moving again. That, coupled with lower rates of quantitative-easing, may do the job. Quantitative-easing alone will not. (The Obama agreement on taxes did surprisingly produce a moderate and welcome stimulus with the extension of unemployment insurance and the payroll tax cut. It is not enough; moreover, the payroll tax cut will increase the supposed Social Security deficit and strengthen the case of those who want to reduce Social Security benefits.)

Why is Obama resisting a more robust stimulus? Part of it has to do with the so-called deficit scare. He has surrounded himself with people who are afraid of increasing the deficit. Ironically, Lawrence Summers has been less of a deficit hawk than many of his other advisors. They think that the voting public is worried about the deficit, that it is a political issue, and they do not want to inflame it further. Obama endorsed the deficit commission. The deficit commission is manned by people who want to cut the deficit. It is not some kind of bi-partisan investigation of the dangers of future-deficits. That to me was a very sad example of politics at work. Obama may believe in fact that these deficits should be avoided. I think that he does not get the state of the weakness of the economy and, in this regard, his advisors have been on balance very bad. They apparently did not realize it until the Fall, when we got the numbers for the second quarter growth rate; that is the growth rate of the economy between April and June, which is something like 1.6 percent. You could have plausibly made a little bit of a case that the economy was coming back six months before that. Rates of growth were alright. They were not great by recovery standards. We had a slow recovery much like we had in 2001 and the subsequent years and 1991 and the subsequent years, but the unemployment rate in the Bush I recession into the early Clinton years never got higher than 7 ½ percent. In the Bush II recession, in the early 2000’s, it never got higher than 6 ½ percent, so we had relatively a weak recovery and expansion. When we had huge jumps in employment in 1974 and 1975 and again in 2002, jumps to 9 percent in the mid 1970’s and jumps to 11 percent under Ronald Reagan, we subsequently had a very rapid recovery and expansion. A steep recession is often followed by a rapid recovery and expansion. That is just not happening now.  It is a different circumstance mainly because of all the debt out there.

Consumers cannot spend because they are paying down their debt. They have lost their houses and they are trying to save them. With unemployment so high, people are worried about losing their jobs if they have not already. In addition, average wages for those who have their jobs are falling. Wages in general did not rise in the expansion of the 2000’s. Family income, household income, and immediate family income in 2009 after the recession, are as low as they were in 1997. In 2007, before the recession, immediate family income or household income was roughly close, but was no higher than it was in 1999. As I said, there has been no increase over the recovery and expansion. This has never happened in the post World War II period. My guess is it probably never happened in industrial history in America. People have not seen increases in wages. They have borrowed like crazy. The consumer debt, as a percentage of personal income, is at extraordinary record levels. The debt service, that is, the interest and the amount you pay back, which takes into account the lower interest rates, is at high levels compared to income.  That started in the late 1990’s under Clinton, but it got crazy in the 2000’s. This means that we are sitting on a very weak foundation for consumers. We are sitting on a weak foundation for banks because they are hesitant to lend. They do not have to lend. They can borrow from the Federal Reserve at near zero interest rates and invest in Brazil, in China, in East Asia. The emerging economies are doing great. The capital flows are rushing to the emerging economies and may indeed create a bubble there because their currencies are feeling upward pressure.

The big problem with TARP was not the money. It was not the 700 billion dollars. Warren Buffet gave money to Goldman Sachs under the same circumstances. I assure you he is not going to be happy if he just breaks even on that investment. I can assure you he is not going to break even on that investment. He is going to make a fortune. The federal government put up the risk capital and they should be making a fortune on that money. The more important issue is that they should have demanded conditions in which these banks lent that money out if they got it. I do not know if they should have nationalized. Many people like the idea of nationalizing. It would have been an enormous bill because you had to guarantee all the liabilities. It probably would not have worked out. It may have been hard to get through politically, but they certainly should have gotten rid of some management in these companies.

The idea that you leave the top management in these companies, who have friends that they protect who make bad decisions, who were responsible for certain kinds of decisions, is outrageous. You needed somebody to clear that out, but there was nobody around. Jamie Diamond, who is a smart man, was credited—here is one of the great ironies—for not getting too deep into the mortgage financing business, the securitization business. Jamie Diamond has a subsidiary at JP Morgan Chase called Chase Mortgage. They wrote sub-prime mortgages also, like Mozillo did at Countrywide. All the big banks and investment banks had a subsidiary, separate from their securitization operation. They wrote sub-prime mortgages. They were creating all these bad debts and possibly bad debts in competition with Mozillo. The mortgages were feeding the securitizations, the securitizations were feeding the mortgages and it got pretty crazy. Now with a Republican House, it seems like it will be impossible to get more stimulus through. So I do not seek any serious easy way out of this except slow growth for a long time. Some smart economists are talking about a lost decade, much like Japan’s lost decade. One advantage we have is that we learned something about Japan’s lost decade. The dumb conclusion was that stimulus did not work. The correct lesson is that there was not enough of a stimulus in that decade to get the Japanese economy going.  That does not mean stimulus would completely relieve the American economy of any cost. These things are not costless. There is not going to be any costless solution to get out of this for America.  We got in very deep. And how did we get in deep? I would like to talk about that a little bit.

What is the American economic growth strategy? America has not had a true growth strategy for thirty or forty years. After World War II, Alan Brinkley argues, the Democrats gave up social policy for economic growth. We believed then that if you controlled cyclical fluctuations in the economy, you could maximize growth. Keynesianism was heralded, adopted, believed in because using Keynesianism as a tool we can maximize the powers of expansion and minimize recessions. In fact in the late 60’s and early 70’s, people believed the recession was cured. If you eliminate or minimize the downturn and maximize the upturn you are increasing your rate of growth. That was the growth philosophy. There were a lot of other things going on. We built the highways and invested in education. There were more remnants of faith in government. I do not think it was ideal. It was never ideal in American history needless to say. A lot of Keynesianism was basically military Keynesianism; in those years it was called “war Keynesianism”. The real systemic risk in America I still think is not the financial industry, but the defense industry. When the Korean War was over, Lockheed and all those guys had legislators in their pocket. They said that we cannot stop spending at virtually the same rate we have been spending because our war technology will fall behind. Of course they had the Soviet Union to stoke fear in us. Then attitudes changed in the 1970’s. One of the clear proximate causes of the attitude shift was very high rates of inflation coupled with high rates of unemployment. These were punishing to the American public. I believe the American public and its policy makers, ultimately Democratic policy makers, panicked in this period. This confluence of events coupled with anger about racial and other social programs in the 60’s, Watergate, and the Vietnam War led to a very strong anti-government sentiment. This sentiment was stoked effectively by people in office and by the takeover of the economics profession by thinkers like Milton Friedman.

Here are the bookends. As Governor of California, Ronald Reagan thought he did not have much of a conservative record to run for president on in the early 1970s.  He was always thinking about running for President and wanted a better conservative legacy. Reagan came out with this idea for passing a constitutional amendment to cut the California state income tax permanently, substantially and permanently. Reagan campaigned everywhere. Milton Friedman joined in on the campaign. Many well known conservatives were involved in this. But it lost. It was a huge setback for Ronald Regan. Some thought his career was over. It was voted down by the Californians in early 1972. They voted against cutting their income tax and limiting it forever. In 1978, six year later, they voted overwhelmingly for Proposition 13 and the huge cuts in property taxed. Those are the bookends of change.

I would like to add something however about economics that may be a little technical, but it is very important. There was not a simple takeover of economics by classical conservative economics. Conservative economists are classical economists who believe markets should be unfettered, but were also very concerned about making markets work properly. Conservative classical economists are worried about monopolies. They are worried about free and open access to markets, oligopolies, information in markets, lack of conflicts of interest and so forth. The economics that took over in the 70’s I would call for lack of a better name liberalism in the 19th century sense of the term. It is not original, that word is not confined to Milton Friedman type economics. But the difference is this: Friedman had a political agenda, which was to cut government even if it meant economic sacrifice in the short run. I believe that neoliberal agenda, as some deem it, came to dominate everything he and especially his influential followers.  Obviously, Ronald Reagan was part of that. Friedman was probably not the first person to think in those terms, but he wrote about it in the 1960’s and published it in Capitalism and Freedom. He was willing to have big deficits because he had a bigger agenda, let’s take government out of the way. He believed that if you got government out of the way you would have more prosperity, but it was a compromise, which was taken and became the rule. The best example of that, and I am bringing it around to what happened in America, is financial de-regulation. That neo-liberalism began to influence Democratic economists, people who considered themselves liberal. There are still economists at Harvard who consider themselves liberal in the modern sense—that is, progressive—one or two of them actually are still progressive, but they are at least ten years older than I am. Younger economists there began to adopt certain of Friedman’s ideas about reducing regulation and so-forth, especially anti-trust issues, which are not very much talked about and should be. What happened in the 1990’s? The mainstream economists would preach to emerging economies, developing countries, third-world countries, to get the market incentives right. They would preach conservative economics as though all you had to do was get your incentives right and get your markets working correctly. But here’s the point: what was going on in the financial industry violated principles of conservative economics, of classical economics.   And yet the economics community did not erupt in anger.

Milton Friedman’s predecessors were people like Henry Simons, very strong classical conservative economists, who disliked monopolies. There was a big fight over the power of monopolies within the Chicago department. The new guard displaced the old guard and changed the Chicago school’s attitude towards monopoly. That was sort of the beginning of a neo-liberal lie. I go back because it played itself out in the mid-1990’s. Classical economists would be up in arms about financial deregulation of the economy of any stripe because it violated classical economics. It violated the way markets should work. The credit rating agencies had absurd conflicts of interests that meant markets could not possibly work. The compensation schemes for bankers and traders, where you are compensated to take risk and you are not penalized if you lost money, violates conservative classical economics rules. The lack of transparency, the lack of open information and price setting in the over the counter derivatives markets, which became enormous and contributed to the catastrophe in a big way, went against classical economics. Classical economics would demand open markers, transparency and information. Yet, the mainstream economics field was not up in arms about this. The conservative economists were not up in arms about this. We had two chances under Bill Clinton to regulate the derivatives market and make it open. It was not only in 1999. The Clinton Administration was not on board. Certainly Alan Greenspan was not on board. They could have also regulated in 1994. The Democrats refused to force companies to put stock options for their executives and CEO’s on the books. Where were economists on this? They had an extreme view about the efficiency of stock markets. Investors would take the expenses of stock options into account, went the argument. There were other examples of that. The Democrats also voted against allowing investors to sue securities firms. That’s not all that happened by any means. Alan Greenspan firmly ended the Glass-Steagall Act long before Congress did in 1996. Basically, they let investment banks do what they wanted to do. My point here is that economics became neo-liberalism. It did not become conservative economics.

So what was the growth theory in America? Was it focused on dealing with fluctuations, minimizing cyclical fluctuations, or was there something else going on? Well I think it was this neo-liberalism gone haywire based on conservative economics’ classical principle, which is that economies adjust on their own to optimal rates of economic growth. Keep government out. Conservative economics, just to re-stress this point, would say that you have to make sure markets work. The neo-liberals did not even worry about this. So what did we do? We had one policy target, one policy aim, for at least twenty five years, keep inflation low. Inflation was kept low at roughly 2 percent a year with the objective (the pain of that was borne by workers because keeping inflation low required keeping wages low) that worked itself out in many ways. Inflation was successfully kept low. The other policy principle was deregulation and it all fit into this one idea: that economies would adjust on their own. Public goods and public investment were given a back seat, most notoriously in the Clinton Administration. When the Clinton Administration had a budget surplus they refused to put it into public investment.

A financial re-regulation program should address two problems. One is to prevent crises. The other, which is not talked about, is to make sure the financial community does what its supposed to do, which is allocate savings, allocate capital to productive uses in America. Now why have economists not questioned that in the last 30 years? In the 1980’s, capital, debt capital, and bank capital was used to make hostile takeovers. The preponderance of evidence is that most of those hostile takeovers did not work out. The premium paid was never justified by the profits. In the 1990’s we did indeed have a high technology boom. Much of it was real. But much or more of it was fantasy. The 1990’s was probably the most financially corrupt decade since the 1920’s. We’ve forgotten and been so negligent about this history, the media helped suppress it for so long. We do not understand at all how corrupt the 1990’s were. You could not keep a job as an investment analyst if you did not lie about the companies you followed.  You could not keep a job as a big time accountant in the 1990’s, if you did not allow your client to cook the books. Investment bankers gave under the table pay-offs to executives, including many idolized high-technology executives.

We think of the saints of that time as the high-tech nerds who were interested in technology and not in money. Yet, Frank Quattrone and a bunch of other investment bankers were giving under the table stock to the CEO’s of these high-tech companies and to the investment managers that bought them. Not you or I and our pension and IRA’s , but the investment managers who ran our pension funds and IRA’s. The result was a ridiculous boom in fantasy and absurd investment that came crashing down. The fact is that the NASDAQ index of stocks is where these high-technology companies were posted, which went public. They reached 5,000 in March 2000 and fell by 80 percent in the next year and a half to two years. Today, it is still at only 50 percent of the high ten or eleven years ago. Most of these companies went out of business. Those that did not were selling for under a dollar. Almost none of them in the early 2000’s reached their IPO price. My point is the financial system, wasted enormous amounts of money. I have not even talked about Enron and Worldcom and hundreds where hundreds of billions of dollars were wasted. This is the perfect example of a financial system diverting your savings and my savings. Good dollars went into very bad silly investments and they made a fortune doing it. A re-regulation system should be dedicated to making sure the financial system allocates capital efficiently and productively. And you tell me whether you’ve heard anybody in the Obama Administration talk about that issue in any serious way. That white paper, the Obama Administration did in June 2009 and that Timothy Geithner was in charge of had no theme, no thesis about the various causes of the problem, no objectives. It was a plan to plug the holes in the dam.

The thing that the executives always say is that financial crises happen every five or six years. Bob Rubin says it. Warren Buffet says it. Jamie Diamond made a big issue of it. These things just happen. It’s the price of capitalism. Nonsense. WE never had a crisis like this one in the professional careers of any of these men. The last one of such dimensions was 75 years ago.  Evidence rarely seems to be a factor. There is no evidence that an inflation rate of 2 percent will produce more rapid growth than an inflation rate of 3 percent. Yet, the economics profession talks about, how we have to stay at two percent. There is no evidence that higher inflation begins to impede economic growth unless it gets very high. These guys are remarkably irresponsible.

But the fact is many bad things have been happening, since the rise of neo-liberalism and financial deregulation in the late 1970s.  Here’s a list. We had a Mexican crisis in 1982. The Fed and the IMF had to bail out the big banks, a completely altruistic thing. We had a stock market crash in 1987. We had a junk bond crash and a savings and loan crash in 1989, which led to the recession of 1990. We had a near crash in 1994 when Alan Greenspan suddenly raised interest rates and we had the peso crisis of Mexico that year, on which Robert Rubin rested his reputation by supporting a federal bailout.  We saved Mexico with a forty billion dollar rescue package. Of course we actually saved American institutions who had lent money and other western institutions, who had lent money. In 1997 we had an East Asian financial crisis. We protected people here who had no idea of how devastating those crises were to those economies—and those people. That was pure depression in East Asia.  Much of it had to do with the end of capital controls that the Clinton Administration favored, so that foreign capital could go in and out of these countries. It was a devastating blow. In 1998 the Russia defaulted, Long Term Capital Management went under. The Fed organized a bailout by the banks. Around 2000-2001 there was the great high-technology crash and the biggest bankruptcies of all time, Enron and WorldCom, 2000-2001.  Finally the housing bubble and financial institution crash of 2007-2008.

I am going to repeat those dates 1982, 1987, 1989, 1994, 1997, 1998, 2000, and 2007-8.  That is eight financial crises. The conventional wisdom has been that we handled all those crises. We did not handle all those crises. They all hurt the American economies significantly. They all cost jobs. They often resulted in recessions. They used up capital that should have been used for more productive purposes. These were the consequence of the blind deregulatory process.

This essay is based on a talk given at the Logos Salon in the fall of 2010.