Bow down to the Bubble: Larry Summerian Endorses Bubbleonian Madness and Paul Krugman Embraces the Hansenian Stagnation Thesis*

By L. Randall Wray

{*Sorry, I couldn’t resist. As many of NEP’s readers know, Michael Hudson has long advanced the argument that America’s policymakers have purposely created Bubbleonia—NOT to generate growth but rather to enrich the thieves at the top. And many of you are familiar with the work of Geoffrey Ingham—a fellow Chartalist traveler—who has focused on J.M. Keynes’s “Babylonian madness”, the period after Keynes had discovered the writings of A.Mitchell Innes that led him to explore the origins of money in Babylonia. Hudson is also a scholar of that period. Alvin Hansen reintroduced the thesis of secular stagnation, giving it a Keynesian flavor.}

Larry Summers has made a big splash by (finally) recognizing that the US has had a series of financial bubbles. (See here.)  Duh! Who wudduv thought? The Reagan years were just a bubble, driven by thrift excesses. The Clinton years were just a bubble, driven by dot-com excesses. And the most recent real estate boom and bust was just a bubble, driven by Wall Street’s thieving Investment Banks. Bubbles-R-US. It’s all we’ve got going on.

But don’t blame Larry for the bubbles, the last two of which he played a huge role in fueling by playing water-boy for Wall Street’s deregulation movement. Nay, it’s the stagnationary version of TINA: there is no alternative to bubbles because the US is caught in secular stagnation.

Paul Krugman and many others have picked up the “brilliant” argument of “the smartest guy in any room”, Summers. (See Krugman here ; See DeLong here; and See Vinik here.) They’re falling all over themselves to resurrect Larry’s tarnished reputation. He was thought to be a shoe-in at the Fed, until mass revulsion forced Obama to throw smart-guy Larry out of contention. Frankly, I’ve never understood the adulation of Larry. Yes, he had a couple of reasonably good academic papers (over three decades ago), but his career since then has been a series of embarrassing miss-steps, from proposing that developing nations should be turned into toxic waste dumps to proclaiming women unfit for science and on to flushing millions of dollars of Harvard’s endowment down the toilet.

In any event, let’s focus on the message, not the messenger. Here’s Larry’s brilliant message (my paraphrase):

Since the days of Reagan, the “natural” rate of interest that equates saving and investment at the full employment level of output has drifted deep into negative territory. What this means is that given saving propensities, consumption demand is depressed. To fill the demand gap we need a lot of investment (or government spending or net exports—more later). But given depressed demand, firms don’t really want to invest; indeed to get them to invest as much as households want to save at full employment, we would have to pay them interest on their borrowing. As we know from Keynes, ex post saving equals investment, but that is achieved only by having insufficient investment so that many people are unemployed. The unemployed are forced to save less than desired to maintain the equality.

If we could push the real rate well below zero (ie: firms “pay” a negative rate—equivalent to receiving interest on their borrowing) then we could push up investment, raising employment and income, and hence increasing saving so that it would come to equality with investment at full employment.

While we cannot push nominal rates below zero (you can hold cash and get zero), we can raise inflation. More technically, the real interest rate is equal to the nominal rate less expected inflation. So if that Expectations Fairy could get everyone to expect 5% or 10% inflation, the real rate would be far enough below zero, and presto-change-o we’d end stagnation.

But we’ve got a stubborn Fairy. She won’t believe Uncle Ben when he says he’s holding pedal-to-the-metal until he gooses inflation. So the only thing he (and Greenspan before him) can do is to cause serial asset price bubbles.

In the 1980s Washington bubbled up prices of jack-a-lope ranches in the Southwest; in the 1990s it was pet-dot-com firms that marketed kitty litter on-line; and in the 2000s it was sliced-and-diced NINJA mortgages that defaulted when the first payment came due. They all crashed spectacularly, of course.

But, you see, that’s a good thing. Better to have boomed and then busted than never to have boomed at all.

Bow down to the Bubble.

Thanks, Larry, for all you’ve done for the economy. In his “bravura” performance, he even managed to work in his preferences for deregulation—in spite of all the havoc he wrought: if we re-regulated, Wall Street might stop producing asset bubbles, and then we’d really be up the creek without a pot to piss in.

Krugman—as he is wont to do—puts all of this into his liquidity-trapped ISLM model. (See Krugman here for an exposition.) We’re in a permanent liquidity trap, where normal monetary policy won’t work. While fiscal policy would work, we cannot use it. (Full disclosure: Larry and Paul would be willing to use fiscal stimulus, but that is considered by Washington to be out-of-bounds. Indeed, Paul could argue that in a liquidity trap, with a horizontal LM curve, fiscal policy is super-duper effective as you’d shift out the IS curve without crowding-out investment since the interest rate is stuck. But we can’t go there because deficits are a no-no within the beltway.)

Martin Wolf—who ought to know better, since he’s a better Keynesian who has incorporated Wynne Godley’s sectoral balances within his own framework—seems to have bought the argument. Wolf argues:

Mr Summers is not the first to identify the possibility of so-called “secular stagnation”: the fear of emulating Japan’s lost decade has been in the minds of thoughtful analysts since the crisis. But his was a bravura performance.

Why might one believe him? It is possible to point to three relevant features of the western economies.

First, the recovery from the financial crisis of 2007-08 has been decidedly weak. In the third quarter, the US economy was just 5.5 per cent bigger than at its pre-crisis peak, more than five years earlier. US real gross domestic product has continued to decline, relative to the pre-crisis trend. Moreover, such weakness has endured, despite ultra-expansionary monetary policies.

Second, today’s crisis-hit economies experienced rapid rises in leverage, particularly in the financial and household sectors, together with strong jumps in house prices, before the crisis. This was a “bubble economy”. Many governments, notably in the US and UK, also adopted expansionary fiscal policies. Nevertheless, none of the obvious symptoms of excess – particularly above-trend economic growth or inflation – appeared in Britain or America before the crisis hit.

Third, long-term real interest rates remained remarkably low in the years before the crisis, despite strong global economic growth. The yield on UK long-term index-linked gilts fell from close to 4 per cent to about 2 per cent after the Asian financial crisis and then to negative levels after the financial crisis. US Treasury inflation-protected securities (TIPS) followed a similar course, albeit later.

Well, sure, recoveries are weak, and leverage was and remains high. But why would one expect interest rates to rise before the crisis? Remember the Great Moderation? Bernanke helped to convince markets that credit risk was a thing of the past, inflation had been successfully dispatched by competent central bankers, and we’d entered a new era of permanently low spreads. And, besides—as I’ll explain in a minute—the real interest rate notion is pre-Keynesian. But the worst thing about Wolf’s argument is that he adopts the “glut of savings” approach to the crisis—something entirely at odds with Godley’s exposition that Wolf frequently endorses.

Where do they go wrong? Let me count the ways. Then I’ll provide an alternative. (For an insightful critique, see also Yves Smith.)

1. The current fascination with the Wicksellian “natural” real interest rate analysis seems to have begun during the “jobless recovery” of Bush, senior. (See the paper I wrote with Dimitri Papadimitriou back in 1994.) The Fed was thrashing about for an alternative to Friedmanian monetary targeting—because it had failed. As we showed, the Fed proposed, and serially dropped, a wide range of potential targets—from expected inflation targets, to something called “P-star”, and from gold prices to ex ante real interest rate targets. The problem with a real rate target is that it is a compound term—the nominal rate (which the Fed can hit) and expected inflation (which the Fed cannot even determine with accuracy, much less control it). After floating the idea, Greenspan quickly dropped it. For a while, the Fed wandered around the wilderness without focus: Governor Lindsey admitted: “we look at a whole raft of variables—we ignore nothing and we focus on nothing”; Governor LaWare said: “I get a feel for what I think is going on”; and policy formation was likened to “reading tea leaves”, or following “intuition”.

Over the next couple of years, academics developed the “New Monetary Consensus” and the Fed adopted a version based on the Taylor rule such that its nominal rate target would be adjusted taking into account demand gaps and deviation of actual inflation from desired. (See here.)  When inflation, globally, remained low, the Fed and other central bankers were glad to take the credit. By 2004 Chairman Bernanke announced the Great Moderation and we thereupon collapsed into the Great Recession. You all know how that turned out.

2. But that Wicksellian notion came back via the Expecations Fairy. If the Chairman can send out a boatload of Fairies to convince “markets” that inflation will rise, then the Fed can control both the nominal rate and expected inflation. It can make the “real” market rate equal to the Wicksellian “real” natural rate that equates saving and investment in the Loanable Funds market.

Keynes had already dealt with this. He argued that the old Loanable Funds model is wrong, because it has investment demand and saving supply determining the interest rate, but we know that investment equals saving regardless of the interest rate. No, it is adjustment of income that equates saving and investment. He further argued, therefore, that any interest rate is a natural rate in the sense that it is consistent with saving and investment equilibrium.

There is, however, one unique interest rate that is consistent with saving=investment at full employment. This he called the neutral rate.

Now this might all sound like a quibble, a semantic difference from the arguments of Summers and Krugman—they, too, argue that ex post saving always equals ex post investment, so the problem is that rates are currently too high to allow that equality to occur at full employment. True enough. However, their argument is based in “real” terms while Keynes’s was in nominal terms.

Keynes clearly anticipated the problem that the hypothetical neutral rate might need to be negative for the saving=investment equilibrium to be consistent with full employment. Where he parted company with the Hicks-Hansen-Samuelson ISLM Keynesians was over the belief that this is a problem to be resolved with monetary policy.

Keynes argued that the cause of unemployment is not really that the interest rate is too high but that the “marginal efficiency of capital” (the return to investment) is too low. The MEC can easily be negative: looking to the future, if investment is expected to produce losses, the MEC is negative and there is no monetary policy that can induce firms to take those losses. For Keynes, there was no reason to introduce a notion of “real”—the problem is nominal. Yes, the nominal rate cannot fall below zero, but the nominal expected returns can be negative. So, no investment, no matter how loose monetary policy is.

Keynes did perceive some advantage of inflation, which can raise the future expected returns relative to today’s cost of investing. That would raise the MEC relative to the (nominal) interest rate. This is not because some imaginary “real” rate becomes zero but rather because the MEC rises with higher expected returns. However, in a slump with depressed expectations, even Fleets of Fairies will not do the trick. You need some real evidence that things will get better. And it must be personalized: a higher general rate of inflation does not mean that your expected returns will be higher. You want more demand. Even if monetary policy could cause inflation, you need higher expected sales to induce putting in place more capacity. Monetary policy cannot guarantee that.

You need fiscal policy.

As an aside, the worst thing that happened to mainstream macro since the mid-1960s was the introduction of expectations into mechanical-hydraulic Keynesianism. First we got Friedman’s adaptive expectations that presume short-run fooling, then Lucas’s rational expectations with fooling only in the case of random policy, then Real Business Cycle theory with no fooling at all, then New Keynesian fooling due to quasi-rational rigidities, and then finally on to belief in magical mysterious and apparently mercurial Expectations Fairies. But that’s a big and controversial topic for another day.

3. The Summers and Krugman crowd that roots for bubbles to fuel expansion choose to ignore the most insidious aspect of Bubbleonia: it is the most successful instrument ever devised for moving income and wealth from the bottom 99% to the top 1%. And there is a nice, tight, vicious circle: by taking from those who are willing to spend, and giving to those who are far too rich to spend (much of their income), you depress the “real” economy. The only way to counter that is to get the losers of income and wealth to borrow to fuel consumption. As Rick Wolff has powerfully explained, that’s what we’ve been doing since the early 1970s.

Bubble-icious asset price booms not only redistribute to the top, but they also ensure that bubbles are the only way to fuel the economy precisely because all the income and wealth are at the top. Financialization of the economy synergizes these processes, adding layers of finance (ie, debt) on all “real” economic activities. This is why most of the impact of bubbles is in the financial sphere, with relatively little impact on the “real” economy during the bubble phase. The commercial real estate bubble of the Reagan years did create some construction jobs, but the direct economy-wide impact was fairly small. The dot-com bubble had even less impact—it mostly just capitalized future profits of imaginary firms that would never generate a cent of income. The most recent bubble, housing, had a bigger impact because house-building plus furnishing new MacMansions did create jobs and incomes, and rising home values generated wide-spread capital gains that propped up consumption.

But whatever bubbles up must crash. Commercial real estate; dot-coms; houses. Only the last one had nation-wide and disastrous impacts because not only did the prices of the newly built homes underlying the asset price bubble collapse, but this also depressed virtually all house prices everywhere in the country. And in the bubble phase, people had hocked their already owned homes to fuel consumption. So now they are losing them.

Just as Clinton’s dot-com bubble had boosted Federal government tax revenue—which grew at a year-over-year pace above 15 percent, the real estate bubble also boosted growth of Federal government revenue at a pace above 15 percent per year. In the first case, it actually generated the Clinton budget surpluses; in the second, it caused the budget deficit to decline rapidly. Accelerated growth of Federal tax revenue sucked income and wealth out of the private sector. Add on top of that the Fed’s rate hike of 2004 and skyrocketing energy prices, so that American consumers found their finances squeezed to the breaking point.

And so we crashed. The rich made out like bandits both on the way up, and even more so on the way down. As I predicted back in 2005, the real estate bubble and collapse would move all wealth to Bush’s ownership class. (See here.) Well, we should also give Obama credit, as he’s overseen what is almost certainly the biggest transfer of wealth to the one-percenters in the ownership class that the world has ever seen.

No wonder Summers neglects to talk about the downside of the upside of bubbles.

4. Even though loanable funds had a stake driven through its heart by Keynes, it is resurrected in remarkable ways. Here’s an example. Martin Wolf is thoroughly learned in the teachings of Wynne Godley, and yet in his piece cited above, he argues that our chronic stagnation is due to a “glut of savings”:

One of those weaknesses is the “global savings glut”, which can also be labelled an “investment dearth”. Low real interest rates are evidence of such a glut: there were more savings searching for productive investments than there were productive investments to employ it.

Another indication of the savings glut was the “global imbalances” – the huge current account surpluses (net capital exports) of east Asian emerging economies (particularly China), oil exporters, and several high-income economies (notably Germany). These economies became net suppliers of savings to the rest of the world. This was true before the crisis and it remains true today.

Before the financial crisis, the US absorbed much of the global excess savings, but not in productive investments. Despite easy access to cheap credit, fixed investment declined as a share of GDP after 2000. One reason for this fall was that the relative prices of investment goods declined: the share of real investment remained stable, while that of nominal investment shrank. Except in the pre-2000 stock market bubble, business also financed its investment out of its own savings: it did not need finance from elsewhere.

But Wynne taught us that balances balance. If there are external dollar savings in the world, they were created by US current account deficits; they balance dollar for dollar. It makes no sense to talk about an “excess”—foreigners exported to America and they got dollars that are mostly used to buy US Treasuries. It makes no sense to argue that the global exporters are “net suppliers of savings to the rest of the world”—the importers created those savings accumulated by exporters. There are no “extra” savings anywhere—surpluses are the accounting record of deficits, and they match dollar for dollar, yen for yen, and euro for euro.

You cannot have a “savings glut” and “investment dearth”. Nay, as Keynes taught us, investment creates saving. Dollar for dollar. An investment dearth would be matched by a savings dearth—not a glut! There’s no “excess saving” to finance a stock market bubble! Wolf confuses a micro level statement (a firm can finance its investment out of its “saving”—retained earnings) with a macro statement (business finances investment out of saving). The first can be true, the second is a logical error.

Wolf knows all of this, I am sure. In his attempt to lionize Summer’s supposed “bravura” performance he takes leave of his better senses.

5. The Summerian stagnationist theory is seriously deficient in identifying the cause. Again, no wonder. The Washington Keynesians like Summers have played a big role because they’ve never mounted a defense against the anti-government Neoliberals. Both Krugman and Summers give lip service to the need for more fiscal stimulus, but their deficit dovishness prevents them from offering a coherent argument.

Here’s the deal. Stagnation results when government spending grows more slowly than GDP. In other words, if government spending as a share of the economy stops rising, we’re up that creek without a pot.

This is the Domar Problem, analyzed extensively by two Portland professors, Vatter and Walker, over their careers. While virtually all mainstream economists believe in a long-term Say’s Law (supply creates demand, so the ultimate constraint on long term growth comes from the supply side), the real constraint on long-term growth in a developed capitalist economy is always on the demand side. (Note that there’s nothing new in the Summers/Krugman recognition of secular stagnation; David Levy called it a “contained depression” in 1991; Wallace Peterson announced a “silent depression” in 1994; and I demonstrated in 1999 that the problem is chronically constrained demand. At a recent Levy Institute conference in Rio, Paul McCulley laid out what he called a fundamental economic principle: Microeconomics and Macroeconomics are inherently different disciplines. Macro is demand-side; micro is supply-side. For any practical time horizon, demand always drives supply. – See here.)

I know what I’m saying is heretical, even though it is fully backed by all the data. And this stagnation is not due to a liquidity trap, or to a negative “natural” rate of interest. It is in the nature of the productivity of capitalist investment in plant and equipment. To put it in simple terms, the problem is that investment is just too damned productive. The supply side effect of investment (capacity creation) is much larger than the demand side effect (the multiplier), and the outcome is demand-depressing excess capacity. We call that a demand gap.

Let me draw on a paper I wrote in 2007, which was one of the last papers I wrote before the crisis hit. (For an earlier paper on secular stagnation that blames demand constraints, see the one I wrote with Marc-Andre Pigeon.) In this paper I focused on long-term stagnation, following the arguments of Domar and Vatter&Walker. Here’s a quick summary from the paper that lays out the problem.**

In the General Theory, Keynes had addressed the demand-side effects of investment: rising investment generates income that in turn induces consumption spending. Keynes singled out investment as the major “autonomous” component of spending, as it is focused on future sales and expected profits over the life of the plant and equipment. Hence, fluctuations of investment “drive” the economy. Because Keynes was most interested in explaining the determination of aggregate output and employment at a point in time, he tended to hold constant the productive capacity of the economy. Whether the economy was operating at full capacity or with substantial excess capacity could then be attributed to the level of effective demand, itself a function of the quantity of investment.

If the economy were operating below full capacity, then the solution would be to raise effective demand—either by encouraging more investment, or by increasing one of the other components of demand. After WWII, “Keynesian policy” came to be identified with “fine-tuning” of effective demand, accomplished through various investment incentives (tax credits, government-financed research and development, countercyclical management of interest rates) and countercyclical fiscal policy. In practice, policy tended to favor inducements to invest over discretionary use of the federal budget—indeed, “more investment” has been the proposed solution to slow growth, high unemployment, low productivity growth, and other perceived social and economic ills for the entire postwar period.

However, Domar had already recognized the problem with such a policy bias at the very beginning of the post-war period. When we turn to the subject of economic growth, it is not legitimate to ignore capacity effects as investment proceeds. Not only does investment add to aggregate demand, but it also increases potential aggregate supply by adding plant and equipment that increase capacity. To be more precise, a portion of gross investment is used to replace capital that is taken out of service (either because it has physically deteriorated, or because of technological obsolescence), while “net investment” adds to productive capacity. Further, note that while it takes an increase of investment to raise aggregate demand (through the multiplier), a constant level of net investment will continually increase potential aggregate supply. The “Domar problem” results because there is no guarantee that the additional demand created by an increase of investment will absorb the additional capacity created by net investment. Indeed, if net investment is constant, and if this adds to capacity at a constant rate, it is extremely unlikely that aggregate demand will grow fast enough to keep capital fully utilized. This refutes Say’s Law, since the enhanced ability to supply output would not be met by sufficient demand. As such, “more investment” would not be a reliable solution to a situation in which demand were already insufficient to allow full utilization of existing capacity.

Vatter and Walker carried this a step further, showing that after WWII, the output-to-capital ratio was at least one-third higher than it had been before the war. Due to capital-saving technological innovations, it takes less fixed capital per unit of output so that the supply-side effects of investment will persistently outpace the demand-side multiplier effects (for example, as a constant level of net investment adds to capacity at a rising rate). The only way to use the extra capacity generated by net investment is to increase other types of demand. These would consist of household spending (on consumption goods, as well as residential “investment”), government spending (federal, state, and local levels), and foreign spending (net exports).

Vatter and Walker believed that growth of government spending would normally be required to absorb the capacity created by private investment. Indeed, they frequently insisted that government spending would have to grow at a pace that exceeds GDP growth in order to avoid stagnation.

This should not be interpreted as endorsement of Keynesian “pump-priming” to “fine-tune” the economy. Indeed, Hansen had previously demonstrated that pump-priming would fail. If government increases its spending and employment in recession, raising aggregate demand and thus, economic activity, only to withdraw the stimulus when expansion gets underway, will simply take away the jobs that had been created, restoring a situation of excess capacity. The larger the government, the harder it becomes to cut back spending because jobs, consumption, income, and even investment all depend on the government spending. According to Vatter and Walker, in a well-run fiscal system, government spending will rise rapidly when investment is rising (to absorb the created capacity), and then will still rise rapidly when investment falls (to prevent effective demand from collapsing). They call this a “ratchet”—rather than countercyclical swings of government spending, “government as a share of the economy should rise indefinitely”. Adolf Wagner had argued that economic development leads to industrialization and urbanization, which generates an absolute, as well as a relative, increase in the demand for more government services (of course, J.K. Galbraith made a similar point). Hence, for political and socioeconomic reasons, government should grow faster than the economy. If it does not, not only will this leave society with fewer publicly provided services than desired, but it will also generate stagnation through the Domar problem.

These arguments concerning secular trends can be supplemented by the Kalecki/Minsky analysis of the role of government over the cycle. Aggregate profits are equal to investment, plus the government deficit, plus the current account surplus, plus consumption out of profit, and less saving out of wages. When investment falls, profits fall. As Minsky put it, past investment undertaken on the expectation of future profits cannot be validated at the lower level of investment, depressing current investment, and further lowering profits through a process of cumulative causation. In a big government economy with a budget that automatically swings in a counter-cyclical manner, deficits are created that attenuate effects on profits. Capital-saving innovations increase the capacity effects of investment, thus, so long as investment remains above replacement levels, potential aggregate supply rises. To utilize this new capacity, aggregate demand must increase even though investment has fallen to a lower level.

Unless another source of demand fills the gap, the government’s budget must become more stimulative. This is more easily accomplished with a bigger government because of the larger potential swings of its budget balance relative to the size of the economy as a whole. Minsky argued that government must be at least as large as investment, however, government will have to be larger to the extent that investment swings are large and if automatic swings of the budget are relatively small. Further, as discussed below, persistent trade deficits will increase the role of government in maintaining profits and demand.

Compare this explanation of the chronic stagnation with the Summers/Krugman argument that it’s all due to an unobservable “natural” real interest rate that has fallen below zero; and with their argument that to counter the stagnation we need more bubbles.

In my paper I extended the Domar Problem analysis to take account of the headwinds facing the economy of the 2000’s:

it is necessary to update the analysis to take account of major changes that have occurred since the mid 1990s: a) growth of consumption—financed by borrowing—has played a surprisingly large role in fueling growth over the past decade; b) a chronic, and growing, trade deficit has worsened the dynamics of growth; and c) there have been fairly substantial changes to tax policy, especially under the current administration.

I concluded the paper with warnings about the dangers facing the economy.

[T]here are real dangers facing U.S. growth—both in the near term, and over the longer run. Federal government purchases are not growing on trend above the rate of GDP growth. Since 1960 this has been somewhat offset—first by federal transfers to state and local government, and later by growth of transfers to households in the form of “welfare” and old-age pensions. However, welfare spending essentially stagnated after the early 1970s (relative to GDP), and Clinton ended “welfare as we know it” by pushing tight constraints on individuals and on states that will prevent social transfers growth. Further, the supposed “unfunded liabilities” of Social Security and Medicare are used by generational warriors in their attempt to dismantle the safety net for seniors. While successes have so far been limited (to payroll tax hikes and phased increases to the normal retirement age—both pushed through in “reforms” formulated by a commission headed by Alan Greenspan in 1983), they might be more successful in the future. Finally, the federal government has been less supportive of state and local government spending since the mid 1970s. Ironically, this has occurred even as responsibilities have “devolved” to the states—leading to a recurring “fiscal crisis” at the state and local government level.

On the other side of fiscal policy, taxes are overly restrictive. State and local taxes are, on the whole, regressive. Given a presumed inverse relation between the propensity to consume and the level of income, regressive taxes reduce aggregate demand. At the federal level, payroll taxes are regressive, but worse, they penalize employment by taxing both wage earners and wage payers. This raises the cost of domestic employment, favoring employment in nations that do not tax payrolls. Finally, as discussed above, many taxpayers will not correctly anticipate the AMT and will be hit with an “April surprise” in the form of an unexpected tax bill, with possible ramifications for spending next spring and summer.

The third area of concern is the trend rate of growth of private sector debt. To be sure, debt has been growing persistently since 1960, however, recent private sector deficits have accelerated the rate of growth of debt relative to income. Household debt stands at twice disposable income. Willingness to deficit spend helped to fuel the Clinton boom, and fueled the Bush “recovery.” This might have been due, in part, to “democratization” of access to credit—which is not necessarily a bad thing. In addition, the strength and length of the Clinton boom, as well as the stock market bubble and new economy hype, probably raised expectations of American households. When the bubble came to an end, the private sector temporarily retrenched, but borrowing soon was renewed at a rapid clip.

Since 2001, two factors appear to have played the dominant role in generating household deficits. First, the Bush recovery has been weak in terms of jobs created, and, more importantly, in terms of growth of wages. This is the first “expansion” since WWII in which real wages have not risen, indeed, the median hourly wage actually fell by 2% since 2003. Wages and salaries have reached their lowest share of national income since data began to be collected in 1947—just 45% of GDP in the first quarter of 2006, compared with 53.6% in 1970 or 50% as recently as 2001. Even workers at the 90th percentile have seen real pay fall for the past three years. A detailed study of census data found that all of the growth of median income in the United States from 2001 to 2005 was due to growth of incomes of those over age 65; for those under age 65, income fell by an average of $2000. The real income of men was actually lower in 2005 than it had been in 1973. In 2005, the top quintile received more than half of all income, while the share of other quintiles continued to fall. So, to some extent, growth of debt is necessary to maintain rising—or even constant—living standards in an environment of stagnant or falling real income, except at the very top of the income distribution.

That explains some of the “push” into debt, while the real estate and commodity price bubbles provided the “pull.” After the stock market crash (of the early 2000s), investors looked for alternative earning assets, and found them in commodities and real estate. The commodities price boom gained attention because of the impact of rising (and now, falling) crude oil prices on gas prices and U.S. inflation. While it is beyond the scope of this article, much more needs to be written on this topic, including an analysis of the role played by pension funds and hedge funds in fueling the commodities boom, as well as an examination of the possible impacts on the United States and world economies of the coming crash of commodities prices. This could easily reduce GDP growth by a half of a percentage point or more. Here we will consider only the real estate boom, which has added a significant boost to aggregate demand and generated 30% of employment growth during the recovery.

U.S. housing wealth doubled from $10.4 trillion in 1999 to $20.4 trillion in the first quarter of 2006. Households used their homes like ATMs, with “cashout equity” financing consumption, taking out at least $50 billion per year. In addition, mortgages have been increasingly in the form of higher interest rate “non-prime” loans as buyers stretched to afford more expensive homes. Indeed, in 2005, a quarter of all mortgage loans were non-prime, compared with just 11.5% in 2004. For blacks, non-prime loans accounted for a shocking 55% of home purchase loans. Further, about half of the growth of non-prime loans is in the form of “piggy-back lending,” or second lien mortgages to provide a “down payment” when the buyer cannot come up with the usual 20% down payment. Much of the borrowing was at variable interest rates that are now beginning to rise. Indeed, over the next few years, several trillion dollars of ARMs will reset. Goldman Sachs estimates that the expected ARM reset will swallow 10% of the income of a typical household with an ARM, amounting to $6600 per year in additional mortgage payments, or $24 billion per year in the aggregate. To be sure, interest paid by one household is received by another as interest income. However, financial wealth-holders tend to be richer and older than the average household, so the impact on aggregate demand could be significant. Unfortunately, almost all news from the real estate front is now bad, with sales falling, inventories rising, and weak mortgage demand. Rising interest rates and falling house prices would be a recipe for consumer distress. Further, it is not necessary for housing prices to actually fall in order for consumers to be forced to reduce spending, as they have relied on rising prices to collateralize their borrowing and deficit spending. If households merely bring spending back into line with their incomes, the hit to aggregate demand would be around 4% of GDP.

The fourth area of concern is globalization and external pressure on wages and prices. While many analysts emphasize the effects of increased openness on the U.S. trade balance, that is not really the issue at hand. As elementary economics teaches, imports are a benefit and exports are a cost, so net imports represent net benefits. The problem is that elementary analysis presumes full employment. The United States can reap the net benefits of its trade deficit only if it operates at full capacity. Unfortunately, the instinctual response to trade deficits is to reduce domestic demand by imposing fiscal and monetary policy austerity—which only compounds the problems generated by the leakage of demand to imports. This ensures that the potential benefits of a trade deficit will not be enjoyed. The correct response is to find employment for those displaced by a trade deficit, and to ramp-up domestic demand to cover the trade deficit leakage. That, however, is extremely difficult in the current politico-economic environment, in which the trade deficit is attributed to American consumers “living beyond their means,” by relying on “foreign savings.” In truth, the U.S. current account deficit is the source of the dollar assets accumulated by foreigners. While it may be true that American consumers are over-indebted, their debt is in dollars and it makes little difference whether that is owed to domestic wealth holders or to foreigners. What does matter is that foreign competition has been reducing U.S. wages and salaries, and, perhaps, causing American job loss. However, this becomes a problem only if U.S. policy refuses to respond with job creation, as well as protection for decent living standards. Again, this is a medium term or even long run problem, not simply a result of business cycle forces. It is not clear that policy makers understand the nature of the dangers, nor can they mount a proper response because they see exports as a benefit and imports as a cost.

The final longer-term problem is the growth of “neoconservative” ideology. While this may not be easy to define in precise terms, it represents a turn against the “mixed economy” in which “Big Government” has a positive role to play. Essentially, it is a return to Hoover-era laissez faire in which the ideal is a small government, and in which private initiative is supposed to fuel economic growth. That may have been fine in the 19th century, when the economy was relatively undeveloped and productive capacity was limited. In that era, high private investment added to demand and to supply to an approximately equal degree. However, technological advance and innovation increased the capacity effects of investment to the extent that they easily outstripped demand side effects.

Hence, while the neoconservative ideology might be appropriate to some stage of the development of capitalism, it is clearly out of place in the modern economy, where the capacity effects of investment are huge. Further, the neocons would violate Wagner’s Law by reducing the relative size of government as the economy develops. This ignores the social desire and need for increased provision of social services as the economy grows. The argument that J.K. Galbraith made in the early 1960s concerning the relative dearth of public services is only very much stronger today—with unmet needs for universal health care, for universal access to higher education to prepare youth for the “knowledge” economy, and for greater public involvement in finally eliminating the remaining inequalities that result from intransigent racism, sexism, and cultural biases.  All of these are difficult issues and there is no plausible argument or evidence that they can be resolved through “private initiative.” In fact, the neocon ideology has played an important role in reversing progress made since WWII on these and other fronts. Neocon policies reward the privileged and punish the have-nots. The rich get vouchers for well-funded private schools; the poor see funding of their public schools reduced. The rich get tax relief on capital gains and inheritances; the poor get higher local sales taxes and federal payroll taxes. The Katrina victims are evicted from Femaville trailers while the Haliburtons get no-bid contracts to rebuild New Orleans as a playland for well-heeled business conventioneers. Obviously, this reduction of the role played by government moves the U.S. economy in the wrong direction.

As Hyman Minsky used to argue, capitalism was a failed system in 1930. The growth of “Big Government” was singled out by Minsky and by Vatter and Walker as the necessary medicine to build a viable and robust version of capitalism. Minsky always insisted that there are “57 varieties” of capitalism, with different systems appropriate to different historical epochs. Unfortunately, the modern Hooverites are attempting to return to 1929, that is, to a system that was not even appropriate to the pre-war period. The evolutionary or institutional approach taken by Domar, Minsky, and Vatter and Walker, which recognizes the necessity of the “mixed economy,” is the alternative that will help us to formulate policy appropriate to today’s problems.

Well, we know what happened next! We collapsed. We’re still collapsing. We’ll continue to collapse until we understand the positive roles that government must play in the economy.

Bubblemania is not the answer.

**Note: see the paper for citations.

74 responses to “Bow down to the Bubble: Larry Summerian Endorses Bubbleonian Madness and Paul Krugman Embraces the Hansenian Stagnation Thesis*

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