http://chronicle.com/weekly/v54/i31/31b01001.htm
Chronicle of Higher Education, from the issue dated April 11, 2008
THE MATERIAL WORLD
America's Exhausted Growth Paradigm
1980 brought a new kind of business cycle, one that's no longer sustainable
By THOMAS I. PALLEY
The American economy is most likely in recession, and high debt and
housing-sector problems spur fears that this downturn could be far more
severe than the recessions of 1991 and 2001. The Federal Reserve and
Treasury have taken unprecedented actions to stimulate the economy
through interest-rate cuts, infusions of liquidity, and tax cuts, all of
which are entirely justified but constitute short-term economic
firefighting.
While America certainly needs to deal with the latest trough in the
business cycle, we also need to recognize that the growth paradigm that
has driven our economy for the past generation is exhausted. That also
has implications for the global economy, which has relied on America as
the buyer of last resort. Should the American economy slow, it is not
clear other countries have either the capacity or the will to develop
alternative engines of economic growth.
The recent economic expansion began in November 2001 with an extended
period of jobless recovery, and for most of the expansion, employment
growth remained below par. That compelled the Federal Reserve to lower
interest rates despite a so-called recovery, to keep rates low for an
extended period, and to raise them only gradually thereafter. The Fed's
actions prevented a relapse into recession, but only by triggering a
bubble in housing prices. They also fostered a chase for yield among
investors that led to a disregard of risk, and that has come home to
roost in the form of house-price deflation and massive losses in credit
markets.
Why was the expansion so weak despite the massive tax cuts of 2001 and
large increases in military and security spending? The answer is the
overvalued dollar and a trade deficit that drained spending, jobs, and
investment from the economy. As a result, much of manufacturing failed
to participate in the expansion. Indeed, manufacturing actually lost 1.8
million jobs between the end of 2001 and the end of 2007. That is
unprecedented, as never before has manufacturing lost jobs during an
expansion.
The U.S. policy of a strong dollar bears substantial blame for the trade
deficit. The policy was initiated by the Clinton administration on the
advice of Treasury Secretary Robert E. Rubin, and the Bush
administration continued it. The effect has been to make imports cheaper
and exports more expensive, thereby increasing imports, decreasing
exports, and encouraging offshoring of production. That, in turn, caused
job cuts in manufacturing, reductions in production capacity, and
reduced investment in domestic manufacturing.
Trade policy has also played a significant role by encouraging American
corporations to move production offshore and shift to global sourcing.
Compounding those trends were the export-led growth policies of China
and other East Asian countries. Those policies promoted Asian exports
and foreign direct investment in those economies, while hampering
American exports.
The trade deficit and disregard for manufacturing are part of a broader
policy paradigm in place since 1980 that created a new kind of business
cycle. The business cycles during the administrations of Ronald Reagan,
George H.W. Bush, Bill Clinton, and George W. Bush have strong
similarities and are very different from those before 1980. The
similarities are the detachment of wages from productivity, large trade
deficits, inflation, losses in manufacturing jobs, and rising household
debt.
The post-1980 business cycle has relied on financial booms and cheap
imports. Financial booms have provided collateral to support increased
borrowing that has financed spending on consumption. Increased borrowing
has also been supported by easing of credit standards, and by financial
innovations that have widened access to credit. Meanwhile, cheap imports
have ameliorated the effects of wage stagnation.
That pattern contrasts with the earlier business cycles that rested not
on borrowing but on wage growth tied to productivity growth and full
employment. Spending, combined with full employment, encouraged
investment, which increased productivity and fueled higher wages.
The shift from the old to the new business cycle was the result of
profound political change associated with Reagan's election in 1980. It
inaugurated a period in which business has been ascendant and labor
battered. The shift was intellectually rationalized by economists such
as Milton Friedman. The old business cycle rested on the combination of
New Deal institutional innovations that strengthened labor, combined
with demand-management measures pioneered in Keynesian economics. The
new business cycle rests on policies that have sought to erode and
repeal New Deal institutions, and demand management has been redirected
to lowering inflation rather than securing full employment. Indeed, the
language of full employment has been discarded.
The differences between the post-1980 and pre-1980 business cycles are
starkly illustrated by policy. Previously the trade deficit was viewed
as a serious problem because it was a leakage of spending from the
economy that undermined employment and production. Since 1980 the trade
deficit has been viewed as a helpful form of inflation control, and it
has also helped hide the effects of wage stagnation.
The new business cycle has also changed monetary policy. Previously it
was geared to supporting labor markets, maintaining full employment and
wages, and encouraging the spending that drove investment and
productivity growth. Now monetary policy supports asset prices in order
to encourage borrowing, and rising wages are viewed as an inflationary
threat.
The problem is that the post-1980 paradigm is tapped out. After a
quarter-century borrowing binge, many households have hit their debt
limits. Likewise, prices of assets (especially houses) are at elevated
levels and at risk of falling, in some cases precipitously. In other
words, this business cycle needs inflation in asset prices plus
borrowing to drive spending.
More fundamentally, it is unclear how growth can be restored. Consumers
won't be able to borrow their way out of this recession as they have the
past couple. Lower interest rates are likely to be far less effective
than before, with their effect similar to pushing on a slack string.
Previously households had unused access to credit, which provided a
launching pad for recovery. Now many are in debt to the hilt, and banks
are far less willing to lend to risky borrowers anyway.
Mortgage refinancing is also likely to have weaker effects. First, the
pool of high-interest-rate mortgages has largely been refinanced in
prior recessions, leaving fewer mortgages worth refinancing. Second,
falling house prices will make banks less willing to refinance existing
mortgages, which may exceed house values.
The bottom line is that the post-1980 business cycle, which has relied
on a combination of asset price inflation and persistent increases in
borrowing, appears exhausted. Not only does the economy stand to lose
the economic octane that those processes provided, it could fall into a
downward spiral if asset prices decline and households shun further
debt. Under these conditions, the Federal Reserve is likely to be able
to do little to jump-start growth.
We need a new economic paradigm that restores the link between wages and
productivity growth, and again makes wage income the principal engine of
demand. Remedying the generation-long rupture of the wage-productivity
link will require the restoration of policies aimed at full employment.
Full employment will give workers bargaining power. That will encourage
wage increases, which will fuel spending, productivity, and investment.
Achieving full employment will require coordination of monetary, fiscal,
and exchange-rate policies toward that end.
Also necessary is a change in the balance of power in labor markets.
That will entail reforms and vigorous enforcement of labor law to end
employer intimidation preventing workers from joining unions and
bargaining for fair contracts. The minimum wage should be tied to
average wages so that it rises as the economy grows. And unemployment
insurance must be broadened and extended.
America must also start to close the trade deficit, which has
hemorrhaged spending and undermined manufacturing. A new exchange-rate
policy should prevent overvaluation of the dollar relative to the
currencies of major trading partners. Only a clear and lasting
commitment to such a policy will convince businesses to invest again in
American manufacturing.
Lastly, developing economies must be weaned from their policies of
export-led growth, and must focus on the development of domestic
markets. In the realm of trade policy, that means putting an end to
unfair international competition based on undervalued exchange rates,
export subsidies, and unfair trade restrictions. That will require a new
international economic architecture that promotes fair and balanced
trade — a task that will require enlightened American leadership.
Thomas I. Palley directs Economics for Open and Democratic Societies.
Previously he was director of the Open Society Institute's Globalization
Reform Project and assistant director of public policy at the AFL-CIO.
This column is adapted from a paper he gave at the most recent annual
meeting of the American Economic Association.
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