Why a depression could happen
by Thomas I. Palley
J U L Y 1 9 9 6
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www.theatlantic.com]
ECONOMISTS are hardly renowned for their ability to predict the economic future. In 1929 Irving Fisher, perhaps the greatest of all American economists, confidently predicted that the stock market would go on to new highs and that the expansion of economic prosperity would continue, with no end in sight. Less than two months later came the crash; the economy had already entered what was to become the Great Depression. Published in 1987, Ravi Batra's best-selling The Great Depression of 1990 predicted just what the title says. So much for predictive accuracy.
Compounding the problem of prediction is the tendency to believe that each business-cycle boom will last forever -- that the business cycle is dead. Predictions of when the next recession will occur aside, however, there are now solid grounds for believing that the economy is again vulnerable to the sort of seismic shock that generated the Great Depression. The period from 1950 to 1970 is often referred to as the Golden Age of American capitalism. Real per capita income grew in those years at 2.25 percent a year, and prosperity was democratized as huge numbers of Americans entered the middle class. Indeed, a new working-middle class was created, as blue-collar workers came to enjoy the benefits of homeownership, and rising wages allowed them to buy household appliances and new cars and to take vacations.
Since 1970 this expansion and diffusion of prosperity has stopped, and the Golden Age has been replaced by a Leaden Age, in which economic growth has been accompanied by falling wages and rising unemployment. Real (in terms of purchasing power) average weekly wages peaked in 1973, at $308.03 (1982 dollars), and by 1991 had fallen to $260.37, a decline of 15.5 percent. Yet the productivity of American workers increased by 11 percent over the same period. From 1951 to 1974 unemployment averaged 4.65 percent; from 1975 to 1993 it averaged 6.97 percent.
This waning of prosperity reflects a shift from the Main Street capitalism of the Golden Age to the Mean Street capitalism of the Leaden Age. The hallmark of the former was that it generally worked for the benefit of the average citizen by sharing the fruits of growth among all. The hallmark of the latter is an economic environment that pits citizen against citizen for the benefit of those who own most of America. This shift is the direct result of a refashioning of the nation's economic architecture and a reversal of the policies associated with the Golden Age. It has opened the possibility of another Great Depression.
Since the Second World War the U.S. economy has had nine recessions, defined as two consecutive quarters of declining output. The normal pattern has involved an increase in the rate of unemployment and also "disinflation" -- a decrease in the rate of inflation. The most severe of these recessions was that of 1981-1982, when unemployment exceeded 10 percent for the first time since the 1930s. The most recent recession, which began in 1990, appears to be qualitatively different from preceding recessions in that the subsequent recovery has been much milder, and the process of disinflation has continued throughout the recovery period. Thus, rather than picking up, inflation has continued to fall during the recovery, and we now have close to zero inflation. This means that were the U.S. economy to enter a new recession, it would be likely to experience deflation: prices and wages would actually fall. Were this to happen, the burden of interest payments on the debts of consumers and businesses would increase enormously, thereby making for a collapse of both consumer spending and capital spending by businesses.
It is for this reason that deflation has historically been associated with periods of economic depression. A reasonable definition of depression is a period of prolonged unemployment in excess of 10 percent accompanied by deflation. The recession of 1981-1982 showed that rates of unemployment in excess of 10 percent are again possible, whereas the most recent recession has raised the specter of deflation. The twin characteristics of depressions are therefore now potentially in place. Behind this new circumstance lie the changed conditions associated with the emergence of the Mean Street economy. The high level of indebtedness in the U.S. economy implies that if prices and wages start falling, spending and fresh borrowing will most likely collapse, and bankruptcies will rocket. The economy could then find itself in a contractionary spiral, with wage deflation feeding a collapse in spending, and collapsing spending feeding further wage deflation.
Prolonged Recessions,
Tenuous Recoveries
ONE indication of our growing economic fragility is the recession of 1990. The accepted story is that the Iraqi invasion of Kuwait and the ensuing spike in oil prices gave a sudden shock to the confidence of American consumers, damping their spending and pushing the economy into recession. This recessionary shock was amplified by the large debts that American households and corporations had built up during the 1980s.
Whereas the role of debt in propagating the recession was real and important, the consumer-shock story resembles the snowball theory of avalanches. Moreover, it illustrates the complete confusion that characterizes modern economics. On the one hand, consumers are told to spend, spend, spend! On the other, they are told to save, save, save! Similarly, whereas huge consumer debt burdens are an important component of the new economic fragility, their existence is explained by developments associated with the shift to the Mean Street economy. Debt, therefore, is both a symptom and a cause of our troubles.
Just as the causes of the 1990 recession have been poorly explained, so have its prolonged nature and the weakness of the subsequent recovery. Economists consider the recession to have ended in the first quarter of 1991, but substantive recovery did not really begin until the second half of 1993. Thus for almost three years the economy was effectively dead in the water. This kind of prolonged stagnation distinguishes the current recovery from previous postwar economic cycles. Moreover, the economic recovery has been extremely anemic by postwar standards. In the fifty months after the trough of the recession, in late 1990, the economy created 7.8 million jobs. That is 40 percent below the average rate of employment growth in the first fifty months of the previous two economic recoveries.
Throughout this period of putative recovery consumer confidence has been notably weak. Income data for 1994 show that real median wages fell by more than two percent. Thus the median household actually suffered a decline in its standard of living. Not only has income been falling, but job security has declined as corporate downsizing continues. The threat that production will be relocated to low-wage regions, both within and outside the United States, is a persistent and growing source of wage restraint.
The Fragile Household
FOREMOST among the causes of the prolonged 1990 recession and its subsequent weak recovery is an underlying deterioration in the robustness of the demand for goods and services.
The silent depression (the erosion of wages and the increase in unemployment rates) afflicting ordinary American households has weakened consumer purchasing power and shifted income away from wages and toward profits and executive salaries. This, more than anything else, has created a structural weakness in demand. This development has been obscured, and its impact delayed, by the tremendous growth of household debt that began in the 1980s.
Expansion of household debt has always been an important source of demand growth in the U.S. economy, paving the way for expansion of the mass market. In past decades, however, household borrowing rested on a presumption of rising incomes to pay it back, and was therefore "demand-leading." Today, with wages declining, debt is being incurred simply to maintain existing living standards. "Demand-leading" debt has become "demand-maintaining." Because new borrowing causes a cumulative growth in household indebtedness and raises the interest payments debtor households must make, indirectly, to creditor households, the demand-maintaining capacity of new borrowing is unsustainable. In general, low- and middle-income households are net debtors, while high-income households (of which there are few) are net creditors. Consequently, demand-maintaining borrowing aggravates the underlying problems of weak demand and unequal income distribution.
Ultimately households hit their debt ceilings. This can be temporarily delayed -- either by raising debt ceilings and allowing households to pile up more debt or by lowering credit requirements and lending to less-creditworthy households. The flood of invitations to obtain credit cards and the raising of mortgage-lending ceilings from the old "three times gross income" to "four times gross income" show that this has in fact been happening. Again, the delay is only temporary, because households may voluntarily stop borrowing when they realize their financial vulnerability. The unsustainable growth of debt, rather than the invasion of Iraq, is the likely explanation of the onset of the 1990 recession -- and it also threatens to end the current recovery.
Once households run out of income to service existing debt, and borrowing stops, maintaining demand becomes difficult. Flagging demand for goods and services causes businesses to reduce output and lay off workers. This lowers wage income and further undermines households' willingness and ability to borrow, thereby worsening the underlying problem of demand.
These problems would be bad enough in an economy with strong labor unions and low unemployment, but they are likely to be worsened in an economy in which labor is weak and companies not only lay off workers but also force wage concessions from those not laid off. Widespread wage concessions could weaken demand to the point where mass layoffs occur. Such a possibility now haunts the U.S. economy, and that is why the next recession may turn into a depression.
Shaky Stabilizers
JUST as household borrowing can sustain the economy, so, too, can borrowing by the federal government. During the 1980s the federal government ran up huge deficits that were financed by borrowing to fund government spending and employment, both of which contributed significantly to demand. A large component of this spending was the defense buildup -- a classic example of military Keynesianism (by no means the best sort of Keynesianism!) at work. The impact of this spending was augmented by large tax cuts for the wealthiest households in the country. A better policy would have been to give the tax cuts to ordinary households, which spend a greater share of their income. Issues of equity aside, we would have achieved the same level of demand with smaller deficits.
This period of maintaining demand through federal deficit spending is ending, and the household sector and the government sector may thus be forced into cutting spending at the same time. The pressure to cut government spending is largely political, and derives from a misunderstanding of the economics of government deficits. Though deficits can be extreme and dangerous, at less than three percent of U.S. national income our deficit is neither. Just as individual households borrow to finance homes and cars, we should expect government to borrow to finance highways, sewers, schools, airports, public buildings, and the like (the good sort of Keynesianism).
Moreover, the government plays a critical role in providing the financial sector with safe liquid assets to hold as part of its portfolios. In a growing economy with a growing financial system, we should expect government to borrow -- both to fund its expenditures and to lubricate the financial system.
What the level of the deficit should be is impossible to say. Though it was certainly too high during the Reagan era, we have now moved to the opposite extreme of deficit phobia. This phobia is being opportunistically exploited in order to refashion government so as to lessen the protections it gives to ordinary workers. This shift in policy is making workers more vulnerable to the discipline of the market -- sharpening competition among workers for scarce jobs -- and increasing the power of business over labor. This is the result of such developments as the declining value of the minimum wage, the declining value of Aid to Families with Dependent Children payments, and suggestions for limiting need-based claims on welfare. The rhetoric accompanying this retrenchment is that of ending "dependency," yet to end dependency in any real way demands the creation of "opportunity." This requires running the economy at high levels of employment, ensuring that jobs carry a living wage, funding education and job training, and increasing the earned-income tax credit to strengthen the incentive to work. This is not the direction of policy now. If one were to design a system not to end dependency but to increase economic insecurity the better to raise profits for employers, one would design today's economy.
The proposed balanced-budget amendment, requiring zero deficits, threatens to lock the federal government into dangerously destabilizing financial practices. In recessions, when tax revenues fall with falling economic activity, the government would have to either cut spending or increase income taxes to balance its budget. Either course would reduce total spending and aggravate the recession.
With or without a balanced-budget amendment, we appear to be following a political trajectory (sanctioned by Republicans and Democrats alike) intended to diminish greatly the economic role of government. This diminution threatens the economic stabilizers of the Golden Age, which ensure that the government automatically supports demand when the economy begins to trail off into recession. These stabilizers work through the progressive income tax and the national system of income supports. The current Republican policy proposals threaten in varying degrees to end the federal government's capacity to act as an automatic stabilizer by subcontracting its functions to the states, by reducing income-tax progressivity, and by having government "wither on the vine."
Attempts to reform welfare by subcontracting the functions of the federal government to state governments threaten this important component of the system of automatic stabilizers. Whereas the federal government funded welfare programs on the basis of defined standards that were independent of the number of claimants, the proposed new arrangements will simply involve block grants to the states, which would not be required to respond to cyclical fluctuations in need. Under block grants the federal government would no longer automatically pump more welfare spending into the economy during recessions, which is when need goes up and demand must be stabilized.
These shifts to contractionary fiscal practices are occurring when the composition of federal outlays has itself become more contractionary. The enormous increase in the national debt arising from Reagan-era deficits has caused a leap in interest payments -- now 14 percent of federal outlays. Since the debt is held primarily by the very wealthiest households, these payments amount to a "reverse Robin Hood" transfer program. The net effect is contractionary because the wealthy spend less of their income than do ordinary Americans.
When Ronald Reagan entered office, the national debt stood at just under $1 trillion. When George Bush left office, it stood at $4 trillion. It is hard to see what we got in return. The Reagan-Bush deficits have an almost Machiavellian quality to them: unable to persuade the American public to abandon its commitment to the New Deal system of welfare, unemployment insurance, and Social Security, Presidents Reagan and Bush ran up huge debts that have financially boxed in government, thereby threatening these programs with insolvency. Moreover, since the benefits received and taxes paid by ordinary Americans have remained largely unchanged, this increase in debt has served to give the government an appearance of profligacy. Thus public opinion has turned against government, so that we are now willing to contemplate dismantling the system of automatic economic stabilizers such as the progressive income tax, unemployment insurance, Medicaid, and welfare.
The Deflationary Fed
THE other great instrument of economic stabilization has been monetary policy, which uses the Federal Reserve's control over interest rates to adjust the money supply and the availability of credit. In the past the Fed used this power to ensure high levels of employment. Today it is exclusively committed to achieving zero inflation and has been willing to accept whatever levels of unemployment are necessary to that end.
As a result interest rates and unemployment have been much higher in the 1980s and 1990s than they were in the period 1950-1970. The true unemployment resulting from this crusade against inflation far exceeds the official unemployment rate, a point eloquently documented recently by Lester Thurow in The American Prospect. At the beginning of this year almost eight million people were unemployed, yielding an unemployment rate of 5.6 percent. But an additional five million discouraged workers are not actively seeking work, because of the lack of job opportunities. There are also 4.5 million workers working part-time involuntarily. When all these workers are accounted for, the true rate of unemployment is closer to 14 percent.
Inevitably, unemployment and underemployment have weakened the position of labor and contributed to the shift in income distribution from wages to profits. Moreover, the Fed now interprets any sign of wage increases as incipient inflation, and responds by raising interest rates. Since wage increases are the means by which labor shares in productivity growth, this policy is tantamount to helping corporate and financial capital to gang up on labor.
The Federal Reserve vividly illustrated its new stance in 1994, when it raised interest rates six times. Just as the long-awaited economic recovery was picking up steam, the Fed slowed employment growth. It claimed that its action was necessary to prevent inflation from accelerating, but never produced compelling evidence of the danger of inflation. Defenders of the Fed say that it will always be criticized for taking away the punch bowl just when the economic party is warming up. However, the real problem is that most working Americans haven't been invited to the party.
The Federal Reserve is constantly trying to persuade itself that inflation is accelerating in order to justify its predisposition to raise rates. This is a dangerous game: given the fragility of the current economy, a rate increase could halt the recovery and send the economy into a tailspin. It is not clear that reversing interest rates could then straighten the economy out again. This is surely the lesson of the last recession, which required three years' worth of interest-rate cuts to produce a meaningful recovery.
The Fed has been lucky so far to escape the consequences of its policies. The wave of mortgage refinancings and household-loan consolidations that took place in the late 1980s and the early 1990s reduced the amount of debt service that households had to pay and thus helped to stave off a deeper recession. However, such refinancing is ultimately limited by the amount of other debt taken on when interest rates were at their peak and by the number of mortgages -- gradually this stock has been exhausted. And because of the shift to variable-rate mortgages, the refinancing of which is not worthwhile (except to lock in rates), refinancing is not likely to provide such stimulation again. Consequently, demand will be more fragile in the next recession, and recovery harder to achieve.
There are other barriers to refinancing and low rates. During the last recession housing prices fell, and many homeowners in the Northeast and California saw their equity eroded. Banks won't refinance without equity, and if housing prices fall in the next recession, this problem will be compounded. At the same time, banks have been lowering credit standards, increasing the risk of default. This risk is reflected in market rates, which means that there are limits to how low the Fed will be able to push rates in the event of another recession.
Demographics and
Depression
THE aging of the Baby Boom generation and the generalized graying of America also increase the likelihood of an economic depression. Household expenditure patterns have a life cycle, with people tending to borrow and spend more when they are young. In middle age, after child-rearing is over, people begin to save more, in order to pay off their debts and to provide for old age.
The size of the Baby Boom, and the fact that Baby Boomers delayed starting families, have made these life-cycle forces work in the economy's favor for the past twenty years. They help to explain the enormous increase in household borrowing that occurred in the 1980s, and have served to mitigate the adverse consequences of the polarization of income distribution. Now the inexorable force of demographics is turning against the economy, and it is unlikely to be offset by the influx of young immigrants, who tend to enter on the bottom rung of the economic ladder, with low incomes, poor job prospects, and little access to credit. Their net contribution to demand will not compensate for the aging of middle-class America.
Finally, this demographic reversal is compounded by the system for financing Social Security. Contributions to Social Security are economically equivalent to a tax. Right now payments into Social Security vastly exceed payments out, because large numbers of Baby Boomers are still working. This situation will continue through the first decade of the twenty-first century, so that Social Security contributions will be a net contractionary drain on the economy. In recent years this contractionary effect has been offset by federal spending. Current moves to balance the federal budget mean that the contractionary effect will be increasingly felt.
Labor Markets and
Globalization
PERHAPS the single most important factor in the growing fragility of the economy is developments in labor markets. Deriving from both structural change within the economy and adverse economic policy, these developments have caused declining wages and widespread job insecurity. Capital mobility has increased, enabling firms to freeze wages and benefits or to obtain outright concessions under the threat of relocation to low-wage regions. Lower transportation costs, improved electronic communications and long-distance management technologies, and the deskilling of jobs through technology have all made it easier to shift operations to low-wage regions, even if the labor in those regions is unskilled.
Worsening the wage squeeze is a free-trade policy that has lowered tariffs. Tariffs reduce the incentive to produce overseas, and tariff reductions increase the profitability of expatriate production, thus exacerbating the threat to wages and jobs posed by firms' enhanced ability to move. The temporary job gains resulting from exports of machinery and equipment for new factories overseas have been more than offset by the job losses that have followed when production has moved and factories here have closed. Moreover, this trend toward actual or threatened expatriate production shows no sign of abating. The North American Free Trade Agreement and the General Agreement on Tariffs and Trade both lowered tariffs and are likely to increase the pressure on the wages of most Americans.
Also contributing to the pressure on wages has been the decline in trade-union power. Union membership has fallen from approximately 35 percent of the work force in 1954 to 14 percent in 1994. Unionization among private-sector workers is a mere 11 percent. In part this decline reflects the declining size of those industries in which unions historically were strongest. But it also reflects the antagonism that many American nonunion workers feel toward unions, which have come to be viewed as just another special interest, without any particular moral standing.
This change in popular perception has been disastrous for both union and nonunion workers. Unions depend for their long-term survival on popular support, and as that support has waned, they have become increasingly vulnerable to decertification drives by management and to replacement by nonunion workers. But the existence of strong unions confers benefits on nonunion workers, since companies are willing to pay higher wages and provide more benefits to prevent the spread of unionization. The decline of unions has been accelerated by the politically driven turn in policy at the National Labor Relations Board which occurred in the 1980s -- most forcefully exemplified by the Reagan Administration's crushing of the air-traffic controllers' strike. This has made the creation of unions more difficult, union decertification and the replacement of striking union workers less difficult.
Taken together, these changes have significantly weakened the position of American workers relative to companies. This trend shows no sign of abating. The structural changes in labor markets make it more likely that wage levels will crumble in a severe economic downturn.
Businesses are increasingly willing to subcontract work and to use poorly paid temporary workers (who are in fact semi-permanent). The availability of large numbers of unemployed workers means that wage concessions will be relatively easy to obtain in a downturn. In this regard the deep recession of 1981-1982 was a significant harbinger. It marked the first time since the Second World War that wage concessions and givebacks were widespread. Beyond a certain point the position of labor in the economy cannot get weaker without grave macroeconomic consequences. Household debt burdens could become intolerable, consumer spending could collapse, financial markets could be confronted by a wave of defaults, and economic activity would plummet. It is hard to see how policy could turn such a situation around.
The Internationalization of
Deflationary Policy
CHANGES in the international economy and the push for global free trade also make a depression more likely. Economists assert that free trade is good for American workers, and they have persistently advocated the elimination of tariffs. But they draw no distinction between, say, trade with West Germany and trade with Indonesia.
Without doubt international trade promotes product choice and lowers prices through international competition. However, when trade rests exclusively on wage differentials, as does most trade with the Third World, it implicitly becomes an instrument for pushing down wages and pushing up profits. Free trade promotes competition not only between individual products but also between different economic systems. Thus it can become a force for implementing the lowest standards in workplace safety, environmental protection, and social-welfare legislation, since business in advanced countries will push to eliminate these costs in order to remain internationally competitive.
In this fashion ill-considered free trade can promote a "race to the bottom" that lowers wages, job security, and social-welfare standards. This possibility has become all the more real with the tremendous increase in the ability of business to organize production in a global way, most often in underdeveloped countries. The greater mobility of capital, and improved global communication and transportation systems, will make the race to the bottom a much more severe problem in the future.
This prospect is clearly evident from the emerging data on the effects of NAFTA. The early numbers are in, and they are not good. The U.S. merchandise trade surplus with Mexico reached a peak of $5.4 billion in 1992, the last year before NAFTA was approved. By 1994 it had fallen to $1.3 billion, and by the end of 1995 it had become a deficit of $15.4 billion. This marks a three-year deterioration of $20.8 billion. Supporters of NAFTA claimed that every billion dollars of exports would generate 19,000 jobs. If that's true, NAFTA has already cost the U.S. economy 395,200 jobs, almost all of which were in the relatively well-paying manufacturing sector. This cost is separate from the depressing effect that Mexican daily wages of $6.00 have had on American wages. The export of jobs will continue as companies such as Ford, Mattel, Zenith, and General Electric shift production south of the border.
Changes in international financial markets have also promoted a deflationary bias. The introduction of new electronic technologies has increasingly interlinked financial markets. Thus holders of wealth now have portfolios containing financial assets from around the world. In its perpetual search for the highest rates of return, financial capital moves rapidly between countries in response to small differences in interest rates. This development has been encouraged by economic policies abolishing controls on the international movement of capital. Financial globalization has accelerated; as a result many countries have only limited control over domestic interest rates, and have thus largely lost the power to pursue expansionary policies based on low interest rates. Worse, there is now pressure to raise interest rates in order to guard against the possibility of sudden outflows of funds.
Pressures for deflationary bias have also been evident in dealings with less developed nations. Here the key institutions are the International Monetary Fund and the World Bank. Both these institutions were founded to stimulate global economic expansion and development, yet getting aid from them, particularly the IMF, has increasingly been made contingent on the implementation of "financial reform" programs that involve disinflation, cutting welfare and government spending, deregulation, and the abolition of capital controls. This list of reforms effectively serves to lock a country's domestic economic policy into a contractionary stance rather than promoting adjustments that encourage sustainable growth.
Finally, developments in the economics profession increasingly cast a deflationary shadow across the world's economies. This is because most economists support policies of zero inflation achieved by high real interest rates, fiscal austerity, balanced budgets, limited social and infrastructure spending, free trade, and the globalization of financial markets. Since economists act as policy advisers around the world, the economics profession has become a de facto means for coordinating and implementing deflationary policy on a global scale. This contrasts with the Golden Age, when the economics profession advocated Keynesian policies of robust demand, high employment, and low interest rates, and thereby served to foster global expansion.
The past twenty-five years have witnessed a persistent weakening of structural conditions within the U.S. economy. This weakening has been predicated on changes in labor markets which have undermined the position of American workers, polarizing income distribution and increasing job insecurity. The effects of these changes have been obscured by a debt binge by households and government, and by favorable demographic factors. However, households now face increasing financial constraints, government faces political constraints, and the demographic situation is changing radically. At the same time, in the face of increased capital mobility, wages continue to decline and job insecurity widens. These are the grounds for believing that the next economic recession could spiral into a depression.