Prospects for the European Economy

We can conduct a similar analysis of the European economy as we did for the US economy.

We will restrict our discussion to the Euro Area, the countries which share a common currency, the euro. The euro creates a unique, separate trading bloc, the internal dynamics of which need to be understood both to assess the performance of the individual member countries, and to assess their place in the world economy.

Within the larger scheme of the globalist production and consumption network, the Euro Area plays a unique role. It functions neither as a supply region nor a demand region. The Euro Area’s role vis-à-vis the rest of the world is that of a demand region for raw materials/energy, and a supply region for manufactured products.[1]

Up until 2012, it ran a roughly even balance of trade with the rest of the world, as can be seen from the following graph. Euro Area Balance of Trade

Hence, in the run-up to the credit crisis of 2008, the Euro Area did not run a sizeable trade deficit, as one might expect given its status as a region full of First World “rich” countries.

But this is not to say that it was not afflicted by similar problems of trade imbalances. The difference is that these imbalances manifested themselves within the currency area. In this sense, the Euro Area acted as mini-world economy, manifesting similar consumer/producer relations. Here as well the divorce between production and consumption reared its head.

If we break down the figures for separate countries, this becomes clear. In the following graph, we see development of the current accounts of eight key Euro Area countries.[2]

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Prior to 2001 and the advent of the euro, the current accounts of these countries ran closely together. France and Italy, for example, usually ran current account surpluses, while Germany ran current account deficits. But all of this changed with the advent of the euro. From that point we see wide discrepancies between the various current accounts. Germany and the Netherlands begin running significant surpluses, while countries like Spain, Italy, and Greece begin running significant deficits.

We can glean from this that the Euro Area itself became divided into supply regions and demand regions. Supply regions run trade surpluses; demand regions run deficits. The major net suppliers were Germany and the Netherlands. The major net demanders were Spain, Greece, and Portugal.

We can also glean from this that consumption was paid for, not by reciprocal production, but by debt. As we have learned by now from previous posts, trade imbalances have to be “financed”: in other words, they are paid for by debt. When trade imbalances are incurred, the countries running trade surpluses are also exporting capital: this is called a capital deficit. What they are doing is exporting demand, by exporting excess savings. To put it bluntly: they are extending the credit to the consuming countries that these countries require to buy their production.

Such an arrangement was made palatable by the euro. The euro was to be the panacea for all economic ills. Participation in the euro was to automatically bring participation in prosperity. And in the early years of the euro project, that surely seemed to be the case. Funds flowed freely from North to South, fueling a boom across these countries, especially in the period 2005-2007, as the following graph indicates.

euro area gdp growth splits

Source: World Economic Outlook Database, April 2016

But this growth was fueled by the debt implicit in the current account imbalances shown in the previous graph. Capital exports (i.e., credit from the exporting to the importing countries) were fueling consumption. The assumption was that the euro constituted surety for this indebtedness. The debtor/consumer countries being locked into the arrangement, they would not be able to devalue their currencies to reduce the value of that debt. And so it was safe to furnish the credit that would pay for the southern countries’ consumption.

Spain was at the epicenter of this debt/consumption nexus. We can get an idea of this by juxtaposing external debt with the balance of trade, as pictured in the following graph. Spain Total External Debt

External debt exploded from €600 billion in 2002 to €1.6 trillion in 2008, while the trade deficit deteriorated from $4 billion/month in 2001 to $10 billion/month in 2008.

This debt binge, as in the US, took the form of a housing bubble. “The only way [Spain] was able to grow for many years prior to the crisis was with a surge in domestic credit that expanded the nontradable goods sector – real estate and consumption, for the most part, with surging real estate itself fueling further borrowing and consumption.”[3]

But it was not only Spain that in this manner paid the piper. Other countries as well participated in this spending binge, as the following graphs indicate:

Portugal Total Gross External Debt Greece Gross External Debt

Greece is of course the poster child for the, in retrospect, exorbitant and entirely irresponsible spending spree that characterized the pre-crash period, and which was gladly financed by the exporting countries of the North. The only problem with this method, as we saw with the world economy, is that it is unsustainable. At some point, the punch bowl is taken away, and whoever is left holding the bag is also left holding a slew of “odious debt.”[4]

In the aftermath of the credit crisis, the Euro Area has had to adjust to the collapse in consumer demand, just as has the United States. In one respect the two have followed similar paths: government deficit spending has served to fill the gap. The following graph shows how government debt has grown in the US and in the Euro Area. Euro Area Government Debt to GDP

The trajectories are quite similar, although the magnitudes differ somewhat: the US’s ratio of debt to GDP has burgeoned to over 100%, while that of the Euro Area now exceeds 90%.

This is one way the Euro Area has compensated for the drop in demand. Another is by resorting to exchange rate depreciation. This has improved the terms of trade for Euro Area exports and thus helped improve economic growth. Euro Dollar Exchange Rate - EUR/USD

The trend line refers to the exchange rate of the euro vis-à-vis the dollar, and clearly indicates a downward trend, which has the effect of making Euro Area exports more attractive. Because of this, the surplus on the Euro Area balance of trade has steadily widened. The Euro Area is thus attempting to export its way out of its present difficulties. But we now know where such a strategy leads: to dependence upon foreign demand, which itself is funded by capital exports.

We should make mention of one other attempt to boost demand: quantitative easing. Here as well, the Euro Area has followed the lead of the US, force-feeding the central banks’ balance sheets with bonds, which has the effect of flushing the money market with liquidity.

The following graph shows the extent of the operation. Here again, the trend lines are similar although the magnitudes differ somewhat: the Federal Reserve System now has about $4.5 trillion on its balance sheet, while the Euro System has about €3.4 trillion (about $3.8 trillion at current exchange rates). Euro Area Central Bank Balance Sheet

This together with deficit spending was to bolster economic growth. Nevertheless, that growth has remained fairly anemic: Euro Area GDP Annual Growth Rate

The fact of the matter is, neither of these strategies for fomenting growth are sustainable.

Quantitative easing is only a temporary panacea; at some point those bonds are either returned to the market or become due. In both cases, this removes liquidity from the money market.

The attempt to export one’s way to growth is likewise a dead end, as every country that has tried it has eventually discovered, to its cost. This is why Japan is moribund and why China is heading in that direction. Export-led economies need import-led economies to absorb their production; if those import-led economies for whatever reason stop importing and stop demanding, the export-led economies are left high and dry with essentially superfluous production capacity. On top of that, the trade imbalances that are required for this model require the continual buildup of debt, a similarly unsustainable course of action.

This is the reason why economists like Michael Pettis keep urging these export-led economies to rebalance away from dependence on exports towards a more balanced model based first and foremost on domestic demand. This would restore Palley’s “virtuous circle of growth” and the link between production and consumption, having the one pay for the other in the circular flow of the properly functioning economy.

What stands in the way of this? Recall Pettis’s explanation (in this post) of the techniques by which export-led economies generate excess capital with which to fund trade surpluses. They do so by implementing various policies that in effect force their own citizens to “save” rather than spend. Pettis’s list includes:

  • consumption taxes such as VAT, which reduce by the amount of the tax, the amount consumers may consume;
  • tariffs, which artificially increase the price of imported consumer goods, thus in essence forming another consumption tax;
  • financial repression, in which the state runs the banking system and rigs it in favor of commercial borrowers and against consumers, so that consumers have less money to spend on consumption.

In the European situation, it is VAT which jumps out on this list. VAT constitutes an enormous hindrance to consumption spending. The result is to ease pressure on exchange rates and so foment export performance, but at the expense of domestic consumers.

In his book The Great Rebalancing, Pettis points out another method by which Europe’s economic engine, Germany, has been able to generate the massive trade surpluses it has in recent years, especially in the light of its trade deficits in the 1990s. This came about through wage repression. German workers have agreed to have wage growth restrained in order to promote the greater good, which in this case is the German export machine. Pettis’s explanation merits quotation in extenso:

After German reunification in the early 1990s, Germany faced the problem of very high domestic unemployment. It resolved this by putting into place a number of policies, agreed on by trade unions, businesses, and the government, aimed at constraining wages and consumption and expanding production in order to regain competitiveness and generate jobs. Although these policies may have made sense for Germany and the world in the 1990s, … the creation of the euro introduced a new set of currency and monetary rigidities that would change the impact of these policies both within Germany and abroad.

Specifically, as wage growth was constrained in Germany by relatively tight monetary policy in the German context, it was left unconstrained in peripheral Europe because monetary policy there was, paradoxically, too loose given underlying conditions of rapid growth and rising prices. These policies resulted in an increasingly undervalued euro for Germany relative to the rest of Europe, low wages for its level of productivity, high consumption and income taxes, and expensive infrastructure funded by these taxes.

In that case it is not surprising that German GDP growth exceeded the growth in German household income, because households were effectively forced to subsidize employment growth, and this subsidy reduced disposable household income and consumption relative to total production….

The high German savings rate, in other words, had very little to do with whether Germans were ethnically or culturally programmed to save— contrary to the prevailing cultural stereotype. It was largely the consequence of policies aimed at generating rapid employment growth by restraining German consumption in order to subsidize German manufacturing— usually at the expense of manufacturers elsewhere in Europe and the world.[5]

The upshot of all of this is, Europe is as wedded to the system of neo-mercantilist trade imbalances as is the rest of the world. It is here that change needs to come, but no policy proposals are in the offing that even bring this problem set to the table, much less propose solutions to it.

Notes
  1. “[The] Euro Area runs regular trade surpluses primarily due to its high export of manufactured goods such as machinery and vehicles. [The] Euro area is a net importer of energy and raw materials. Germany, Italy, France and Netherlands account for the largest share of total trade. Main trading partners are the United Kingdom (12 percent of total exports and 10 percent of imports) and the United States (13 percent of exports and 6 percent of imports)” (TradingEconomics.com).
  2. As we outlined in the previous post, the current account is similar to the balance of trade and provides the same sort of indications.
  3. Michael Pettis, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy (Princeton: Princeton University Press, 2014), p. 4/29 of ch. 6 (ebook version).
  4. Jason Manolopoulos, Greece’s ‘Odious’ Debt: The Looting of the Hellenic Republic by the Euro, the Political Elite and the Investment Community (London and New York: Anthem Press, 2011).
  5. The Great Rebalancing, ch. 6, pp. 10-12/19.

Prospects for the US Economy

THE WORLD ECONOMY IN RÉSUMÉ

In the previous post we outlined the structural condition of the world economy, and in particular the structural flaws it contains.

The main flaw is the divorce between production and consumption.

Prior to the establishment of this new macroeconomic structure, supply and demand were roughly in balance in the domestic economy.

We can see this by taking a look at the balance of trade of the United States between 1950 and 1980. In that period, the US economy was the major trading partner for the rest of the world – not to mention that the dollar was then, as it is now, the currency in which world trade is conducted – so that its trade data can serve as a useful proxy for the development of the broader world economy.

United States Balance of Trade

During most of this period, the US balance of trade was roughly in balance. Only towards the end of the period did it begin displaying the sharp divergences that would characterize the period since then, albeit here the magnitude of the imbalances is still very small. As we shall see, they have since taken on major proportions.

During this earlier period, some countries did indeed display trade imbalances. Where this was the case, it was the byproduct of colonialist relationships, such as with “banana republics” the role of which was to produce bananas; the same was true of sugar or rubber or oil. These commodities were produced for export, and the economies depending upon such exports were thus at the mercy of the whims of the world market.[1]

So this lack of balance between supply and demand was an exception to the rule. But since the establishment of the new macroeconomic order, that balance in domestic economies has been rudely disrupted by a new way of linking production and consumption.

In the new structure, the world has been parceled out into various supply and demand regions. Low-wage, developing countries have been designated as supply regions. They are used as sources of raw materials and production. The rich, developed countries have been designated as giant piggy banks. They have been allocated the role of consuming this production.

All of this is orchestrated from the top by the global corporate elite, which uses politicians, the media, the entertainment industry, and academia to further this “bread and circuses” New World Order of universal colonialism. The world is, indeed, their oyster.

This new order no longer balances production and consumption in a symbiotic circular flow within domestic economies. Instead, massive trade imbalances are created, each of which has to be financed. This means that it is debt, not production, that is paying for consumption. The system mortgages the future in favor of the present.

The magnitude of the new order’s collective trade imbalance, and thus dependence on debt, is indicated in the following graph:

The graph shows the current account balance for the world, the advanced economies, and developing economies over the period 1980-2016. The current account balance is a bit different from the balance of trade, as it includes income payments and transfer payments between countries. But these latter are relatively negligible as compared with trade in goods and services. So the two measures are roughly comparable.

What the graph shows is that the changes in the world economy in evidence since the late 1970s accelerated towards the end of the 1990s. Developing countries began generating an enormous collective current account surplus, in line with their role as the world’s producers; while advanced economies developed an enormous current account deficit. This persisted until 2010. With the credit crisis (actually the “debt-funding” crisis) the situation has since reversed somewhat: debt financing has since become hard to come by.

The upshot is that current account (and trade) imbalances became the norm for the world economy during this period, and since these imbalances had to be financed, they have left behind a mountain of debt that at some point will have to be paid off.

Within this framework, the United States has occupied the central role; it is the “consumer of last resort.”

The question now is, has anything changed with regard to the functioning of the US economy to indicate that it has broken with this structurally flawed global economic mechanism? Our conclusion in the previous post was very summary; we opined, with Palley, that stagnation was the direction the economy was headed, given the lack of any sign of a break with this failed model. Let’s look in more detail at the developments in the US economy since the crash.

WHAT THE STIMULUS DID TO PROMOTE ECONOMIC RECOVERY

Prior to the 2008 credit crisis, the US financed its consumption-oriented trade deficit via the housing bubble. This unsustainable method led to the crash. Since then, the US has turned to various schemes, in order to continue to finance this consumption.

The main such policy has been a return to good old-fashioned Keynesian deficit spending. Barack Obama justified this policy back in 2009:

Economists on both the left and the right agree that the last thing a government should do in the middle of a recession is to cut back on spending. You see, when this recession began, many families sat around the kitchen table and tried to figure out where they could cut back. And so have many businesses. And this is a completely reasonable and understandable reaction. But if everybody — if everybody — if every family in America, if every business in America cuts back all at once, then no one is spending any money, which means there are no customers, which means there are more layoffs, which means the economy gets even worse. That’s why the government has to step in and temporarily boost spending in order to stimulate demand.

That speech blames the banks for the crisis, while explaining also why the banks needed to be propped up and bailed out. Only a politician could argue both of these in the same speech and be applauded for it.

The problem with this kind of thinking, as we stressed in the previous post and shall further elaborate below, is that it does nothing to address the underlying structural economic framework that had the crash as its inevitable consequence.

The stimulus came in the form of the American Recovery and Reinvestment Act of 2009. Predictably, the ARRA did not lead to economic recovery. How could it, when it did not even begin to address the underlying problem of debt-financed consumption? The only change was that the government was taking on the debt, rather than consumers directly.

The ARRA set a precedent for deficit spending which has continued, albeit in more muted form, since then. The US has been running record budget deficits in every year since, as can be seen from the following graph:

As can be seen here, the Obama administration has been running deficits that dwarf those even of the George W. Bush administration, which used to take the prize for this dubious distinction.

This has led to a near-doubling of government debt as a percentage of GDP during the Obama administration’s term of office:

United States Government Debt to GDP

All of this deficit spending might be considered beneficial in the long term if it went to funding investment as opposed to consumption – in other words, if it went to addressing the structural flaw of the divorce between production and consumption. Was it being used to finance investment in productive capacity, so as to restore the “virtuous circle?” Borrowing to finance investment is borrowing to finance growth; borrowing to finance consumption, on the other hand, is simply selling the future out to the present.

This is the criterion. So then, what kind of spending has the federal government been engaging in? In the main, it is consumption as opposed to investment spending, as the following pie chart suggests:

Data is for the 2015 federal budget. Source: Politifact.com

Items such as Health (Medicare and Medicaid) and Social Security are not investment but consumption. Other items on the list can be viewed as partly one and partly the other. In particular, social welfare payments and salaries to civil servants/military personnel qualify as consumption.

Therefore, much of this spending is money distributed to citizens to fund consumption. Which means that much of the federal deficit and federal debt goes toward consumption spending. The same holds true for state and local levels of government.

In other words, most of the burgeoning deficit and debt have gone toward picking up the slack left by the bursting of the housing bubble.

This means that Keynesian deficit spending has not been addressing not economic recovery or restoration, but simply maintaining the status quo that gave us the housing bubble in the first place!

Structurally, nothing has changed.

This is evident from an examination of the US trade deficit during the course of the first 16 years of the 21st century, thus both prior to the crash and posterior to it.

The deficit peaked during the artificial boom years prior to the crash. But – and this is the point – since then, although the magnitude of the deficit has decreased, it is still running at nearly $500 billion per annum.

The thing to understand about the trade deficit is that it, too, has to be financed. In other words, the trade deficit has as its flip side, increased debt. How much of that debt ultimately is owed by the federal government, through its deficit spending agenda, is difficult to say. But what we can say it is this: the trade deficit continues unabated, while government deficit spending has grown enormously. The conclusion can be drawn, then, that government spending has picked up at least part of the slack left by the bursting of the housing bubble.

In other words, the structural flaws of the world economy as outlined in the previous post have not been addressed; only different means have been found to keep the system going as it is currently structured, precisely without addressing its structural flaws, because to do so would harm the interests that are profiting from the current arrangement.

WILL FUTURE ECONOMIC POLICY ADDRESS THE STRUCTURAL ISSUE?

The question remains, is there any prospect of this issue being addressed? As we saw in the previous post, Palley had no confidence that it would be with the Obama administration, and his prediction proved to be correct. But what now? With the 2016 elections we are facing a changing of the guard. Can the candidates’ positions shed any light on this?

One thing is for sure, the latest trade deal, known as the Trans-Pacific Partnership (TPP), is on both candidates’ bad list. This despite the fact that President Obama is continuing to push the deal, attempting to get the appropriate legislation passed by Congress before his term of office expires. Clinton’s opposition does appear to have been forced by both Sanders’ and Trump’s vociferous opposition, and many expect a Clinton administration to include among its priorities the passage of this bill, perhaps with minor modifications.

In a nutshell, the problem with this bill is that it sets up further machinery to arrange trade, not in the interests of the particular countries involved, nor to restore the virtuous circle of domestic economies, but to maintain and perpetuate the production/consumption divorce.

What more might we expect from a Clinton administration? Conveniently, we have a major address on economic policy to work with, given by Hillary Clinton on August 11th. Its key proposal is a renewed stimulus plan that ostensibly will provide the greatest investment in “good-paying jobs” since World War II: “We will put Americans to work, building and modernizing our roads, our bridges, our tunnels, our railways, our ports, our airports. We are way overdue for this, my friends. We are living off the investments that were made by our parents’ and grandparents’ generations.”

The problem here, of course, is that this is precisely what Obama promised. ARRA was supposed to provide a major boost to employment, while also renovating the country’s infrastructure. But as the Wall Street Journal put it in a post-mortem (Obama’s Stimulus, Five Years Later),

The federal government poured billions into the government and education sectors, where unemployment was low, but spent only about 10% on promised infrastructure, though the unemployment rate in construction was running in double digits. And some of the individual projects funded by the law were truly appalling. $783,000 was spent on a study of why young people consume malt liquor and marijuana. $92,000 went to the Army Corps of Engineers for costumes for mascots like Bobber the Water Safety Dog. $219,000 funded a study of college “hookups.”

In the main, the money went not to infrastructure, nor even to productive investment generally, but to the maintenance of existing favored activities in “the government and education sectors,” – thus, essentially, as favors to groups largely supportive of Democratic Party politics.

Will it be any different this time around? In terms of dollar amount, Obama’s stimulus dwarfed Hillary’s $275 billion. Donald Trump has also proposed spending on infrastructure. As The Atlantic points out, “Trump, a builder by blood, has pledged to double that figure, at least. He has called for spending up to $1 trillion on new roads, bridges, broadband, and more.”

If that were all that was to it, then we wouldn’t have much to look forward to as far as structural change is concerned. But Trump has made other proposals as well, which are well worth delving into. We defer that analysis to a later date.


 

  1. For an example of the vulnerability of such export-dependent economies, see Jane Jacobs, Cities and the Wealth of Nations (New York: Simon & Schuster, 1984), ch. 4, “Supply Regions,” which uses the example of Uruguay as a country that was totally dependent upon the cattle industry for exports (meat, leather), which got rich from this trade, but which went into steep decline after that trade collapsed in the 1950s.

What This Election is Really All About

The Economics of the 2016 Election Cycle

The current election cycle in the United States is like none other in recent memory. At least in terms of vitriol, it is no contest. But beyond the partisan slams back and forth lies a deeper fundamental reality which really lies at the heart of the contest.

In fact, despite surface appearances, this is not a typical Democrat versus Republican, left-wing versus right-wing, liberal versus conservative, election. It goes far deeper than that.

My own wish is that partisans on both sides would suspend judgement for a moment, follow me through a rather involved analysis of the economics underlying the current political situation, and think through the implications. In advance, the author thanks you for your attention.


Vantage points are everything. We have a good one provided us by the Keynesian economist, Thomas Palley. Palley’s leftist credentials are impeccable, as might be expected from a former Assistant Director of Public Policy for the AFL-CIO. As such, the following exposition can make the claim, at any rate, to being something other than a mere partisan discussion. The hope is that we get beyond the left-right divide as it has manifested itself in the current political landscape, to the underlying realities that transcend that divide as currently manifested.

Back in 2009, Palley wrote a significant article[1] outlining the real underlying causes of the financial meltdown and credit crisis of 2008. In the course of explaining that catastrophic course of events, Palley ends up providing a succinct summation of the condition of the world economy generally, that retains its applicability to this day.

As Palley has it, the standard explanations of market failure do not go nearly far enough, which is a significant admission by a left-leaning economist. For the usual explanation of economic problems provided by economists of this persuasion puts the blame precisely on market failure. This time is different. “Most commentary has … focused on market failure in the housing and credit markets. But what if the house price bubble developed because the economy needed a bubble to ensure continued growth? In that case the real cause of the crisis would be the economy’s underlying macroeconomic structure” (p. 1).

In other words, the housing bubble was not an unfortunate unforeseen occurrence: it was fostered by deliberate, albeit blind, policy. How and why such a situation would actively be pursued, is the burden of Palley’s article.

The roots of the said macroeconomic arrangement actually go back decades. Palley traces them to the onset of the Reagan administration of 1980. “Before 1980, economic policy was designed to achieve full employment, and the economy was characterized by a system in which wages grew with productivity. This configuration created a virtuous circle of growth …. After 1980, with the advent of the new growth model, the commitment to full employment was abandoned as inflationary, with the result that the link between productivity growth and wages was severed. In place of wage growth as the engine of demand growth, the new model substituted borrowing and asset price inflation” (p. 2).

We must register a quibble with the timing of events here. 1980 did not happen in a vacuum. The hyperinflation of the 1970s is what discredited these Keynesian policies and the Reagan policy responses were the fairly obvious policy response. Anyone who lived through that period knows just how helpless everyone felt at the inability to tame the inflation dragon. In that regard, the Reagan response was inevitable and welcomed.

What really precipitated the new macroeconomic arrangement was the abandonment of the previous such arrangement, the post-war Bretton Woods currency and trade setup. This occurred not in 1980, but in 1971, with President Nixon’s abandonment of the dollar-gold link. What this meant was a switch from fixed to floating exchange rates, which together with the advent of OPEC and skyrocketing oil prices, deranged a hitherto relatively stable situation currency and trade situation.

A graph provided in another of Palley’s articles[2] suggests the same correlation:

Productivity and real average hourly wage and compensation of US non-supervisory workers, 1947-2009. Source: EPI analysis of Bureau of Economic Analysis and Bureau of Labor Statistics data.
Productivity and real average hourly wage and compensation of US non-supervisory workers, 1947-2009. Source: EPI analysis of Bureau of Economic Analysis and Bureau of Labor Statistics data.

As can be seen in the accompanying figure, the divergence between productivity and compensation/wages begins in the early 1970s, corresponding with the breakup of Bretton Woods. So, it was the early 1970s and not 1980 that saw the change in fortunes of which we are speaking.

The new arrangement was characterized by a new priority: globalization. The preference for globalization expressed itself in a new attitude toward trade deficits. “Under the earlier economic model, policymakers viewed trade deficits as cause for concern because they represented a leakage of aggregate demand that undermined the virtuous circle of growth. However, under the post-1980 model, trade deficits came to be viewed as semi-virtuous because they helped to control inflation and because they reflected the choices of consumers and business in the marketplace” (p. 5).

This is a crucially important statement. It provides the kernel of what has been happening over the last 40 years. “The virtuous circle of growth” is Palley’s way of formulating what we in our own model (as described in the accompanying course) refer to as the circular flow of the economy. In essence, all economies are local, then regional, then national, and only then international. A “virtuous circle of growth” is what we understand as the domestic economy. But arrangements can be made that discombobulate this order. What we then have is the domestic economy subordinated to supranational interests. In essence, it is a form of colonialism. And that is what Palley is referring to when he speaks of a “leakage of aggregate demand.” The circular flow is disrupted; supply and demand are disconnected from each other in the domestic economy, diverted toward an international economy characterized by trade deficits and surpluses, the ineluctable by-products of these “leakages.”

This arrangement is papered over by appeals to free-market principles. Hence the epithet “neoliberalism.” These trade deficits do indeed help to control inflation, but at a steep price. And they may reflect “the choices of consumers and business in the marketplace,” but without consumers and business realizing that there is a flip side to these cheap imports, and that is the loss of employment and productive capacity.

For what do these trade deficits actually represent? For one thing, the systematic suppression of wages on both sides of the trade equation. “American workers are increasingly competing with lower-paid foreign workers.” This is obvious and well-known. What is less well-known is what is going on with these foreign workers: “That pressure is further increased by the fact that foreign workers are themselves under pressure owing to the so-called Washington Consensus development policy, sponsored by the International Monetary Fund (IMF) and the World Bank, which forces them into the same neoliberal box as American workers.” They are both being disadvantaged; they are being played against each other. For the loss of purchasing power on the part of American workers is not compensated for by increased demand from abroad, for foreign workers likewise are deprived of purchasing power, despite the fact that they are on the receiving end of the job-offshoring program. “Neoliberal policies not only undermine demand in advanced countries, they fail to compensate for this by creating adequate demand in developing countries” (p. 7; emphasis added).

This is the double bind in which workers find themselves, both in developed and developing countries.

In developed countries this arrangement has hit the manufacturing sector particularly hard. The idea has been spread abroad that in the US the decline of the manufacturing sector is the result of inevitable trends, in particular, increased productivity. But this does not explain the loss of jobs: “A smooth long run declining employment share brought about investment and innovation that creates a more efficient manufacturing sector is a fundamentally different proposition from decline caused by adoption of a policy paradigm that dismantles the manufacturing sector by encouraging off-shoring and undermining competitiveness” (p. 4). It is the latter, not the former, that explains the loss of manufacturing jobs. That is to say, the new macroeconomic arrangement with its leakage of production to low-wage countries is the real reason.

Accompanying the loss of manufacturing jobs has been a steady divergence in income share. “Between 1979 and 2006, the income share of the bottom 40 percent of U.S. households decreased significantly, while the income share of the top 20 percent increased dramatically. Moreover, a disproportionate part of that increase went to the 5 percent of families at the very top of income distribution rankings” (p. 6). Palley also points to increased labor market flexibility and the abandonment of full employment as a policy objective as factors behind widening income inequality, but the obvious driver of the process is the pressure on the job market brought on by the offshoring of jobs.

All of this has displaced what Palley terms the “stable virtuous circle growth model based on full employment and wages tied to productivity growth” (p. 9). What has taken its place? The new arrangement “based on rising indebtedness and asset price inflation.” These two, not productive activity, generate the income to fund consumption.

In the new arrangement, production takes place in developing countries, while consumption takes place in developed countries. Production has been divorced from consumption. This is the reality behind the ever-present trade imbalances characterizing the modern global economy.

In the old model, in line with Say’s Law, production funds consumption and consumption, production. This is the circular flow of the domestic economy, Palley’s “virtuous circle growth model.” The new model divorces production from consumption. Production no longer pays for consumption: the producers in developing countries have their wages suppressed, and so cannot provide increased demand, while the consumers in developed countries are not producing and selling enough to pay for their consumption. The shortfall is paid for by taking on debt: in terms of economic jargon, this is known as “financing the trade deficit.”

This in turn leads to asset bubbles. “Since 1980, each U.S. business cycle has seen successively higher debt/income ratios at end of expansions, and the economy has become increasingly dependent on asset price inflation to spur the growth of aggregate demand” (p. 9). Various asset markets have done duty to generate this asset inflation and thus artificial prosperity, yielding the dot.com bubble, stock market bubbles, and housing market bubbles. These bubbles are self-feeding phenomena: increases in asset prices spur borrowing based on those asset prices, which in turn encourages further spending leading to further increases in asset prices. But they also provide income to sustain standards of living that essentially are beyond the means of the underlying wealth-producing capacity of the economy.

Palley speaks in particular of the “the systemic role of house price inflation in driving economic expansions.” He points out that “Over the last 20 years, the economy has tended to expand when house price inflation has exceeded CPI (consumer price index) inflation.” This is true for the Reagan expansion, the Clinton expansion, and the Bush-Cheney expansion, and so is “indicative of the significance of asset price inflation in driving demand under the neo-liberal model” (p. 10), which has truly been a bipartisan affair.

Of course, “The problem with the model is that it is unsustainable.” It requires continued excessive borrowing and continued reductions in savings rates, which can only be sustained by ever-expanding asset inflation, which eventually must come to an end.

This dynamic lay behind the credit crisis of 2008, only this time things were different. Mainly, the degree of indebtedness, the breadth of participation in it – as might be expected from a bubble generated by the broader housing market – far exceeded previous instances and precipitated the enormous blow to the real economy, not to mention the carnage wrought to the financial economy.


Behind this macroeconomic structure lay the disruption of the production-consumption linkage of the domestic economy. It was this that made necessary the generation of artificial prosperity to maintain a standard of living, a level of consumption, without any connection to the level of production.

This macroeconomic structure was supported by trade policy. Palley points to the establishment of the North American Free Trade Agreement (NAFTA), the establishment of the “strong dollar” policy after the East Asian financial crisis of 1997, and permanent normal trade relations (PNTR) with China in 2000, as the “most critical elements” of the global economic arrangement. These were “implemented by the Clinton administration under the guidance of Treasury secretaries [sic] Robert Rubin and Lawrence Summers.” The measures “cemented the model of globalization that had been lobbied for by corporations and their Washington think-tank allies” (pp. 12-13).

The upshot was a global economic arrangement featuring a “triple hemorrhage:” leakage of spending on imports, leakage of jobs overseas, and leakage of investment overseas.

We gained a new economic arrangement in which trade deficits became the rule and the world became the production zone for US corporations, which could turn around and sell this production to compatriot consumers. “At the bidding of corporate interests, the United States joined itself at the hip to the global economy, opening its borders to an inflow of goods and exposing its manufacturing base. This was done without safeguards to address the problems of exchange rate misalignment and systemic trade deficits, or the mercantilist policies of trading partners” (p. 14).

This created a “widening hole” in the economy “undermining domestic production, employment, and investment.”

NAFTA in particular ushered in a new era of exchange-rate policy. “Before, exchange rates mattered for trade and the exchange of goods. Now, they mattered for the location of production” (p. 15). This worked to the advantage, of course, of multinational corporations, enabling them to pursue the policy of producing in low-wage markets and selling the production in developed markets. This in turn led to a strong dollar policy, likewise pushed by multinationals. “This reversed their commercial interest,” as US corporations previously favored a weak dollar, for obvious reasons.

The collapse of the peso in 1994 was a direct result of this new policy. In the new arrangement, the cheap peso was a boon to US corporations producing in Mexico and exporting to the US. “The effects of NAFTA and the peso devaluation were immediately felt in the U.S. manufacturing sector in the form of job loss; diversion of investment; firms using the threat of relocation to repress wages; and an explosion in the goods trade deficit with Mexico …. Whereas prior to the implementation of the NAFTA agreement the United States was running a goods trade surplus with Mexico, immediately afterward the balance turned massively negative and kept growing more negative up to 2007.”

The strong dollar policy was further implemented during the series of financial crises in the late 1990s, starting in East Asia. “In response to these crises, Treasury Secretaries Rubin and Summers adopted the same policy that was used to deal with the 1994 peso crisis, thereby creating a new global system that replicated the pattern of economic integration established with Mexico” (p. 16). The strong dollar increased the purchasing power of the US consumers: “critical because the U.S. consumer was now the lynchpin of the global economy, becoming the buyer of first and last resort.”

One result of this policy was that “manufacturing job growth was negative over the entirety of the Clinton expansion, a first in U.S. business cycle history” (p. 18). Positive business cycle conditions obscured the underlying trends; to add insult to injury, “the Clinton administration dismissed concerns about the long-term dangers of manufacturing job loss. Instead, the official interpretation was that the U.S. economy was experiencing—in the words of senior Clinton economic policy advisers Alan Blinder and Janet Yellen—a ‘fabulous decade’ significantly driven by policy.” Janet Yellen is, of course, the current Chair of the Federal Reserve Board.

The final step in this process was taken when China was granted the status of PNTR and then admitted to the World Trade Organization. “Once again the results were predictable and similar to the pattern established by NAFTA—though the scale was far larger.”

Hence, all the pieces were put in place during the 1980s and 1990s, but they did not come to full fruition until the crisis of 2008. “From that standpoint, the Bush-Cheney administration is not responsible for the financial crisis. Its economic policies … represented a continuation of the policy paradigm already in place. The financial crisis therefore represents the exhaustion of that paradigm rather than being the result of specific policy failures on the part of the Bush-Cheney administration” (p. 21).


Given the above, it is obvious that the credit crisis of 2008 was not the result of the usual suspects, deregulation of financial institutions and banks pushing excessive lending for no other reason but greed. The excessive lending was built into the structure; the entire world economy depended on it, for only through this asset-inflation-induced debt could US consumption, the driving force of economic growth in developing countries, be paid for.

So what is needed is paradigm change. And in this context, Palley, writing in 2009, makes a prophetic statement.

The case for paradigm change has yet to be taken up politically. Those who built the neoliberal system remain in charge of economic policy. Among mainstream economists who have justified the neoliberal system, there has been some change in thinking when it comes to regulation, but there has been no change in thinking regarding the prevailing economic paradigm. This is starkly illustrated in the debate in the United States over globalization, where the evidence of failure is compelling. Yet, any suggestion that the United States should reshape its model of global economic engagement is brushed aside as “protectionism. [sic]”, which avoids the real issue and shuts down debate (p. 25).

“Shuts down debate,” indeed. In the intervening period between 2009 and 2016, the topics of trade deficits, currency arrangements, and multilateral trade deals, have consistently been dismissed as matters of concern, denigrated as unworthy of debate; while proponents of such a re-evaluation have been routinely dismissed as cranks undeserving of serious attention.

As it happens, two candidates for the office of President have put this issue on the table, despite the bile they have received for it: Bernie Sanders and Donald Trump. The concerns of both have been dismissed out of hand by regnant opinion-makers. This should not come as a surprise. After all, “The neoliberal growth model has benefitted the wealthy, while the model of global economic engagement has benefitted large multinational corporations. That gives these powerful political interests, with their money and well-funded captive think tanks, an incentive to block change” (p. 26). Furthermore, “Judging by its top economics personnel, the Obama administration has decided to maintain the system rather than change it,” and subsequent history confirms this. In fact, at the time of writing, President Obama is promoting the latest iteration of this neoliberal arrangement, in the form of the Trans-Pacific Partnership (TPP).

It is not only the Obama administration that continues to push this arrangement. The entire Washington establishment, both Democrat and Republican, is fully behind the continuation of this unsustainable model. Given this intransigence, what is the logical next step? Palley points to it, and subsequent history has only confirmed it: “stagnation is the logical next stage of the existing paradigm” (p. 27). Ever-burgeoning debt that only gets rolled over and never repaid, leads, as the example of Japan teaches, only to economic stagnation, the so-called zombie economy.

Where does Hillary Clinton stand on this issue? Recent statements indicate softening in the direction of Sanders’ position, including announced opposition to TPP. Besides the pronounced skepticism with which such proclamations have been greeted by the left wing of the Democratic Party, there is the little matter of track record. After all, it was during her husband’s administration that all the pieces of the neoliberal program were implemented, and on that, she was with him all the way. Nothing in her subsequent record either as Senator for New York, or as Secretary of State, would indicate otherwise. Quite obviously, her current registered opposition to TPP was driven by Sanders, Trump, and poll numbers.

But beyond this is her place within the framework of what has become the Clinton global network. This network is anchored by a range of institutions: the Clinton Foundation, the Clinton Family Foundation, and the Clinton Global Initiative, among others. The Clinton Foundation was established in 1997 with the purpose to “strengthen the capacity of people throughout the world to meet the challenges of global interdependence.” The Clinton Global Initiative is part of this entity, although between 2009 and 2013 it was hived off, presumably in connection with Clinton’s stint as Secretary of State, to avoid the appearance of conflict.

Articles such as this one from the Washington Post, providing The Inside Story of How the Clintons Built a $2 Billion Global Empire, yield a glimpse into the global reach the Clintons enjoy within the current neoliberal framework. In fact, one might paraphrase Palley’s characterization of the US by saying that indeed the Clintons are joined at the hip with the neoliberal framework. We might go so far as to say that Hillary Clinton is the poster child of this framework, which doubtless is part of reason she enjoys such favorable press despite the fact that she carries so much baggage, of the kind that would have eliminated just about any other candidate.

And so it can be argued that the globalist corporate elite, which props up, and benefits from, the neoliberal arrangement, is promoting the Democrats’ progressive agenda, using it, exploiting it, the better to ensure that this pernicious arrangement remains cemented in place. Hillary Clinton is certainly progressive on social issues. The question is, is she progressive on economics? Let the record speak for itself.

Notes
  1. Thomas I. Palley, “America’s Exhausted Paradigm: Macroeconomic Causes of the Financial Crisis and Great Recession,” IPE Working Papers 02/2009, Berlin School of Economics and Law, Institute for International Political Economy (IPE). Available at https://goo.gl/gRkfD7.
  2. “Making Finance Serve the Real Economy,” in Thomas I. Palley and Gustav A. Horn (eds.), Restoring Shared Prosperity: A Policy Agenda From Leading Keynesian Economists (CreateSpace Independent Publishing Platform, 2013), p. 74. Available at http://goo.gl/1uJZv6.