In theory, yes—that is, if Friedman was right to specify a credit contraction as the underlying cause of the Great Depression, then a credit expansion on the scale accomplished and proposed by Paulson and Bernanke should restore investor confidence and promote renewed economic growth; it should at least abort an economic disaster. But if a credit contraction was not the underlying cause of the Great Depression and its sequel in our own time, then no amount of credit expansion will restore investor confidence and promote renewed economic growth.
The historical record of the 1930s and the slow-motion crash of the stock market since 2007 would suggest that Friedman’s theoretical answer to our question lacks explanatory adequacy—and that Paulson and Bernanke’s practical program, which follows the Friedman line, has not restored, and cannot restore, investor confidence. The effective freeze of interbank lending that, contrary to recent news reports, was already an alarming index as early as September 2007 would suggest the same thing. (“The system has just completely frozen up—everyone is hoarding,” said one bank treasurer back then. “The published LIBOR [London interbank overnight] rates are a fiction.”
Moreover, a severe recession now waits on the other side of recapitalization, mainly because consumer confidence, spending, and borrowing have been compromised or diminished, if not destroyed, by the credit freeze and the stock market crash: “Discretionary spending is drying up as Americans grapple with higher food and energy prices, depressed home values and diminished retirement accounts” (Wall Street Journal 10/9/08). Every indicator, from unemployment claims to retail sales, now points toward an economic crisis on a scale that has no postwar parallel.
Monetary policy, no matter how imaginative and ambitious, can’t address this crisis. For just as a credit contraction was not the underlying cause of the Great Depression, so the reflation and recovery of the larger economy were not, and are not, the natural consequences of a financial fix. Our questions must then become, what was the underlying cause of the Great Depression, and how does the current crisis recapitulate the historical sequence that produced the earlier economic disaster?
And finally, if monetary policy cannot solve the real economic problems that now face us, what more is to be done?
As I argue in Part 1, the Great Depression was the consequence of a massive shift of income shares to profits, away from wages and thus consumption, at the very moment—the Roaring Twenties—that expanded production of consumer durables became the crucial condition of economic growth as such. This shift produced a tidal wave of surplus capital that, in the absence of any need for increased investment in productive capacity (net investment declined steadily through the 1920s even as industrial productivity and output increased spectacularly), flowed inevitably into speculative channels, particularly the stock market bubble of the late 1920s; when the bubble burst—by my calculation, when nonfinancial firms abruptly pulled out of the call loan market—demand for securities listed on the stock exchange evaporated, and the banks were left holding billions of dollars in distressed assets. The credit freeze and the extraordinary deflation of the 1930s followed; not even the Reconstruction Finance Corporation could restore investor confidence and reflate the larger economy.
So recovery between 1933 and 1937 was not the result of renewed confidence and increased net investment determined by newly enlightened monetary policy (the percentage of replacement and maintenance expenditures in the total of private investment actually grew in the 1930s). It was instead the result of net contributions to consumer expenditures out of federal budget deficits. In other words, fiscal policy under the New Deal reanimated the
new growth pattern that had first appeared in the 1920s—that is, it validated the consumer-led pattern that was eventually disrupted by the shift of income shares to profits, away from wages and consumption, between 1925 and 1929.
That consumer-led pattern of economic growth was the hallmark of the postwar boom—the heyday of “consumer culture.” It lasted until 1973, when steady gains in median family income and nonfarm real wages slowed and even ended. Since then, this stagnation has persisted, although increases in labor productivity should have allowed commensurable gains in wages. Thus a measurable shift of income shares away from wages and consumption, toward profits, has characterized the pattern of economic growth and development over the last thirty-five years.
We don’t need Paul Krugman or Robert Reich to verify the result—that is, the widening gap between rich and poor, or rather between capital and labor, profits and wages. Two archdefenders of free markets, Martin Wolf of the Financial Times and Alan Greenspan, have repeatedly emphasized the same trend. For example, last September Greenspan complained that “real compensation tends to parallel real productivity, and we have seen that for generations, but not now. It has veered off course for reasons I am not clear about” (Financial Times 9/17/07). A year earlier, Wolf similarly complained that “the normal link between productivity and real earnings is broken” and that the “distribution of U.S. earnings has, as a result, become significantly more unequal” (Financial Times 4/26/06).
The offset to this shift of income shares came in the form of increasing transfer payments—government spending on entitlements and social programs—
since the 1960s; these payments were the fastest-growing component of labor income (10 percent per annum) from 1959 to 1999. The moment of truth reached in 1929 was accordingly postponed. But then George Bush’s tax cuts produced a new tidal wave of surplus capital with no place to go except into real estate, where the boom in lending against assets that kept appreciating allowed the “securitization” of mortgages—that is, the conversion of consumer debt into promising investment vehicles.
No place to go except into real estate? Why not into the stock market or, better yet, directly into productive investment by purchasing new plant and equipment and creating new jobs? Here is how Wolf answered this question back in August 2007 when trying to explain why the global “savings glut”—this is how Ben Bernanke named his special concern before he became the chair of the Fed—was flowing to the United States: “If foreigners are net providers of funds, some groups in the U.S. must be net users: they must be spending more than their incomes and financing the difference by selling financial claims to others,” Wolf began. “This required spending is in excess of potential gross domestic product by the size of the current account deficit [the difference between spending and income]. At its peak that difference was close to 7 percent of GDP. . . . Who did the offsetting spending since the stock market bubble burst in 2000? The short-term answer was ‘the U.S. government.’ The longer-term one was ‘U.S. households.’”
Wolf argues that once the dot.com bubble burst, the Bush tax cuts and the resulting federal deficit became the “fiscal boost” that forestalled a “deep recession.” Then he turns to the different, but similarly effective, “deficit” created by consumer debt: “Now look at U.S. households. They moved ever further into financial deficit (defined as household savings, less residential investment). Household spending grew considerably faster than incomes from the early 1990s to 2006 [as wages stagnated, credit cards became ubiquitous, and mortgage lenders became more aggressive]. By then they ran an aggregate financial deficit of close to 4 percent of GDP. Nothing comparable has happened since the second world war, if ever. Indeed, on average households have run small financial surpluses over the past six decades.”
And while consumers were going deeper into debt to service the current account deficit and finance economic growth, corporations were abstaining from investment: “The recent household deficit more than offset the persistent financial surplus in the business sector. For a period of six years—the longest since the second world war—U.S. business invested less than its retained earnings” (Financial Times 8/22/07).
Greenspan concurred: “Intended investment in the United States has been lagging in recent years, judging from the larger share of internal cash flow that has been returned to shareholders, presu
mably for lack of new investment opportunities.”
So the Bush tax cuts merely fueled the housing bubble—they did not, and could not, lead to increased productive investment. And that is the consistent lesson to be drawn from fiscal policy that corroborates the larger shift to profits away from wages and consumption. A fiscal policy that cuts taxes on the wealthy and lowers the capital gains levy will not, and cannot, work to restore growth because increased investment does not automatically flow from increased savings created by tax cuts—and, more importantly, because the conversion of increased savings to increased private investment is simply unnecessary to fuel growth.
The Wall Street Journal admitted as much in its lead editorial of October 23, 2008, titled “An Obamanomics Preview.” It was an admission by omission, to be sure, but it nonetheless makes my point. Here is how it works: “After the dot.com bust, President Bush compromised with Senate Democrats and delayed his marginal-rate income tax cuts in return for immediate tax rebates. The rebates goosed spending for a while, but provided no increase in incentives to invest. Only after 2003, when the marginal-rate cuts took effect immediately, combined with cuts in dividend and capital gains rates, did robust growth return. The expansion was healthy until it was overtaken by the housing bust and even resisted recession into this year.”
By this account, robust growth after 2003 was a function of increased incentives to invest that were provided by reductions in tax rates on dividends and capital gains. But the Journal’s editorial board cannot—and does not—claim that such growth was the consequence of increased investment because, as Wolf and Greenspan emphasize, rising profits did not flow into productive investment. Growth happened in the absence of increased investment. Again, savings created by tax cuts do not necessarily translate into investment, and, as the historical record cited by the Journal itself demonstrates, increased private investment is simply unnecessary to fuel growth.
This last simple fact is the sticking point. It has not been, and cannot be, acknowledged by existing economic theory, whether monetarist or not. That is why the following axiom, which is derived from study of the historical record rather than belief in the world disclosed by economic theory, will sound startling at the very least: there is no correlation whatsoever between lower taxes on corporate or personal income, increased net investment, and economic growth.
For example, the fifty corporations with the largest benefits from Ronald Reagan’s tax cuts of 1981 reduced their investments over the next two years. Meanwhile, the share of national income from wages and salaries declined 5 percent between 1978 and 1986, while the share from investment (profits, dividends, rent) rose 27 percent as per the demands of supply-side theory—but net investment kept falling through the 1980s. In 1987, Peter G. Peterson, the Blackstone founder who was then chairman of the Council on Foreign Relations, called this performance “by far the weakest net investment effort in our postwar history.” Yet economic growth resumed in the aftermath of recession, in 1982, and continued steadily until the sharp but brief downturn of 1992.
The responsible fiscal policy for the foreseeable future is, then, to raise taxes on the wealthy and to make net contributions to consumer expenditures out of federal deficits if necessary. When asked why he wants to make these moves, Barack Obama does not have to retreat to the “fairness” line of defense Joe Biden used when pressed by Sarah Palin in debate or, for that matter, by the leader of the liberal media, the New York Times itself, which has admonished the Democratic candidate as follows: “Mr. Obama has said that he would raise taxes on the wealthy, starting next year, to help restore fairness to the tax code and to pay for his spending plans. With the economy tanking, however, it’s hard to imagine how he could prudently do that” (10/7/08).
In fact, if our current crisis is comparable to the early stages of the
Great Depression, it is hard to imagine a more prudent and more productive program.
Bibliographic Essay
What follows is part endnotes and part bibliographical essay. I have tried to indicate the sources from which I have drawn evidence and ideas and to cite readings that provide background for, verification of, or challenges to my arguments.
From Dusk to Dawn: Chapter 1: Origins and
Effects of the Reagan Revolution
On the oil shock and stagflation in the 1970s, see John M. Blair, The Control of Oil (New York: Pantheon, 1976), Alan S. Blinder, Economic Policy and the Great Stagflation (New York: Academic Press, 1981), Mancur Olson, The Rise and Decline of Nations (New Haven, CT: Yale University Press, 1982), and Michael Bruno and Jeffrey D. Sachs, Economics of Worldwide Stagflation (Cambridge, MA: Harvard University Press, 1985). James Q. Wilson’s “cultural” diagnosis of the urban crisis, Thinking About Crime (New York: Basic, 1975), was revised and reissued three times by 1985. Martin Scorsese’s filmic depictions of the related dangers are Mean Streets (1973) and Taxi Driver (1978).
On the Keynesian consensus and the supply-side challenge, see Theodore Rosenof, Economics in the Long Run: New Deal Theorists and Their Legacies, 1933–1993 (Chapel Hill: University of North Carolina Press, 1997), and Herbert Stein, Presidential Economics: The Making of Economic Policy from Roosevelt to Reagan and Beyond (New York: Simon & Schuster, 1984). David Stockman quotations are taken from The Triumph of Politics: How the Reagan Revolution Failed (New York: Harper & Row, 1986); compare this account against Paul Craig Roberts, The Supply-Side Revolution (Cambridge, MA: Harvard University Press, 1984). Martin Feldstein’s work can be sampled in Martin Feldstein, ed., Taxes and Capital Formation (Chicago: University of Chicago Press for the National Bureau of Economic Research, 1987).
Paraphrases and quotations of George Gilder are taken from Sexual Suicide (New York: Quadrangle, 1973) and Wealth and Poverty (New York: Basic, 1981). The left-wing version of the very same concerns is Barbara Ehrenreich, The Hearts of Men: American Dreams and the Flight from Commitment (Garden City, NY: Doubleday, 1983). Charles Murray’s Losing Ground: American Social Policy, 1950–1980 (New York: Basic, 1984) was a sensation that still lives on as an underground cult classic among conservative activists, as does a later, even more controversial book, The Bell Curve: Intelligence and Class Structure in American Life (New York: Free Press, 1994), coauthored with Richard C. Hernnstein.
Henry Kaufman, Felix Rohatyn, and Lloyd Cutler, among others, are quoted and discussed in James Livingston, “The Presidency and the People,” Democracy 3 (1983). See also Lester Thurow, The Zero-Sum Society (New York: Penguin, 1981), Ira Magaziner and Robert B. Reich, Minding America’s Business (New York: Vintage, 1982), and Michel Crozier, Samuel P. Huntington, Joji Watanuki, The Crisis of Democracy: Report on the Governability of Democracies to the Trilateral Commission (New York: New York University Press, 1975), for evidence of bipartisan worries about the economic effects of the dysfunctional political culture inherited from the centrifugal 1960s.
The economic theories of Milton Friedman and Friedrich von Hayek take the form of political manifestoes in, respectively, Capitalism and Freedom (Chicago: University of Chicago Press, 1962) and The Road to Serfdom (Chicago: University of Chicago Press, 1950); see the appendix above titled “Their Great Depression and Ours,” on how Friedman’s ideas became the mainstream in thinking about business cycles like the 2008–2009 economic crisis. Related ideas are explored in Ludwig von Mises, Human Action (New Haven, CT: Yale University Press, 1949). Irving Kristol’s doubts about such ideas are registered in Two Cheers for Capitalism (New York: Basic, 1978); quotations are taken from here. Herbert Croly’s seminal books are The Promise of American Life (1912) and Progressive Democracy (New York: Scribner’s, 1914); like his friend Theodore Roosevelt, Croly was a big-government liberal who believed that state capitalism was the obvious alternative to socialism as it was developing on the American scene. When conservatives like Kristol and John McCain cloak themselves in the mantle of TR and Croly, we should not, then, debunk their supposed hypocrisy; we should instead ask whether their fear of actually exist
ing socialism is warranted by the available evidence.
Michael Novak’s ambitious gloss on Max Weber is The Spirit of Democratic Capitalism (New York: Simon & Schuster, 1982); all quotations are taken from here. His competition was Daniel Bell, The Coming of Post-Industrial Society (New York: Basic, 1973) and Charles Lindblom, Politics and Markets (New York: Harper, 1977). The journal founded by Bell and Irving Kristol, The Public Interest (now The National Interest), contains the poignant record of the neoconservative movement away from consensus on the moral ambiguities of capitalism. The long-term effort of American intellectuals to map a twentieth-century world not governed by the heartless logic of anonymous market forces is brilliantly evoked by Howard Brick, Transcending Capitalism (Ithaca, NY: Cornell University Press 2004).
Liberation Theology did threaten to become the mainstream of Catholic doctrine in the 1970s and 1980s, at least in the Western Hemisphere: see Phillip Berryman’s primer, Liberation Theology (New York: Random House, 1987), and David Tombs, Latin American Liberation Theology (Boston: Brill, 2002). Quotations and paraphrases in the text are from Gaudium at Spes (1965) and “Justice in the World” (1971). See also Gustavo Gutierrez, A Theology of Liberation, trans. Sister Caridad Inda and John Eagleson (Mary-
knoll, NY: Orbis, 1973), which is probably the single most important document of the movement.
Barrington Moore’s Social Origins of Dictatorship and Democracy (Boston: Beacon, 1966) should be compared with Maurice Dobb, Studies in the Development of Capitalism, rev. ed. (New York: International, 1963), T. S. Ashton, ed., The Brenner Debate (New York: Cambridge University Press, 1987), and the primary source itself, Karl Marx, Capital, trans. Samuel Moore and Edward Aveling, 3 vols. (Chicago: Kerr, 1906–1909), especially the treatment of “primitive accumulation” in volume 1.
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