Thomas Palley

If you have a pulpit and say something over and over again, that something may eventually come to be believed. No one has a bigger pulpit than Alan Greenspan, Chairman of the Federal Reserve, who for the last decade has been saying that the secret of America’s prosperity is its economic flexibility. But there is another explanation, which is asset bubble Keynesianism. It too can make for a jolly old time – at least for a while.

We are now approaching the post-Greenspan era when consumers may finally have “maxed-out,” and the new era promises to test the two hypotheses. If Mr. Greenspan is right, we have nothing to fear. The good times will keep rolling. If he is wrong, the American economy could face a day of reckoning, at which time it will be important to re-examine the economic policies and rhetoric of the last two decades.

The Chairman’s thinking was recently on display (October 12, 2005) with a major farewell speech titled “Economic Flexibility,” made to the National Italian American Foundation. So too was his propensity to re-write economic history. The years 1945 – 1975 witnessed the fastest annual economic growth rate in American history, and the country grew together with all sharing in prosperity. Since then, growth has slowed and we have grown apart, with those at the bottom getting a smaller share of the economic cake. However, these facts did not deter the Chairman from declaring the period 1945 – 75 to be one of growing failure, and the ensuing period to be one of great success. A case of “If history does not support theory, too bad for history.”

The Greenspan view is eloquently simple. The key to resilient prosperity is economic flexibility, which “is most readily achieved by fostering an environment of maximum competition. A key element in creating this environment is flexible labor markets.” Such flexibility makes “the economy more resilient to shocks and more stable overall” and is key to growth in standards of living.

Even granting Chairman Greenspan his (contentious) claims about U.S. prosperity, there is another explanation of why growth has been more stable and why America avoided a deep recession after the 1990s stock market bust. That explanation is America has been borrowing its way out of successive crises, and has enjoyed a bout of “asset bubble Keynesianism.” Spending rather than flexibility has stabilized the system. However, borrowing can store up trouble if not used wisely, and America’s borrowing has been allowed to leak away through the trade deficit. Now households are burdened with debt, and by frivolously using up our credit the American economy is poorly positioned to escape future economic shocks.

It is easy to mistake the borrowing binge for economic flexibility, since increased access to credit has been the result of financial innovation and deregulation. The 1980s introduced the junk bond market. The 1990s introduced the home equity loan, and today we have the interest-only home loan. We have also shifted from defined benefit to defined contribution (401k) pension plans. Paradoxically, these make us worse off in retirement, but we feel better and spend more pre-retirement. When the stock market goes up, people feel wealthier when their 401k statements come in, and they can also borrow against 401k wealth. None of this happened under earlier pension arrangements.

There is one area where financial deregulation and innovation have truly helped. That is the shift from state banking to national banking, which means individual banks now lend across wide regions. This has diversified risk, helping avoid cascading bank failures when loans have gone bad. Another innovation that has helped spread risk is securitization, which is a form of second-hand loan market. This has enabled banks to bundle loans and sell them to insurance companies and pension funds. However, risk can be spread but not gotten rid of, so the system is still exposed to a really big bust.

Not only has Chairman Greenspan misinterpreted the economic effects of financial innovation and deregulation, he also deeply misunderstands competition. The Chairman laments that “Many working people, regrettably, equate labor market flexibility with job insecurity,” and he proposes maximum competition. But if competition is to deliver shared prosperity, it must be nested in a set of rules that ensures appropriate income distribution and prevents undesirable forms of competition. All of this must be done while preserving the incentive to produce. Mr. Greenspan’s view, which has prevailed in the design of globalization, recognizes none of this and takes us back in the direction of 19th century style competition.

If the asset bubble Keynesianism hypothesis proves correct, policy will need to revisit the questions of financial regulation and unbridled competition. There are better forms of Keynesianism that ensure a robust level of spending based on fair and stable structures of income generation. That should be the goal of economic policy.

This entry was posted on Saturday, November 12th, 2005 at 4:28 pm and is filed under U.S. Policy. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.