Posted: 14 Nov 2011 02:00 AM PSTDean Baker is co-founder of the Center for Economic and Policy Research. He previously was a senior economist at the Economic Policy Institute and an assistant professor of economics at Bucknell University. He has a Ph.D. in economics from the University of Michigan. His latest book, The End of Loser Liberalism, has recently been released to download free of charge on the CEPR website.
Interview conducted by Philip Pilkington, a journalist and writer based in Dublin, Ireland.
Philip Pilkington: The problems we currently face are without doubt, as you say, purely demand-based. Certainly all the evidence I’ve seen – from both sides of the pond – leads to this conclusion too. I know that in the book you say that this too is part of evading the real problems underlying the crisis. As you’ve said in the previous part of the interview, these are largely to do with seriously unbalanced income distribution and a lack of purchasing power among workers. You’ve said in the book that these problems have been generated by the ‘trickle-up’ or ‘supply-side’ economics theories that became popular in the 1970s and were implemented thereafter.
Do you think that your profession – and, for that matter, those commentators and policymakers that they have trained – are ignorant of the problems you highlight in the book because they are so beholden to supply-side theories or do you think that they use their supply-side theories as an ideological mask to make political arguments? If the former is the case, then how on earth has economics become such an irrelevant and dogmatic discipline? And if the latter is the case the how has the profession become so corrupted?
Dean Baker: Just to be clear, the prevailing dogma in the profession is not exactly supply-side as people ordinarily think about it. Rather, it is the idea that monetary policy can deal with any demand shortfalls. The idea here is that if consumers are not spending enough to keep the economy near its full employment level of output, then we can simply have the Fed lower interest rates until it sparks enough consumption and investment that it brings the economy back to full employment.
There was sort of a neat test of this with Clinton’s deficit reduction in the 90s, where the mainstream of the profession saw one thing and my take was quite different. Their view was that we got the deficit down – which reduces demand – but then interest rates fell and we made up the gap. While we did make up the gap, it was not done in a sustainable way. It was the result of a stock market bubble driven consumption boom. There was little appreciation of the fact that this was a bad way to go at the time and there is still little appreciation in the economics profession of the fact that the 90s expansion was not on a sustainable course.
In terms of why economists believe what they do, I think it is a combination of ideology and corruption, although the sort of crude corruption that got highlighted in Inside Job, with people just selling their expertise for dollars, is rare. The idea that monetary policy could deal with any demand shortfalls was pretty widely held across the profession until recently in part because it was not so obviously wrong. There is no doubt that lowering interest rate can boost the economy and monetary policy was reasonably effective in bringing the US economy quickly back to something near full employment in the 80s after the steep downturn in 1981-82. There was a similar story in Europe as well.
Now part of the picture depends on what is considered full employment. We had unemployment rates in the best years of the 80s that would have seemed horrible from the perspective of the late 60s. (The unemployment never fell below 5.0 percent for any month in the decade. By contrast, it was averaged just 3.5 percent for all of 1979.) However, economists justified the higher unemployment rate by saying that the structural rate of unemployment had risen, meaning that we had more people who would be unemployed because they lacked the skills for the jobs available or they didn’t live where the new jobs were being created. This structural unemployment story was considerably more important in Europe than the US, with many countries seeing their unemployment rate rise from around 2-3 percent in the 70s to near double-digit levels in the 80s and 90s. Anyhow, this allowed them to define away any demand-side problem.
In the US case, it was held as an absolute article of faith that the unemployment rate could not get below a range estimated to be between 5.6 percent to 6.4 percent without triggering inflation. It was remarkable that Greenspan kept interest rates low so that the unemployment could fall to first 5.0 percent in 1997 and then 4.0 percent in 2000. He never would have done this had he been a conventional economist. (Two Clinton appointees to the Fed argued with Greenspan at the time that he should raise rates to head off inflation.)
My take-away from this experience is that we had demand side unemployment in the early 90s that eventually went away as result of the demand generated by the stock bubble. The conventional economists’ view of this experience is that something changed in the U.S. economy in the mid-90s that allowed the unemployment rate to fall to lower levels.
If we ask why economists would believe something about the world that seems to fly in the face of evidence, my answer would be that it is the easiest path for them. The vast majority of economists have no interest in upsetting the apple cart. They wanted to be economists because it is a relatively well-paying and prestigious profession. The way you move ahead in the profession is you repeat what the people who are more prominent than you are saying. This carries no risk. If they are right you can share in the glory. If they end up being wrong, then you have the “who could have known?” excuse.
In terms of the leading lights of the profession, they have no reason to change what they are saying because no one is ever going to cause them to lose their job or even their standing because they are wrong. How many people even missed a promotion because they failed to recognize the largest economic crisis since the Great Depression? Since the status quo position in the profession fits in well with most powerful interest groups, and everyone has been in the habit of repeating the same lines, there is little real pressure for change.
This is a depressing description of the profession, but people should understand that economics as practiced in the world cannot be seen as a neutral science. The deck is definitely stacked. Again, it is not typically in the form of someone getting money to push a particular line, it is more attributable to the way the profession has developed over the last five decades.
PP: What I don’t understand is this idea that deficit reduction leads to lower interest rates. My understanding is that central banks in modern economies have full control over the interest rate – they set it through open market operations. You can see this today in the US and the UK, who are running large deficits and low interest rates. But you could also see it in Japan in 90s and 00s. To the best of knowledge, even before they undertook QE in Japan there were low interest rates mirroring high deficits. Another example is during the 1974-75 recession in the US. Budget deficits soared but interest rates remained relatively low.
I could go on and on, but my key point is that modern central banks seem to have full control over interest rates through open market operations.
Tell me, do you adhere to this “deficit leads to higher interest rates” view? What’s it all about? I can’t make any sense of it.
DB: The argument would be that deficits at full employment will lead to higher interest rates. It is always hard to measure this one since every time the economy goes into a downturn the deficit increases. A good statistical test would control for the business cycle, but our controls are not perfect. There is also an issue of expectations. If the deficit is low today, but expected to be very high in a couple of years, then we would expect this to lead to higher interest rates today.
Furthermore, if we want a fair test we have to pull out the impact of monetary policy. If the Fed raises interest rates because we have a large budget deficit, then the high interest rates are, at least immediately, the result of Fed policy, not the budget deficit.
I think there is some truth to this story, but it is hugely overstated. The basic story is that if we are at full employment, then running large deficits puts strains on resources. We are running out of workers, factories and other producers are operating at capacity, there are shortages of housing and commercial property. This will lead to upward pressure on prices (i.e. inflation) and upward pressure on interest rates. I think the story holds at full employment, but the economy has rarely been close to full employment in my view over the last three decades. Certainly we were in 2000, perhaps in 2007, but not on many other occasions. This means that larger deficits would not have had much impact on interest rates, assuming the Fed did not deliberately push them higher.
PP: Okay. Sorry to get a bit wonky here, but I think its worthwhile having this discussion.
I’d tend to agree with you that the underlying argument is usually one about inflation. When you really push a policy wonk on the issue they always end up saying that inflation is the key danger. But in your book you seem to indicate that aggregate demand – that is, overall spending power – in the Clinton and Bush years was largely driven by bubbles and massive private sector credit expansion (manifesting as negative savings rates).
If this is true, an increase in government spending in these years may have softened the need for bubbles and household credit expansion, right? What do you think? Were the debates in these years really upside-down?
DB: Absolutely, the obsession with budget deficits under both Clinton and Bush was entirely misplaced. Deficits could occur for bad reasons, as certainly was the case with Bush tax cuts that disproportionately benefited the wealthy, and wars that did not need to be fought, were not good reasons to run deficits. However, the deficits themselves were not a problem. If this money had gone to build up the infrastructure or to educate our children we would have been made much richer as a result of the deficits.
As it was, if we had balanced the budget in the Bush years, the impact would likely have been primarily weaker growth and more unemployment. There was no obvious alternative source of demand in these years. Of course if deficit reduction was accompanied by a serious effort to push down the dollar, and thereby boost net exports, then it could have created many jobs.
But the push to lower the dollar was independent of the budget deficit. There clearly was little political will to reduce the value of the dollar. That would not have changed if the budget deficit had been lower.
PP: Moving on, in the book you make the claim that had the financial system been allowed to melt down we would not actually have ended up in another Great Depression. This is not to say that you don’t recognise that letting the financial system melt down would have caused a lot of problems – for banks, of course, but also for pension funds and the like – but you say that those in charge of the bailouts exaggerated the importance of the financial sector. Could you explain briefly what you mean by this? And what do you think should have been done at the time of the bailouts?
DB: The point here is that we know how to reflate an economy. Massive government spending will do it. It got us out of the Great Depression, although not until World War II created the political consensus for the level of spending that was necessary to actually do the job.
A financial collapse cannot condemn us to a decade of stagnation and high unemployment. That only comes about from a prolonged period of political failure. If we had allowed the banks to collapse in the financial panic of 2008 then we would have had the opportunity to pick up the pieces and get the economy back on track with a massive stimulus program.
Of course it was best to not let the banks collapse. However the bailout should have come with real conditions that would have ensured the financial system was fundamentally restructured. This would have included breaking up the too big to fail banks (on a clear timetable, not necessarily at that time), serious caps on compensation, a commitment to principle write-downs and other real conditions.
At that time the banks were desperate. Without a big dose of public money they would almost certainly have been insolvent, so they would have had little choice but to accept whatever conditions were imposed. As it was, they almost got President Obama thanking them for taking taxpayer dollars in the bailout.
PP: Any ideas about what could be done with the banks now? Or is the damage already done?
DB: We still need to reform and downsize the financial sector. We don’t have the same leverage over the banks as we did at the peak of the crisis when we could have slapped whatever conditions we wanted on the loans and guarantees they needed to stay alive, but Congress can still pass laws that will rein in the industry.
At the top of the list is a financial speculation tax. A modest tax on financial transactions will do much to reduce the rents in the industry and to eliminate or drastically reduce short-term trading that serves no productive purpose. It will also raise a ton of money.
The second thing is breaking up the too big to fail banks. There is no justification for allowing banks to be able to borrow at below market interest rates because they enjoy an implicit government guarantee.
The third item on my list would be re-instating a Glass-Steagall type separation between commercial and investment banking. The Volcker rule, which limits proprietary trading by banks with insured deposits, was a step in the right direction. However it looks as though the industry is using the rule-making process to turn the law into Swiss cheese. It is likely that most banks will be able to find loopholes that will allow them to do as much proprietary banking as they want.
Anyhow, these would be my top three reforms. Politically, all of them would be very tough sells right now. By contrast, at the peak of the crisis, the industry would have voluntarily agreed to the last two in order to get the money they needed to stay alive.
PP: You write in the book that the idea that the banks repaid all the money from TARP is misleading. Could you explain this, because this myth is very prevalent in the mainstream media?
DB: Yes, this is really kind of a joke. The banks got loans at way below market interest rates from the government, and we are supposed be grateful that they repaid the loans? The difference between the market interest rate and the rate they actually paid amounted to a huge subsidy. This is something that anyone with even a passing familiarity with business or economics would recognize, which is why it is so insulting when political figures go around yapping about how the money was repaid with interest.
To see this point, suppose the government gives me a 30-year mortgage at 1 percent interest. If I make all my payments and pay off the mortgage has the government made money? By the logic of the politicians claiming that we profited by the bailout, the answer is yes.
A serious assessment would look at what the market rate for these loans was at the time they were made. To take one example, just before we lent $5 billion to Goldman through TARP, Warren Buffet lent $5 billion himself. He got twice the interest and a much more generous deal on warrants. Plus he knows that it was likely that the government would bail out Goldman if it got in trouble.
Elizabeth Warren commissioned a study of the implicit subsidies in the bailouts when she was head of the TARP oversight panel. As I recall, it came to over $100 billion on just the first batch of TARP loans to the large banks. This didn’t count the value of later TARP lending, the much larger lending programs from the Fed, nor the extensive set of guarantees provided by the Fed, Treasury, and the FDIC.
All of these commitments involved enormous subsidies. In the business world firms pay huge amounts of money if they want their debt to be guaranteed. And everyone understands that a below market loan is essentially a gift. That is why it is so insulting when they try to imply that the public has profited from these loans.
You can make the argument that it was good policy to subsidize the financial industry to get through the crisis, but to pretend that we did not subsidize them is just dishonest.
PP: Finally, and I think this is the biggest question of them all. It seems to me that today only those on the left have anything to say about the economy. The right – and the so-called centre – talk themselves in circles. Some come across as lunatics; others simply appear to be deeply confused about what is going on today. So, I guess the left is in a pretty good position in that all that they had been warning about for years – from the dangers of wealth inequality to the very real existence of major financial instability – has come to pass in an extremely apocalyptic way.
Yet, their prescriptions are shunned and they are still largely ignored. Minsky’s name is mumbled from time to time – rarely coherently, from what I can see – and Marx and Keynes are regularly invoked in the popular financial press, but it all seems to be nothing but parlour games. While what the left may have said a few years ago might have been ignored and even ridiculed, today it is treated like a sort of carnival sideshow: those supposedly in-the-know come along for a gawk but once they’ve picked up enough of the fancy ideas to come across as trendy at the dinner table they’re back to supporting contradictory and unsustainable policies and engaging in the very speculation and risk that they tut-tut.
What are progressive people to do in such circumstances? The whole thing has become quite bizarre. We’re still on the fringes and yet, at the very same moment, we’re taking up centre stage. How do you navigate in such a world? What do you think are the most effective interventions? In short: what are we supposed to do from here on in?
DB: Yes, what is to be done?
Well, the first thing is to be clear on where we are. We are up against an opposition that has almost complete control of the public debate. If you just stand back for a moment: here we are with 26 million people unemployed, underemployed or out of the work force altogether, millions of people facing the loss of their home, a huge cohort of baby boomers on the edge of retirement with nothing to support themselves but their Social Security and the topic that stands at the center of national debate is reducing the deficit. This is close to crazy.
What is even more incredible is how we got here. We have people who have literally been wrong about everything having to do with the economy over the last 5 years. They totally missed the $8 trillion housing bubble, the largest asset bubble in the history of the world. They were yelling about the budget deficit in 2006 and 2007 as the collapse of the housing bubble was about to explode the economy.
Then they underestimated the severity of the downturn, telling us the economy was going to bounce right back. And, then they got the interest rate story wrong. They told us that the large budget deficits caused by the downturn would lead the bond vigilantes to send interest rates through the roof. Instead they fell through the floor.
So who gets listened to in national debates, those who have been consistently right on all the key points, or those who have gotten things as wrong as you possibly can? Okay, we know the answer to that, but this knowledge is important. We are dealing with people who have no argument; they are relying on their control of public debate to get their way.
Fortunately, we are better situated to contest this now than we were 15 or 20 years ago because of the Internet. We have ways to reach a much larger audience and expose this nonsense than was true in 1990 or even 2000. We have to find creative ways to embarrass these folks.
I think the media is central to this story. There are a large number of reporters who like to believe that they are doing a good job. They can be shamed. When they get the facts wrong, we can expose it. When they rely exclusively on a narrow group of ‘experts’ all of whom want to cut Social Security and Medicare, we can expose that as well. This is the reason that I have my Beat the Press blog. I find that there are many reporters (not all) who will try to be reasonable if you can show a clear bias in their reporting. It shouldn’t be the case that getting everything wrong about the economy over the last decade is the main criterion for being taken seriously in policy debates.
Of course we have to push policies that are clear and simple and have real impact. This is one of the reasons that I am huge fan of a financial speculation tax. This is simple and makes so much sense to people. We impose a small tax that would be almost invisible to any person who uses the financial markets for their normal purposes (e.g. saving for retirement or borrowing for a business), but would totally nail those who buying and selling by the day or by the hour. And, it raises a ton of money to keep the deficit hawks happy.
Now that we actually have a bill that has been introduced in Congress and even scored by the Joint Tax Committee ($350 billion over 10 years), it will be great to see how long the budget hawk types can pretend that it doesn’t exist.
More generally we have to constantly look for points of entry where we can find politically feasible policies that make a difference and also make a point. The key policy fulcrums, areas like the Fed, dollar policy, and trade policy, are going to be out of reach for a while. But while we educate people about the importance of these policies we can try to push policies at the state and local level that can have an impact.
I am huge fan of work sharing, which can be done at the state level. Imagine that we had gone the route that Germany did. It had no better growth than the US but its unemployment is now half a percentage point lower than it was at the start of the downturn. States can go down this road, maybe not as far Germany, but certainly much further than they have so far.
We can also push at patent protection for prescription drugs. A lot of states have borders with Canada. Getting drugs there is a great thing to do. If state or local governments can do anything to institutionalize an importation process – pressing the limits of the law – then it can save money, provide people with needed drugs, and teach everyone that drugs are expensive because the government gives Pfizer and Merck patent monopolies.
In the same vein, we can try to promote trade in health care. There are top quality medical facilities in India, Singapore and elsewhere that can perform medical procedures at one fifth or one tenth the cost as in the United States. This can mean paying $20,000 for a procedure that might cost $200,000 here. If patients can take advantage of these facilities and share the savings with the government or private insurers than more and more people will come to recognize that health care in the United States is expensive because the government is protecting the incomes of highly paid medical specialists, hospitals, medical instrument manufacturers and drug companies. This is a great place where we can clearly use the market against the one percent.
It is always possible to find ways to make a point; to advance a progressive agenda. We have to be fast and we have to be opportunistic. But most of all we have to stop working from a script drafted by the right. The right can get mass public support for a pro-market agenda. They cannot get mass public support for an agenda that explicitly uses the government to redistribute income upward to the one percent. That has been the policy for the last three decades. Our job is to make sure that everyone knows it.