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Mexico City, May 2007

PROSPERITY AND CRISIS IN THE WORLD ECONOMY:

YESTERDAY, TODAY, AND TOMORROW

What I want to do in this talk is offer an account of where the US, and world, economy is at today,

and where it’s going.

To do this, I want to look at the current period from three temporal perspectives, focusing in ever

more closely on the present--first from a long run perspective, then a medium run perspective,

and finally a short run perspective.

--The long run perspective encompasses here the whole postwar epoch, from the end of the 1940s

into the present, and especially, for present purposes, the long period of economic slowdown for

most of the capitalist world, which began in 1973.

--The medium run perspective takes as its point of departure the early 1980s, the point at which

the world economy began its shift toward neoliberalism and the US economy initiated what

turned out to be a very major, but ultimately abortive, economic recovery between 1985 and

1995.

--Finally, the short run perspective runs from 1995 to the present, a period of ongoing bubble

economy, featuring first the stock market bubble of the second half of the 1990s, then, the

housing price bubble of the last five years or so.

1. THE LONG RUN: FROM LONG BOOM TO LONG DOWNTURN

i. Worsening Stagnation

To begin with, as is well understood, the postwar economy naturally divides itself into two parts, a

long boom running from end of 1940s to 1973, and a long downturn from 1973-present.

For at least the last decade the financial press and the politicians have assured us that we’re at the

end of stagnation and on the verge of a great new boom.

But the facts of the matter are quite different

Not only has the long downturn persisted right into the present.

But, for the advanced capitalist economies, there been a more or less continuous worsening of

performance, in terms of virtually all of the standard economic indicators, business cycle by cycle.

In fact, during the last six years, for the new business cycle that began in February 2001, the

performance of the US economy, and the advanced capitalist countries more generally, economic

performance has been the worst for any comparable period since 1950 (except the one including

the recession of 1974-1975).

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[for a quick take on this see See Table 13.1 Declining Economic Dynamism, especially the last, far

right column]

What accounts for this pattern of economic performance?

To me the key is the pattern of profitability.

For the period from the end of the 1940s to the later 1960s, you have persistently high

profitability,

From the mid-1960s, you have a major fall in the rate of profit.

And, perhaps most important, there is no recovery of profitability right through to the end of the

century.

So, it would be my most general proposition that persistently high profit rates accounted for the

long postwar boom, the shift from high to reduced rates of profit from the mid-1960s to the mid-

1970s accounted for the transition from boom to stagnation,

and persistently low profit rates accounted for the long downturn, extending right into the

present.

[For these propositions, see Line graphs 15.6 and 0.4, and also the Table 15.1]

The underlying theory behind these proposition is pretty straightforward.

First, the rate of profit is a rough and ready determinant of the surpluses firms have at their

disposal .

In addition, the realized rate of profit is the best predictor firms have of prospective profits, i.e.

the future profits that they can expect.

So, when profitability is high you get high investment—that is, high growth of the capital stock--

and high growth of employment; when profitability is low, you get the reverse, the slow increase

of investment and employment.

If we apply these generalizations about profitability and capital accumulation to the postwar

period as a whole, we can get an initial understanding of the pattern of economic evolution.

Between 1948 and the late 1960s, profitability remained high and made for the long boom.

But, between 1965 and 1973 the profit rate fell, fell further between 1973 and 1979, and never

did recover during the following two decades.

The result was that the growth of the capital stock and of employment fell.

Because the growth of capital stock fell, the growth of plant and equipment per worker fell, and

productivity growth declined.

The decline of productivity growth made it more difficult for the economy to accommodate wage

increase, so put further downward pressure on the economy. Because not only the growth of

productivity, but also the increase of employment—that is, the demand for labor-- declined, so did

real wage growth.

[See again Table 13.1 Declining Economic Dynamism]

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You can look at the same progression from the stand point of demand, the direct driver of the

economy.

Because the profit rate fell, firms had smaller surpluses, so cut back on capital accumulation, with

the result that the growth of investment demand—meaning the demand for new plant and

equipment—fell.

Because the profit rate fell, firms reduced the growth of employment and the growth of wages,

with the result that consumer demand fell.

Because governments sought to help capital to improve the conditions for profitability, they

reduced the growth of government spending, especially on social services, so the growth of

government demand fell.

Because the growth of investment demand plus consumer demand plus government demand fell,

and continued to do so, we got economic stagnation and indeed worsening economic stagnation.

In sum, the bottom line is that a fall in the rate of profit and the failure of the rate of profit to

recover, has made for the long term decline and stagnation of aggregate demand, and this had

made for the extension of the long downturn.

Again, economic performance has gotten worse and worse, business cycle by business cycle since

1973, the most recent business cycle, with the one that continues into the present the worst of

all.

[I portray this progression from decline in profit rate to ever worsening stagnation of demand in

Tables 15.1 through 15.6, which, as you can see, proceeds from profit rates to investment to

labor productivity, then to employment and compensation per person, then to aggregate

compensation and the growth of government spending.]

ii. The Fall in the Rate of Profit: The Rise of Over-capacity in Manufacturing

Well, if the decline—and especially—the failure of recovery of the rate of profit is behind the long

period of slowed growth, the fundamental question is, obviously, what was responsible for the

trajectory of the profit rate?

This is, of course, a huge theoretical and historical question, too big to fully answer here.

I will therefore have to content myself with a very schematic outline.

So, the basic ideas is that the Great Postwar Boom in the advanced capitalist countries should be

understood as a process of uneven development, which was driven by the interaction between an

early developing, socially and technologically advanced, and hegemonic bloc of capital focused on

the United States, and a later developing, socio-technologically backward, and hegemonized blocs

of capital in western Europe and Japan.

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The later developing blocs derived their economic dynamism from their highly organized

capitalisms, high levels of intervention by their states in their economies, their cheap factors of

production, especially cheap labor, their ability to borrow advanced technology from the US, and

their ability to translate the very rapid growth of plant and equipment into economies of scale and

high levels of learning by doing.

High levels of investment and productivity growth, allowed them to grow with historically

unprecedented rapidity, especially by recourse to manufacturing exports.

The US early developing bloc derived its dynamism, by contrast, from its technological leadership

and, in particular from the foreign direct investment of multinational corporations and the

overseas expansion of its international banks, as well as the initial strength of its great

manufacturers. In other words, US expansion in the 1950s and 1960s entailed the first phase of

the process of globalization that has continued to this day.

At first the interaction between the US economy, on the one hand, and the Japanese and west

European economies on the other, was highly symbiotic, i.e. mutually supportive, and this gave

rise to the historically unprecedented economic dynamism of the postwar boom.

Japan, Germany, and western Europe expanded rapidly, especially by seizing huge chunks of the

world manufacturing export market from the US and the UK.

But US companies also did quite well:

US manufacturers were able to prosper by continuing to dominate the huge domestic US market,

while US multinational corporations and banks invaded Europe en masse.

Nevertheless, after a point, what had at first been symbiosis dissolved into conflict…basically, a

heightening struggle for shares of the world market.

Thus, from the mid 1960s, what we see is a marked intensification of international competition,

which led in turn to the rise of over-capacity in the international manufacturing sector.

As a result of that over-capacity, firms across the world system found that they could no longer

mark up, or raise, prices above costs of production sufficiently to sustain their profits, and

manufacturing profit rates fell sharply between 1965 and 1973, bringing down profit rates for the

private sectors of the advanced capitalist economies taken together.

Manufacturing profit rates for the advanced capitalist economies taken in aggregate fell further

between 1973 and 1979…and have not recovered since.

There are various sorts of evidence for the proposition that it was manufacturing over-capacity

that was behind the fall in the rate of profit across the advanced capitalist economies between

1965 and 1973 and through to 1979.

But, the basic one is that, the fall of the rate of profit was largely confined to the manufacturing

sectors, which were exposed to international competition..

Non-manufacturing was pretty much unaffected.

[See Figure 8.1 and the accompanying Table on Manufacturing and Non-Manufacturing Net

Profit Rates, as well as Figure 9.1.]

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To take the point a bit further, there was no fall in the rate of profit in the US non-manufacturing

sector, even though costs of production rose much faster in that sector than in the manufacturing

sector.

The reason is that non-manufacturers, shielded as they generally were from international

competition, were able to avoid over-capacity and raise their prices in response to rising costs, to a

much greater extent than were their counterparts in manufacturing, who were usually subject to

international competition and over-capacity.

[For this, see Table 8.1 Costs Prices and Profitability in the US (manufacturing and non-

manufacturing sectors).]

iii. The Failure of Profit Rates to Recover: The Persistence of Over-Capacity

But, if the initial fall in the rate of profit resulted from the onset of over-capacity in the advanced

capitalist economies, this poses a huge problem.

How come the profit rate has stayed down for so long, and has still failed to recover?

Why was there no adjustment?

This problem of the persistence of reduced profitability imposes itself with special force because,

from the time of the initial fall in the rate of profit between 1965 and 1973, we know that firms

and governments devoted themselves with ever greater determination and self-consciousness, to

implementing measures with the specific purpose of bringing the rate of profit back up, by

attempting to reduce costs and by transforming their ways of doing business and altering state

regulation. .

--They unleashed a very broader assault on the working class, by reducing the growth, and

sometime absolute levels, of wages and social services.

--They sought to neo-liberalize the economy by de-regulating labor and commodity markets,

privatizing state enterprises, and freeing up the formerly repressed financial sector.

--They shifted capital out of high cost, low profit manufacturing lines, especially into financial

services..

--They forced open markets for commodities, foreign direct investment, financial services, and

short-term capital throughout the less developed countries.

--They stepped up foreign direct investment for the purpose of relocating manufacturing in

selected regions of what had been the third world in order to combine low cost but increasingly

skilled and well-educated labor with the best possible technique, creating in the process complex

networks of production or production chains.

--They turned increasingly to speculation, in ever more sophisticated forms,

--They sought profits throughout much of the global south by means of the rapid inflow and

outflow of hot money to and from newly freed-up markets in financial assets .

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In fact, all of the foregoing interrelated measures—which we now call “neoliberal globalization”--

constituted nothing more nor less than an ever more systematic, indeed ever more frenzied,

attempt to cope with the pervasive and persistent problem of reduced profitability.

But the overriding fact remains that, although they were pursued ever more vigorously during the

1980s and 1990s, these measures taken together failed to prevent the economy’s performance

from worsening as time went by and--the bottom line—they failed to restore the rate of profit.

As a consequence, as of 2000, the long downturn remained very far from overcome.

Why then did the rate of profit fail to recover? In particular, why didn’t we see the processes that

we would normally expect to take place when there is over-capacity in specific lines of

production—specifically, the shifting of capital and labor out of low profit into high profit

industries and the shakeout, or elimination, of high cost, low profit means of production?

It seems to me that there were three main processes at work:

First, contrary to the intuitions of standard economics, the great capitalist corporations of the

advanced capitalist world did everything they could to remain in the industries that they already

occupied, even though these industries were burdened by over-capacity.

Only very tardily and with the greatest reluctance did they respond to their profitability problems

by withdrawing plant and equipment and labor from oversubscribed lines of production.

Instead, the great corporations, tried to defend their positions in the world market as long as

possible by falling back on their so-called “proprietary capital’—specifically, their established

connections with suppliers and customers, and, above all their technological capacity.

On this basis, they sought to improve their competitiveness by cutting costs by means of

expanding investment as much as they were able, even in the face of reduced rates of return.

In effect, because they had built up all of this “intangible” capital--which they could only use in

their own industries and could not transfer to new lines of production--they decided to fight for

greater market share rather than switch lines.

But, this of course, only exacerbated the problem of over-capacity.

Second, simultaneously, one after another region of East Asia—from the northeast Asian NICs, to

the southeast Asian Little Tigers, to the Chinese behemoth-- extended ever further the processes

of uneven development that had set off the long downturn in the first place.

Like the Europeans and Japanese before them, the East Asians did so by successfully exploiting

the potential advantages of coming late—especially by combining their cheap but relatively skilled

labor with advanced technologies borrowed from the west, in the context of highly organized

capitalisms and elevated levels of state intervention.

The East Asian economies proceeded up the technological ladder with unprecedented speed,

especially by means of ever deepening regional integration with one another, made possible by

accelerating foreign direct investment as well as by trade.

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On that basis, they rained down ever greater torrents of increasingly sophisticated manufacturing

products on already over-supplied world markets, increasing still further the stress on world

manufacturing profit rates.

[For this, see Table 15.14 on Shares of the World Market in Manufactures, 1970-2005]

In sum, what we witnessed, in the face of already-existing over-capacity, was the insufficient exit

of high cost low profit means of production in the core and too much entry of low cost high profit

means of production in the periphery.

But, of course, insufficient exit and too much entry should have brought even worse over-

capacity…and in fact it did, as the manufacturing profit rate across the advanced capitalist

countries was lower at the end of the 1970s than it had been at the start.

Yet, the question then arises, if the tendency to reproduce over-capacity persisted and at times

got worse, why didn’t the world economy experience more serious recessions and even

depressions… and thereby, eventually, the shakeout of high cost low profit means of

production…and thereby a recovery of profitability?

The main answer in my opinion is that the governments of the advanced capitalist world, led to an

ever increasing extent by the US, made sure that titanic volumes of credit were made available--

through ever more varied and baroque channels, both public and private---to firms and household

to soak up the surplus of supply over demand.

Basically, what we witnessed was the historically unprecedented and ever increasing growth of

borrowing, and this allowed the world economy to secure the demand it needed to counteract the

problem of over-capacity and prevent depression.

The bottom line, so to speak, is that, for political reasons, governments, through the expansion of

borrowing, forestalled the deep recessions or depressions that had, historically, eliminated excess

capacity and in that way allowed the economy to regain its profitability.

Nevertheless, the outcome was the predicament that faced the world economy as it entered the

new millennium in the year 2000.

On the one hand, the growth of borrowing at levels that continued to break all previous records

kept up demand, and in that way prevented profitability from falling even further, past a certain

point.

In particular, the spectacular growth of debt kept the economy turning over in the wake of the

serious recessions of 1974-5, 1979-1982, early 1990s, and early 2000..

On the other hand, precisely because demand was kept up by increased borrowing, the shakeout

of high cost, low profit means of production was slowed down and limited.

As a consequence, over-capacity was reproduced, and the rate of profit failed to recover.

Because the profit rate failed to recover, investment growth, employment growth, and wage

growth continued to slow down, resulting in slowed growth of aggregate demand and decreasing

economic dynamism.

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So, between 1973 and the present, we did not get a system shaking crisis, as in the 1930s.

What we got instead was the continuation of stagnation over three decades.

As the economy entered the new millennium, profit rates had still failed to recover and the long

downturn continued.

[See again Figures 15.6 and 0.4 and table 15.1]

II. MEDIUM RUN: LIBERALIZATION AND THE ABORTIVE US RECOVERY, LATE 1970S-MID-1990S

So, that’s the long run, big picture, so to speak—from long boom to long downturn.

What about the medium run?

From a medium term perspective, against the long-term background of the continuation of the

long downturn, there are two new developments that are key, both originating in the early 1980s.

i. First, there was the shift to neo liberalism, which led to the worsening of the problem of

aggregate demand for the system as a whole.

ii. Second, against the background of marketization and declining growth of demand, there was a

very major, but ultimately abortive, recovery of the US economy, led by its manufacturing sector.

Let’s look at these two developments, in order.

i. The Emergence of Neoliberalism, 1980-1995

As is well understood, the initial response to falling profit rates and problems of economic growth

in the world economy in the late 1960s and early 1970s was Keynesian government budget deficits

and easy credit, which was designed to stimulate growth by subsidizing, or pumping up, aggregate

demand.

Nevertheless, by the end of the 1970s, Keynesianism had failed, and the reason for this, from the

standpoint I am arguing, was quite clear.

The government deficits--i.e. the borrowing by the government and resulting increased

spending—did keep up growth by providing added demand.

However, the additional demand had the effect of allowing high cost, low profit firms to continue

in business, rather than going bankrupt…and this sustained over capacity and prevented the

recovery of the profit rate.

The upshot was that, during the 1970s, profitability didn’t collapse, but it didn’t recover either.

As a result of the low profitability of firms, as the 1970s progressed, one saw, in response to

Keynesian deficits—i.e. increased demand—runaway inflation, rising government deficits, rising

trade deficits, and a falling dollar..

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By the end of the decade, the decline of the dollar was threatening the role of the dollar as the key

international US currency, and the Federal Reserve, under chairman Volcker, had to step in.

The so-called Volcker shock of 1979-1980 was designed to set the economy on a new path by

imposing unprecedentedly high interest rates and balanced budgets.

The central goal was to increase unemployment, so as to break the back of inflation and undercut

workers organization so as to reduce wage growth.

But the aim was also to wipe out the huge ledge of over-capacity in manufacturing that continued

to build up in the 1970s.

The increase in unemployment, decrease in wages, fall in inflation, and elimination of

manufacturing over capacity was supposed;

--to pave the way for the recovery of manufacturing profitability

--to facilitate the shift of the economy into financial services

--and to promote a financial expansion by driving up interest rates to attract foreigners to invest in

US Treasury Bonds.

The underlying idea was to reduce the role of government in guiding and supporting the economy,

and let the free market drive the economy.

But, the problem was that the Volcker shock gave rise to the worst recession of the postwar

period with unemployment soaring to 12% by 1982.

It also precipitated the international debt crisis of the less developed countries…and fears of world

depression.

The Reagan administration was unwilling to accept a further deepening of recession and a possible

crash.

So, for political reasons, there was some reduction in interest rates and, especially, the biggest

shot of Keynesian deficits in world history.

The huge resulting increase in aggregate demand did save the US, and in turn, the advanced

capitalist economies taken together, by keeping profit rates from falling too much, and thereby

allowing growth to continue.

But, this same increase in aggregate demand slowed that shake out of over-capacity on a

systemwide scale that was needed in order to sharply raise profitability, with the result that the

economy continued to limp along.

The result was that Keynesianism continued…and a full turn to neoliberalism did not take place.

The real discontinuity—the real turn to neoliberalism—would not take place until the early 1990s.

At this point, one witnesses, through the advanced capitalist economies, not only tight credit, but

a turn to balancing the budget—in other words, a full-fledged attempt to put an end to Keynesian

regulation and the stimulation of the economy through budget deficits.

This took place in the US, when Bill Clinton took office, in 1993, under the guidance of his

economics czar Robert Rubin, formerly CEO of Goldman Sachs, the huge NY investment bank.

It took place in Europe in preparation for the Maastricht Treaty, ushering in a unified European

currency.

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The outcome of the combination of tight credit and budget balancing was dramatic:

for the first time during the postwar epoch, the advanced capitalist economies were left to

regulate themselves mainly by way of the free market.

Nevertheless, the results were just the opposite of what the advocates of neoliberalism had hoped

for.

Since profit rates across the system still remained low, especially in manufacturing, firms

responded to the decline in demand brought about by the decline of government deficits and tight

credit, by cutting costs more viciously than before, especially by laying off workers and reducing

capacity.

As a result, between 1991 and 1995, Europe and Japan experienced their worst recessions of the

postwar period, driven by the collapse of their exports and the huge contraction of their

manufacturing sectors.

In the US, meanwhile, there was a jobless recovery.

At the same time, to make matters worse, the East Asian NICs and Little Tigers experienced their

biggest export boom ever.

So, the free market brought not recovery, but ever deeper stagnation to the world economy into

the middle of the 1990s.

The world economic pie grew ever more slowly.

Indeed, the years 1990-1995 witnessed the slowest growth of the postwar epoch up to that time

(except again for the years around 1974-1975).

ii. The Abortive US Recovery, 1980-1995.

Against the background of deepening global stagnation, the US economy staged a major, though

paradoxical recovery.

This began with the Volcker shock of 1979-1982.

At this juncture, high interest rates and a high dollar did lead to a crisis of in the US manufacturing

sector.

The resulting shake out of high cost, low profit manufacturing means of production and the

accompanying huge reduction of manufacturing employment, created the necessary pre-

conditions for what ultimately turned out to be a significant rise in the rate of profit.

The big cut in the manufacturing labor force initiated an important increase in manufacturing

labor productivity.

But what really sustained the recovery of profitability was, in the first place, a huge repression of

wage growth. Employers prevented manufacturing wages from rising for ten years.

Even more important, with the Plaza Accord of 1985, the leading capitalist countries agreed to

bring down the value of the dollar, and, over the next decade, the dollar fell very sharply.

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The combination of wage stagnation and dollar devaluation brought a very major increase in US

international competitiveness in manufacturing and manufacturing export growth…and that

issued, in turn, in a huge increase in the manufacturing rate of profit… by about 70 per cent

between 1985 and 1995.

[This is shown in the graph called “US Net Profit Indexes, 1978-2001”]

By 1995, the rate of profit in the US private sector, although not yet returning to the levels of the

postwar boom, had come back to its level of 1969 for the first time in a quarter century.

The recovery of profitability ultimately detonated the beginning of a significant economic

acceleration in the US.

From 1993-1994, the US economy was finally witnessing big increases in the growth of

investment, of employment, of productivity, and GDP.

It looked like the US economy might be initiating a new long boom…with the prospect of carrying

the rest of the world behind it.

But, in the end, due to the profound underlying weakness of the world economy as a whole, the

US economy was unable to sustain its recovery.

As I’ve emphasized, from 1973, as a consequence of the generalized failure of the profit rate to

recover, the world economic pie had grown ever more slowly…and the first half of the 1990s was

the worst of all.

As a result, we encounter a kind of hydraulic—or zero-sum—dynamic, where the gains secured by

one country or group of them comes necessarily at the expense of others.

So, a country or a group of countries would find itself with a low currency that brings about lower

prices, superior competitiveness and thus increased market share and profit.

But, in this constrained context, this would come directly at the expense of rivals with a high

currency…and vice a versa.

What therefore happened between 1985 and 1995, when the US manufacturing sector was

increasing its competitiveness and, in that way, its market share and rate of profit, the opposite

side of the same coin was that the German and Japanese manufacturing sectors, which were

sustaining rising currencies in this period, were experiencing declining competitiveness, falling

market share, and declining rates of profit.

The gain of one came at the expense of the other.

In other words, as the US improved its rate of profit and its economic performance, Japan and

Europe were seeing their profit rates fall in tandem.

As the US manufacturing sector was finally recovering, the manufacturing sectors of Japan and

western Europe were experiencing their worst crises.

[You can see this illustrated in Figure 15.3 Manufacturing net profit rate indexes: US Germany,

Japan]

By 1995, the Japanese yen had hit its highest level of the postwar epoch, and the Japanese

economy was freezing up.

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So, the leading capitalist governments had to get together to bail out Japan and Germany, just as

they had bailed out the US a decade earlier with the Plaza Accord.

The so-called Reverse Plaza Accord pushed the dollar back up and brought the yen and mark back

down, and this did put a stop to the Japanese and German recessions and got them growing again.

But, by raising the value of the dollar, it also undermined the basis for the US manufacturing

recovery up to that point by undercutting US manufacturing competitiveness.

In fact, between 1995 and 2000, under pressure from dollar revaluation, the US manufacturing

profit rate reversed course, and began a precipitous decline…and this started to send the US

economy into a slowdown.

Again, the point is that in the face of a stagnant economic pie—and manifesting that stagnation—

the gains of one economy or set of them come at the expense of the other.

This was the trap in which the world economy found itself in the second half of the 1990s.

[You can see this reversal by taking a look, again, at that Figure 15:3]

III. THE SHORT-RUN: BUBBLE-NOMICS, 1995-2005

This brings me to the last section, on the short-run perspective: basically the period 1995-2005.

i.The stock market bubble drives the economy, 1995-2000

The bottom line is that, by 1995, the world economy was at an impasse—the turn to reliance on

the free market—by which I mean ceasing to depend on Keynesian budget deficits to push up

aggregate demand—had left the advanced capitalist economies in their worst recession of the

post-war era between 1991 and 1995.

The US recovery up to 1995, based on the low dollar, had exacerbated the problems of western

Europe and Japan.

The turn to the Reverse Plaza Accord, which brought about a low yen and low mark, did overcome

the recessions in Japan and Germany, but it also cut off the US recovery.

It thereby brought to the fore the central underlying problem: that of aggregate demand.

During the length of the long downturn, the failure of profitability to recover had meant, as I have

continued to emphasize, declining investment, consumption, and government demand.

What had kept the world economy growing was the subsidies to demand provided by Keynesian

government deficits, especially US federal deficits, i.e. federal borrowing and spending.

In fact, Keynesian deficits had gotten ever larger between the middle 1960s and the end of the

1980s.

But, as we have seen, the Clinton administration decided to balance the budget, and this put an

end to the support for demand provided by government deficits.

Especially since the US profit rate had, from 1995-1997, begun to reverse itself, the big question

was, where is the demand going to come from to drive the economy.

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This is where Federal Reserve Chairman Alan Greenspan comes in, with a novel plan to stimulate

the US economy.

By 1995 and 1996, stock market had already begun to rise, as a result of the Reverse Plaza Accord:

Money was pouring in from Japan into US Treasury bonds to push the dollar up, but this also

pushed long-term interest rates down, and this stimulated the stock market

At the same time the dollar’s rise also pushed up the value of stocks

So equity prices were rising fast.

Therefore, as people may remember, at the end of 1996, Alan Greenspan made his famous

warning about “Irrational Exuberance” in the stock market.

And, of course, there was irrational exuberance because profitability in the real economy was

going down while the stock market was going up.

But, in fact, the stock market continued to rise and Greenspan did absolutely nothing about it, a

fact not lost on investors.

As the economic expansion continued, he not only failed to raise interest rates in the normal way

but, in fact, lowered them at every point at which there was the slightest worry in the stock

market, for example in late summer 1997 or especially in late 1998, in the wake of the East Asian

Crisis.

As a result: we saw a record run-up of the stock market…as profits flattened out and fell.

[see graph on profits and stock prices]

There was of course a method to Greenspan’s madness.

As companies’ stock market valuation rose they were worth more, so they were able to borrow

money ever more easily.

At the same time, especially high tech companies, which experienced the biggest stock increases,

were able to issue their over valued shares to raise massive funds.

This gave companies of all sorts an enormous increase in their capacity to invest…which of course

was extremely paradoxical for, at this very time, profitability was going down.

But: the fact was that firms were flush with cash despite their declining profitability and this made

it possible for them to drive a huge takeoff between 1995 and 2000.:

Investment grew fast and employment grew fast.

We had, in other words, the famous New Economy Boom.

What was going on?

Greenspan realized that the economy, on its own, was short of demand.

So, what he did was exploit the wealth effect of rising asset prices to usher in a new form of

stimulus, which I would call Stock Market Keynesianism or Asset Price Keynesianism.

Under traditional Keynesianism, the government borrowed and spent to stimulate demand.

Under stock market Keynesianism, thanks to the Federal Reserve’s low interest rates, firms and

individual got wealthy on the stock market.

This allowed them to borrow and spend and in this way to stimulate demand.

The result was that corporations invested a lot and households consumed a lot.

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It was due to all that borrowing, that we got the New Economy boom.

According to Greenspan himself, between 1995 and 2000, the wealth effect of the stock market

run up amplified GDP growth by one-third.

But the problem was that the New Economy boom was without real foundations.

This was because, as I’ve been emphasizing, profitability was at this very moment sharply falling.

The growth of borrowing drove up stock prices in defiance of profits, and ratios between the

prices of companies’ stocks and their earnings reached an all time high.

The growth of borrowing drove up output, but because output grew in the face of already existing

over-capacity, profitability fell even further..

It was only a matter of time until there would be a serious recession..

ii. The housing bubble drives the economy, 2000-2006

In the year 2000, the New Economy Boom came to an abrupt end.

Over-capacity all across the manufacturing sector made for a huge fall in profitability.

The stock market crashed.

The economy went into recession.

Symptomatically, the recession was almost totally focused on the manufacturing sector, the place

where over-capacity was concentrated.

The fall in the manufacturing profit rate accounted for the entire economy wide fall in profitability

in between 2000 and 2002,

The loss of jobs in manufacturing, 3 million jobs, accounted for all the jobs lost in the economy

between 2000 and 2004.

There was no increase in manufacturing capital stock for four years, and this accounted for all of

the decline in the growth of the capital stock for the whole economy at this time.

Simply put, the so-called New Economy had radically worsened manufacturing over-capacity and

the resulting recession delivered a huge shock to the system.

In 2000-2001, GDP and investment declined more rapidly than at any other point during the

postwar period…and it looked like there might be a depression.

But, at this point, Alan Greenspan came to the rescue once again, with his new form of

Keynesianism, so-called asset-price Keynesianism.

At this point, housing prices had already been going up rapidly, as rich people had taken their

money out of the stock market and put it in the housing market.

Greenspan brought down interest rates extremely rapidly, and he kept them below zero in real or

price-adjusted terms for three years.

People could now borrow money cheaply and demand for houses rose rapidly.

As a results, housing prices skyrocketed between 1995 and 2000, just as the prices of stocks had

skyrocketed between 1995 and 2000. .

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Because peoples’ houses were now worth much more than before, they could borrow much more

against their houses value.

Between 2000 and 2005, household borrowing as a percentage of household income smashed all

records, and this made possible a huge increase in the growth of personal consumption..

It was indeed the growth of personal consumption that accounted almost entirely for the new

cyclical upturn that began in 2001.

Housing accounted for 30 per cent of all the growth that took place in the same period.

[see graph housing and growth]

So, as between 1995 and 2000, between 2000 and the present, asset prices have come to the

rescue of the economy.

But the question is, what will be the outcome?

It was Alan Greenspan’s idea to rely on the wealth effect of housing prices to allow households to

people to vastly increase their borrowing and in that way to vastly increase their consumption.

The growth of consumption would drive the economy, while manufacturing corporations worked

off their over-capacity.

Greenspan expected that some manufacturers would go bankrupt, others would use up their

superfluous plant and equipment.

Sooner or later, manufacturing profitability would rise, and corporations would begin to increase

investment and employment and once again drive the economy forward.

In the meantime, households’ increased borrowing and consumption, based on rising housing

prices, would keep the economy going.

But the problem is that, today, six years after Alan Greenspan started to stimulate the economy

with his low interest rates, the economy has still barely responded.

Employment growth has been by far the slowest of the postwar period.

Investment has grown very slowly.

Real wages have stagnated.

In other words, up till now, the corporations have not yet begun to shoulder their responsibility

for pushing the economy.

As a result, the growth of GDP has been the slowest for any comparable period since World War II

(with the exception of the period 1970-1976, which witnessed the worst recession since the

1930s)..

What explains this pattern and what can we expect?

It seems to me likely that Greenspan’s policy is turning out to be counter-productive, actually

backfiring.

What we therefore seem to be experiencing since the recession of 2000-2001 is a pattern that’s

been repeated throughout the long downturn…that is, a turn to one form or another of

Keynesianism to drive the economy through increased borrowing.

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This borrowing does keep the economy turning over.

But, at the same time it prevents the shakeout that’s to get rid of manufacturing over-capacity,

fully restore profitability, and restore the economy to dynamism.

So, as is normal, in response to their over-capacity and their reduced profit rates, starting in 2000

manufacturers cut back investment, employment, and wages.

This made for a huge hit to aggregate demand that the economy has experienced over the past

four or five years.

If the federal reserve had not intervened, there would very likely have been a very serious

recession.

The fed’s intervention did, as we have seen, drive up housing prices and in that way household

consumption and in that way economic growth, keeping the economy turning over

But, nevertheless, at the same time, the demand created by the housing bubble allowed

manufacturing firms with too much capacity to continue to use that excess plant and

equipment…without having to either go out of business or shed superfluous means of production.

As a result, over-capacity has continued…and continued to discourage investment and

employment. .

Meanwhile, Greenspan’s low interest rates, instead of encouraging investment in plant and

equipment, has made possible massive investment in paper assets of all sorts.

As a consequence, we have today asset price bubbles of all kinds—in bonds, in commodities, and

of course especially in housing.

Simultaneously, instead of investing new plant and equipment or employing more workers, firms

are paying off their debts, paying out dividends, and buying their own stocks to drive up their

value.

The bottom line is that we have bubbles on the one hand and a crisis of investment and

employment on the other.

Finally, just like the stock market bubble of the 1990s eventually burst, the housing bubble is now

beginning to deflate.

As it does, people are borrowing much less than before

As they borrow much less than before, they are consuming less than before.

As a result, the economy has been slowing down over the past year.

Against this background, it’s possible that a sudden burst of investment and employment could

save the day…but, given the slowdown that is being driven by the deflation of the housing bubble,

it’s not easy to see what would motive the corporations to do this.

It’s never easy to predict what the economy is going to do.’

But, from where we sit today, it looks much more likely that we’ll see a new recession before we

see any break from stagnation or new long upturn.