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The recovery from the 2007-2008 global financial crisis (GFC) came to a dramatic end with the onset of the COVID-19 pandemic. Setting the pandemic aside for the moment, the 2009-2020 recovery was the weakest on record, despite record low-interest rates and quantitative easing (QE) policies engineered by the Federal Reserve.
A major reason for the fragile recovery was the sharp increase in income inequality that began during the 1980s. The divide between the top 10% and bottom 90% of U.S. households widened significantly, though it was obscured for a time by rising real estate prices. The sharp housing price declines that occurred during the GFC prompted the turn toward populist sentiment accompanied by the erosion of democratic institutions.
In combination with the pandemic, this now calls for a strong long-term policy response. The Great Depression provides the best analogues to where we are today. It demonstrates how a long-term solution can be created that restores a stronger and more stable foundation for future economic activity, accompanied by shared prosperity. None of this can be achieved without the assistance and guidance from the U.S. government (“all of us”). It is now time to abandon ideology, get practical and think “BIG!”
Over the past 40 years, government has been abandoned as a source of economic growth and development. In fact, whenever anyone proposes a government program, the first question is “How will we pay for it?” For reasons that are discussed below, money is not the primary obstacle. Instead, the main barrier to new government programs, especially over the past four decades, has been ideological, tracing back to a belief in “free markets” and the “invisible hand.” Mainstream neoclassical economics has become captive to the notion that “government bad, markets good,” despite the historical record. Reagan memorably stated: “Government is not the solution to our problems; government is the problem.” Similarly, former UK Prime Minister Margaret Thatcher argued: “There is no such thing as public money. There is only taxpayer money.” Both Reagan and Thatcher were adamant supporters of free markets and the “invisible hand,” given the stagflation they both inherited. Both strongly opposed government intervention in the economic sphere, as have most subsequent leaders. This market-knows-best view has been accepted as common-sense by neoclassical economists and by most policymakers for four decades. As Thatcher put it, “There is no alternative” (TINA).
Most subscribe to Thatcher’s view of money. Even mainstream neoclassical economists, like Paul Krugman, agree that money is something physical, e.g., coinage, paper or gold. These economists use the “loanable funds” theory. However, Ben Bernanke made a revealing comment in an interview with Scott Pelley of 60 Minutes in early 2009. Pelley asked how the $85 billion bailout of AIG was financed using taxpayer funds. 1 Bernanke responded: “To lend to a bank, we simply use the computer to markup the account they have with the Fed.”
Bernanke clarified that the Fed has the authority to create money (or technically, reserves) “out of thin air,” which suggests that that there is no finite limitation on the Fed’s ability to create money. This response raised a number of additional questions related to “how we will pay for it.” If the Fed can create money to support AIG, then why can’t it do the same to support non-financial businesses, individuals, infrastructure, green technology, etc. For better or worse, Bernanke’s response opened the door to thinking about the analysis of money proffered by proponents of modern monetary theory (MMT).
In normal times, most money is created by commercial banks. However, when the economic system is in extremis, the central bank can step in and create money. In fact, most of us have been taught that central banks are responsible for money creation. This is factually incorrect. Under normal economic circumstances, more than 95% of all money is created when banks make loans (given double-entry bookkeeping). Only in a crisis will money creation tend to shift to the central bank. In response to the GFC, for example, the Fed conducted QE. It exchanged reserves that it created (“at the push of a keystroke”) for Treasury securities and mortgage-backed securities (MBS) that previously had been held by financial institutions. By reducing the number of those securities outstanding, this action pushed down yields and raised asset prices. The main beneficiaries of those policies were the top 10% of households, who own about 90% of all financial assets.
The 2009-2020 recovery was artificially-driven and survived only because the Fed inserted itself as the “market-maker of last resort.” The failure to provide debt relief directly to the middle-class, that had suffered the loss of roughly 44% of its net worth during the GFC, was at the heart of the fragile recovery. Average debt levels for middle class household remained elevated at 120% of their incomes, down from a record-high of 157% in 2007, though still well above the 67% in 1983 (Wolff 2017). Pressures on those households came from flat wages that compelled many to borrow (often against rising house prices) to finance living standards from 2001-2007. The borrowing itself fueled the house price boom that eventually went bust in 2008.
Middle-class household balance sheets will be further imperiled by the job and income losses from the pandemic. A massive program of debt relief will be required for many of those households, if they are to contribute once again to economic growth. Hopefully, policies can be created that address both the pandemic and these other challenges. The failure to provide debt relief to middle class households during the GFC has left a legacy that persists today.
In some ways, conditions today mirror the Great Depression, though hopefully the current crisis will be shorter-lived (yet we simply do not know). Many middle-class households and businesses will be forced into bankruptcy, the financial system will likely be stressed given failures to repay debt, and the full economic impact is impossible to discern. Given vulnerable balance sheets even before COVID-19, aggregate demand could collapse. The government has responded forcefully with the Coronavirus Aid, Relief and Economic Security (CARES) Act, a $2.3 trillion program designed to stabilize economic conditions. And the Federal Reserve has come forward with a $4 trillion package of its own, consisting of lending programs to a variety of mostly non-financial businesses. However, even policymakers recognize that these policies are not going to be sufficient. More will be needed.
In response to further deterioration, the Fed might (in consultation with the Treasury) directly inject liquidity into the bank accounts of households where one or more adults are unemployed. The amount of support could be set as a share of the median wage. Other actions will be required to address the needs of those who do not have bank accounts, e.g., the homeless. These actions will bolster aggregate demand and might also reduce the risk of social unrest. Needless to say, this is not a preferred course, of action. However, it may be the only course available, given potentially extensive dislocation. Fortunately, the issue of “where will the money come from” can be safely ignored. Any inflation can be resolved later. This type of approach is being applied in various European countries and can be implemented quickly by the Federal Reserve.
This type of action no doubt sounds outrageous (it is!), but it may be the only available short-term policy, should the CARES Act and Fed programs prove insufficient. In fact, it may be the “least-worst” solution to a severe (yet hopefully temporary) challenge. To stave off a complete collapse of aggregate demand and a depression, quick action may be required, and the Fed uniquely has the tools to respond.
Thinking BIG: Reconstruction Finance Corporation (RFC)
There is a need to “think big” in terms of how to respond as the COVID-19 pandemic fades, given the financialization of the economy, the GFC and the rise in inequality since 1980. The bottom 90% have been beleaguered by stagnant wages and excessive debts, having lost 44% of their net worth when the real estate bubble collapsed. Meanwhile, the top 10% of households (and even more so the top 1% and the top 0.1%) have enjoyed rapid growth in wealth and income over the past 40 years (often at the expense of the bottom 90%). The polarization of households (bottom 90 versus top 10) is directly linked to the shift toward finance-led growth that began during the 1980s. The chart below illustrates the per capita income multiple for the top 1% and 10% of relative to the bottom 90% of households. Both ratios peaked at the end of the 1920s (just before the Great Depression and then declined from 1929 until the shift toward free markets occurred in 1980, after which it rose sharply.
Prior to the transition during the 1980s, wages were closely tied to productivity growth and government played an active role in economic growth helping to provide for shared prosperity. Similar to that era and in response to COVID-19, et al, the “thinking BIG” will require that government be restored as a partner in economic development, much as it was from 1945-1980. Notably, the Reconstruction Finance Corporation (RFC) was created during the Great Depression. Properly structuring a similar entity will allow policymakers to implement and finance solutions that address current challenges.
Over the past 40 years, government got a bad rap. The notion that the private sector is always and at all times responsible for jobs and innovations is an ideological fantasy that was mostly conjured up by neoliberal economists. As Mariana Mazzucato (2013 and 2019) noted, the creation of the internet and the iPhone grew out of research conducted by the U.S. government during World War II. The profits from those two innovations went directly to technology firms, despite the fact that the early stages of research were fully financed by the government (which did not even collect a “finder’s fee”). As Mazzucato noted, the system of national accounts (SNA) ignores the “value” created by the government and instead allocates the creation of wealth to the firms that commercialize the technologies, underestimating the creation of value by the government.
This fits with the ideological view of government as a cost-center and not a source of innovation. What can a public investment arm achieve that the private sector will not? To understand this, we need to take a closer look at the role of the RFC during and after the Great Depression.2 Throughout its lifetime, from 1932 to 1957, the RFC was instrumental in stabilizing the banking system, rebuilding housing, expanding electrification throughout rural America, building bridges, roads, schools, hospitals, parks, and supporting the arts. In addition, the Defense Production Corporation, formed under the RFC, successfully financed defense production during World War II. Interestingly, the RFC did all of this without utilizing taxpayer money by borrowing from the capital markets and from banks.
The head of the RFC, Jesse Jones, was a banker from Texas with an extensive background in real estate and investment. He appreciated the virtues of the capitalist system but recognized that the vastly weakened private banking system was ill-equipped to fund the rebuilding of the U.S. economy. The quote below captures some of the remarkable achievements that the RFC financed:
The government hired about 60% of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana State Capitol, much of the Chicago lakefront, New York's Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads and a thousand airfields. And it employed 50,000 teachers, rebuilt the country's entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.
Unfortunately, the extraordinary record of the RFC was long forgotten by the time the U.S. abandoned the New Deal in favor of neoliberal financialized policies during the 1980s. Stagflation during the 1970s set the stage for the shift toward “free markets,” as growth slowed and business increasingly came into conflict with organized labor. Government supported business in the conflict and agreed to lift Depression-era constraints on financial markets, catalyzing the financialization of the U.S.economy . In addition, the shift toward what is sometimes called “privatized Keynesianism” (individuals borrowing in place of government) enriched the finance industry. Households borrowed to supplement stagnant incomes, fueling the rise in real estate prices, in a situation that proved to be both unsustainable and costly. Financial sector profits as a share of total corporate profits increased from an average of 10-15% during the 1960s to 40% in 2001-2002. This financialized framework ultimately collapsed in the 2007-2008 global financial crisis. In response, the Fed stepped in to fill the gaps and eventually became the “market maker of first resort.” This was hardly how a successful “free market” should work! The financialization era has “failed the marketplace test.”3
Speculative activities have hardly slowed since the GFC, though many of them have moved from traditional commercial banks into shadow banking institutions. Only 15% of credit created by the financial sector currently supports non-financial business. The rest finances speculative asset-based transactions with other financial firms. In addition to the decision to ignore the need for debt relief for the bottom 90% of households, the government failed to restructure the financial system, much as had been done during the Great Depression. Rahm Emmanuel said that “a crisis should never be wasted,” but unfortunately that is precisely what happened. And what has followed has been an elongated, but very weak recovery.4
In contrast to the GFC, legislation adopted during the 1930s restructured the financial system, constraining both banks and other financial institutions from engaging in excessive speculation, while channeling them toward supporting productive activity.5 The key was the decision to compartmentalize finance, with each sector handling distinct activities. Interest rates were regulated, as were securities markets, and FDIC insurance was created for small depositors. More than 40 years of financial stability resulted from these policies as banks and other financial firms were directly linked with productive capital, with real GDP growing at a rate of nearly 4% per year. Fed Chair Marriner Eccles noted that, “laissez faire in banking and the attainment of business stability are incompatible.”6 Churchill likewise stated, “I would rather see finance less proud and industry more content.”
The financial framework established under the New Deal gradually eroded as the financial system was deregulated and liberalized beginning in 1980. The “Volcker shock” raised interest rates to nearly 20% in an effort to combat inflationary pressures, and this in turn fueled speculative activities within the financial sector. As constraints were removed on finance, the shift toward speculative activities, as opposed to grinding out longer-term returns from productive activities, was inevitable. Keynes remarked about the “euthanasia of the rentier” in the years leading up to the Great Depression. Minsky labeled the post-1980- era of short-term speculation, “Money Manager Capitalism.” The shift in banking and finance resulted in the financialization of economic activity. Speculative activities dominated productive activities. Asset-price bubbles formed in stocks, real estate and other assets, driven by the unregulated and explosive growth in credit and financial innovations (e.g., securitization and derivatives). As capital standards displaced quality underwriting, credit quality deteriorated, resulting in serial asset price bubbles that eventually burst.7
Unfortunately, the financial system that created the GFC has not changed. Finance is unequipped to contribute in any meaningful way to the type of rebuilding that will be required as the pandemic fades. A 21st century RFC will be needed to meet these new challenges. It will fund improvements in infrastructure, including roads, ports, electrical grid improvements, medical facilities, transportation systems, and implementation of green technologies, all of which will create jobs. It will support existing businesses and innovations (with the government assuming an equity share). Whether an investment is productive has little relationship to whether it is privately or publicly financed, despite the ideological arguments marshaled by advocates of free markets. It all depends on how the funds are deployed, as the original RFC, which ended its life with a net profit, clearly demonstrated.
The 21st century RFC will need to focus on capital development with a long-term investment horizon, much as public banks in other developed countries have done. Unlike the existing private financial system, it will not be under the pressures of short-term profits and shareholder value maximization; it will purposefully be designed to take a long view. This solution will leverage the government’s (low--cost) balance sheet, much as the RFC successfully did during the Great Depression. Investments should be initiated that are sustainable, productive and capable of generating incomes and wages, much as was done during the Great Depression.
Can this be done again?
A note of caution is in order here. Government financing can be obtained at a relatively low cost, but must be used prudently and wisely, not wastefully, as some will argue eventually will be the inevitable end-result of the current CARES Act. The tendency is, unfortunately, for undeserving companies to feed at the public trough (e.g., hedge funds and for-profit colleges that seek support). Strategic thinking about the specific objectives of the RFC must be thought-out and proper leadership identified. Many of the heads of the RFC during the 1930s themselves came from business and were extraordinarily pragmatic and creative. They developed remarkably thoughtful and innovative solutions. And when something did not work, they would try something else. By far the most challenging part of a 21st century RFC is to develop the proper culture.8 If this cannot be done, it is difficult to see how we get from where we are today to a more stable, prosperous economic system, especially given the current reckless state of the financial system.
Conclusion
Operating under the New Deal, the U.S. economy generated three decades of “shared prosperity” after World War II, a period characterized by rising wages, strong household balance sheets, declining inequality and record levels of GDP and productivity growth. However, as New Deal policies were abandoned and the economic system shifted in ideological and policy terms toward unfettered markets and financialization, the concept of shared prosperity disappeared along with much of the middle class. This was no coincidence.
The COVID-19 pandemic adds yet another dimension to the need to change the way business is conducted today. Fortunately, there are history and tools that can assist us, if we open our minds and excise the ideological constraints that have, for 40 years, impaired our imagination. It is time to head back to the future.
John Balder is working on a book titled: Beyond the Free Market Myth: Restoring Shared Prosperity. He spent more than twenty-five years as a global strategist building innovative investment strategies at firms that included GMO and SSgA. Prior to that he worked with the U.S. Treasury and the Federal Reserve Bank of New York having begun his career with the House Committee on Banking, Finance and Urban Affairs in Washington D.C. He currently works part-time as a global strategist with Wellesley Investment Partners. These views are strictly his own and do not represent any organization with which he has been or is affiliated.
Further Reading and Citations
Balder, John M. (2018). “Financialization and Rising Income Inequality: Connecting the Dots,” Challenge: The Magazine for Economic Affairs, August 2, 2018.
Brown, Ellen (2019). Banking on the People: Democratizing Money in the Digital Age, Democracy Collaborative, Washington DC. 2019
Mazzucato, Mariana (2013). The Entrepreneurial State: Debunking Public VS. Private Sector Myths, Public Affairs, New York, 2013.
Mazzucato, Mariana (2018). The Value of Everything: Making and Taking in the Global Economy, Public Affairs, New York, 2018.
Pettifor, Ann (2017). The Production of Money: How to Break the Power of Bankers, Verso, London, 2017.
1 AIG in September 2008 (directly after Lehman Brothers declared bankruptcy) could not finance its extensive credit default swap exposures to a number of financial institutions that included Goldman Sachs and JP Morgan Chase.
2 The RFC was established in 1932 under President Hoover, though it did not obtain its full potential until Franklin Delano Roosevelt became president.
3 For more on the relationship between financialization and income inequality, see Balder (2018).
4 Mariana Mazzucato (2018) states that even Adam Smith, known for the invisible hand, believed that a truly free market must be free of speculation and that government actions was needed to eliminate speculation. This is often neglected by so-called free market supporters.
5 Under the 3-6-3 Rule, banks borrowed at 3%, lent at 6% and were on the golf course by 3 pm.
6 In my view, Eccles was by far the most creative and insightful Fed chair ever. He never attended college nor did he study economics. He began as a banker in Utah and then arrived in Washington DC, delivering testimony in February 1933. In 1934, he became Fed Chair and served until he retired in 1951. His insights and contributions were nothing short of remarkable.
7 Banks were once considered the “guardians of credit,” though that role has been overcome by securitization, etc. Whether a return to the postwar banking system is possible will be covered in a subsequent article.
8 Needless to say, if it is not possible to rebuild faith in government, all of these efforts may come to naught.
Read more articles by John M. Balder
