Back To Basics

Dr. Thomas Palley was chief economist of the U.S.–China Economic and Security Review Commission. Prior to joining the Commission, he was director of the Open Society Institute’s Globalization Reform Project. He has written for The Atlantic Monthly, American Prospect and The Nation magazines. He can be reached at www.thomaspalley.com.

Democrats have rightly identified China , uncontrolled deficits and Wal-Mart-style competition as looming threats to the American economy. However, they remain hard-pressed to counter the free-market/free-trade story of mainstream economists that these are all for America’s long-run benefit.

In a previous column in TomPaine.com, I explained why Democrats have lost their voice on the economy. Now it is time to examine where the Democrats can find their voice. America’s problems cannot be solved by better messaging, but only by good policy rooted in sound economic analysis. And to find that analysis, Democrats must look to their own past.

The Great Depression of the 1930s was an era of tumultuous economic debate. Though now largely confined to history books, those debates have vital relevance for today’s challenge of globalization. The economy of that earlier era was marked by callousness, gross inequalities of wealth and vicious boom-bust cycles. These problems were ultimately solved by a combination of New Deal institutional reforms and Keynesian economic stabilization policies. While some of the reforms of that period may have aged, the economic principles that motivated them remain intact. This is a cruel irony, since the thinking that can help address our present malaise has been forgotten by the party that once championed such thinking.

The policies that emerged from the Depression provided the foundation of the prosperity that followed World War II. But familiarity and success tend to breed forgetfulness. As a result, the thinking forged on the anvil of those hard times has been gradually expunged. It's been replaced with revived pre-Depression era free-market thinking. Carried by this intellectual tide, policymakers have created a modern variant of the Victorian economy under the rubric of globalization.

Today’s economic conditions hint of the 1920s: a period when America experienced a credit boom and a speculative bubble while the rest of the world experienced relative stagnation. Hopefully, enough post-Depression era policy thinking remains to avoid another great slump. But simply avoiding a slump is not sufficient. The challenge before Democrats is to champion policies that will once again engender the broadly shared prosperity that defined the early post-war decades. That, in turn, will require recovering economic thinking that has been relegated (by mainstream policy advisers) to the history books.

One lasting contribution from the Depression came from the British economist John Maynard Keynes, who identified the importance of total demand for determining employment. Total demand is defined as the aggregate of household, business and public spending within the economy. Unemployment can result from reduced spending by business and households. At best, markets are painfully slow in dealing with such declines, and at worst they can get trapped with permanent high unemployment.

Keynes recognized that the price system of market economies does not automatically ensure adequate total demand, and what works for an individual product market does not automatically work for the economy as a whole. In individual markets, lower prices make goods relatively cheaper, providing an incentive for households or businesses to switch expenditures away from other products. However, for the economy as a whole, this mechanism does not work, since all prices (including wages) are falling. There is no ability or incentive to increase spending. Worse than that, the mechanism may operate in reverse, as falling prices increase the burden of debts and interest payments, which reduces demand and can also bankrupt the banking system.

Consequently, there is reason for policy to step in and stabilize demand to avoid such outcomes. This is the classic contribution of Keynes, sometimes referred to as countercyclical spending. The essence of the principle is that when household and business demand falls off, government should step in and, through federal spending on infrastructure or social services spending, stop the downward spiral and prime the economy. Indeed, George W. Bush, following in Ronald Reagan’s footsteps, has used defense spending for a similar—but less effective— purpose.

A second vital contribution, now forgotten, came from American “institutional” economists, who emphasized the significance of the nature of competition. The most famous living proponent of this American school is John Kenneth Galbraith. Whereas Keynes’ analysis gave birth to the modern field of macroeconomics, American institutionalists focused on the microeconomic failings of the system. These failings were framed in terms of the “competitive menace,” a notion that echoes today’s concept of the race to the bottom—epitomized by Wal-Mart.

Institutionalists did not challenge the idea that self-interest and profit are major motives for economic action, but they did recognize that their pursuit could lead to suboptimal outcomes. What appears to maximize well-being from an individual perspective can be suboptimal once the competitive interplay of actions is taken into account. Thus, when Wal-Mart refuses to pay health benefits, other retailers are forced to go in this direction to remain competitive and survive. Likewise, when Wal-Mart sources globally, so too must other retailers. The result is erosion of American manufacturing jobs and wages. Even wages in developing countries are harmed when Wal-Mart plays them off against China.

Such a perspective leads to the idea of "regimes of competition," and policy should aim to create a competitive environment in which working families prosper. The challenge is to design regulatory institutions (regimes) that balance the Keynesian need for stable flows of demand and income with the capitalist need for economic incentives. Such market regulation prevents excessive price fluctuations, and also prevents the kinds of pre-depression monopoly and exploitation that weakened America’s income and spending base.

The New Deal embodied much institutionalist policy in the form of laws establishing a minimum wage, the 40-hour work week, the right to overtime and the right to join unions. These labor laws complemented consumer product safety laws. The New Deal also introduced law regulating financial markets, which paired with earlier legislation establishing the Federal Reserve as regulator of the banking system. Together, these regulations established an economic regime that excluded destructive competition, ensured a “Henry Ford” distribution of income whereby workers could buy the things they produced, and prevented market tendencies to deflation.

Viewed in this light, American institutionalism provided a new microeconomic thinking that paired logically with Keynes’ macroeconomic analysis. Keynesian monetary and fiscal policies stabilized the business cycle, while institutionalist market regulation built the middle class, and together they underwrote the great prosperity of the post-World War II era.

However, even as these policies were being put into practice, they were being driven out of economics classrooms and textbooks. Whereas Keynesianism won mainstream standing, its microeconomic counterpart never did. One reason was institutionalism’s focus on capitalism’s crueler failings, which was politically unacceptable in the Cold War era of geopolitical competition. This meant institutionalism was driven out of classrooms by the end of the 1950s, and was subsequently driven out of policy shops and legislative chambers by the end of the 1970s.

Globalization has again raised the specter of destructive competition, calling for a resurgence of institutionalist thinking. However, such thinking is now barred and obliterated by post-Cold War, free-market triumphalism.

This has enormous practical and political consequences. Absent the one-two combination of Keynesianism and institutionalism, globalization will likely stumble badly. Similarly, well-intentioned progressive politicians in America and Europe, looking to tackle the problems of globalization, will find themselves lost as long as they adhere to the laissez-faire thinking that dominates universities.

This risks making progressives irrelevant for economic policy. In the 1930s, the economics of the day proved not up to the challenge of the Great Depression, forcing the development of new economic ideas. The same holds today for globalization.