Many countries are now debating the causes of the global economic crisis and what should be done. That debate is critical because how we explain the crisis will influence what we do.
Broadly speaking, three explanations exist.
Explanation No. 1 is the "government failure hypothesis" associated with the Republican Party. It claims the crisis is rooted in the U.S. housing bubble, which was due to government intervention in the housing market and failure at the Federal Reserve. Government intervention drove up house prices by encouraging home ownership beyond people's means, while the Federal Reserve pushed interest rates too low for too long in the prior recession.
Explanation No. 2 is the "market failure hypothesis" associated with the Clinton wing of the Democratic Party. It claims the crisis is due to inadequate financial regulation. First, regulators allowed excessive risk-taking by banks. Second, regulators allowed perverse pay incentives within banks that encouraged management to engage in "loan pushing" rather than "good lending." Third, regulators pushed deregulation too far. Together, this permitted financial excess that fueled consumer debt and the house price bubble.
Explanation No. 3 is the "destruction of shared prosperity hypothesis" associated with the labor movement and New Deal Democrats. It claims the crisis is rooted in the radical free market philosophy of Milton Friedman and Ayn Rand that has guided economic policy for the past 30 years. The resulting flawed policy infected financial markets via inadequate regulation, but that is just one part of a much larger problem.
The radical free-market approach was adopted in the late 1970s and early 1980s. From 1945 to 1975 the U.S. economy was characterized by a "virtuous circle" Keynesian model built on full employment and wage growth tied to productivity growth. Productivity growth drove wage growth, which fueled demand growth and full employment. That provided an incentive for investment, which drove further productivity growth and higher wages.
After 1980 the Keynesian model was gradually replaced by an anti-worker free-market model that cut the link between wages and productivity growth and created a new economic dynamic.
Before 1980, wages were the engine of U.S. demand growth. After 1980, debt and asset price inflation became the engine.
The new conservative economic model can be described as a "policy box" that pressures workers from all sides. Corporate globalization put workers in international wage competition via corporation-friendly free-trade agreements and business off-shoring. Relentless anti-government policy attacked the legitimacy of government and pushed deregulation regardless of dangers. In labor markets, corporations attacked unions and policy weakened worker protections and wage supports like the minimum wage. Finally, policymakers abandoned their commitment to full employment, creating job insecurity and weakening worker bargaining power.
The new model created a growing "demand gap" via wage stagnation and increased income inequality. The role of finance was to fill that gap. Within the United States, financial deregulation, innovation and speculation enabled finance to fill the gap by lending to consumers and spurring asset inflation. U.S. consumers in turn filled the global demand gap. However, all of this was unsustainable and destined to crash.
These three different explanations make clear what is at stake because each has its own policy response. For government failure proponents, the response is to double-down on radical free-market policy by further deregulating financial and labor markets, deepening the Federal Reserve's commitment to low inflation regardless of employment costs, and further shrinking government by tax cuts that drain the budget. That is the Romney-Ryan platform.
For market failure proponents, the response is to strengthen financial regulation but continue with the rest of the existing free-market paradigm. That means continued support for corporate globalization, labor market flexibility, small government and preferring low inflation to full employment. In many ways, this approach characterized the first three years of the Obama administration. It explains measures like the Dodd-Frank banking reform, which aimed to deal with financial market failures, and it explains why the Obama administration was reluctant to intervene in the housing market.
For those believing the destruction of shared prosperity is the cause of the crisis, the challenge is to replace the Milton Friedman-Ayn Rand policy approach with a new worker-friendly Keynesian approach. That new approach would restore the link between wages and productivity growth. It involves repacking the policy box, taking workers out and putting corporations and financial markets in so that they serve the public interest. It requires restoring commitment to full employment; rethinking globalization and stopping the economic race to the bottom; creating a new government agenda that funds public investment and permanently secures Medicare, Social Security and quality public education; and replacing anti-worker policies and labor laws with policies that promote shared prosperity -- in other words, a New Deal for the 21st century.
The critical insight is that each explanation carries its own policy prescriptions. Consequently, the explanation that prevails will strongly impact future policy. That places economics at the center of the political debate, which is why understanding economics is so important for the coming elections and the policy battles to come.
Thomas Palley is senior economic policy adviser for the AFL-CIO. This article is based on his new book, "From Financial Crisis to Stagnation: The Destruction of Shared Prosperity and the Role of Economics," Cambridge University Press, 2012.