Richard B. Freeman, Harvard, NBER; CEP, LSE, Rupert Johnson Lecture, Washington & Lee: November 9, 2009

Can the US Restore Shared Prosperity post the Financial Meltdown?

1- What the Crisis Taught us

2 – The Current situation

3 – Desperately seeking a new American model of capitalism

The crisis taught us: 1) Don't Trust Market Capitalism to These Guys

Student: Everything you told us is a lie .Me: Who me? Couldn't be!Student: You economists said there would never be another

great depression. You said financial markets were efficient. You said monetary policy works. You said ...

Experts from IMF to World Bank to academics to financial quants and heads of central banks know less than you or I thought they did.

These collateralized subprime mortgages are AAA rated. Our models prove it. Trust us, emperor. The Invisible Hand that made your magnificent suit guarantees your investment. And we throw in a some swaps as insurance.

In ancient times – or was it 2-3 few years ago – this is what the establishment believed

Washington Consensus globalization – deregulate, privatize, balanced budget --> growth for all.

IMF: Liberalize financial markets; Trust global finance

OECD Jobs Study: labor flexibility, deregulation, and limitation on institutions

US Government: Rubin, Summers, Greenspan: Ditch Glass-Steagall restrictions on banking. Don't even think about regulating derivatives. Trust the market.

Massive about-face on macro-policies, regulations, public policies to deal with global problem, but many already were retreating from the orthodoxy. Analysts had too strong priors, ideology, front-running. Not enough empirics, behavior, aberrant thinking.

2) Laissez-faire capitalism fails because the crown jewel of finance operates as a

casinoThe last 30 odd years, we have experimented with Wall

Street “Trust market” version of capitalism. The experiment led to stagnant real wages for most Americans, huge inequality, and economic instability

We took our eyes off the ball of the dangerous part of capitalism. Policy was about reforming labor institutions, social welfare state whose inefficiencies exercised IMF, World Bank, Washington Consensus, Thatcher-Reagan economics. But labor/social welfare inefficiencies cannot kill economies. Financial excess can. The dangerous part of capitalism is uncontrolled greed in finance, socially perverse incentives, and crony capitalism.

Things go bad in finance in one sudden event – the fat tail of power laws → insurance is good.

IndyMac Bank was the largest S&L in Los Angeles, seventh largest mortgage originator in the United States. Its failure on July 11, 2008, was the fourth largest bank failure in United States history

3) The power of incentives and greed, the key insight of micro-economics

4) The Octopus We Forgot:Crony Capitalism

If the “natural state”/attractor of an economy is crony capitalism with finance as its core , economics must rethink institutions & regulations

IMF ex-Chief Economists View

“elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis …they are now using their influence to prevent … reforms. One channel of influence … the flow of individuals between Wall Street and Washington. Rubin … Paulson … Greenspan-- Simon Johnson

“ single biggest distortion … is when a number of private institutions are deemed by political and regulatory authorities as too systemic to fail. … The consequences …a system of crony capitalism. … …corrupt officials can hide behind the doctrine of systemic importance to bail out favored institutions … two sets of rules, one for the systemically important, and another for the rest of us.” Raghuram Rajan

the financial system has become very bloated in size and needed to shrink “ Ken Rogoff

If you don't believe these radical nuts, try Adam Smith for size:We rarely hear, it has been said, of the combinations of masters,though frequently of those of workers. But whoever imagines, upon this account,that masters rarely combine, is as ignorant of the world as of the subject.” (Wealth of Nations) (book 1, chapter 8)

Source:https://blogs.law.harvard.edu/mytown20 09/

2. Current Situation: My town

Unemployment Rates in Ten Major economies, April 2008-Sept 2009

Jobs Grim for the foreseeable future

Why? long global recession

IMF: recessions associated with financial crisis are longer and more severe … recoveries to pre-crisis output levels … typically slower. On average, financial crisis-associated recessions last 1.5 years …longer than other recessions. … almost three years to get back to pre-recession output levels.

• Globally synchronized recessions are also longer and deeper (and) … more sluggish. So this is sobering evidence for today, given that we have both financial sector driven and globally synchronized recessions.

• the current recessions are likely to be unusually severe, and the forthcoming recoveries sluggish.

(Chapter 3 of the World Economic Outlook 2009 (studying 120 recessions and recoveries across advanced economies since 1960).

Jobless recoveries and long term losses to labor

In US/other countries employment has increasingly lagged GDP so GDP and stock market may rise but workers still suffer.

Argentina –poster economy of WC 1999 collapse → jump in poverty, unemp, inequality, risk of populist economic harm

Sweden – poster economy of welfare state – 1992 housing/ banking crisis --> modest rise in inequality but continued high unemployment with long term jobless

US – Job losers take decades to recover; those who graduate/lose employment in recession lose human capital big.

Korea – 1998 Asian financial crisis– inequality rises to 2nd highest in OECD, decline in formal sector jobs.

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total income GINIlabor income GINI

Korea Inequality

Korea and China have recovered … but China used large bank loans that may not be credit-worthy

Korea

• 1998 forced by IMF &US to raise interest, create 8-9% unemployment, massive strike over right to fire law.

• This time, huge fiscal stimulus, reduced over time hours, lower real wages – concessionary firm level CB; Govt support for maintaining employment with wage freeze; strengthened UI

What About US? INTRADE PREDICTION MARKET

Still on thin ice. Banking sector more concentrated than before, still taking

risks, too big to fail?

3 DESPERATELY SEEKING NEW POLICIES

“The past eight years have discredited once and for all the philosophy of trickle-down economic – that tax breaks, income gains, and wealth creation among the wealthy eventually will work their way down to the middle class… those ideas have been tested and they have failed … they’ve brought our economy to a halt. And now is the time to move forward, not back… we need economic opportunity to trickle up.”

But what is the philosophy of trickle-up economics moving forward?

                                   

1) Shared Capitalist arrangements that organize work so that workers share in rewards and decisions. They are the labor market part of any system that seeks to use market to share the benefits of economic growth broadly.

Reforms in corporate governance

Reforms in compensation: do not allow stock options to be expensed unless available to all.

Reforms in labor relations

This goes with the trend in markets – team activity, group incentives; ideally links self-interest and cooperative behavior; works best when done for business reasons

Four Suggestions

Shared capitalism in US: % of work force 2002 2006 2010?

Profit sharing In profit-sharing plan 33.5% 38.4%

Received profit share last year 23.8% 30.2%

Gain-sharing In gain-sharing plan 23.2% 26.8%

Received gain-sharing bonus last year 17.1% 21.3%

Own company stock 21.2% 17.5% Stock options Hold stock options 13.1% 9.3% Granted options last year na 5.3% Any of above 43.1% 46.7%

2. Make banking and finance BORING so “best and brightest” form real businesses, do S&E, etc, instead of finding ways to cut corners, takes huge one-sided risks, etc.

Preventative policies means innoculating financial markets from new instruments; change incentives at the top; strengthen regulations to fight the pressures of crony capitalism to engage in massive rent-seeking; break up big banks;CATCHING THE CRIMINAL AND SHAMING THE NEAR CRIMINAL.

Lieutenant Colombo’s suggestions: Increase police; Strengthen financial fraud unit inspectors;

Run financial sting operationsI don’t know enough to understand mezzanine CDOs or midnight CDSs, sir, but I am impressed. To make $200 million while the firm goes bankrupt and people who bought its productslose their pensions and

homes means you must be either the smartest or luckiest banker in history or a &#@! crook like Ken Lay, Bernard Madoff, or what’s-his-name, Mr Ponzi. Which is it – lucky, smart, or crook?

3. Build Countervailing Power to monitor finance and regulators

“For too long, the rules of Wall Street have been written by the bankers themselves. This year, that has to change. Americans for Financial Reform is a coalition of nearly 200 national, state and local consumer, labor, retiree, investor, community and civil rights organizations that have come together to spearhead a campaign for real reform in our banking and financial system.”

http://ourfinancialsecurity.org/ a coalition with AFL-CIO, AARP and some 200 other groups to make sure the zombie bankers don't do us in again.

4) Reduce inequality, with more progressive taxes if necessary: US level of inequality is potentially inconsistent with long term sustainable growth

Huge incentives to top→ crime + chicanery +speculation Inequality → lobbyists and greater regulatory capture

Credit becomes functional surrogate at bottom for real wage increases in spurring consumption

Conclusion: collapse of the Wall Street model opens door to build different

capitalist model: Can we do it ?

Let's ask the economists' oracle