Editor's note: A version of this post previously appeared on the Politics and Policy blog of the London School of Economics.
Debates around austerity continue to generate a good deal of political heat, yet the underlying questions regarding the future of the neoliberal growth model in the wake of the global financial crisis are far more interesting.
Many see the crisis as the final nail in the coffin of the free market program, showing it to be an exhausted growth model only kept alive through unsustainable infusions of debt. Major political-economic reconstruction is needed to put things right, we are told.
Putting aside that such radical reforms have not been forthcoming, is this analysis correct? Is neoliberalism a term generally describing the free-market policies that have prevailed in the West since the Reagan and Thatcher years dead? As I detail in a recent paper, the main problem with neoliberalism is not a failure of production, it is a tendency toward excessive credit growth leading to downturns that undermine output gains. Tempering the credit cycle through macroprudential financial regulation is the corrective for this problem.
What, according to critics, is the terminal defect of neoliberalism? "Financialization," a rather plastic term used to denote the rise in private debt and the increased size and significance of the financial sector, among other things. Far too many of the accounts of financialization fail, however, by interpreting descriptive data (the financial sector got larger) with causal explanations (its size caused the crash). The properly specified version is the debt-driven growth hypothesis, epitomized by the works Robert Brenner and Colin Crouch. This starts from the proposition that neoliberalism is underproductive, leading to declining profits and wages. Corporations and individuals have to increase borrowing to maintain consumption and growth. Private debt continues to rise, which is unsustainable over the long term, leading to the disaster of the 2008 crisis. If neoliberalism simply restarted, this hypothesis claims, a new debt bubble would form, producing perhaps even greater calamities. In this view neoliberalism as a growth model is dead yet lives on a zombie political economy.
While a popular characterization of events, the supporting evidence is not compelling. For example, increased home equity withdrawal is used as a primary indicator of debt-driven growth, and it did indeed rise in the U.S. and the U.K. in the years immediately before the crisis. Conversely, it was at its lowest in the 1990s, when both countries' economies were flourishing. Debt did not drive growth except in the years immediately prior to the crisis. It is an argument for a bubble, not a structural flaw.
Yet there is another way to understand the crisis the financial instability hypothesis associated with the writings of Hyman Minsky and Charles Kindleberger. Neoclassical economics sees markets as stable and self-correcting. The financial instability hypothesis highlights how markets artificially inflate assets values, inducing procyclical credit growth. Booming markets lead risk to be discounted, with ever more speculative investments being embraced. As more institutions do this, others follow. Risk, rather than being diversified, becomes synchronized. With everyone following suit, the health of each bank becomes increasingly dependent upon other institutions' health. This produces systemic instability and potentially a collapse, dragging the real economy with it. Rather than being an equilibrium system that weeds out bad investments, free market economies especially those with large financial sectors go through cycles of stability, fragility, and crisis.
Credit spiked in the late 1980s and early 2000, in each instance just prior to a recession. The greater the spike in credit, the greater the crash. In sum, the evidence is more favorable to understanding the crisis as the collapse of a credit cycle. (See the full paper for a thorough exploration of the empirical evidence.) The problem for neoliberalism is not productive exhaustion, it is financial volatility.
The solution is macroprudential financial regulations which seek to monitor and control systemic risks. Much as Keynesians called for government spending to counter the business cycle, macroprudential regulations seek to constrain rising credit cycles before they inflate sufficiently to produce a crisis.
Policymakers have an array of tools available to pursue this goal. These include: countercyclical capital ratios or liquidity buffers that vary over time (such as the liquidity coverage and net stable funding ratios proposed in Basel III), to capture the dynamic movement of risks; or maximum leverage ratios, to put an absolute cap on financial institutions' risk portfolios.
Macroprudential regulation also has the advantage, both from the perspective of the state and market actors, that it is not concerned with specific financial products. By focusing on the overall amount of credit in the system, macroprudential oversight gives financial markets the independence to develop new products and services, the successful regulation of which has often eluded regulators anyway because of the speed of innovation. It is still early, but there is a growing recognition of credit cycles as a problem warranting government action, leading to the development of appropriate regulatory tools and institutions (e.g., the Financial Stability Oversight Council).
Why try to save neoliberalism at all? Critics see naught but failure disappointing output and rising inequality punctuated by economic collapse. That is a vivid yet incorrect characterization. A more measured conclusion is that neoliberalism delivered the economic goods successfully for an extended period of time.
Liberalization is only one factor leading to rising inequality, with technological changes and the integration of hundreds of millions of new manufacturing workers from China, India, and elsewhere playing very strong supporting roles. The financial crisis wiped out income gains of the previous decade, not of the entire neoliberal era. Neoliberalism has produced real growth, but in a two steps forward, one step back process.
All that said, macroprudendtial regulation is a long-term solution for ensuring economic stability once growth has been reinvigorated, not a mechanism for recovery. Reinvigorating growth and reducing public and private debt is likely to be a long, hard slog. This is perhaps the strongest argument in favor of macroprudential regulation: recognizing just how damaging credit cycles can be shows how vital it is not to get into that hole in the first place.
Terrence Casey is the editor of The Legacy of the Crash: How the Financial Crisis Changed America and Britain (Palgrave, 2011) and a professor of political science at the Rose-Hulman Institute of Technology in Terre Haute, Ind.