Contending Theories of the Current Economic Crisis

When the US housing bubble burst in 2007, turned into a financial crisis, and then into a global economic crisis, economists generated different explanations and remedies for what had happened. The most commonly heard explanations in the media came from Neoclassicals and Keynesians. If one looked beyond the dominant discourses and poked around the interstices of the profession, one would encounter explanations from Institutionalists and Marxists, but these were largely marginalized in the media, reflecting their marginalization in the profession. These views were more likely to be heard in protests on the streets, such as during the Occupy movement, although in a language that was less theoretical and more characterized by simple slogans. But even on the streets, the left did not always control the message, as the right stirred up populist anger with the Tea Party protests, using a distinct set of slogans reflecting their own agendas.

For those without basic economic literacy, these different protest movements with their diverging messages sowed confusion, at least for a time. But as the crisis dragged on and the solutions offered by the dominant paradigms failed to restore full employment, the discourses at the margins of the profession gained more attention. This article surveys the various explanations of the crisis and the solutions offered, and puts the populist slogans into the context of the paradigms from which they emerged. While the Neoclassicals appeared largely discredited, the return to Keynesianism could not fix the economy, due to an inadequate fiscal stimulus, a monetary stimulus hampered by reluctant borrowers and lenders, mounting government deficits, and an unwillingness to seriously tackle gaping inequality and a military industrial complex dependent on endless war. Institutionalists provided useful insights, particularly on inequality, consumerism and predatory behavior, but lacked an analysis of the systemic problems of the US capitalist economy. Marxists focused on the systemic causes of this crisis of capitalism, but were unable to produce a unified analysis and consistent message. Nonetheless, the Marxist scholarship produced during this crisis made significant advances, which will be invaluable for future investigations and interventions.

The Neoclassicals

Neoclassical economics, the dominant paradigm in economics since the 1980s, provided theoretical underpinnings for much of the policy crafted by the Republican Party as well as by many Democrats. It believes in free markets, the laissez-faire economics of Adam Smith, David Ricardo, and Jean Baptiste Say, which was later formalized and mathematized by Stanley Jevons, Leon Walras, Alfred Marshall, and others. In the 20th century, Neoclassicals found a home at the University of Chicago, whose more famous proponents included Milton Friedman, Gary Becker, and Robert Lucas. Individuals are assumed to be rational, self-interested, utility-maximizing agents with given tastes and preferences, assumptions that form the basis of the rational actor model. How these tastes and preferences are shaped remains external to the model. Firms have perfect information and are profit-maximizing entities responsive to the price signals of market forces, which ideally are perfectly competitive. The economy is believed to run most efficiently when many small producers compete with each other, and when markets are left alone, unhindered by government intervention. Markets are self-equilibrating; after any disturbance they should quickly return to equilibrium, where supply equals demand and any shortages or surpluses would disappear (including unemployment in labor markets). The Neoclassicals did acknowledge some room for intervention in the form of monetary policy, but for Milton Friedman, it was best for the Central Bank to keep the money supply on a steady path, growing merely to accommodate the growth of the economy. The Neoclassicals adhered to the belief in small government – the smaller, the better. Indeed, Grover Norquist once quipped that his goal was to cut government in half to get it down to the size where “we can drown it in the bathtub” (Dreyfuss 2001).

After the financial meltdown in 2008, Neoclassicals were taken to task for having failed to predict the crisis. Why didn’t they see the bubble in the housing market? Why was nothing done sooner to avert the meltdown? Some admitted they were mistaken in their beliefs, modified their theories, or left the Neoclassical school altogether. Alan Greenspan, former Chairman of the Federal Reserve, admitted the crisis had exposed a “mistake” in free market ideology, that he had been “partially wrong” in his hands-off approach to the banking industry, and that the credit crisis left him in “shocked disbelief” (Clark & Treanor 2008). Richard Thaler admitted that part of Neoclassical doctrine was flawed – i.e. the rational actor model – and tried to remedy this through insights from behavioral economics, with its examination of emotions and psychology in shaping individual behavior (Cassidy 2010). Thaler and other behavioralists discovered that money can activate certain circuits in the brain producing excitement and irrational behavior, and bubbles can emerge as investors get caught up in the “highs” of making more money. They proposed establishing early warning systems to warn investors and policy-makers of emerging asset bubbles. Other Neoclassical economists left the school altogether. For example, Richard Posner criticized his Neoclassical colleagues for their assumptions that prices would always reflect the fundamentals of supply and demand and that asset bubbles could not exist, and shifted to Keynesianism (Cassidy 2010, Posner 2009).

While some Neoclassicals began jumping ship, others such as Eugene Fama, Robert Lucas, and John Cochrane stood their ground and defended the paradigm they had spent so many years building (Cassidy 2010). After all, many had received Nobel prizes for their ideas, such as Fama for his efficient-market hypothesis stating that prices of stocks and other financial assets accurately reflect all the available information about economic fundamentals. Lucas was recognized for his theory of rational expectations, which posited that individuals and firms were intelligent decision-makers who made the best predictions with the information available and responded accordingly. For Lucas, recessions were caused by temporary confusion on the part of economic actors who couldn’t distinguish between changes in their own situation and changes in the overall price level (Krugman 2009b).

Not only did Neoclassicals fail to predict the asset bubbles and crashes, most thought it was pointless to establish measures to guard against them. For many, stock market crashes and their subsequent recessions were triggered by outside shocks and essentially unpredictable, and thus there was nothing policy makers could or should do to intervene (Krugman 2009b). The best medicine during recessions was the old laissez-faire approach of doing nothing and just hoping for the best. Markets would take care of things on their own, since markets were self-equilibrating and self-regulating.

When external shocks did not serve as a viable explanation, the bête noire was government impeding the market mechanism from working its magic. Government regulations (specifically the Community Reinvestment Act, CRA) and agencies (such as Fannie Mae and Freddie Mac) were particularly targeted for causing the 2007 crisis. Neoclassicals claimed that due to the CRA, the government forced mortgage lenders to lend to low-income minority communities, and that the government instructed Fannie Mae and Freddie Mac to buy subprime mortgages and mortgage securities (Krugman 2010).1 Nor did Neoclassicals approve of government intervention in the form of government spending to shore up aggregate demand, as this would lead to crowding out (i.e. upward pressure on interest rates, making it more expensive for the private sector to borrow and spend). Their remedies were the same old policies advocated for the last 30 years – more deregulation, more tax cuts and smaller government. Even some years into the crisis, when corporations were sitting on almost $2 trillion in profits and not making investments, business executives and their Neoclassical spokespersons claimed the reason was because government regulations were too onerous and taxes were too high (Lynch 2013).

An offshoot of the Neoclassical paradigm was the Austrian school, which shared a belief in laissez-faire markets and small government. Stemming from the ideas of Schumpeter, F.A. Hayek and Ludwig von Mises, the Austrian school differs from the Neoclassicals in its critique of mathematical and empirical methodologies and its emphasis on complexity, process, and change. During the 2007 crisis, Austrian school ideas were perhaps most widely heard from Ron Paul and his supporters. In the Austrian school’s theory of business cycles, it is the creation of liquidity by the Central Bank and the fractional reserve banking system that causes economic crises ( 2011). By lowering interest rates, the Central Bank provides cheap financing through the banking system that merely fuels speculative bubbles, fosters inefficient businesses that would not otherwise survive, and results in a misallocation of capital. The popping of the bubble and the resulting recession are part of a natural process that allows prices and wages to adjust and unprofitable businesses to fail. According to this liquidationist approach, the uncompetitive businesses should be allowed to go under (together with their workers). In the long run, once wages fall low enough, the lower labor costs will encourage firms to expand and hire. There is no concern for the workers who become unemployed while they “wait” for the economy to recover. We are in a “survival of the fittest” world. Neither the Central Bank nor the government should intervene to rescue the economy. Increasing the money supply merely triggers inflation, or worse, hyperinflation. The adherents to this line of thinking tend to support a return to sound money (a stable money supply), or a return to the Gold Standard. Some even argue that the Central Bank should be abolished.

Those who were not convinced by the Neoclassical or Austrian school explanations (It’s outside shocks! It’s the government! It’s the Central Bank!), or their remedies (Free markets! Downsize government! Return to the Gold Standard! Abolish the Federal Reserve!), hunted around for other explanations. The Keynesians now had a chance to take over the bully pulpits.

The Keynesians

After the 2007 crisis, there was a resurgence of interest in John Maynard Keynes, who argued, during the height of the 1930s Great Depression, that the market mechanism sometimes fails to bring the economy to a full-employment equilibrium. After the stock market crash of 1929 and the subsequent banking crisis, falls in income and wealth led to a collapse in investment, consumption spending and aggregate demand. The economy eventually moved to equilibrium, but was stuck far below full employment, with some 25% of the workforce unemployed. For Keynes, doing nothing and waiting for the long run when markets would eventually adjust was unacceptable. He famously quipped, “in the long run we’re all dead.” During the 1930s depression, as unemployment mounted, homeless encampments expanded, and lines at soup kitchens grew longer, the calls to topple the capitalist system grew ever louder. Keynes’s support of government interventions aimed at saving the capitalist system on the brink of collapse.

Keynes argued that government should step in to compensate for the lack of demand from business and households. Government spending could create jobs for the unemployed, and tax cuts and transfers (e.g. welfare) could help shore up household income and boost consumption spending. In the 1930s, New Deal programs (such as the Works Progress Administration (WPA) and the Civilian Conservation Corps (CCC)) hired people to build dams, roads and bridges, create trails in federal parks, and produce art in US cities. Unemployment insurance, welfare (AFDC), and social security were established. New banking regulations included the Glass-Steagall Act, which separated commercial from investment banking. The wall created by the Glass-Steagall Act meant that if an investment bank chose to speculate and take on excessive risk, it would be allowed to fail. The Federal Deposit Insurance Corporation (FDIC) provided deposit insurance to ensure that deposits in member commercial banks would be insured up to a threshold amount.

These government interventions produced a 30-year period (from 1945 to the early 1970s) in which the US economy prospered and recessions were mild and brief. The lesson for Keynesians was that governments could successfully intervene to combat recessions and stabilize the business cycle. However, by the mid 1970s, Keynesians lost influence, in large part because their demand-side stabilization tools were incapable of dealing with the simultaneous problems of high inflation and unemployment. Attempts to tackle unemployment by expansionary fiscal policy just made inflation worse, and attempts to combat inflation by contractionary fiscal policy made unemployment worse. The imposition of wage and price controls was one alternative briefly tried in the Nixon years to combat high inflation. But ultimately Paul Volcker’s Federal Reserve imposed a contractionary monetary policy, jacking up interest rates to extremely high levels, which led to the severe recession of 1981-82.

The limitations of Keynesian economic policy gave rise in the early 1980s to the ascendancy of Neoclassical economists and politicians such as Reagan in the US and Thatcher in Britain. They proceeded to undo many of the government interventions and state programs from the earlier period, and introduced supply-side policies that dramatically cut costs to business (the costs of labor, taxes, regulations, etc.). Taxes, especially for the wealthy and corporations, were slashed, and government spending for welfare programs and federal agencies was significantly reduced. Public entities were privatized and regulations were lifted in many sectors of the economy, such as transportation. Deregulation in financial markets came somewhat later, with the Gramm-Leach-Biley Act of 1999 (which repealed the Glass Steagall Act), the Commodity Futures Modernization Act of 2000, and the lifting of leverage requirements.

Financial deregulation plays a key role in the Keynesian explanation for the 2007 crisis. There was little oversight over financial institutions, which invented ever more risky financial instruments, such as derivatives, collateralized debt obligations (CDOs) and credit default swaps (CDSs), which allowed risk from the sub-prime mortgages to be passed along from mortgage brokers to investment banks to insurance-like companies like AIG. As banks took on ever more leverage to make risky bets, the lack of a firewall between the investment banks and commercial banks spread the risks more widely. Banks had become so hugely intertwined that if the system were to collapse, the large investment banks (not just commercial banks) would need to be rescued.

Lack of government oversight enabled mortgage brokers sell sub-prime loans, such as the “NINJA” loans to people with no income, no jobs, and no assets. The housing bubble was fueled by these lax lending practices, as well as by a global savings glut and capital inflows from countries such as Germany, Japan and China. When the housing bubble popped and prices fell, and as homeowners went into foreclosure, banks experienced a drop in the value of collateral and the financial instruments derived therefrom. This triggered the financial meltdown of 2008 as banks went under. But the fall in housing prices also meant declines in household wealth and consumption spending based on this wealth. Business experienced declines in sales and laid off workers, which led to further falls in income and drops in consumption spending. The drop in overall aggregate demand from falls in investment and consumption spending pushed the economy downwards into a deep recession, causing the unemployment rate to rapidly rise, reaching 10% (and higher when the underemployed and discouraged were taken into account).

The Keynesian solution advocated by economists such as Paul Krugman (2008, 2012), Joseph Stiglitz (2010), and Dean Baker (2009, 2010) was for the government to step in to rescue the economy. First, the financial sector had to be stabilized in some fashion (through the $700 billion TARP bank bailout).Then came fiscal stimulus programs, such as the $787 billion ARRA stimulus of 2009,3 comprised of tax cuts, transfers, and some government spending for job creation. The Federal Reserve launched an expansionary monetary policy by setting interest rates as low as possible, and then engaged in non-traditional monetary tools of “quantitative easing” (injecting trillions of dollars into the banking system), aimed at rescuing the banks and encouraging investment spending.

An additional target of Keynesian policies was the stimulation of exports, through export promotion programs (trade agreements, tariff reductions, export credits, etc.), and expansionary monetary policy that depreciated the currency, making exports cheaper. But various factors impeded the ability of the US to export itself out of this crisis. When the 2008 financial crisis struck, the panic around the world led to a “flight to safety” to the US dollar, keeping the dollar strong and preventing exports from becoming the mechanism to boost aggregate demand.

The 2007 crisis exposed fault lines within the Keynesian paradigm, particularly between the New and Post Keynesians. The New Keynesians, such as Mankiw and Romer who had produced microfoundations to the Keynesian macroeconomic models, posited that institutional rigidities may cause markets to get stuck outside of equilibrium. For example, sticky nominal wages in the labor market (from union contracts, minimum wage laws, “efficiency wages,” etc.) and institutional rigidities in other markets (e.g. menu costs) can prevent wages and prices from adjusting, resulting in involuntary unemployment. Many of the New Keynesians recognized the need for intervention to combat recessions, but Mankiw preferred using monetary policy, and if fiscal policy was required, he preferred tax cuts to government spending or transfers (Mankiw 2009a, 2009b). During the 2007 crisis, after the interest rate on federal funds was set as low as possible, the emphasis remained on monetary policy, as the Central Bank used the unconventional tool of “quantitative easing.”

On the other hand, Post-Keynesians, stressing the role of confidence, expectations, and fundamental uncertainty, pointed out that increasing the money supply could be ineffective in this crisis. Drawing upon the ideas of Paul Davidson, Sidney Weintraub, and especially Hyman Minsky, Post-Keynesians saw the root of the crisis lying with a deregulated financial sector that took on too many risks and too much debt (Tabb 2012, Keen 2011). Minsky had argued that the euphoria within financial circles that builds up during booms can lead to ever more risk and debt being taken on by speculators. At a certain moment (the ‘Minsky moment’), debts become larger than the ability of speculators to pay them off, euphoria turns to panic, and the financial sector becomes riddled by instability and crisis (Minsky 1986).

Financial instability and crisis can then spill over onto the real sector, particularly with investment spending in productive sectors. Investment spending (non-residential) is a function not just of the interest rate and capacity utilization, but also of business confidence and expectations of future sales, profits, and GDP, and therefore may not respond to lowered interest rates. Consumer and business confidence (or ‘animal spirits’) can suddenly change in a positive or negative direction. During a deep recession with high unemployment and falling household income, firms may be reluctant to borrow and spend if they lack confidence or expect future sales and profits to remain depressed. As firms sit on their cash, the economy moves into a liquidity trap. Injecting more money into the system is like pushing on a string, rendering monetary stimulus ineffective in combating the recession.

Furthermore, banks may be reluctant to lend the injected funds, especially after a collapse in asset prices has put banks at risk of going under. The funds may end up either sitting stationary, or used for speculation. A better prescription, according to these Keynesian critics, was for the government to step in with direct spending on job-creating projects, financed by borrowing (thereby incurring deficits). Indeed, these Keynesians engaged in a spirited defense of more deficit spending, asserting that now was not the time to balance budgets. Not only was government fiscal stimulus necessary, but as Shiller and Akerlof pointed out in Animal Spirits, the government needed to be aggressive and formulate a stimulus (including one which targeted credit markets) that was large enough to restore the confidence (the ‘animal spirits’) that had plummeted during the crisis (Shiller & Akerlof 2009).

The Keynesian explanations (It’s deregulation! It’s market failure! It’s lack of aggregate demand! It’s lack of confidence!) resulted in many of the remedies (More government regulation! Increase the money supply! Promote exports! More deficit spending! Create jobs!) that were more or less enacted in the years immediately following the 2007 crisis. However, even the Keynesian remedies were proving insufficient to the task of solving this crisis. Krugman and other Keynesians bemoaned the inadequacy of the ARRA stimulus, arguing it should have been much larger to get the economy out of its hole (Krugman 2009a). They capably dismissed Reinhart and Rogoff’s warnings about rising government deficits turning into sovereign debt crises,4 since the US government could continue to borrow at historically low interest rates, given the US dollar’s status as reserve currency, its destination in “flight to safety,” the willingness of the US Central Bank to buy government bonds, and lack of crowding out (in which the increased demand for bonds would push up the interest rate and “crowd out” or discourage investment spending by the private sector). But the government entered the crisis with pre-existing deficits and debt, generated by Bush’s Norquist-inspired tax cuts for the wealthy, combined with spending on wars (including the endless “war on terror”). Shouldn’t these taxes be restored to help shore up budgets? Shouldn’t the spending on wars be put to an end? The Keynesians called for more deficit spending, while remaining fairly silent on ending the wars and reversing the tax cuts for the wealthy and corporations.

Furthermore, Keynesians did not adequately address the power of corporate-funded lobbyists who were able to weaken the fiscal stimulus and financial regulations intended to rein in the banks. Nor could their policies fully remedy the roots of inequality that had so shifted aggregate demand towards consumption by the wealthy. So as bankers continued getting bonuses, as lobbyists weakened the new financial regulations, as speculators gambled with free money, as governments imposed austerity after inadequate fiscal stimulus packages, and as the crisis of high unemployment dragged on, it seemed evident that the emperor’s clothes were threadbare, if he had any clothes at all.

The Institutionalists

In the fringes of the economics profession one could sometimes hear the odd gadfly, the lone voice in the wilderness, articulating a different vision of economics. Often working for low pay under marginal conditions, these economists may have had clothes that were literally somewhat threadbare. But with the financial meltdown in 2008, their voices became louder, more confident, and more strident. After all, the Keynesian approach seemed to be missing deeper problems that needed to be tackled.

Some of these voices resonated with an institutionalist quality. The roots of institutionalism stem from economists Thorstein Veblen and John Kenneth Galbraith. Veblen’s ideas reflected the time and place in which he lived (the US Northeast between 1898 and 1923), a period marked by historic levels of income and wealth inequality, with the excesses of the first Gilded Age and the Robber Barons. Darwin’s ideas of evolution had made an impact in academic circles, including those Veblen traveled in. Veblen saw the “warrior” leisure classes of his day engaging in predatory behavior, taking advantage of the weaker menial working classes (Sackrey et al. 2010). He observed how leisured elites engaged in forms of consumption that did not follow the regular law of demand. The higher the price, the more desirable the commodity, for the status and social positioning it could confer. The more ostentatious, the more the commodity marked the social power and privilege of the elite. He termed this spending “conspicuous consumption,” for only its visibility would produce the desired effect in securing power and garnering obedience from others (Sackrey et al. 2010). Such status spending had spillover effects down through the social ladder, as even lower income consumers engaged in forms of consumption in order to keep up with their peers or those just above them (what Veblen called “pecuniary emulation”).

After the 1929 stock market crash, the Great Depression, and the New Deal reforms, income and wealth inequality in the US fell, and in the 1950s and 1960s a broad middle class emerged. Middle-class households now had the income to consume the goods and services produced by corporate America, and consume them they did – in vast quantities. John Kenneth Galbraith, writing in the post-war period, warned of new dangers in this mass consumption. He examined how consumerism was driven by ever more advertising in order to create new “wants” for the new products created by corporate America, and was concerned about the environmental implications of mass consumption and the drain of resources of private consumption away from the provision of public goods (Sackrey et al. 2010).

By 2007, a new Gilded Age had emerged in full force in the US. Income and wealth inequality reached levels not seen since their peak in 1929. In 2005, the share of household income (before taxes and transfers) going to the bottom 20% was 3.4%, while the share going to the top 20% was 50.4% (Wolff 2010a). The growth in inequality in the US was particularly rapid after 1980, and flowed to the very top (the top 1%). From 1980  to 2005, the richest 1 percent got more than 4/5 of the total increase in income. Between 1979 and 2007, the income for the top 1% rose 275 percent. By 2011, the richest 1% of the population owned 1/3 of US net worth (Wolff 2010a). Johnson and Kwak likened the income and wealth disparity in the US to that of a third-world banana republic, where a small oligarchy had accumulated financial power and had taken control of both the worlds of finance and government (Johnson & Kwak 2010).

The bubble years – the stock market bubble of 1995-2000, and the even larger housing bubble of 2002-07 – were also marked by tax cuts for the wealthy and the concomitant excesses of conspicuous consumption. CEO compensation packages became ever more outrageous, mansions bigger, corporate jets more numerous (as highlighted in Ferguson’s documentary Inside Job). For those lower down the social ladder who rubbed shoulders with their wealthier neighbors (whether at the shopping mall, school, church, or dance hall), the forces of pecuniary emulation kicked in as they tried to match the spending of their peers or those just above them on the social ladder. Middle and lower income households, whose incomes were stagnant or falling, used debt in order to consume at levels comparable to their peers, or to attempt to maintain the standard of living of their parents. The level of indebtedness climbed ever upwards. As long as housing prices rose, middle-class people could refinance and take out loans to maintain their aspired standard of living. But when the housing bubble burst and this level of consumption could no longer be sustained, the middle and lower income households were squeezed, yet chided and berated for “living beyond their means.” Robert Frank and his colleagues found that the areas with largest financial distress were those where income inequality had grown the fastest and where people with the lower incomes had vastly overspent in their efforts to “keep up with the Joneses” (Frank 2007, 2010).

While these forms of consumerism had perverse ecological consequences for the planet, that didn’t stop the superrich from continuing to spend in excess. Only the middle and working classes were to tighten their belts; the predator class could go on partying like it was 1999. Furthermore, predatory behavior during the bubble years was rife, especially on the part of sub-prime mortgage lenders taking advantage of poor people in minority communities. They even tricked borrowers who would otherwise have qualified for prime loans to take sub-prime loans with worse conditions. These predators were emboldened by a weak state that had insufficient regulators to enforce the rules on the books, and by deregulation that had eliminated the rules altogether. William Black highlighted the fraud, criminality, and predatory behavior of these mortgage lenders and bankers, and lamented the lack of any criminal prosecutions (Black 2005, 2009). James K. Galbraith took the critique one step further, arguing that the state itself had become a predator state, doing the bidding of the corporate elite (Galbraith 2008). The idea of the laissez-faire market was a myth; by capturing the state, corporations had garnered policies that served their own interests. Charles Ferguson also highlighted the way the financial industry in the US had become ever more predatory, and how its influence extended to various social institutions, even Economics departments in academia (Ferguson 2012).

To stop the excesses of the modern day Robber Barons, Institutionalists called for a return to the populist politics of the Progressive era. For the Institutionalists, remedies for injustices from the 2007 crisis would include prosecuting criminal behavior and extending reparations to the victims, especially the minority communities that experienced drastic declines in wealth and income. Individuals, especially the CEOs of the financial institutions that engaged in fraud, would be held responsible for any crimes committed. But the politicians and their academic ideologues who crafted the theories and passed legislation that enabled the climate for fraud (such as Robert Rubin, Alan Greenspan, Phil Gramm, Lawrence Summers, etc.) would also be held responsible and punished in some way (e.g. by losing their jobs, being disinvited from public speaking, having their public accolades eevoked, etc.). Many of these politicians and academics had joined the CEOs to sit comfortably among the top 1%.

The institutionalist explanations (It’s inequality! It’s predation!) were echoed in the populist cries of protesters on the streets (Tax the rich! Tax the corporations! Cut military spending! Stop foreclosures! Indict the criminals! Jail the bankers!). “We are the 99%” became the rallying cry of the Occupy Movement. Certainly the inequality of wealth and income were fundamental to the problems that gave rise to the crisis, but how did we get to this point in the first place? The Institutionalists seemed to lack such an analysis. Was the problem a few bad apples, a few individuals and specific companies who engaged in predatory, fraudulent, or criminal behavior? Would it be enough to hold individuals responsible for their various misdeeds? Or was the problem larger than that, with the system itself? Meanwhile, as “markets” were demanding austerity, in the form of government cutbacks and labor market reforms that punished workers even more, the stage was being readied for the resurgence of class struggle.

The Marxists

When the crisis struck in 2007, contemporary Marxists (such as Brenner 2009, Carchedi 2010, Kliman 2012, Harmon 2010, Foster & Magdoff 2009, Magdoff & Yates 2009, Duménil & Lévy 2011, McNally 2010, Harvey 2011, Wolff 2010, Albo, Gindin & Panitch 2010, and Panitch & Gindin 2012) argued it was the capitalist system that was in crisis. The individual bankers and mortgage lenders were operating in a capitalist system that was ruthless in its search for short-term profits, inherently unstable and prone to crisis due to its own internal contradictions.

Long before Keynes and the Institutionalists came on the scene, Marx had been a powerful critic of classical political economics, denouncing the market mechanism as a veil that obscured underlying relations of exploitation. Dispossessed of the means of production, workers were compelled to offer their labor power to a capitalist employer in order to survive. The capitalist paid wages equal to only a portion of the value that the worker produced in any given day. The rest (surplus) flowed to the capitalist who decided what to do with it. The term Marx used for this form of theft was exploitation. Capitalists used various strategies to squeeze more surplus value from their workers, such as lowering wages, or having workers work longer hours or more intensely to produce more output per hour. This intensification of exploitation produced ever-greater surplus (profits) for the capitalists, which they accumulated and distributed in various ways to secure their conditions of existence. They could use it for new technology, marketing and advertising, mergers and acquisitions, lobbying and political campaign contributions, or to fund media, academic, and religious institutions to shape public opinion. A class struggle arose as workers resisted exploitation by joining unions and pushing for higher wages, a shorter workday, and better working conditions. But capitalists were also in a constant struggle with one another, to secure more profits lest they succumb to their competitors.

The capitalist system periodically went into crisis, with the last major capitalist crisis of the 1930s ‘solved’ by government spending from the New Deal and WWII. The post-war period was marked by relative growth and prosperity until the early 1970s, when conditions changed with the rise of automation, global competition, and a profit squeeze from rising wages (won by militant labor union struggles of the late 1960s and early 1970s). Then came the stagflationary oil price shocks of 1973-74 and 1979. Together, these factors resulted in falling profits during the 1970s. By the mid-70s, real wages for non-supervisory workers began to stagnate and no longer kept up with productivity increases (Wolff 2010).

Marxists diverged in their analysis of the 2007 crisis, with some seeing it caused by the tendency of the rate of profit to fall.5 As machines replaced workers, capitalists have fewer workers from whom to extract surplus value, and the resulting falling rate of profits creates chronic stagnation (Brenner 2009, Carchedi 2010, Harmon 2010, Kliman 2012). For these scholars, the 1975-2007 period exhibited falling rates of profit that ultimately led to the 2007 crisis.

Others argued that the rate of profits was restored in the 1975-2007 period (Wolff 2010, Harvey 2011). Capitalists found ways of getting around falling profit rates, by increasing the rate of exploitation of workers, finding new sources of cheap labor from women and immigrants, and moving manufacturing to less developed countries (Wolff 2010). Volcker’s contractionary monetary policy and the severe recession of 1981-82 enabled capitalists to attack unions, whose membership fell from 30% of the labor force in the mid-1970s to under 13% by 2010 (BLS 2013). As labor’s bargaining power weakened, real wages fell; the pay for average non-supervisory workers has dropped by more than 10% since the 1970s (Rogers 2011). In addition, capitalists were able to secure cheaper prices for other inputs (such as oil). Deregulation also brought down costs, while at the same time corporate taxes were slashed. The list of ways that companies in this period offset falling profit-rates is so long, according to Harvey, “that it renders the neat explanation for a solid ‘law’ of falling profits as a mechanical response to labor-saving technical innovation more than a little moot” (Harvey 2011: 94).

While these capitalist responses may have temporarily solved the 1970s falling rate of profits crisis, they sowed the seeds for a second crisis later on, a crisis of underconsumption, overproduction and overaccumulation, as rising profits led firms to over-expand and over-produce. The newly produced commodities must be sold, which is a problem, as frozen wages result in insufficient demand. Unsold goods then pile up, which drives down prices and profits. Without seeing further opportunities for profit, capitalists will curtail their investment in new plants and equipment, and growth will come to a halt.

Capitalists tried in several ways to work around the underconsumption problem. One way was to soak up excess demand by its own consumption, in the form of luxury expenditures, but this could hardly be sufficient. Another strategy was making credit for debt-financed consumption available to workers. The wealth effect from the housing bubble led to a degree of optimism among workers that encouraged them to spend, even in the face of stagnant wages. Alternatively, workers financed consumption by working longer hours, or sending more members of the household into the workforce (Wolff 2010). All these factors were operative in the US, at least until 2007; they reached their limits when the housing bubble burst and households could no longer take out equity from their homes to finance consumption. Capitalists tried to respond by seeking innovations, new markets (e.g. the BRIC countries), new bubbles to drive consumption, and/or new areas to commodify, such as household services or privatization of public sector services.

How have these diverging explanations in the falling rate of profit debate fared in the face of empirical data in the 1970-2007 period? Did the rate of profit fall (as Kliman and others contend), or was it restored (as Harvey and Wolff maintain)? Duménil and Lévy examined the data and found that whether the profit rate was falling or rising depends on how profits are measured. When dividends are not included in profits, the profit rate has indeed declined, but when interest and dividends are included, then the rate shows an increase since the 1980s, though not to the high levels of the 1950s and 60s (Duménil & Lévy 2011: 51, 58). However when corporate taxes are subtracted, profits were restored even to the 1950s-60s levels (58). So the falling rate of profit theorists (such as Kliman) have a point in asserting that the rate of profits in the form of retained earnings for investment (in factories, machines, etc.) did indeed fall. However, it only fell because corporations (i.e. their boards of directors) paid out ever more of their profits as dividends to shareholders. The dramatic reduction in corporate taxes from 1950s levels further increased flows to shareholders. So really, a crisis of profits was not at all hindering capitalist corporations in the post-1980 period. Rather, there was a shift of profits away from productive investment in firms and away from taxes, and instead into the hands of private shareholders.

Also in dispute is the question of under-accumulation or over-accumulation of capital. If profits are falling, there is less for capital accumulation; for companies to make productive investments, they may then resort to borrowing and taking on more debt (Brenner 2007). On the other hand, a restoration and growth of profits may result in over-accumulation of capital. If there is a glut of unsold goods and not enough opportunities for productive investment of the profits, then the excess may be channeled into speculation or other arenas (Harvey 2011, McNally 2010). In this latter scenario, it is the over-accumulation of capital that gave rise to financialization, and the resulting bubble and crash.

However, other Marxists saw the causes of the 2007 crisis lying not in the real sector, but in the financial sector (Albo et al. 2010, Panitch & Gindin 2012, Duménil & Lévy 2011).6 For Albo et al., financialization emerged in 1971 and predated any crisis in industrial capitalists’ profitability. The turning point was the onset of inflation in the late 1960s, due to the US’s attempt to achieve both guns (spending on the Vietnam war) and butter (Johnson’s war on poverty). The inflation and flood of US dollars abroad eroded the value of the dollar, making it more difficult for the US to maintain the fixed exchange system. The turning point was 1971, when Nixon took the US dollar off its tie with gold and ushered in the new regime of floating exchange rates, which led to volatile currency fluctuations and the creation of new financial instruments such as derivatives, futures, and options used for currency exchange speculation, hedging risk, etc. When loose monetary policy led to excessive lending and indebtedness, the process of securitization was invented, which repackaged debt as a “security” that could be purchased (McNally 2010: 99). By the 1990s, the financial world was busily trading CDOs, CDSs, and other toxic financial instruments that would be rated AAA. The crisis emerged when an out-of-control financial sector finally reached its limits after the housing bubble popped and the precarious financial deck of cards came tumbling down.

Unlike Keynesians who supported state intervention to save the capitalist system, Marxists wanted to replace the system altogether. After the last capitalist crisis of the 1930s, the capitalist system was left intact, which enabled the capitalist class eventually to regroup and to unravel the reforms that had been put in place to soften the system (Wolff 2010). The fundamental capitalist class dynamic would continue, in the form of a constant tug of war between attempts by the public to re-regulate, re-tax, and temper the excesses of the capitalists, and attempts by capitalists to undo the regulations, cut taxes, and weaken and shrink governments. The economy would also continue to experience crises of falling rate of profits, overproduction and underconsumption, perpetually going from one crisis to another.

But replace the system with what? Like other schools of thought, Marxism splintered into various traditions, each with different proposed solutions. Some favored public ownership, while others favored central planning or some combination of the two, such as in the former Soviet Union. Others rejected the Soviet model for its lack of democracy, and called for democratic decision-making in publicly owned enterprises and planning decisions, and for an economy built around meeting human needs and the survival of the ecosphere rather than corporate profits. Resnick and Wolff argued that the Marxism described above missed an important aspect of Marx’s work (Resnick & Wolff 2002). They pointed out that for Marx, the class process was not about property ownership or about planning versus markets, but about the production, appropriation, and distribution of surplus labor. In the capitalist class process, workers produce the surplus, but the capitalists appropriate and distribute it. The fundamental class conflict is between workers and capitalists over the surplus, and eliminating this exploitative class relation is key to liberating the working class. The producers of the surplus should themselves collectively be the ones to appropriate and distribute it. For large modern enterprises, this may entail workers constituting the boards of directors, making decisions about how surpluses are appropriated and distributed, or workers collectively producing, appropriating, and distributing surplus in the form of worker cooperatives. Unfortunately, many of these economic alternatives have yet to be fully worked out, but worker cooperatives have proved their effectiveness from the Mondragon region of Spain, to cooperative experiments in Argentina, Venezuela, and even Cleveland, Ohio.

The Marxists’ explanations (It’s the system! It’s capitalism!) led to calls for changing that system (Public ownership! Democratic planning! Production for need, not for profit! Occupy the boardrooms! Democratize the workplace!). It remained to be seen how widely these calls would be heard, as the global economy remained in a weak and precarious state through the years after the 2007 crisis.


The crisis of 2007 clearly discredited the Neoclassical school of economics. Why did these economists not see the crisis coming and why did they do nothing to prevent it? But would the crisis produce a return to Keynesianism? Certainly, Keynesian ideas and policies made a comeback. But as the wealthy and corporations continued to enjoy tax cuts, and as the military-industrial complex continued to be enriched by the endless “war on terror,” deficits climbed upwards and the government turned to austerity. In addition, for all the Keynesian appeals for state intervention, the state acted more in the interests of big corporations and the wealthy, than in the interests of ordinary people. If anything, it was populism that made a comeback, as ordinary working Americans balked at the excesses of the new Gilded Age, and came out into the streets in Tea Party protests against “big government,” and in the Occupy protests against corporate America and the über-wealthy (the top 1%). For progressives, the problem wasn’t government per se, but government that was used to serve the interests of the big corporations, allowing a revolving door between Wall Street and Washington to spin out of control.

Marxists took the progressive populism one step further, providing a class analysis to examine why this excess of power and privilege had become so exacerbated. It was due not just to the behavior of individuals and the institutions they inhabited, but to a crisis in (and potentially of) the system of late-20th-century capitalism. As Wolff suggested, the current crisis was not yet a crisis of capitalism, as the latter would depend on the extent of the breakdown, the impact of policy responses, and how socialists intervened (Wolff 2009). While many Marxists supported the remedies advocated by the Institutionalists (such as taxing the rich and corporations and using those revenues for job creation; cutting spending on the military and other boondoggles; re-regulating to prevent predation; punishing economic crimes and extending reparations to the victims), they argued that the deeper problem lies with the capitalist system and the institutions that sustain it. It was not enough to return to a form of state capitalism, with Keynesian state interventions to better manage the crisis-prone system. A strategy that focused on such a return would likely be less successful in gaining support from workers this time around (Wolff 2009). The time was ripe, they pleaded, to change that system altogether and introduce democratic socialism, with democratic workplaces and worker-comprised boards of directors, and with institutions that serve the needs of people and the planet, instead of generating profits for the few.


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*Special thanks to Teddy Rachmat who suggested I write this paper, the students in my Winter 2011 Political Economy course at Fairhaven College, Tim Koechlin and Fletcher Baragar for their feedback on an earlier draft, and Triny Tresnawulan for her research assistance.

1. Keynesian economists, such as Paul Krugman, have aptly refuted these claims, pointing out that the CRA was established in 1977 long before the recent housing bubble in 2002-07, and that enforcement of the CRA was actually weakened during the housing bubble years. Plus, most of the subprime lending came from institutions not subject to the CRA, such as Countrywide and Ameriquest. The private sector mortgage lenders were involved in subprime lending to a much greater extent than were Fannie and Freddie, whose market share of the subprime market actually declined during the years of heightened subprime lending. Fannie and Freddie only got more aggressively into sub-prime lending late in the game in 2005-06 as they tried to regain market share (Krugman 2010).

2. TARP = Troubled Assets Relief Program. There were other options available, such as nationalization or bank liquidations. Keynesian critics of the TARP bank bailout argued that it was enacted with no strings attached (e.g. no limits on bonuses) and allowed the banking sector to become more concentrated.

3. ARRA = American Recovery and Reinvestment Act.

4. Reinhart & Rogoff warned that if the downturn was long and the recovery slow, as is often the case after real estate crashes and banking collapse, the rise in government deficits could turn into sovereign debt crises and lead to slower growth (Reinhart & Rogoff 2011).

5. I first developed the following argument in a review essay on Albo et al. 2010, Harvey 2011, and McNally 2010, for the Review of Radical Political Economics, forthcoming.

6. The following section also draws upon my above-cited review essay (note 5).

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