3 – The Keynesian Paradigm



We have seen in the previous paper how we are entering a phase of transition to a new world order led by China and its Asian allies, and set to promote a massive push towards economic development, Eurasian integration and generalised economic growth.  This expansive push will most likely provide favourable conditions for the resurgence of a progressive economic paradigm.  In other words, the apparent chaos that we are experiencing at the moment in reality hides a very important positive development: we have reached a junction in history in which the conditions of the world economy and the geopolitical shifts taking place are providing us with a golden opportunity to finally escape neoliberalism and go back to a much more humane type of capitalism, the Keynesian type that was in place between 1945 and the mid 70’s.  This would allow us to revive the welfare state, to rebalance the distribution of wealth and power in our society and then eventually also to start considering more politically advanced initiatives, such as transitioning towards post-capitalism.  There are two obstacles however: a) the difficulty of escaping the status quo and making a definite move towards the new Asian-led world order, and b) if and when we are able to make this geopolitical shift and, along with it, resurrect a Keynesian economic paradigm, how do we avoid the pitfalls that caused its demise?  In other words, how do we maintain the economic conditions for its survival?  To answer these questions we need to first look at the events that paved the way for the adoption of a Keynesian economic paradigm in the West at the end of WWII, and then those that caused its demise in the 1970’s.

Geopolitical shift + economic necessity paving the way for a new economic paradigm in 1944 

Geopolitical shift – Our current situation bears many resemblances with the situation present  in 1944 when, along with a new hegemony, a new economic order was ushered in with the Bretton Woods Agreement.  Back then the change of economic paradigm happened after a series of extraordinary events: two major wars, the Russian Revolution and the breakdown of the previous paradigm (1929 Financial Crash, Great Depression, New Deal).  Back in 1944 the geopolitical re-alignment that paved the way for the Keynesian economic paradigm was the product of a clear-cut post war settlement that had divided the world in two rival blocks headed by the US and the USSR.  At present the geopolitical shift will hopefully be less traumatic, not involving major wars, but also, for the same reason, less clear-cut, and will probably happen bit by bit as country after country shifts allegiance due mainly to pressures from its impoverished population, given the un-sustainability of the current economic arrangements. All sorts of about turns, cold war tactics, internal strife and general confusion can be expected in the meantime, as individual states, as well as political parties and social coalitions within them, are teetering between the two options.  But eventually the compass of economic necessity points in one direction:  joining the geopolitical alignment that promises to bring back growth and prosperity.

Economic necessity – the geopolitical realignment was the condition that paved the way for a new economic and political order in 1944.  But the reason why a progressive, redistributive paradigm was chosen (presumably not the best option from the point of view of the ruling elite) had a lot to do with economic necessity: the previous liberal economic architecture had collapsed and the spectre of widespread unemployment and social unrest haunted western capitalism.  At the time of the Great Depression the main problem that policy makers had faced was how to restart the economy in the presence of negative expectations on the part of investors and businesses: as there were millions of unemployed workers with no safety net, the lack of purchasing power in the real economy meant that private businesses could not be expected to restart investing and producing.  Thus, at the end of WWII the main priority was to avoid a repetition of such a disgraceful state of affairs, resulting in widespread desperation and resentment (and giving rise to fascism and communism among other things).  With this strategic aim in mind (the preservation of capitalism) it was decided that the main goal of economic policy would have be to a) spend into the real economy (what we now call QE for the people) in order to keep aggregate demand high enough to sustain full employment, b) to create safety nets for society that would act as automatic stabilisers of aggregate demand and living conditions, c) for what concerns long term economic management, to build up infrastructure and to support strategic industrial productions.  In other words, the way to avoid widespread unemployment (and consequent social unrest) was by building up a viable economy by means of industrial policy, a well functioning welfare state and management of economic cycles by means of counter-cyclical spending.  For that purpose, a regulatory framework was created under the Bretton Woods agreement to enable states to manage their economies and fence them off from unfettered market forces.  We could say that the people in power acknowledged the fact that the only way for capitalism to work for the majority of the population (and thus ultimately to avoid self-destruction) was by putting in place a state managed economy.  This is a crucial lesson which in the West we probably need to re-learn, but which has not been lost in other parts of the world, most notably China.

Taking a closer look at the Keynesian economic paradigm

The Post-war economic settlement consisted of three main aspects:

  1. a) financial regulation (also called financial repression) – this is the very foundation of this economic paradigm which, giving priority to the real economy at the expense of the financial one, can only come into existence in a time when the financial elite is weak and unable to prevent that its main weapon, creative finance, is deactivated by state intervention. Financial repression consisted of a raft of measures designed to keep the financial economy in check: restrictions of cross border capital movements, strict limits on bank creation of credit (achieved in part by ‘moral suasion’ from the central banks, in part by requiring high fractional reserves of more than 20%), caps or ceilings on interest rates, creation and maintenance of a captive domestic market for government bonds, by requiring banks and pension funds to hold the debt of their own governments (in the USA, big banks were required to hold cash or bonds equivalent to 24 per cent of the money they’d lent out. In the UK it was 28%.  By 1950, bank loans across fourteen advanced capitalist countries equalled just one fifth of GDP – the lowest since 1870 – Post Capitalism p. 83). This whole ‘financial repression’ arrangement (keeping interest rates below inflation, preventing savers and capitalists to move money out of their countries in search of a better deal and forcing them to hold government bonds instead) enabled governments to pursue the economic policies they desired without having to worry about keeping the financial markets happy for fear of capital flights.  In addition, it produced the effect of channelling money into productive investment, rather than speculative finance as, with interest rates below inflation, this was the only way investors could hope to make money, by producing something new, or by producing more efficiently and generating high returns in the real economy.  Needless to say, the separation of investment banking from retail banking (or Glass-Steagall Act.) was in force and creative finance had been pretty much suppressed. Sheltered from financial speculation, individual states were able to spend for the purpose of creating a viable economy.  It was a national sort of economy, based on industrial policy, on the welfare state, and on state management of aggregate demand in order to produce full employment.  But it must be noted that ultimately state action was supported by a favourable international framework at the top of which was the hegemonic power, the USA, committed to promoting economic growth with its virtually unlimited spending capacity, due to the fact that its fiat currency replaced gold at the centre of the international monetary system.  At the same time, we must not forget that what ultimately supported this fiat currency system and its ability to promote economic growth was an immense leap forward in terms of technology and productivity, itself a legacy of the war time economy. We must now look at the role of the new international monetary system that came out of the Bretton Woods agreement.
  2. b) The new international monetary (and governance) system was based on clear and explicit rules, administered by new international institutions created ad hoc (IMF, World Bank, etc.), designed to promote economic growth, and ultimately sustained by American hegemony. The new currency system that replaced the gold standard, although formally modelled along similar lines, over time completely subverted the original concept of the gold standard, as it was a fiat system. Like the gold standard, it was based on fixed exchange rates (fluctuating within a narrow band of plus/minus one percent and modifiable only in exceptional circumstances), with all currencies pegged against the US dollar, which was in turn pegged to gold at a fixed exchange rate of $35 an ounce. Over time the convertibility of dollars into gold (valid only for foreign central banks) turned out to be only nominal (as the US increasingly created money without constraints) and its main role was to function as a justification for the ‘exorbitant privilege’ that this system granted the US dollar:  the role of international exchange and reserve currency.  This effectively granted the USA the privilege to create money and buy with it any goods produced around the world, while every other country would have to earn (by exporting) the dollars needed to pay for its imports.

Putting in place a system of fixed exchange rates was officially meant to promote stability.  In reality this type of arrangement, a currency union, is highly unstable, as different countries present different economic structures with different levels of competiveness which, in absence of the rebalancing mechanism provided by fluctuating exchange rates, tends to result in high and unsustainable trade imbalances.  But keeping all partner countries tied to fixed exchange rates granted the USA complete control, as other countries would have to follow the same monetary policy in order to maintain a fixed exchange rate. For such a system to work, a high amount of co-operation between participating countries is needed in order to keep trade imbalances to a minimum. This co-operation was promoted and ultimately sustained by the hegemonic power that would put pressure on its partners (not only deficit but also surplus countries) to reduce trade imbalances and, in addition, would use its privilege of being able to create the international currency in order to act as the spender of last resort (= importer of last resort) to keep the system working smoothly.

Despite its injustice (being clearly stacked in favour of the US) and rigidity (due to fixed exchange rates) the system worked very well for the first 25 years because the hegemonic power, which had also economic hegemony (by far the most competitive industry, resulting in huge trade surpluses) was committed to maintaining the conditions for generalised growth of the world economy, by creating money and also by recycling its trade surpluses and investing them in the partner countries first to rebuild their industrial capacity, and then to favour their economic growth and adoption of a ‘consumerist’ lifestyle (along the lines of the American dream).

  1. c) So far we have considered the software of economic governance, but we must not forget that this arrangement rested on the hardware of adopting new technologies that resulted in high and rising productivity, which in turn made possible reconciling good profitability and capital accumulation with high wages and a generous welfare system. This high productivity was the legacy of WWII. In the words of Paul Mason (Post Capitalism p. 84-86) ‘A major change had taken place during wartime, with the state taking control of innovation. By 1945 national bureaucracies had become adept in the use of state ownership and control to shape private sector behaviour……within giant segments of American industry, during wartime management effectively operated like a profit-driven state-planning bureau.  At the Federal level, research and development was centralised and industrialised by the Office of Scientific Research and Development.  The way it operated was to treat research as a public property, to suppress competition and to plan not just production but the direction of research.  And though the USA perfected it, all major combatant states attempted it.’ …. This culture of innovation survived the transition to peacetime …. In this sense, the wartime economy gave birth to one of the most fundamental reflexes within the capitalism of the long boom: to solve problems through audacious technological leaps, pulling in experts from across disciplines, spreading the best practice in a sector, and changing the business process as the product itself changed.  The role of the state in all this contrasts with the meagre role of finance.  Finance had been effectively flattened during the 1930’s.   What emerged from the war was a very different capitalism.  All it needed was a raft of new technologies – and these were plentiful: the jet engine, the integrated circuit, nuclear energy and synthetic materials…. To sum up ‘state direction produced a culture of science-led innovation.  Innovation stimulated high productivity.  Productivity allowed high wages, so consumption kept pace with production for twenty-five years.  An explicit global rules system amplified the upside.  Fractional reserve banking stimulated ‘benign’ inflation (i.e. for the real economy)which, combined with financial repression, forced capital into productive sectors.  P80   ‘Across the developed world, the new techno-economic paradigm was clear – even if each country had its own version.  Standardised mass production – with wages high enough to drive consumption of what the factories produced – was unleashed across society. ‘ 84 ‘

Problems arising from the Keynesian paradigm

This expansive and redistributive economic regime worked well for about 25 years, resulting in sustained growth with low or no inflation.  In the words of Paul Mason, (Post Capitalism, p. 79-80) ‘The US economy more than doubled its size between 1948 and 1973.  The economies of the UK, West Germany and Italy each grew fourfold in the same period.  For the entire period, Western Europe’s average annual growth rate was 4.6 %, close to double that of the 1900-1913 upswing.  This was growth driven by productivity on an unprecedented scale.  The results are evident in the GDP per-person data.  For the sixteen most advanced countries, per-person GDP grew at an average of 3.2% per year between 1950 and 1973.  (For the entire period between 1870 and 1950 it had averaged 1.3%.)  Real incomes soared: in the USA the majority of households saw their real incomes rise by more than 90 per cent between 1947 and 1975′. The trick behind growth without inflation was rising productivity, which allowed both wages and profits to rise without having to increase prices.  In the advanced countries productivity grew at 4.5 per cent per ear, while private consumption grew at 4.2 per cent. The rising output of automated machinery more than paid for the rising wages of those operating them.   The trick behind rising productivity was state promoted and funded innovation in science and technology (industrial policy) along with financial repression, which channelled money into productive investment.  This arrangement worked well for as long as productivity rises kept pace with wage rises and for as long as the competitive advantage of the US economy allowed it to have trade surpluses and keep the dollar at the centre of the international monetary system.  This upswing started to come to an end in the late 60’s, when investments could no longer increase productivity at the previous rate.

When productivity rises started to taper off (but wages kept on rising due to high union bargaining power) and American economic supremacy came under challenge by Germany and Japan, the Keynesian paradigm started to run into serious problems. That is, once the buffers of American hegemony and rising productivity, which had kept trade imbalances and inflation at bay, started to wear thin, these two problems started to rear their ugly heads.  However, it must be noted that although they brought about the downfall of the Keynesian paradigm (and we will see how and why in a little while) these two problems in the end are only the technical manifestation of deeper causes that are political (and not technical) in nature: the eternal tensions between nations and between social classes.

Starting with the first problem:

Geopolitical tensions leading to trade imbalances: As the US helped to speed up the reconstruction of the industrial capacity of its allies, it didn’t take long until they were again able to compete, with the consequence that by the end of the 60’s the US had lost its economic hegemony.  By 1971 its trade surpluses had turned into substantial deficits, also due to the exorbitant expenditures caused by the Vietnam war.  The loss of competitive advantage combined with high expenditures resulted in a constant drain of US gold reserves.  Eventually it became clear that there were far too many dollars in the international markets compared to the US gold reserves, and this unleashed a run on the dollar that could only end one way, with a default, better known as ‘the closing of the gold window’ by President Nixon in 1971.  This spelled the end of the Bretton Woods monetary system and its fixed exchange rates.  From then on the world economy lost its anchor, exchange rates started to float and everything became unstable and confused, as the system transitioned to a new economic paradigm.  If technical problems were only technical and not, at a deeper level, political in nature, the default of the USA would simply have spelled the end of the dollar standard and the negotiation (perhaps with a new Bretton Woods style conference) of a more egalitarian monetary system with new rules and perhaps new ways of cooperating (perhaps along the lines suggested by Keynes himself at the Bretton Woods conference, by creating an international currency named Bancor).  But obviously the hegemonic power had no intention to re-negotiate with its ‘allies’ the relative positions of the various currencies as international reserves, and thus proceeded to implement a different type of economic order that would enable it to retain the dollar standard by attracting other countries’ surplus money into its financial system (that is, by replacing trade surpluses with capital surpluses). We’ve seen in the previous chapter (2a Petrodollar vs Golden Yuan) how the USA proceeded to continue imposing its currency (no longer backed by trade surpluses and the gold deriving from them) as the main international currency by means of the petro-dollar agreement (backed, in turn, by military force) and then proceeded to dismantle the Bretton Woods regulatory framework in order to put in place a new economic paradigm (based on finance) that would allow it to control and steer the world economy by controlling global financial flows.

The ‘interregnum’ of the 70’s – Between the default 1971 (which marked the end of the currency union) and the dismantling of all the other Bretton Woods rules and regulations, which started in earnest at the end of the 70’s, there was a period of interregnum between economic paradigms in which the US ability to act as importer of last resort had considerably declined and thus the problem of trade imbalances came to the forefront, giving rise to more or less explicit tensions between nations.  We will see later the strategies and remedies adopted by various countries in order to deal with the problem of trade imbalances.  For the moment we must turn to the other twin problem presented by the Keynesian paradigm, that of inflation.

Class conflict leading to inflation – after 30 years of spending into the real economy to create full employment, in the 70’s there was a tight labour market with strong unions, able to negotiate high wage increases, resulting in low profit rates (although high overall volumes of profit, given the long term growth).

Already in 1943 the Polish economist Kalecki had predicted that the Keynesian paradigm would hit a wall eventually.  He had foreseen its dynamic evolution rather accurately: pursuing full employment would result in tight labour markets, giving unions a lot of bargaining power and the ability to negotiate successfully frequent wage rises, often above productivity increases.  In presence of closed economies (the Bretton Woods rules limited cross border capital movements) the only way for businesses to make good profits would be by pushing up prices.  This would in turn lead to further requests of wage rises in order to re-coup the eroded purchasing power of wages, thus causing further price increases and so on, giving rise to a rather problematic inflationary spiral.  Kalecki predicted that this would cause a collapse in profitability and investment (employers going on strike).

For the first 25 years after WWII in which productivity rises were particularly high, economic growth was compatible with price stability but then, when productivity started to taper off but union demands remained the same, the problem predicted by Kalecki started to manifest itself and with a vengeance, as there was also another powerful cause fuelling inflation, the oil price shocks of 1973-74 which followed the default of the dollar.

This state of affairs (rising wage share and declining profit share of GDP) was undesirable in itself for the capitalist class for obvious reasons, but the main problem was probably not even economic but political: society was becoming more democratic and less hierarchical, with workers/voters having more wealth, more education and more choices, and thus demanding more control both in the workplace and in government affairs.  We will see later how the neoliberal paradigm would turn around this state of affairs by depriving the states of control over money creation (achieved by making central banks independent from government control), disabling their spending power and thus creating unemployment and insecurity in society.  In this sense, we could say that more than an economic paradigm neoliberalism is a political paradigm, a method of obtaining political control by producing a dysfunctional economy.

We now need to see how we got there, that is, how resolving the problem of inflation in the US (with dramatic interest rate hikes – what became known as the Volcker Shock) meant the start of the neoliberal paradigm.  We will use the narrative proposed by John Kenneth Galbraith in his book ‘A history of economics, pp. 266-281 abridged)

Inflation leading to the dismissal of the Keynesian paradigm – Galbraith’s story

What seemed economically symmetrical in the operation of the system [the Keynesian paradigm] proved to be politically asymmetrical.  Deflation and unemployment called for higher public expenditure and lower taxes, which were politically very agreeable actions.  Price inflation, on the other hand, called for lower government expenditure and higher taxes, which were far from politically agreeable.  Moreover, they were not effective against the modern form of inflation, price-wage inflation, as it came to be called.  In the US for most of the good 25 years inflation had not been an issue.  The rate of inflation started to accelerate, however, after 1966.  It went up by more than 6 percentage point between 1969 and 1970, nearly 8 between 1972 and 1973 and nearly 14 from 1974 to 1975.  In these new circumstances the political asymmetry became evident, as now economic advisers would have to advocate tax increases and expenditure reductions.

A further and yet more serious problem derived from the character of this new form of inflation, strongly connected with the power of corporations.  With industrial concentration corporations had achieved a very substantial measure of control over their prices, while unions had achieved substantial control over the wages and benefits accorded to their members.  From the interaction of these entities had come a new and powerful inflationary force: the upward pressure of wage settlement on prices, the upward pull of prices and living costs on wages.  This was the interacting dynamic that came to be called wage-price spiral.

In Europe and Japan, as inflation became increasingly a threat in the 1970’s, steps to limit wage increases became normal, accepted policy.  Wages were negotiated within the framework of existing prices and with a general view to keeping those prices stable.  In 1971-73 the administration of Richard Nixon introduced formal wage and price controls which, in combination with a relaxed fiscal and monetary policy, helped him enormously in the 1972 elections.  But in the English-speaking world none of these efforts were considered legitimate, as neither unions nor business firms were inclined to accept government interference with wages and prices.  The traditional defenders of the market had decisively powerful allies.

Finally, at the end of 1973 there came the large increase in oil prices resulting from the cartel action of oil-producing states, OPEC.  In 1971 the price of oil had been less than three dollars per barrel, in 1973 it had already climbed to 8/9 dollars, it hovered between $12 and 13 between 1973-79, and then there was another major oil shock in 1979 which brought the price to a dramatic $30 per barrel. Between 1972 and 1981 the index of the prices of household fuels in the United States climbed from 118.5 (1967=100) to 175.9, a nearly six-fold increase.  All of this was the result of the US default of 1971:  as the value of the dollar against gold plummeted after that event (from $35 in 1971 to $90 in 1973 and by 1979 all the way to $455!), the oil producing countries increased the dollar price of their oil in an attempt to maintain the real value of their revenues constant.  This way the US exported to its partner countries the inflationary consequences of the dollar default.  The rising prices of oil, in turn, caused a severe recession and the new phenomenon of stagflation, that is, a stagnant economy with continued inflation.  The stagnation was the effect of the dramatic oil price increases, while the inflation was the effect of both oil price increases and union continued demands (along with corporations determination to maintain their profit rates), but the detractors of the Keynesian paradigm only tend to quote the second aspect as a cause of the economic turmoil of the 70’s which, it has to be admitted, is a structural tendency with this paradigm. Galbraith continues as follows:

As tax increases and expenditure cuts would have been highly unpopular, and wage/price controls were unpopular as well (besides going against free market economic orthodoxy) there remained one highly available political course of action: monetary policy and Milton’s Friedman’s monetarism as the new economic orthodoxy.  Monetarism would circumvent the uncomfortable political asymmetry of Keynesian policy.  No tax increases would be necessary nor any curtailment of public expenditure [at least not immediately].  Nor would there be any enlargement of government function; all monetarist policy could be accomplished by the central bank, with only a negligible staff.  For some monetary policy had (and has) another even greater appeal, overlooked among economists: it is not socially neutral.  It operates against inflation by raising interest rates which, in turn, inhibit bank lending and consequent deposit – that is, money – creation.  High interest rates are wholly agreeable to people and institutions that have money to lend and these normally have more money than those who have no money to lend or, with many exceptions, those who borrow money.  In so favouring the individually and institutionally affluent, a restrictive monetary policy is in sharp contrast with a restrictive fiscal policy, which, relying as it does on increased personal and corporate income taxes, adversely affects the rich.  Conservatives in the industrial countries, especially in Britain and the US, have given strong support to monetary policy.  As the 1970’s passed, inflation persisted.  Higher taxes, lower public expenditures, direct intervention on wages and prices, were all ruled out as remedies.  As sufficiently observed, only monetary policy remained.  So in the later part of the decade, by the ostensibly liberal Carter administration in the US and the avowedly conservative government of Margaret Thatcher in the UK, strong monetarist action was initiated.  The Keynesian Revolution was folded in, the age of John Maynard Keynes gave way to the age of Milton Friedman.

The initial results of the new policies were far from reassuring.  Economic expansion was arrested, but wage-price interaction continued.  So did the effect of the OPEC cartel.  Another word was added to the economists’ lexicon, stagflation, which describes a stagnant economy in association with continuing inflation.  In the end, inflation was crushed.  Money is not related to prices through the magic of Fisher’s equation [the quantitative theory of money] but through the high interest rates by which bank lending and deposit creation are controlled.  In the early 80’s interest rates were brought to unprecedented levels in the US : now against double-digit inflation stood double-digit interest rates.  The latter curtailed demand for new housing construction and for automobiles and other credit-supported purchases.  And in 1982 and 1983, they brought a sharp restriction in business investment expenditure.  With this came a large increase in unemployment, to 10.7 % of the civilian labour force in late 1982.  Also the highest rate of small business failures since the 1930’s and severe pressure on farm prices.  Further, the high interest rates brought in a strong flow of foreign funds, which bid up the value of the dollar, curtailed American exports and strongly encouraged imports, especially from Japan.  The overall result was the deepest economic depression since the Great Depression.  But in 1981 and 1982 there came a marked decline in the rate of inflation in the US and by 1984 the Consumer Price Index was nearly stable.  There was a similar, although considerably less dramatic, decrease in the inflation rate under similar monetarist policies in Britain.

Monetarism, or more precisely the restrictive consumer-spending and business-investment effect of high interest rates, had worked, by producing a severe economic slump, a cure no less painful than the condition remedied.  The success of the policy in the US was also the result of a related circumstance: the excessive vulnerability of the modern industrial corporation to a combination of a restrictive monetary policy, the high interest rates through which it operates, and the resulting adverse exchange rates.  These effects were enhanced by a developing corporate senility, with further advantages to foreign competition.  That the unemployment induced by high interest rates would lessen trade union bargaining power was not surprising.  Orthodox economics accepted that unemployment would lower wages and this way achieve full employment.  Not foreseen, however, was the effect on the employing corporation.  In steel, automobile, machinery, mining, airline and other industries the aggregate effect of the policy, including the foreign competition [enhanced by the increased exchange rate], curtailed sales, led to extensive plant idleness and threatened bankruptcy and the cessation of operations.  In this situation unions were forced to negotiate wage and benefit reductions, in an effort to avoid plant or industry shutdown.  It had not previously been realised that strong trade union action required a strong employer position.

This according to Galbraith – but now we need to complete this story.  What Galbraith stops short of saying, is that killing inflation was not really the main objective of the operation, but rather a convenient justification for it: killing the unions was the real objective, and killing the productive economy in the process was collateral damage.  The real target were the unions, employment, and the level of confidence and power that the masses had acquired in 30 years of progressive politics and economics, which threatened the undisturbed rule of the elite.  What has been called a ‘revolt of the elites’ (by Christopher Lasch) is what took place in those years, and the means to achieve a turn around in the balance of power in society, was the neoliberal revolution, of which rising the interest rates was the first firing shot.

We have seen that the Bretton Woods currency union (with its fixed exchange rates) had already been abandoned, following the US default of 1971, but most of the rules and regulations that ensured relatively closed, state managed economies (also known as mixed economies – part capitalist, part ‘socialist’) and in which a regime of financial repression played a fundamental role, were still in place.  We have mentioned how between 1971 and the beginning or the neoliberal revolution there was a period of interregnum in which governance of the world economy was uncertain and countries were making up their policies as they went along this phase of turmoil (not unlike what is happening now, in 2018).  This brings us back to trade imbalances, the other twin problem of the Keynesian paradigm.

Trade imbalances during the ‘interregnum’

Trade imbalances are a fact of life, regardless of the economic regime adopted.  They depend from the fact that trading partners have different economic structures, with different degrees of technological advancement and abilities to keep their prices in check.  Economic development should in theory reduce them but before this happens, they cannot be eliminated, and need to be managed.

Even before the end of the Bretton Woods currency union, the problem of maintaining trade balanced had already manifested itself starting from the late 60’s and early 70’s.  After 1971 the US were no longer able to act as the importer of last resort for its area of influence, and the cooperation between the nations making up this area was seriously weakened, although formally it remained in place.  Eventually the pressure to cooperate was abandoned in 1979, at the G7 summit in Tokyo.  This can be considered another firing shot signalling the start of the neoliberal revolution: from then on there would be no pressure on surplus countries to keep their trade surpluses in check, thus leaving all the burden of adjustment on the weaker countries alone, the ones with the tendency to accumulate trade deficits.

There can be several strategies to keep trade deficits in check, most of them, unfortunately detrimental to the Keynesian paradigm and therefore to the real economy.  Before we get to the strategies, we must clarify how and why trade deficits undermine the ability of a country to pursue expansionary economic policies in order to achieve economic growth and full employment.

This is the mechanism through which trade imbalances hinder Keynesian policies: when a country in order to sustain its economy implements expansive fiscal or monetary policies (increasing government spending, decreasing taxes etc.), its GDP will rise, but pretty soon a collateral effect will start to emerge, imports rising more than exports, resulting in persistent trade deficits, unless its trading partners engage in similar expansionary policies.  The reason for this situation is that imports are closely linked to GDP, they rise in step with GDP growth (because, as people have more money, they tend to spend more, including on foreign goods), while exports are not affected by GDP growth, but in the short to medium term, only rise with the growth of the GDP of trading partners (resulting in them importing more goods).  To sum up, expansive economic policies, leading to higher GDP, will also lead to higher imports not matched by a comparable increase in exports (which are not related to a country’s GDP, but to that of its trading partners), hence the tendency to accumulate trade deficits.

Strategies to keep trade deficits in check:

currency devaluation – A possible remedy for this problem that a country can adopt is letting its currency devalue, hoping that, by making its products cheaper for foreign buyers and its imports more expensive for domestic consumers, the country in question would experience a reduction in imports and an increase in exports, thus re-balancing trade.  Apart from encountering the opposition of trade partners (often resulting in what is known as currency wars), this policy has the disadvantage of making imported goods more expensive (this is called in economic jargon ‘deterioration of the terms of trade’ of a country), thus lowering the internal standards of living and also potentially leading to higher inflation.  It is a double edged sword, it all depends on which effect will prevail, the import substitution/export increase, or the increase in the costs of necessary imports, leading to higher inflation and to even less competitive exports. The net effect will depend on the industrial structure of the country in question.  A country that practiced this policy of currency devaluation with a passable amount of success before the advent of the Euro was Italy.  In that particular context (Europe in the last part of the 20th century), this can be considered a defensive policy for all practical purposes, as the main problem in Europe in the 70’s (and later on as well) was represented by Germany’s insistence on practicing restrictive economic policies in order to keep its production costs in check and acquire growing trade surpluses.

Protectionism – another remedy is to limit the amount of goods imported by means of tariffs and quotas.  This strategy was attempted by the UK, as we will see later.  This method is frowned upon by mainstream commentators and it is not ideal, but it does have its merits if a country wants to protect its standards of living and retain strategic industries (or grow new ones), and better alternatives are not available.

So far we have talked about the remedies compatible with maintaining a Keynesian paradigm – now we must get to the incompatible ones:

increase interest rates in order to attract enough capital (= get into debt) to finance  trade deficits.  This is a bad remedy because it tends to further weaken the economy of an already non very competitive country, by making more expensive borrowing the money necessary to upgrade its industrial capacity, an indispensable measure to recover competitiveness and avoid further trade deficits.  This situation over time could give rise to a vicious cycle of ever decreasing competitiveness (due to lagging behind in the technological race caused by the excessive costs of borrowing) bankruptcies, de-industrialisation, with consequent concentration of production in the stronger countries, and ever increasing foreign debt for the weaker ones.  Therefore a country whose government has not been captured by foreign interests would tend to avoid this strategy.  And the easiest thing to do is:

limiting government spending (otherwise known as ‘austerity’) in order to keep trade deficits in check– that is, renouncing or at least putting serious limits on Keynesian policies.  This is the default option for countries unable to upgrade their industrial structure and thus avoid trade deficits: in absence of international cooperation if the leading countries adopt restrictive policies, the weaker ones are obliged to follow suit.

All of the above are ‘solitary’ strategies, but there are also ‘collective’ strategies.  For example a group of countries can have an agreement to pursue expansive policies together.  In that case the burden would fall mainly on the stronger countries to recycle their surplus money in expansive policies, thus helping the balance of payments of their weaker partners.  If this agreement is structured enough it becomes a monetary system, such as the Bretton Woods one.  Unfortunately agreements of this type don’t tend to happen very often.

More often than not currency unions (more or less structured) tend to pursue restrictive policies, although they may not declare it explicitly.  This is the pattern that took place in Western Europe in the wake of the 1971 events.  Over the years the countries making up the European Community tied their currencies into a succession of monetary agreements prescribing somewhat fixed exchange rates, within more or less narrow oscillations bands.  These unions all failed at some point, due mainly to German unwillingness to pursue expansive policies, resulting in the necessity for its trading partners to devalue (thus breaking the agreement), or risk chocking their economies with the austerity necessary to maintain their exchange rates within the agreed oscillation bands.  What would happen is that at some point the weaker countries would have to break out of the established oscillation bands and devalue.  The oscillation bands would then be re-adjusted several times over the course of the years until eventually the currency union was abandoned, and then at some point replaced with a new one.  In the end these currency unions turned out to be an optimum instrument (from the point of view of the ruling classes) to force a diverse range of countries to all follow the same restrictive policies, given Germany’s tendency towards mercantilism (= containment of government spending to keep its prices in check and thus keep its competitive edge in the international markets).

Eventually the European Community countries tied themselves up with the single currency (the Euro) – this was part of the new economic order, the neoliberal paradigm which solves the problem of trade deficits by pegging exchange rates of weaker countries to those of a stronger one, de-regulating financial markets, flooding the weaker countries with easy money, and then giving rise to a boom bust cycle.

Having listed the main options available, let’s now see the actual strategies adopted during the period of ‘interregnum’ between 1971 and the start of the neoliberal paradigm. This is how things actually played out in Europe in the 70’s and 80’s as told by Sergio Cesaratto in his book Six lessons of Economics).

Trade deficits leading to the dismissal of the Keynesian paradigm – Cesaratto’s story

While Italy was more or less coping in the face of Germany’s mercantilist policies by means of frequent currency devaluations (which caused inflation but in the end managed to retain a solid industrial base in the country), both the UK in the mid 70’s and France in the early 80’s tried their own strategies without success.  The first to try was the UK under the Wilson labour government, which came up with a series of measures, known as the Alternative Economic Strategy (AES) put forward by Tony Benn, Industry Secretary between 1974-76.  Against the opposition of the labour right, Tony Benn was determined to sustain British manufacturing and the British economy in that moment of acute crisis (this is the time of stagflation following the oil shocks of 1973-74) by means of expansionary economic policies.  To cope with the adverse effects of these policies on the balance of payments, the AES contemplated both controls on capital movements and a range of protectionist measures, of which the main one was tight controls on imports (incidentally, it also advocated exiting the European Community -the antecedent of the EU- to avoid its ban on industrial policy, considered an obstacle to market competition).  Presumably the economists who had devised the AES estimated that the flexibility of the exchange rate would not be sufficient to rebalance trade in presence of expansive fiscal policies, and that, in addition, a depreciation of the pound might lead to higher inflation, with negative effects on the purchasing power of salaries, internal demand, and popular consent for the labour government. This was also the opinion of Nicholas Kaldor (1908-1986), the most prestigious left wing economist of those times, who over time had become sceptical of the effects of currency devaluation.

The idea behind import controls is very simple:  if a country decides to adopt loose monetary and fiscal policies in order to sustain its economy, we know from economic theory as well as past experience that this will result in increased imports and balance of payments problems.  In order to avoid these problems, the country in question can resort to limiting its imports to the levels existing before the adoption of expansive measures.  This is a defensive policy, as it prevents trading partners from taking advantage of those expansive policies that they themselves are unwilling to practice.  It prevents them from taking a free ride and it is aimed at keeping the money spent by the government in question within its own borders, to sustain the employment and living standards of its own citizens. Obviously a better solution would be that its trading partners adopted the same policies, with mutual benefits and no necessity of import restrictions.  There was an ongoing debate within the left, back in those times, regarding how to get other countries on board, by appealing to the spirit of international solidarity that all left-wing governments should in theory have displayed. But short of having to wait forever (not unlike having to wait for the Revolution and the demise of capitalism), limiting imports was thought to be a practical and quick solution by the Labour government of the time.  Such a policy, while not being a champion of international solidarity, doesn’t do any harm to trading partners either, because it doesn’t reduce imports, it only keeps them constant.  In addition, without import controls after a while it would be necessary to reverse the expansive policies just adopted anyway, in order to rebalance trade, and the benefit to the trading partners would be lost in any case.  Bob Rowthorn (a prominent left wing Cambridge University economist) defended the AES and its national character on the ground that ‘common sense, justice, and the welfare of our citizens, cannot wait until progressive governments will be in power in all our neighbouring countries.  The economic crisis affecting millions of British citizens is upon us, if the left is to remain in power, it needs to adopt policies that will give people some hope here and now, rather than waiting for an improbable socialist revolution.  Hoping for a radical solution in the distant future can only demoralise the workers who are not offered anything in the present.’  However, the AES was short lived.  Under pressure both from national and international capitalists, as well as from the right wing of its own party, the Wilson government caved in. Having incurred into the predictable balance of payments problems, in 1976 the Wilson government decided against the protectionist measures of the AES and opted instead for restrictive fiscal measures coupled with an IMF loan. After a few years Margaret Thatcher was elected and the rest is history.

At the same time that Margaret Thatcher started to put in place the neoliberal economic paradigm, Francois Mitterrand tried in France the same road previously undertaken by Wilson in the UK.  Mitterrand won the election on a very advanced program of nationalisations, redistribution of income in favour of workers and support of aggregate demand by means of expansive policies: it was a Keynesian program bordering on socialism.  However, lack of co-operation from Germany, intent on pursuing its usual restrictive policies, ended the experiment.  Germany had a brief Keynesian season in 1978-79 upon American insistence.  The theory behind this insistence on the part of the Americans was that the three major economies of the world at that time (the US, Germany and Japan) should all three function as traction engines for the world economy, keeping global aggregate demand high, rather than leaving this task only the major partner, the US.  However in 1979, following a second major oil shock (due to the Iranian Revolution) there was another inflationary spike and the German elite decided to resume its restrictive policies and never again indulge in expansive ones.  This sealed the fate of the Mitterrand experiment: the inescapable balance of payments problems emerged in France soon afterwards and Mitterrand did an about turn, implemented restrictive policies (the so called ‘rigueur’) in order to remain within the European Monetary System (EMS – the antecedent of the Euro), thus ruling out currency devaluation as well, and never again ventured to contradict the course of action decided by Germany 

Solutions to the twin problems of inflation and trade imbalances

At this point the obvious question to answer is what would ideally have been the solutions for the twin problems so far illustrated.  From what has been said so far, it is not difficult to pinpoint some progressive and labour friendly solutions to the twin problems of inflation and trade deficits impairing the Keynesian economic paradigm.  Regarding inflation, as suggested by Galbraith:  higher taxation (presumably of the progressive type), lower government expenditure (presumably reducing military rather than social expenditures) along with a concerted effort on the part of unions and corporations to keep both wage and price rises in check.  Basically what is needed is the political management of the labour-capital conflict, rather than repressing labour by repressing production, a cure that kills the patient.  We also need to keep in mind that for the productive economy a moderate rate of inflation is not a problem, it is actually beneficial as it makes more likely that production costs (incurred by businesses at the beginning of their production cycles) will be lower than sales revenues, thus ensuring at the very least nominal profit margins for most firms, resulting in a healthy financial situation which allows the continuation of their activity.  Inflation is also good for government debt (and for private debt), as it enables its reduction (in real terms) when interest rates are kept below the rate of inflation.  What inflation is not beneficial for is the financial economy, as it results in the erosion of financial returns unless interest rates are kept above inflation.  Here becomes useful, in order to understand the political rationale behind neoliberal policies, to go back to the division of society in three major classes, as highlighted by the classical economists:  a) industrial capitalists, b) labourers (both of them constituting the productive economy) and c) rentiers, that is, landlords and financial capitalists.  Curbing inflation is more in the interest of the rentiers than of the productive economy.  Therefore the obsession with inflation that informed the policies of all central banks starting from the 80’s is in large part a political choice, as it serves the interests of the unproductive classes.

For what concerns the balance of payments problems the ideal solution would be concerted economic policies involving all the major trading partners in any relevant group of closely connected countries.  This way in presence of expansive policies incomes and imports of the countries involved would rise in step, as each country would be buying (importing) more, but would also be selling (exporting) more, thus maintaining equilibrium at an optimally high level of economic activity, rather than engaging in the well known race to the bottom.  In absence of such an agreement (or in absence of a strong hegemonic power in control of the international monetary system, and thus able to rebalance trade by creating money and acting as the buyer of last resort, as the US was more or less able to do even with the neoliberal paradigm, up until the crash of 2008) then a country that still wanted to pursue progressive policies needs to consider some form of protectionism:  first and foremost exchange rate policy, then import controls via tariffs and quotas.

All the above measures indicated to solve the twin problems apply to the short/medium term.  In the long term there is an additional and more powerful, but also more difficult solution: upgrading the industrial base of a country by investing in technologies that raise productivity (thus enabling businesses to raise wages without raising prices and still make a profit) and competitiveness in international trade (thus enabling a country to pursue expansive policies without incurring in trade deficits).  In the end, looking at the problem from an historical perspective, improvements in technology are what enabled us to enjoy higher and higher standards of living.  The purpose of monetary and fiscal policy should be, first and foremost, to create the conditions that enable the productive economy to function, and by functioning well the productive economy (which includes also state enterprises) can come up with better and better technologies that make possible higher standards of living.  However, once wealth has been produced by the real economy, monetary and fiscal policies also play a major role in the distribution of it, which is just as important as production to determine our standards of living.  In the short term redistributive policies are the only ones available – therefore in the short term, in which we take the industrial structure of a country as a given, the policies above mentioned (wage/price agreements, international agreements, currency devaluations, protectionism, etc.) are pretty much all that is available to contrast the problems arising from the Keynesian paradigm.  The conclusion therefore is that a high degree of government intervention in the economy (both with anti-cyclical measures and industrial policy measures) as well as political management of the conflict between capital and labour, as well as good geopolitical governance is needed for the Keynesian paradigm to succeed.  This links us back to the fact that the problems with the Keynesian paradigm are ultimately political (and geopolitical) in nature.  Therefore technical solutions (such as increased productivity) can alleviate the problem, but they can never eliminate the necessity for a fully political management of the system.   Not only this, but productivity increases are themselves the product of industrial policy, which comes as a result of political decisions.  On the other hand, the alternative neoliberal paradigm is indeed able to eliminate a lot of political mediation and negotiation, but it does so by waging a covert war against society (with austerity and de-localisations) as well as against weaker countries (with unsustainable debt and the ensuing IMF structural adjustment programs).  However, even from the point of view of the ruling elite, this is only a temporary solution, as eventually neoliberalism is bound to hit the wall of financial collapse, general impoverishment and loss of an adequate industrial structure.   At that point politics, suppressed for many years, comes back again to the forefront with a vengeance, as the dispossessed classes and dispossessed nations raise their heads again, and not necessarily in a pretty (left wing) manner.  But before we get to this terminal stage of neoliberalism, we must see how the paradigm shift was implemented, starting in the leading countries, the US and the UK, and then slowly applied to all countries within their hegemonic reach.  We have already mentioned many of the steps that were taken to terminate the Keynesian economic paradigm, now we must put together the picture of the transition. 

The neoliberal paradigm as the ideal solution for the ruling elite

What was done in order to fix the twin problems of inflation and trade imbalances? Far from engaging in painstaking political mediation to keep those problems at bay, a sort of economic ‘coup d’etat’ was pulled off by the ruling elite, in order a) to maintain American hegemony in the face of waning economic advantage and b) to reverse the balance of power in society in favour of the One Percent (the rentier class).  This coup d’etat has become known as neoliberalism.

We have seen that there was a period of interregnum after the dollar default of 1971, marked by the return to floating exchange rates, the petrodollar agreement, rising inflation, then stagflation and the various strategies adopted in Europe.  In 1979 we have the first firing shots of the neoliberal revolution in the USA, at the hand of the new chairman of the Fed Paul Volcker, who dramatically stepped up interest rates (which had already been rising constantly during the 70’s) to 11% 1979.  In the words of Wikipedia:

US inflation, which peaked at 14.8 percent in March 1980, fell below 3 percent by 1983.[13][14] The Federal Reserve board led by Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. The prime rate rose to 21.5% in 1981 as well, which helped lead to the 1980–1982 recession,[15] in which the national unemployment rate rose to over 10%. Volcker’s Federal Reserve board elicited the strongest political attacks and most widespread protests in the history of the Federal Reserve.  [This abrupt hiking of interest rates became known as the Volcker Shock].

With the election of British Prime minister Margaret Thatcher in 1979 and US president Ronal Reagan in 1980, the US and UK proceeded with a raft of measures to reform the rules of the international monetary system, most notably by deregulating capital movements and abolishing solidarity in international trade, that is, the principle that trade surplus countries were responsible as much as trade deficit countries to keep trade balanced, and should keep their trade surpluses in check.  From then on each country would be let substantially free to pursue only its own narrow self interest, and the adjustment of the balance of payments caused by trade deficits would be left only to market forces: exchange rates which had now become flexible, and capital movements which started to be ever more de-regulated (a long process that took many years, culminating with the repeal of the Glass Steagall Act in 1999).  Another fundamental measure for the establishment of the neoliberal regime were legislative measure passed in many countries to establish the independence of the central banks from government policy – that is, central banks were no longer obliged to finance government spending and keep interest rates low.  From then on if governments wanted to pass expansive measures, they had to finance themselves on the financial markets.  This enabled a slow but sure transfer of wealth from public hands into private hands, and from the middle classes to the upper classes that has never been reversed.

All the measure we mentioned (which were passed at different stages in different countries, in Third World ones enforced by the IMF as a result of financial crises, in Europe as a result of adopting the single currency etc.) contributed to putting in place mechanisms that allowed to privatise and financialise most of the wealth accumulated in the previous golden years.  This is very briefly how neoliberalism, as a means of sucking wealth towards a small elite, actually worked:

As noted, the first move towards the neoliberal economic paradigm consisted of a series of interest rate hikes (the Volcker shock) that took them above the rate of inflation thus producing very attractive rewards for financial capital.  This resulted in a shift of investments from productive activities into financial ones, with consequent gradual dismissal of productive activities and increase in unemployment.  This is what happened as a result the measures above described:

  • Interest rates were increased and finance de-regulated, enabling cross-border capital mobility and thus the de-localisation of production, with consequent trade deficits and the necessity to attract capital from abroad
  • Delocalised production in turn has led to structural unemployment, the collapse of union bargaining power, lower wages and higher profit rates
  • In turn, higher profits contributed to attracting more capital to the stock markets, allowing this game to continue for a long time
  • The diminished purchasing power in the real economy due to lower wages was made up for by means of easy credit that kept a reasonable (and at times even high) level of economic activity. Credit resulted in asset price bubbles.
  • One aspect didn’t change: the hegemonic power, the US, remained committed to maintaining the conditions for generalised growth of the world economy, in part by recycling the trade surpluses of its partner countries flowing in abundance into its financial system, in part by creating money (mainly in the form of credit). The difference with the previous paradigm is that the credit was mainly for consumption, there was no increase in productive capacity but actually its opposite, de-industrialisation.  Obviously in the long term this was a recipe for disaster.

The main feature of the neoliberal economic paradigm is that it is based on consumption not supported by an adequate level of production.  It results in persistent trade deficits with the consequent necessity to attract foreign capitals with good returns in order to pay for imports.  The returns are generated at the expenses of the real economy and of the previously accumulated wealth (by means of privatisations, asset stripping, consumer debt).  It was quite obvious, and it didn’t need economists of the stature of Kalecki, to predict that over time this economic paradigm would hit a big WALL by loading up the economy with unsustainable debt (and thus putting it on the perennial brink of financial collapse) and depleting existing productive capacity and infrastructure, that is, the means to create wealth in the real economy out of which to repay the debts and to sustain high standards of living.  It also contributed to diminishing the military might which backs up the current order at the international level, besides creating the conditions for the emergence of an insidious rival:  the People’s Republic of China, along with various other emerging rivals (the BRICS).

We have seen that high inflation was a pretext (and it was not even due, at least in part, to Keynesian economics, but to the 1971 default and the ensuing oil shocks).  The real reason for the interest rate hikes and for shifting to the neoliberal paradigm was political: a) to maintain American hegemony by attracting huge amounts of capital to Wall Street and the City, thus retaining control of the global economy by controlling global financial flows, and b) to reduce the power of the lower classes by making their lives poorer and more precarious.

The neoliberal paradigm remedied the flaws of the Keynesian one by concentrating production in countries with lower costs, concentrating power in the hands of central banks at the expense of elected governments and relegating workers to a marginal role in society.  These measures decreased wages and thus inflation (the first flaw), and actually increased trade deficits (the second flaw) rather than reducing them, but hid the problem by re-directing sustained financial flows towards the deficit countries for as long as they could guarantee good returns, which were produced ultimately out of the wealth previously accumulated thanks to thirty years of sustained growth under the Keynesian paradigm. Neoliberalism was implemented in the UK and US first, while the rest of Europe held up a bit longer before joining this mad self-destructive course.  The mechanism used to force neoliberalism on the reluctant European workers was to tie up Western European countries to the restrictive policies practiced by Germany ever more tightly over time, by means of various monetary unions: first the ‘currency snake’, then the already mentioned EMS, then finally the Euro.  This is a brief description of this sequence of monetary unions taken from Wikipedia:

After the demise of the Bretton Woods system in 1971, most of the EEC countries agreed in 1972 to maintain stable exchange rates by preventing exchange rate fluctuations of more than 2.25% (the European “currency snake“). In March 1979, this system was replaced by the European Monetary System, and the European Currency Unit (ECU) was defined.

The basic elements of the arrangement were:

  1. The ECU: With this arrangement, member currencies agreed to keep their foreign exchange rates within agreed bands with a narrow band of +/− 2.25% and a wide band of +/− 6%.
  2. AnExchange Rate Mechanism (ERM)
  3. An extension of European credit facilities.
  4. TheEuropean Monetary Cooperation Fund: created in October 1972, allocated ECUs to members’ central banks in exchange for gold and US dollar deposits.

Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank soon emerged as the centre of the EMS. Because of its relative strength, and the low-inflation policies of the bank, all other currencies were forced to follow its lead if they wanted to stay inside the system. Eventually, this situation led to dissatisfaction in most countries, and was one of the primary forces behind the drive to a monetary union (ultimately the euro).

Periodic adjustments raised the values of strong currencies and lowered those of weaker ones, but after 1986 changes in national interest rates were used to keep the currencies within a narrow range. In the early 1990s the European Monetary System was strained by the differing economic policies and conditions of its members, especially the newly reunified Germany, and Britain (which had initially declined to join and only did so in 1990) permanently withdrew from the system in September 1992. Speculative attacks on the French Franc during the following year led to the so-called Brussels Compromise in August 1993 which established a new fluctuation band of +15%. [Wikipedia]

Then in 1997 exchange rates were locked again, this time for good, in preparation for the single currency, and restrictive economic policies were implemented across the board to facilitate an improbable convergence of exchange rates.  The Euro finally replaced individual currencies in February 2002, and the decision was saluted by the media as a cosmopolitan and progressive move. Nobody warned these very unwise Western European governments that by giving up their currencies they were depriving themselves of the most basic instrument they had to protect their industries.  This resulted in loss of industrial capacity in favour of the most competitive country, Germany, and the accumulation of unsustainable foreign debt in the banking systems of the other member states, in the form of consumer debt and mortgages, eventually converted into public debt after the well known bank bail outs following the 2008 financial crash.

The overall result of 40 years of neoliberalism was to concentrate production in the most competitive countries that could reach the lowest costs (Germany, Japan, the East Asian tigers and eventually China) either by practicing restrictive (also called deflationary or mercantilist) policies or by simply being at a lower level of development (and therefore having structurally lower wages).  The result was that everybody else was forced to do the same just to stay in business: compressing government spending, environmental and safety standards, and most notably salaries in order to lower production costs.  However, as not everybody can win the race to the bottom, eventually the result was de-industrialisation, increased debt and impending bankruptcy.  The US, the UK and other English speaking countries (Canada, Australia, New Zealand) avoided outright bankruptcy because of their privileged status in the financial markets, i.e., their ability to issue debt instruments denominated in their own currencies.  But they are constantly on the brink of another major financial collapse that could not, this time around, be covered up by another bail out, with the consequent money creation that would destroy the credibility of their currencies, especially in presence of an alternative in the form of a gold backed Yuan. The temporary solution to impending (or actual) bankruptcy is austerity, a medicine that kills the patient.  In reality, the only way out of this conundrum is by keeping productive capacity evenly spread out in all countries by sustaining national industries with a combination of agreements, flexible exchange rates, import controls and, most crucial, industrial policy.  This is the only way for a country to live within its means and, if it can manage to upgrade its industrial capacity, to ensure rising standards of living to its citizens without getting into debt.

The political conditions for resuming a virtuous economic path

Having established that the only sustainable way forward consists in going back to a revised Keynesian paradigm, which takes into account the problems faced in the 70’s and, with hindsight, takes on board all possible remedial actions in order to make things work, we now need to understand if there is any chance, given the current political and geopolitical situation, that this shift could happen.  This takes us back to the original question of if and how a geopolitical realignment could come about and, with it, its fall-out in political and economic terms.  Initially we made a comparison with 1944, now we need to expand the analysis to include also a comparison with 1974 (the year of the petrodollar agreement), or rather with the 70’s in general, when the elite was able to fold in the Keynesian revolution and operate its ‘revolt’ by cannily and boldly exploiting the favourable economic (high inflation and high amounts of wealth) and geopolitical (fall of the Soviet Union) conditions existing at the time.  The question we are trying to answer with these comparisons is: now that the economic, political and geopolitical landscape is changing fast, do the masses stand a chance to operate, in turn, their own revolt?

Comparison with the 70’s

It is easy to see, if we compare the present economic situation with the situation in the 70’s, when the Keynesian paradigm came into trouble, that we are at the opposite ends of the economic spectrum.  Back then, after thirty years of pursuing full employment as the major objective of economic policy, we had: sustained inflation, labour share of GDP at an all time high, corporate profit rates at an all time low, strong unions, low inequality, relatively closed/national markets, weak finance, weak central banks doing essentially the Treasury’s bidding, and strong parliaments commanding the game.  Neoliberalism took advantage of this economically favourable condition, prospered in large part off the wealth previously accumulated, and by doing so, over time turned the situation around.  Now, after nearly forty years of neo-liberalism, we have systemic deflation rather than inflation, despite all the money created by central banks after 2008 to sustain the financial system. Capital share of national income or GDP is at an all time high, wage share at an all time low, unions are weak everywhere, inequality is high, markets have been globalised, finance is strong, central banks strong, parliaments weak.  We have built the exact opposite regime.  It’s as if the Reagan and Thatcher revolution, just as the Keynesian one before, had become too successful.  Both revolutions carried within themselves the seeds of their own destruction. By being too successful the neoliberal paradigm has reached the end of its useful life and has created the conditions of its own demise.  Uncannily, neoliberalism has taken us back to a situation similar to the 1930’s, when the liberal system had itself stalled.  As we know the situation was eventually resolved with a war, the consequent geopolitical realignment, and a change of economic paradigm.   So let’s go back to the comparison with 1944, which takes into account both the economic situation (the role of economic necessity in shaping what political forces can or can’t do), and the geopolitical one (the role of a new hegemonic arrangement).  Squeezed in between these two factors, is the possibility of a political shift, within each country, that we need to assess whether or not has a chance of taking place.

Comparison with 1944

As previously stated, the present conditions resemble a lot the situation in 1944:

the presence of two rival blocks, an expanding world economy promoted by China (back then by the US), the neoliberal (back then the liberal) economic theories discredited, the economy stalled (=in need of reconstruction after the neoliberal war on the real economy), the presence of high debts (back then war debts), the necessity to rebalance income distribution and restart the economy, the depletion of our economic infrastructure and the necessity to rebuild it.  All these are similar conditions.  There are, however, two main differences: a) in 1944 the new hegemonic power, the US, was able to devise and implement a new international monetary system revolving around its hegemony (and the dollar standard) but kept together also by virtue of solidarity and cooperation between the countries composing the western block.  At the moment there is no well functioning international system of governance in place, as the existing one (still based on the Bretton Woods institutions operating now under remits transformed by the neoliberal revolution) is in disarray and the rival one is still in the making. b) Another main difference is that back in 1944 people’s power was alive and well, with strong unions and political parties, generally high levels of militancy, and the presence of the Soviet Union (and communist China) that emboldened the left and workers in general.  Nowadays unions and militancy are very weak, but the empowerment of the masses could come from the resurgence of a rival block constituting an alternative pole of attraction and from sheer economic hardship that, by giving rise to seething discontent, tends to coagulate political opposition around the so called populist parties.  There is a basic fact of life blowing the wind in the sails of these populist formations: the neoliberal paradigm has stalled and the economy must be re-started.  And it cannot be restarted without at least some redistribution of wealth.  This is a brief summary of the comparative conditions (1944 vs current situation) described so far:

Two rival bocks Second block in formation
US promoting expansion of the world economy China promoting expansion of the world economy
Economy stalled in the 1930’s + war destruction & necessity to rebuild & restart Economy stalled in 2008, necessity to restart + necessity to upgrade economic infrastructure
Liberal economics failed & discredited Neoliberal economics failed & discredited
High public debt (war debt) High private & public (bail out) debt
Formal monetary system/institutional architecture promoting cooperation Current system in disarray – rival system still in formation
Strong left wing parties, unions, militancy from below Weak unions and parties, low militancy but high dissatisfaction giving rise to populism


By making these two comparisons (with the 70’s and with the 40’s) we established that the conditions for the Keynesian paradigm were ripe in 1944 after decades of war and depression; conversely, in the 70’s, after thirty years of prosperity, rising wages and rising inflation under the Keynesian paradigm – and in coincidence with the collapse of the USSR – the conditions were favourable for a revolt of the elite.  Now after thirty odd years of neoliberal economics in some ways we are back to the post WWII situation with economic devastation, unemployment, poverty and…..the rise of a rival block and of political opposition in the form of ‘populism’.  The conditions are ripe again for a change of economic paradigm.  In addition, the intention of China to create an alternative trading circuit and to engage in a massive infrastructure-led development drive, promises to facilitate the possibility of having a couple of decades of growth without serious inflation and without serious balance of payments constraints, not unlike the couple of decades of the post WWII reconstruction and growth, driven by American expansive policies.  These are perfect conditions for the resumption of a 21st century version of the old Keynesian paradigm, but obviously this cannot happen until we leave the old geopolitical arrangements and embrace the new ones.

Of course the ruling elite is putting formidable obstacles along the way (disinformation and manipulation, cold war, terrorism etc.), in a bid to delay and possibly reverse the shift to a new world order that is taking place.  But one major obstacle may be endogenous to our society, as there is understandably a sort of psychological block connected with throwing away the reassuring old allegiances and the familiar old world, and finally jumping the gun to enter an uncertain new world order yet to be made.  This reluctance is understandably much stronger for the people who still have a fairly comfortable life, while is much weaker (or even non existent) among the growing layers of society whose wealth and security (as well as identity and culture) have been going down the drain for a long time.

In social terms, we could say that the crucial thing that needs to happen in order to facilitate this jump into the unknown will be the political re-positioning of the top 10 or so percent of the population (excluding the top 0.1%, the transnational elite at the very tip of the social pyramid).  Back in the 70’s this top echelon of society, which is crucial within the context of national politics (as its political weight is obviously much higher than its numerical weight) joined sides with the transnational elite, the ‘One Percent’ (or more precisely 0.1%) thinking that wage repression and working class repression would be in their interest as well.  However, as the One Percent is now losing its (very modest) bid to control the whole world, and as austerity (necessary to maintain monetary hegemony while trying to turn things around) is devastating the economies of the West, the situation has radically changed.  The economic pie is shrinking in the West and this, along with the necessity to further squeeze the workers, entails also the necessity to cannibalise the top ‘Ten Percent’, the echelon just below the transnational elite.  This is a process that is well under way in the weaker countries, but has started to bite also in the stronger ones.  The bottom line is that, while in the 70’s the interest of the top Ten Percent was aligned with that of the One Percent, so that they cheered the neoliberal paradigm, now their interest is becoming ever more aligned with that of the bottom Ninety Percent.   They have discovered that killing the national economy in order to subdue the workers is like cutting the branch they are sitting on.  They have no choice but to favour the coming back of a national economy, with all the burdensome political compromises and reluctant recognition of the role of the workers in society that this entails.  Under the ideological banner of national identity, faith, tradition and family values (frowned upon by the left but complementary, at bottom, to the centrality of the state – both as economic and geo-political actor – that needs to be re-affirmed) they will probably take the lead within the growing populist movements and, riding the tide of popular anger, will make a strong bid to take back state power in country after country.  It remains to be seen how successful they will be, once taken back the levers of economic management, in re-building the national economies, and this way escaping stagnation and insecurity.  One sure way to facilitate economic reconstruction will be by doing business with that part of the world that promises to grow fast, hence the geopolitical shift, even when not planned or desired by these political formations, will be pretty much inevitable.  We now must turn to analysing what is needed to succeed in the brave new world soon to come, which is in many ways similar to the past, as we have seen, but in other no less important ways also very different and much more difficult, with fewer empty spaces to conquer (except for what concerns the frontiers of knowledge) and much more competition to contend with.  We will talk about this in the next paper.

Go to 4 – The Neoliberal Paradigm