Who Saw it Coming? Wynne Godley.

As we all know, the Queen of England asked her economists why none of them saw “it” (the global financial collapse) coming. In fact, as I have argued, many did see it coming: some economists, some policy-makers, and everyone on Wall Street—who not only saw it coming, but made it happen. Really, it was only the clueless mainstream economists, media pundits, and Alan Greenspan who never saw it coming.

Those of us working at the Levy Institute (www.levy.org) began warning of “unsustainable” domestic private sector borrowing in the late 1990s. We actually thought “it” would happen much sooner—and when the dot-com bubble collapsed and the economy went into recession, we thought the end was near. Admittedly, we called “it” too soon—as households resumed their debt-fueled spending spree (aided and abetted by Wall Street's real estate bubble), the economy recovered. We were surprised, but we continued to warn that the economy was on an unsustainable path. I believe that the crisis that began in 2007 really did result from those processes that we identified back during the Clinton years. In many other pieces, I have located the beginnings of the crisis even further back—to a transformation of the financial sector that began in the 1950s. That work followed Hyman Minsky's approach, which argued that a new, financially fragile, form of capitalism was taking over—what he called money manager capitalism. It was designed to fail. Still, that analysis was in some sense too general to project exactly when the failure would take place.

The other intellectual giant we had at the Levy Institute was Wynne Godley. It actually was his work that was so important to our analyses from 1996 (the year that Minsky died). All of us at Levy used his approach in many publications we wrote that I think did see “it” coming.

In what follows I will present a very brief summary of the main points that Wynne and I made in a Levy Policy Note (PPN99/4) published in 1999. The following passages are word-for-word from that publication. We identified the unsustainable processes that would kill Clinton's “Goldilocks” economy (neither too hot nor too cold—growing just right until it collapsed). I think that analysis holds up well. After the excerpt from that 1999 piece, I will provide an ex ante assessment.

Can Goldilocks Be Sustained? From Godley and Wray PPN99/4 (1999)

Recent economic statistics confirm that our Goldilocks economy continues to grow at a relatively swift pace, in spite of financial turmoil in Asia, Latin America, and Russia and economic recession in a third of the world. The longevity of the expansion is record- setting; it is already the longest peacetime expansion in U.S. history and is about to break the record set by the 1960s Vietnam-era expansion. The expansion's longevity and its strength have tightened labor markets, allowing unemployment rates to remain below 4.5 percent for the past year and raising real wages at a good clip for the first time in a generation.

Perhaps the most potent symbol of the strength of the expansion has been the remarkable turnabout of the federal government's budget, from a chronically large deficit to a substantial surplus. One has to go all the way back to the demilitarization of the economy after World War II to find a comparable shift in the fiscal stance.

By most accounts, the surplus will continue indefinitely. The Congressional Budget Office (CBO) is projecting a rise in the federal budget surplus through the next 10 years from 1.2 percent of GDP for 1999 to 2.8 percent for 2009. Such projections are, of course, contingent on continued economic growth and unchanged budget policies. What we wish to do here is to take the CBO's projections (which are not substantially different from those used by the administration) at face value and determine what they mean for the private sector. As we will explain, government budget surpluses imply that the private sector must have an offsetting deficit.

The financial situation of the domestic private sector is made worse because of the United States's international payments imbalance. Indeed, it is becoming widely recognized that there are two black spots that blemish the appearance of our Goldilocks economy: low household saving (which actually has fallen to zero) and the burgeoning trade deficit. However, commentators have not yet discovered the links between public sector surpluses, domestic private sector deficits, and international current account deficits. Once these are understood, it will become clear that Goldilocks is doomed.

Let us begin with an analysis of the fiscal stance. While most discussion focuses solely on the federal government budget, we prefer to include the state and local government budgets, which show substantial surpluses. This consolidated government balance provides a more accurate assessment of the impact that the overall government budget has on the economy. We also consolidate households and firms for the purposes of our analysis. When the consolidated government balance is negative (i.e., in deficit), the public sector's expenditures exceed its revenues. Ignoring for a moment the foreign sector, this must mean that the private sector's income exceeds its spending, with the difference equal to its net acquisition of government debt.

On the other hand, when the consolidated government balance is positive (i.e., in surplus), the public sector's revenues exceed its expenditures, leading to the retirement of public debt. In this case, the private sector must be in deficit, with income less than spending. The private sector deficit will equal the public sector surplus, and this shows up on balance sheets as a reduction of private sector wealth by an amount equal to the retirement of outstanding public sector debt.
Thus no one should be surprised that as the federal budget moved to surplus last year, American saving rates fell to zero. While it is possible for household saving to be positive when the public sector runs a surplus, this can happen only when firms run large enough deficits to offset the combined government and household surpluses. As it happens, the business sector as a whole is not in deficit, so the private sector's deficit is entirely due to household expenditures that greatly exceed incomes. …

In recent years, the U.S. trade balance has become increasingly negative. When combined with fiscal restriction, this must be associated with a private sector deficit. …

One might then ask, if the fiscal and trade stances are so restrictive, how can Goldilocks appear so robust? The answer is suggested by our accounting identity: the private sector is running a record deficit. Since the end of 1991 private expenditure has persistently risen more than income; indeed, the private sector deficit of the past three years is entirely unlike any that has occurred before. Today, the private sector deficit is 4.5 percent of GDP, with the consolidated government surplus equal to 2 percent of GDP and the balance of payments deficit equal to 2.5 percent of GDP. (The sum of the government and trade balances, of course, equals the private sector deficit.) Before 1992 a private sector deficit was rare, never persisted for more than 18 months, and never exceeded much more than 1 percent of GDP. We are thus in uncharted territory, with a private sector deficit that is (relative to GDP) nearly five times greater than ever before and has already persisted twice as long as any deficit in the past.

If we take the CBO forecasts of a GDP growth rate of 2.0 to 2.4 percent per year indefinitely and an increasing government budget surplus over the next decade and then make reasonable assumptions about the continued deterioration of the U.S. trade account, this implies that the private sector deficit must continue to worsen. In order to validate the CBO's projections, the private sector deficit would have to rise, by our reckoning, to about 8 percent of GDP.

Continued economic expansion in the presence of unprecedented fiscal restriction is possible only if the private sector increases spending faster than its income grows. The balance sheet implication is that private sector borrowing must also grow to the point that the ratio of private debt to disposable income increases to 2.5 from the current ratio of 1.6, which is already a record. We dismiss this projection based on CBO forecasts as implausible in view of the absurd increase in the private deficit and indebtedness that the forecasts require.

Assessment of that Analysis a Dozen Years Later

First, we were correct in arguing that our poor little Goldilocks was doomed—she succumbed shortly after our piece was written, as households retrenched, the stock market crashed, and we moved into recession. Further, we were correct in arguing that Clinton's projections of 15 years of budget surpluses, during which all outstanding federal government debt would be retired, were wildly wrong. In fact, the surpluses killed Goldilocks, and budget deficits returned (and the US government has since run a dozen years of deficits, rising sharply in recent years).

Of course, what we got wrong was our belief that once households retrenched, they would not quickly go back to historically unprecedented deficits. They did. They got caught up in the Wall Street-manufactured real estate bubble. They ran up a debt that had seemed to us in 1999 simply impossible to imagine. To say that America suffered from an episode of mass delusion would be an understatement. I will not repeat here explanations for the real estate boom and bust. Suffice it to say that the more recent run-up of household deficits and debt simply replicated and then expanded upon what we had seen in the bubble from 1991 to 1999 when we wrote the Goldilocks piece.

And since the bubble was orders of magnitude larger, the collapse was that much worse. Exactly how all of this will turn out is at present unknown but beside my point. In all important respects, we identified in the late 1990s the sectoral imbalances that would crash the economy. And that projection was based on Godley's brilliant sectoral analysis, that brought forward a consistent, coherent, and rigorous stock-flow approach that had been sadly lacking from economic analysis.

Anyone who followed Godley's example could not possibly have missed the processes that made “it” happen again.