Thomas Palley, the former Bernard L. Schwartz Economic Growth fellow at the New America Foundation and former assistant director of public policy at the AFL-CIO, joined us here today at the federation to discuss his new book, From Financial Crisis to Stagnation: The Destruction of Shared Prosperity and the Role of Economics. The event is the third in the AFL-CIO summer book series, which includes discussions with noted economists who will talk about their new books on jobs, inequality and the U.S. financial crisis. (Get details and RSVP here.)

In his new book, Palley sets out to explain the cause of the 2008 financial crisis and what can be done to prevent another economic collapse. Here is a Q and A with the author:

Q: In From Financial Crisis to Stagnation, you make the case that the 2008 financial crisis was a “crisis of bad ideas.” What are some of the main bad ideas that led to the financial crisis?

Palley: That’s a tough question. First, I need to explain the cause of the crisis, and then I need to explain how bad ideas were behind those causes. That goes to show how answering a simple question can be very difficult. But let’s have a try.

The deep origins of the crisis lie in the shift to conservative economic policies that occurred around 1980. After World War II, the U.S. and much of the global economy was driven by a virtuous circle “Keynesian” growth model. The key features were full employment and a tight link between wage and productivity growth. Wages fueled demand and created full employment. That provided an incentive to invest, which drove productivity growth and supported higher wages.

After 1980, we dismantled that system by abandoning our political commitment to full employment and breaking the link between wages and productivity growth. That produced wage stagnation, and instead of relying on wages to fuel demand, we turned to reliance on debt and asset price inflation. The negative effects of wage stagnation on demand were covered over by a 30-year credit bubble, which was promoted by financial deregulation and financial innovation. That was the role of debt—to fill the demand gap caused by wage stagnation and rising income inequality.

This system lasted far longer than any of us imagined possible, while the false prosperity produced by Wall Street blinded many to its failings and made criticism difficult. However, the system finally imploded with the financial crash of 2008, which occurred when the economy reached the limits of its capacity to take on debt.

This explanation of the crisis leads to the issue of economic policy. The fingerprints of policy are everywhere when it comes to explaining wage stagnation and the shift to debt and asset price inflation to drive the economy. These policies include corporate globalization; so-called “labor market flexibility” that attacks unions and worker protections like the minimum wage; the attack on government and public-sector workers; and a shift by the Federal Reserve to targeting low inflation at the expense of full employment. The policies also include financial deregulation and regulatory forbearance, which created an unstable financial system.

That finally gets us to the role of “bad ideas.” All of these policies were justified by the bad ideas of neoliberal economists who dominate our top universities and occupy top economic policy positions. These neoliberals justified corporate globalization in the name of free trade; attacked unions and the minimum wage on the grounds they cause unemployment; argued for abandoning full employment by claiming the economy automatically generates full employment; and pushed financial market deregulation on the grounds it creates an economic free lunch by increasing everyone’s wealth.

There is a straight line from bad economic ideas to bad economic policy to bad economic outcomes.

Q: Why do you think flawed, conventional “economic wisdom” is so prevalent among our lawmakers and the mainstream media?

Palley: There are two major reasons. First, lawmakers and journalists are educated in universities, just like the rest of us. In those universities they only get to hear a particular set of economic ideas—conservative economic ideas. That is because economics departments in most universities are monopolized by neoliberal economists who prevent alternative ideas from being taught. Since this is all that lawmakers and journalists hear, that is what they tend to believe.

Furthermore, when they get to positions of power, lawmakers and journalists naturally go to the top universities to seek out economic advice and advisers. That’s natural: they’re not experts, so they go to the places where society tells them the experts are.

The monopoly of ideas is a very dangerous thing, and we are now suffering from a monopoly of conservative economics. There is a lot of pretense that economics is divided, but it is not. I call it the “Coke–Pepsi” myth. Coke and Pepsi engage in titanic marketing battles, claiming to be different. But they are both colas.

The second reason is money. Wall Street, big business and the 1% love the economics we have because it supports their interests. They therefore support think tanks and economists that grind out ideas favorable to the 1%. Politicians need money to win elections and they therefore advocate ideas that attract money. Likewise, journalists want access, and the best way to get access is to support the club.

Q: In your interview with Philip Pilkington at “Naked Capitalism,” you describe a six-step process of the mechanics of the 2008 financial collapse. Can you explain that again for our readers?

Palley: Here's what I wrote there:

The mechanics of the crisis within the U.S. financial system are actually quite simple and can be understood as a six-step process. Step one was the build-up of toxic loans over several years. Step two was when loans eventually started turning sour with the bursting of the house price bubble in 2007, causing loan losses. Step three was the destruction of bank equity caused by mounting loan losses. This process began in the so-called “shadow banking system” and then moved into the Wall Street investment banks and the established commercial banking sector. Step four was the resulting threat of bank defaults triggered by equity destruction. Step five was the rush to cash spurred by the threat of default. That caused a liquidation trap as agents tried to sell financial assets to raise cash, which deepened the extent of asset price declines and caused further equity losses. Step six was the run in the commercial paper market immediately after the collapse of Lehman Brothers (September 2008), whereby banks and financial institutions became unwilling to lend to each other. That put every bank (including Goldman Sachs) on the verge of default, prompting the Federal Reserve to step in and de facto take over the commercial paper market by acting as lender of last resort.

Q: Do you think Dodd-Frank, once fully implemented, will help in fixing any of the problems that led to the 2008 crisis? Please elaborate why or why not.

Palley: In my view Dodd-Frank is a very good and important piece of legislation that updates our system of financial regulation. However, a lot still remains open and will depend on the explicit details of the rules that regulators write to implement the intent of the law.

Dodd-Frank aims to reduce financial speculation and diminish the risk of a systemic collapse. That makes it less likely we will experience another financial crash like the one we had in 2008. However, reducing financial instability is not the same as addressing the deep long-running causes of the crisis. That is why Chapter 1 of my book is titled “Goodbye financial crash, hello stagnation.”

The financial crash represented the end step of a 30-year process. However, during that time the neoliberal economic model undermined the income and demand generation mechanism by imposing wage stagnation and widening income inequality. Those developments were covered over by increasing debt.

Now, the debt machine is broken, but we are still left with the problem of widened income inequality and low wages. That is why we face economic stagnation. Dodd-Frank stabilizes the financial sector, but it does nothing to address this deeper problem of demand shortage due to widened income inequality.

So yes, Dodd-Frank was good and necessary, but it does not get us out of the crisis.

Q: What are some reforms lawmakers should propose to prevent another financial crisis? Are they paying attention to the real causes of the crisis, in your opinion?

Palley: Rather than answer this, let me suggest that folks read my book. The first half of the book diagnoses what caused the crisis and also shows how the explanations of Republicans and conservative economists do not fit the facts. The second half shows the economic policy reforms that are needed, and it also explores the obstacles to change.

The bottom line is ideas matter. At the very beginning of the book I quote Marshall Mcluhan, the famed philosopher of media, who wrote: “We shape our tools and they in turn shape us.” For the past 30 years we have been guided by bad economic ideas.

Thirty years ago working families lost the war of economic ideas. If we want to end the crisis and restore shared prosperity, we must make sure that does not happen again.

Learn more by reading Thomas Palley's book, From Financial Crisis to Stagnation: The Destruction of Shared Prosperity and the Role of Economics, published by Cambridge University Press, 2012. You can purchase the book online.