What if the Credit Crunch Is Just a Symptom?

Rare is a consensus among economists, the practitioners of the dismal science. Yet there seems to be nearly universal agreement about the nature of the current crisis and the parallels with the Great Depression. The paralysis of the capital markets and the inability and/or unwillingness of banks to lend derailed the real economy. By word and by deed, officials and investors seem to concur, but what if they are wrong? What if the credit crunch itself is not so much a cause as a symptom of a larger, structural problem?

Since Milton Friedman and Anna Schwartz's 1963 Monetary History of the United States there has been a rough consensus among economists that the tightening of credit conditions triggered the Great Depression. Speaking as a Governor of the Federal Reserve Board, Bernanke offered these pearls at Friedman's birthday party in 2002 according to press reports: "I would like to say to Milton and Anna, regarding the Great Depression, you were right. We did it. We're very sorry. But thanks to you, we won't do it again."

In an editorial in the Wall Street Journal (18 October 2008), Schwartz identified tightening of credit conditions as the critical similarity between that crisis and the present one. The opinion-editorial pages of the leading newspapers and magazines are replete with similar arguments with only slightly variations on the theme. The policy prescription is clear. Classical, neo-classical and supply-side economic theories agree: Resolve the credit crisis. Provide ample liquidity through financial triage and lender of last resort. This will renew incentives to financial disintermediaries to lend money to business, who in turn will invest, boosting plant and equipment spending, and in so doing create jobs, increase incomes and boost consumption. Re-opening the capital markets will return the economy to its growth path.

Shift in National Income Shares

While this seems like a compelling narrative, it seems to share the vulnerabilities that have signaled the death knell of other great theories: the historical record. An alternative explanation begins with the recognition that the Great Depression and current crisis are linked by macro-economic similarities beyond the dramatic deterioration of credit conditions. The economic expansions that preceded both the 1929 crash and the more recent one shared the common feature of being driven by consumption, especially of durable consumer goods, rather than investment. And in both cases, the increase in effective demand was fueled not by higher real wages and salaries but by increased consumer credit. Net private investment (net of depreciation) declined even as manufacturing capacity, labor productivity and industrial output increased.

While it is often recognized that investment in plant and equipment is labor saving, most observers do not appreciate that it is capital saving as well. This means the depreciation allowances for capital equipment can fund replacement of existing stock and it is this replacement that carries technological advances. Of course this has not always been true in the United States. Starting in the 1920s, this atrophy of new net investment became evident and then WWII and its aftermath reversed it temporarily. These forces, and policy actions, produced a significant shift in national income shares away from wages and salaries and toward profits and dividends.

Modern day Puritans harp on the fact that consumption in the US outstripped income (wages and salaries) claiming it is immoral. Few are willing to consider that for most Americans, the problem is not high consumption, it is low income. Until the early 1970s, there was a social pact between that linked wages and salaries to productivity gains. However, various forces, including the decline of organized labor, have dissolved the pact. Since then real wages have largely stagnated while productivity has risen dramatically. To help blunt the impact of this, transfer payments have been made in the form of "entitlement" and other social spending schemes.

Consumption Key, Not Investment

A shift in income shares also preceded the Great Depression. Work citing American historian James Livingston (Rutgers) found that 90% of American taxpayers had less disposable income in 1929 then they did in 1922, while corporate profits were up by nearly 2/3 and dividends doubled. The top 1% of tax payers experienced more than a 60% increase in disposable income. This combination of a shift in national income shares and a decline in net new investment gave capital few outlets, including conspicuous consumption. It produced a speculative bubble of historic proportions. In the 1920s it was equities. This time it was mainly real estate and derivatives, but also commodities, emerging markets, and other asset classes. These forces finally choked off the household's access to credit and, therefore, effective demand for consumer durable goods. New net private investment did not lead the recovery in the 1930s and it most likely won't lead this recovery either. The capital stock per worker was actually lower in 1939 than 1929, though national output and income had regained pre-Great Depression peaks by 1937.

The historical record is clear: the recovery 1933-1937 was fueled by the rising demand for consumer goods. Rising consumer demand was a result of a shift in income shares from profits and toward wages. This was paid for by government spending, and re-enforced by a re-invigorated labor movement. Economic upswings since have also been fueled by the demand for consumer goods not investment goods. The famous Reagan tax cuts in 1981 aimed at fueling investment didn't. The top 50 corporate beneficiaries actually reduced capital expenditures in 1982 and 1983. Net new investment trended lower throughout the 1980s. Nor have President Bush's tax cuts stimulated new net investment; something many astute observers have recognized.

Policy and Investment Implications

This alternative narrative has significant policy and investment implications. The imbalance that policy makers should address is the imbalance in the shares of national income. In a rising tide, by all means, help the people with the boats, but it is the consumer that has the boats. Consumption accounts for more than 2/3 of the US economy and government spending accounts for the vast majority of the remainder. Contrary to the inherited wisdom, there appears to be no correlation between lower corporate taxes, increased net investment and economic growth. Indeed growth has consistently been recorded even as net investment has fallen. Whereas the conventional view claims the underlying problem is one of a shortage of liquidity and credit, this alternative suggests that to the contrary the problem is one of surplus capital.

Like the proverbial dead atheist that is all dressed up with no place to go, the economy is a victim of its own success. Businesses have been very successful in accumulating wealth, with the help, of course, of favorable tax and regulatory policies, but at the same time, the extensive deployment of capital-saving technology prevented the emergence of new profitable investment opportunities. This drove capital deployment to balance sheet engineering, speculation and ultimately its destruction in historic proportions.

If the credit crunch is indeed a symptom of deeper structural forces, then the solution now, like the 1930s, is to promote consumption through fiscal policy (tax incentives to purchases of consumer durables, a cut in payroll taxes), higher and longer unemployment compensation and massive public investment. Re-linking wages and salaries to productivity growth is not simply a function of fairness, but an issue of economic necessity.

Comments

[Pete Murphy:]

Marc, first of all, regarding your last sentence - "Re-linking wages and salaries to productivity growth is not simply a function of fairness, but an issue of economic necessity." - there has never been a link between productivity and wages. An analysis of BLS (Bureau of Labor Statistics) data bears this out. It is true that wages and productivity rose in lockstep at one time, but it was always demand for labor that drove wages higher, not productivity growth. If anything, increases in productivity tend to drive wages down as workers are freed up and returned to the pool of available labor. But wages rose because there was sufficient demand to re-absorb them back into productive roles. That is what is now broken - the demand for labor is declining as the American labor force is cast into an enormously bloated global labor force.

I agree that the credit crisis is a mere symptom. You have come very close to the root cause of our economic collapse when you identify "consumption" as the problem. The question then becomes, why is consumption declining? As population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

These effects of an excessive population density - rising unemployment and poverty - are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

Please visit my web site at PeteMurphy.wordpress.c... to learn more about this important new theory.

Pete Murphy
Author, "Five Short Blasts"

2008 Dec 12 09:00 AM

[Fabien Hug:]

Great article. I just hope you'll be heard.

2008 Dec 12 09:07 AM

[xmplary:]

Of course it is a symptom. Its certainly not a cause, unless you are look at it as a reason why lending is slow. Maybe a better title would have been good for an otherwise good article.

2008 Dec 12 10:48 AM

[derryl:]

This sounds very close to what C.H. Douglas observed in the 1920s. Industrialization replaces human labor with machine labor fueled by "solar power" (by which Douglas meant oil, coal, etc.). Productivity per man hour dramatically increases which means fewer workers produce all the goods and services that the nation wants to consume. But the people lack buying power to consume all this output because they need jobs to earn income.

Douglas's solution was a "national dividend" paid to all citizens to raise national buying power to the level of national economic output so that the output could all be consumed. He said "the true cost of production is consumption", which makes sense if we think the reason we work is to be able to live and have things. If industrialization allows us to work less and still produce everything we need and want, then the nation needs some other means besides employment income to get buying power into the hands of consumers.

Mercantilism, where every country tries to get this additional buying power by exporting their excess output, is a zero sum equation like musical chairs. It is not possible for "everyone" to export more than they import. In a modern globalized world 'beggar thy neighbor' trade policy should be considered immoral if not illegal. Besides, why work like slaves just to ship all the goods off to another country? Aren't we working so that WE can have those goods?

Wars are good at providing work to make things that blow up and have to be made again, but I doubt anyone thinks permanent war is a good solution to productive overcapacity.

Douglas sees the industrial infrastructure and technology we are born into as a "cultural inheritance". Any modern person's productivity has far more to do with inherited technology than personal effort. He would see the American economy as USA Inc., and the economy's excess productivity would be America's "profit". The buying power to consume that profit would be distributed to the citizens as a national "dividend".

"Excess" productivity is the difference between the total money paid out to suppliers and workers to produce everything--a business's or a nation's break-even costs--and the total of all the prices of the goods produced. Business needs to collect more money in prices than it pays out as costs or else it is "unprofitable" and nobody will bother doing business. Douglas's national dividend supplies the additional money that businesses need to collect in order to make profits.

It's not quite as simple as this but you can read about his "social credit" ideas by Googling "money and the price system". You will find the text of a presentation Douglas made in 1935 to the King and government of Norway, where he lays out all the basics of his thinking.

In a pre-industrial society almost everbody works at agriculture to stay alive. England was the first country to begin industrializing, in about 1740. In Adam Smith's 1776 England there was no "unemployment" because pretty much all work was technically simple so anyone could do it and a large majority of people still worked at agriculture. Smith's free market was essentially a barter system with few externalities like money and profit.

Nobody will barter his 12 eggs for your 10, so there is no capitalist style "profit" in the equation. But if I specialize in eggs and you specialize in tin pots there will be more eggs and pots for everyone and the nation will be richer in economic goods. Everybody produces and trades. But advanced industrialization has changed all that.

No modern farmer invented and built diesel fuel and tractors and national transportation systems, but by using these technologies a single man is able to farm more than 1000 acres. Without technology a family can plant and harvest only a few acres at most. The cost of grain in man-hours is reduced by hundreds of times with heavy equipment so all the grain a nation needs can be grown by a small fraction of the population. Agricultural employment will plummet.

Some of this displaced labor will be absorbed producing tractors and diesel fuel and trucks and roads, but most of it is now "unemployed". In a modern economy only about 30% of workers are employed at direct production. All other employment is in services, including government bureaucracies.

A substantial portion of service work is "make work". As a business owner I would be far better off if my taxes were used to pay bureaucrats to stay home than I am paying them to go to work and think up new ways to interfere with my productive enterprise. Shakespeare had the right idea about lawyers, another interfering make work service sector. But all these people need jobs because work is the only way to get income to live.

Douglas said industrialization does not cause an "unemployment" problem. It causes a "leisure" problem. The very purpose of technology is to CAUSE unemployment by inventing "labor saving devices". Once you have 'saved' all that labor, what are people going to do with their time?

Douglas thought people would use that time to improve themselves. I think he was overly optimistic about the evolutionary state of human nature. I think people still need to work in order to feel right with the world. I personally feel that way.

So what's the solution? I don't know. But I think it helps to recognize the nature of the problem even if there is no obvious way to solve it.

2008 Dec 12 11:13 AM

[wpdragon:]

good article, thought provoking.

enjoyed the comments also.

2008 Dec 12 12:16 PM

[ferguson:]

I am not an economist and the economic arguments presented here escape me. Common sense tells me the following.

-- People cannot continue to consume at an ever increasing rate unless their wages keep pace. Since wages have not kept pace, problems were inevitable.

--The securitization of mortgages and all of the related derivitaves had the effect of expanding the money supply without a commensurate increase in the value of the asset base. The imbalance meant that problems were inevitable.

-- The value of the financial industry is said to be only about 4% of GDP. Yet, at its peak, the financial industry represented more than 20% of the value of the S&P. This disjunction meant that problems were inevitable.

-- The increase in value of the financial industry in relation to everything else was driven largely by the vast opportunities resulting from the creation of a global economy and the boundless and irresponsible greed of corporations and individuals to reap the rewards for their own private benefit rather than the general welfare. Problems were innevitable.

-- Basking in the seemingly limiltess potential of globalization, securitization and expansion of the money supply without pain or consequence, our elected and appointed officials, all beneficiaries of the windfall, either missed the boat, were asleep at the watch, or just took the money and ran before the ship went down or, perhaps, all three.

-- The trillions of dollars that have been lost will not be restored until meaningful relationships between value, reward and cost are re-established.

--

2008 Dec 12 12:25 PM

[Jade Queen:]

Thank you so much for the extraordinarily good article and comments. I struggle to find perspectives that can be combined to make sense.

To some extent, we are still a culture that fights with words, certainly in the non-governmental sector, what there is left of that. In regard to that, I am glad we have some lawyers who are good enough entertainers and who are good-hearted enough to protect at least some of us from the worst corruption.

I reassure myself that neither corrupt federal government nor corrupt local governments presently have the ability to bust every single garage sale or borrowing of sugar from a neighbor.

What I have not seen analyzed much anywhere is the informal economy and its effects.

People in my church who remember the great depression share stories about local currencies and scrips, for example. Teachers were paid with this in certain localities.

They could pay rent with it, but not utilities. I assume they needed to chop wood and carry water when it came to utilities.

That governments bestow odd grants of monopoly to utilities, on the theory they are necessary, seems something Will Rogers or Mark Twain would have been hasty to make jokes about.

It isn't baubles we need to worry about now. We've got plenty. It seems to me it is water, energy, and pollution which should float to the top of the tangle.

We already have situations where earthquakes and floods interrupt supplies to places that don't have clues about subsistence through adversity.

Unpredictable behaviors outside the control of individuals or voluntary communities are called acts of God in legal contracts. I am not sure how to phrase this so as not to offend atheists, but this is a concept persons of good will will need in coming up with outside-the-crumbling-... scenarios.

What do you think about Acts of Whatever?

Anyway, we clearly do need to move to a place of dignity for individuals by, say, letting elders or neighborhoods sell wind- or sun-generated energy to an entity that is bound by contract to have the good of the individual and the community in some auditable process.

This way we could perhaps get things back into a scale where neighbors can see the neighbor whose behavior is out of line and require corrective action before we have to give him three hots and a cot for 800 years.

Doesn't Whatever supply wind, sun, rain, and sand (from which silicon can, with great effort, be formed into useful energy- computing- and communication-devices)... Isn't it becoming obsolete to allow human organizations to go to scales that cannot be held accountable to neighbors, families, or Whatever?

The credit crunch is a symptom of an economy addicted to things that do not sustain health. Transition to walkable neighborhoods where one knows one's neighbors is my favorite multiple-choice scenario, and I'm sticking to it. I'd still like to eat chocolate, but sacrifices may have to be made.

2008 Dec 12 03:47 PM

[Still Renting:]

Ever since I was a kid I wondered how people would earn the money to live in a society where machines produced everything, even the machines. As we approach that there seem to be two alternatives: 1) Just "give" money to people who don't produce so they can consume. 2) Create an economy where people do something, ANYTHING, that gives value to others. Those others then pay them for their "services" and the whole widget circle continues on.

Overly simplistic, I know, but you gotta start somewhere.

2008 Dec 12 06:38 PM

[Steven Hansen:]

wow. i also must echo that the article and comments are excellent.

it is obvious that the liquidity / credit is a symptom. as the main driver of the economy is the consumer - the problem is most likely focused here. the consumer literally over-ran his ability to consume. now we have demand destruction by the retirees and baby boomers.

so we have all this liquidity in the market and it has no where to go. there is a cost for this liquidity. and you, your children, and your grandchildren will pay for this.

2008 Dec 13 12:52 AM

[Alphameister:]

Excellent article, Marc. Virtually all real wealth is driven by productivity gains. And productivity gains in the US in recent decades have been driven primarily by a dramatic expansion of international trade. While the world has benefited greatly from this trade, as have US corporations and their investors, American workers have largely been bypassed by these gains. Republicans refused to acknowledge this very real problem or make any effort to do anything about it, and workers able to tap into home equity and other credit lines to boost living standards didn't object strenuously to their lack of real income growth. But once the housing and credit bubbles burst, it became easy for a populist Democratic party to take control of Congress and the White House. I have no doubt that Obama will lead a major effort to redress the inequities that he and most American workers perceive in the current distribution of wealth and income. Profit margins have only begun a predictable reversion to the mean.

2008 Dec 13 09:36 PM

[xander:]

The problem as I see it is that president Carter and the congressional democrats passed a law that deems rebates of value added taxes to not be an anti-competitive trade practice. Since then, exporting countries like Germany have increased their value added taxes to maximize their mercantilistic exploitation of the USA {20 % value added tax now} . I remember the justification used during the press articles on Carter's proposal as being the alleged necessity to keep western Europe"s income high to diminish the lure Communism had on Europe's working class. Maybe the policy was right while the USSR lived but now it is gone and unfortunately so is much of our working classes income. Time for a real change. We either replace our income tax with a value added tax or we repeal Carter,s exemption for their value added tax rebates in considering whether to impose trade sanctions. By way have our labor union economists had their heads up their rears since Carter,s policy was implemented?

2008 Dec 14 01:36 AM

[nmelendez:]

I still remember my father going to work, my brother and me going to school and my mother looking over the household. After a time, couples both had to work to make ends meet. By 2000, not only did couples had to both work but to have an average lifestyle they had to go into debt.
Like the article and the responses explain, it's not so much a credit problem as a living earnings problem. Companies and government are less and less willing to pay a living wage in exchange for labor.
The greatest example of this is the H1B visas. You have to excuse my disbelief that there are not enough software engineers in the US to meet the demand. Maybe at the wages the companies are willing to pay.
Again, as i previously have mentioned is the idea, not of bringing the world to the US standard but to take the US to the rest of the world labor market levels.
I sincerely believe that is the root core of this deflation.

2008 Dec 21 04:51 PM