Anatomy of a Depression

“Let us all be happy and live within our means, even if we have to borrow the money to do it with.”

Charles Farrar Browne

    The sudden unravelling of the global financial structure seems to have caught a lot of people by surprise, even (especially!) those who profess knowledge of economics and finance. But it should have been (and was) easily predictable, by a simple application of the most basic principles of economics and a rudimentary knowledge of history. The current Depression is rooted in U.S. policies not just of the last ten years but of the last thirty years and even older. When we understand the nature of economic reality, it is easy to understand why the collapse had to occur and why it will inevitably worsen.

    It isn’t my intent here to explain the whole of macroeconomic theory, but there are two fundamental facts that every human being over the age of twelve ought to understand: the nature of wealth and the balance of income and expenditures.

    Every economics text teaches in its first chapter that money is not wealth. Economists seem to hardly ever remember this, though it is the foundation of their discipline. Wealth consists only of goods and services – money is a convenient way of arranging for goods and services to be produced and exchanged, but it is has no value on its own. You might think of your labor as being “worth” fifteen dollars an hour and a satellite phone as being “worth” five hundred dollars, but if you were stranded on a deserted island with nothing but five hundred dollars and your wits, you would quickly realize that five hundred dollars are not necessarily worth a satellite phone, and your labor is worth your life, even without a paycheck! Likewise, money can never be capital; capital (to an economist) consists only of things that are used to produce goods and services. A factory is capital, or a farm, or an education; a billion dollars might buy capital – that is, transfer it from one owner to another – but it does not embody any capital whatsoever.

    Gains or losses of money are never gains or losses of wealth! They represent only a change in the ability of individuals to affect the distribution of wealth, and even that is only by social convention. If one person gains a million dollars at someone else’s loss, that may matter very much to each of them, but the total amount of wealth hasn’t been changed at all. If a bank error erases a billion dollars from existence, or (more likely) a government prints a billion dollars of cash, no wealth has been destroyed or created. The distribution and use of money can indeed have a huge influence on the creation of wealth in the long run, as we shall soon see, but critical errors (like investing in stock markets) arise whenever it is forgotten that money is not wealth and cannot create wealth.

    It may seem perversely wrong at first to say that income and expenditures always balance, but remember we’re not talking about an individual bank account here, but an entire world economy (or a national economy, give or take its foreign trade balance). On an instantaneous basis (thought not in the long run!) it’s a zero-sum game. An expense for one person (or corporation or government) is always an income for someone else – every transaction has a zero balance in the world economy as a whole. Even if money is printed or destroyed, everything still balances because money is not wealth. It’s only a yardstick for measuring wealth – an imperfect one, but the best we have. Although the yardstick gets remarked all the time, the real value of the things being exchanged doesn’t, and every transaction still balances – each gain is lost by some other party.

    Economists divide wealth into two categories – consumer goods (including services) and capital. Consumer goods are things that go directly to the end consumer to be used up, like packaged bratwurst, dental examinations, or refrigerators. Capital is everything used in the process of creating and delivering the consumer goods – factories, mines, unpackaged brats, trucks, dental schools, shopping malls, etc. Sometimes the line between capital and consumer goods isn’t completely clear, but the principle should be. Everything that the economy produces is either capital or a consumer good – so consumption comes at the expense of capital growth, and vice versa.

    And now we approach the crux of it. If people consume everything that they produce, nothing at all is left over to go into capital. In economics, we usually ignore any production that isn’t paid for in money, and that’s a good enough approximation for most purposes – a few people might do a little unpaid work at a hospital, but no one is going to build a hospital in their spare time and give it away. Therefore, we consider either the total of all incomes or the total of all expenses (they’re the same amount, remember?) in any period to measure the total economic output for that period. If everyone spends 100% of their income on consumer goods, 100% of the output must be consumer goods. If people spend 20% of their income on capital, 20% of the output must be capital.

    But what if all the income doesn’t get spent? What happens to the money that people save? The answer, surprisingly, is that there is nothing to save. Recall that money has no value – nor do any of the monetary obligations that most people think of as “savings” – bonds, CD’s, stocks, bank accounts, etc. are all quite devoid of value. Their accumulation adds nothing whatever to the wealth of the future. The only real kind of savings – the only kind that contributes to wealth in the future – is the the stockpiling of actual goods and, much more importantly, the building up of capital that will produce more wealth in the future.

    When you “save” or “invest” money, you are not saving anything at all! By forgoing some amount of consumption in the present, you do not save anything to consume in the future; rather, you allow someone else to consume the share of current production you would otherwise have enjoyed. Hopefully the money you accumulate will allow you to transfer future wealth from other people to yourself (that’s the purpose), but your savings are not wealth and do not in themselves create any wealth for the future. More than saving is required.

    The building up of capital is referred to in economics as “investment”. This is not the same thing as “investment” in finance! Economic investment is that portion of all production which goes to build capital rather than to provide consumer goods. It is equal to the total output of the economy minus all consumption. Whenever you save money (unless you stuff cash in a mattress, in which case you’ve simply reduced the money supply), someone else spends it – the bank loans it out, or the person who sold you securities pays their taxes, or whatever. The money itself may go through many transactions before it’s used to buy something real (i.e., wealth), but ultimately someone else will purchase the wealth that you didn’t. They will buy either consumer goods or capital.

    “Net” savings refers to the amount of savings which are loaned out for real investment (as opposed to consumer loans), as well as corporate profits (or even personal income) that is spent on business expansion without any intermediaries like banks or stock markets. That is, net savings are equal to the amount of current production which hasn’t been consumed. By definition, this is also the amount of capital produced. Thus we see that savings are necessary for investment to happen, but do not guarantee investment – consumer borrowing can cancel them out.

    There’s another catch, and it’s a major one. In fact, it’s the point of this whole discursion. Net savings must, by definition, be used to purchase capital, but not all capital is created equal! In economics, everything that’s not a delivered consumer good is capital – including not just things like steel mills or engineering software, but raw materials, intermediate products, and even inventories of finished goods that haven’t been sold yet. This little accounting trick is necessary to make net savings equal investment, but it means that “investment” doesn’t always translate into genuine economic growth. Sometimes it’s just unwanted goods piling up. It can also be investment in capital that’s not really useful, like liberal arts educations or sociological research, but that’s a different issue.

    Investors – the people who actually spend money on capital, not the people who loan them money – can’t be forced to build productive things like oil refineries or research laboratories instead of producing goods that might go unsold. Well, they could be, but Communism is a whole different can of worms. Sane people (government is of course excluded from this category) will only invest in new capital when they think they can make a profit from it, and this will vary a great deal depending on what kind of new ideas and technologies appear, on rates of interest and taxes, on how strong the market appears to be, and on many other things – consequently, there’s no reason why useful investment should match up with net savings, and it never does.

    The amount of useful capital that investors try to purchase is called autonomous investment. When net savings are less than this amount, some investment won’t happen because too much is being consumed, the economy will grow more slowly than it should, and prices tend to rise because people are trying to consume more than what is being produced. Theoretically, if the discrepancy is too large, the economy could even shrink as not enough investment is available to even replace the capital that is being worn out and depleted.

    On the other hand, if net savings exceed autonomous investment, someone will be forced to make an investment they didn’t intend. This unplanned “investment” will take the form of inventory accumulation. Another way to look at it is that goods are going unsold because people saved money instead of buying them. This situation will normally result in a recession; plenty of resources are available to build capital but businesses are unlikely to expand production when they aren’t even able to sell what they’re already making. They are more likely to cut back, which means fewer jobs, less income, even less consumer buying, and more cuts in production, a vicious cycle which if left unchecked will continue until production has sunk to whatever level the consumers are willing (and still able!) to purchase.

    A corollary is that net savings can’t exceed autonomous investment, at least not for long. When we try to save too much, the economy will shrink until we are unable to save more than just enough to fund whatever demand for real investment is left! This is called the Paradox of Thrift. Beyond a certain point, the more people try to save, the less they are actually able to save.

    You can see that it is necessary, in a free market economy, to have a certain proportion between spending and saving. Either too little saving (too much spending) or too much saving (too little spending) is disastrous. Capitalism inherently tends strongly toward excessive savings, and here’s why:

    The division between spending and saving is heavily dependent on the distribution of wealth. Those with extremely high incomes usually save a very high proportion of it, sometimes nearly all; those with moderate incomes rarely save much more than they borrow. Lower income people don’t even have the option of saving. In the U.S., the top 1% of income earners account for more investment than everyone else combined. If income was evenly distributed, the median income wouldn’t rise that much (less than double) and few people would save anything; the result would be that GDP would decline while prices soared. But if income is too severely concentrated at the top, there isn’t enough spending – the billionaires would prefer to reinvest their funds, but nothing is profitable because there are no customers.

    This is the typical situation in a capitalist economy, because capitalism favors inequality. The more money you have, the more leverage and opportunities you have to make more money. Even if growing wealth for the richest also meant a better living for the workers (and it does sometimes work that way), the distribution becomes more uneven (i.e., the rich gain proportionately more), and that eventually causes the system to fail. The masses might be much more prosperous than the previous generation, yet they still can’t consume what the very wealthy could have ordered into production.

    Historically, economic growth is typically associated with a shortage of labor. A scarcity of workers means an increase in wages (through the “law” of supply and demand). Higher wages mean more customers for whatever goods anyone might think to provide, and thus more business opportunity. The European Renaissance was driven by the Black Plague, which killed so many workers that wages doubled, creating vast new consumer markets. The rapid growth of the U.S. economy for centuries was largely due to underpopulation and the resulting high wages. Other New World nations (and the Southern U.S.) fell behind partly because they depended heavily on slavery and so never developed strong consumer markets. China and India, cheap-labor nations whose modern growth depends on foreign markets, are doomed to the same fate.

    One thing that happens when consumer markets are deficient is that people who have money to “invest” (in the financial sense) will look for other places to “invest” it when there are not enough good opportunities for productive growth. One of these places is government securities (government borrowing is more or less a way of getting the rich to buy things for other people that they can’t buy for themselves, but with the contradictory expectation of being somehow, someday, repaid). Sometimes the money goes overseas. Another common place for dumping surplus “investment” funds is the stock market.

    Naturally, when people spend more on stocks, the price of stocks is driven up – that’s just supply and demand. Also, new investment vehicles will appear to absorb the cash, financial constructs that are just ways of selling the same thing twice. In the Twenties it was holding companies and mutual funds; in the Nineties it was derivatives. The stock market reflects the availability of surplus savings much more than it reflects the health of the business sector. This is why a “bull” market (the nickname is well chosen) is often a sign of approaching recession, and the growth of indirect investments – crap like mutual funds or derivatives – is a warning of dire economic weakness.

    The recent stock market bubble began in 1985, when Reagan was President, and as a result of Reagan’s policies. The bubble (and the underlying economic malaise) has stayed with us; every time consumer spending has failed, the Federal Reserve has manipulated interest rates to encourage more consumer borrowing to prop it up. Obviously, this process can’t go on forever, because it causes consumer debt to grow out of control – sooner or later, the consumers as a whole are unable to service their debt loads and banks will refuse to make low-interest loans to borrowers who can’t repay.

    This is the wall we have run up against. The stock market isn’t the problem, and the root cause of the credit crisis isn’t panic or irresponsible banking. Banks made shit tons of bad loans because the government deliberately made it easy for them and they believed (apparently correctly) that the taxpayers would take the risk while the lenders made the profits. The reason the government encouraged this was to keep Americans borrowing so that Americans could keep buying and keep the corporations in business. The root cause is simply that the American consumer isn’t getting a large enough share of the pie.

    Note that I don’t say a “fair” share of the pie. I don’t give a rat’s ass about vague ideological crapola like economic “fairness”. If the world was fair, there wouldn’t be any really wealthy people able and willing to make the big, risky decisions necessary for growth. If the world was fair, millions of lazy deadheads would be getting euthanasia instead of a welfare check. The right distribution of wealth is that which makes the system work; then everyone is better off whether they deserve it or not.

    And here is why we still blame Reagan for the Depression, twenty years after he left office: his policies are still in force! Reagan gave a truly colossal tax break to the wealthy, cutting the top rate from 70% to just 27%. It’s been raised only slightly since then – in spite of all the rhetoric from Democratic Presidents and Congresses who (rightly) blame Reagan for every recession, no effort has been made to reverse Reagan’s policies.

    The Reagan tax cuts obviously caused a big shift in the distribution of disposable income; even though taxes on the poor were increased only slightly, and consumer incomes did rise for a few years in the Eighties, the very rich enjoyed a far larger increase in income. Naturally they tried to save most of it, but the consumers, who hadn’t gotten the same windfall, couldn’t support rapid growth. Instead of being used to acquire capital, the excess savings had to go into bogus “investments”, i.e., financial instruments like stocks and bonds. The U.S. government sold a huge amount of bonds to the rich, to replace the revenues it had lost by cutting taxes (causing enormous growth of the Federal debt). This helped keep consumption up for a while, since government expenses run almost exclusively to consumption.

    The other big dumping ground for surplus savings was the stock market. The stock market went on a binge that continued with little interruption even after 1985, when economic growth fell off sharply. It’s the same bubble that is now collapsing; the adjustments of 1987 and the early years of this decade were the bursting of secondary additional bubbles-on-bubbles – the real correction has yet to be completed, although it appears to be in progress.

    Reagan wasn’t the only one responsible for too much money being diverted into the stock market. Also to blame are all of the institutions and financial “advisors” that badgered people for the last thirty years to put their savings into the stock market for “retirement”. You know by now that this was very bad advice, and (since I’ve so generously explained it), you know why: the stock market is a zero-sum game, strictly for speculators; it does not create wealth but only exchanges it. For every person who makes a retirement on the stock market, someone else has to lose a retirement. Unfortunately, a lot of people bought into the scam, and pumped even more money into the stock market. This made it go up and therefore seem like a good investment, which attracted more suckers to feed the spiral…

    The other big mistake of Reagan’s administration was to lower the bank reserve requirement. This was what allowed banks to leverage themselves at 30:1; it was part of the easy money policy that helped reverse the Carter recession. It worked, but fractional reserve banking is risky and running a bank with only enough money to back 3% of the deposits is begging for disaster (as we all know now). It would have been better just to print money, which would have done the same thing without the risk and reduced the Federal deficit a little as well. The drop in the reserve requirement would have been easier to undo, but of course it never was because that would reduce the loaning capacity (and profits) of banks that operate at taxpayer risk. The savings and loan crash of 1989 was primarily the consequence of the lowered reserve requirement, and it continues to bear fruit today as overextended lenders are ruined when even a small percentage of their assets go bad.

    So now you have a picture of how the whole thing works (or did work): Consumers don’t have enough money to buy enough crap, so the owners of the crap factories indirectly loan them the money – with nothing but these loans to back up the country’s bank deposits. The consumers take advantage of easy credit to buy houses, causing a bubble in the housing market that gives banks an excuse to make ever larger loans (with over-valued real estate as collateral) to people who can’t pay them back. Consumer spending is still never enough, so excess funds fuel bubbles in stock and commodities markets and drive the real estate bubble even harder. The rising markets create a climate of false optimism when they are actually a sign of deep systemic weakness.

    This obviously can’t work forever because consumer debt keeps piling up, but the government has kept it going for a generation by making it as easy as possible for the consumers to keep right on borrowing whenever the system falters, and by borrowing money on its own account for even more spending. This policy has prevented a crash until now, but it means that the final collapse will be enormous – the consumer debt, the government debt, the bad loans, the inflation of real estate prices and stock prices have all been accumulating for more than twenty years. Mortgage loans and credit cards are now the major source of consumer buying power, and valueless, speculative markets are the basis of many people’s (formerly planned) retirements.

    This whole process has happened, more or less exactly, before. The Twenties were a close parallel to the Nineties: there was economic growth that benefited mainly the wealthy, a rapid growth in consumer debt, a surging but erratic stock market laden with leveraged securities, and eventually a decline in sales followed by a drop off of real investment and growth followed by a huge stock market bubble after the economy had already begun to sour. In both cases ordinary people who had no business in speculation put their savings into the stock market bubble. In both cases, people borrowed money for “investments” – buying stocks on margin or real estate on interest-only loans. In both cases the Federal Reserve exacerbated the problem by feeding the system with cheap money. In both cases new “tech” industries of dubious viability led the bubble – dot coms in the Nineties, radio and others in the Twenties. In both cases, a lot of rhetoric was thrown around to “justify” why the economy was somehow fundamentally different and there would never be another crash. In the Twenties the buzzword was “New Era”, in the Nineties it was the “New Economy”. Anyone who remained visibly skeptical was scoffed at as living in the past or worse. And in both cases, then as now, most “authorities” continued, throughout the cataclysm, to announce that nothing had really changed, things were about to turn around, and the pre-crash “prosperity” would return promptly.

    The reality, of course, is that only a change in the distribution of income can do more than postpone the inevitable. As long as consumers are unable to buy without borrowing, the economy is doomed to a cycle of declining sales, declining production, declining employment, and growing poverty. The longer the cycle runs, the worse the outlook will appear to any prospective business venture, and the harder it will be to break out of. Having the government borrow and spend, in place of consumers, is just a temporary delaying tactic that has probably run its course – not even governments can carry infinite debt.

    There are important differences between the new Great Depression and that of the Thirties, of course. One is that the Fed has managed to keep the illusory “boom” going for a longer time, so we are more heavily dependent than ever on borrowing and bubble pricing. Another, perhaps more ominous, difference is that the U.S. government entered the first Great Depression with little debt. Now, the government is already burdened with crippling debt, even before tax revenues have really fallen off. There does not seem to be any possibility of financing a “New New Deal” through borrowing (as if the government wasn’t big enough already!). The Washington regime is also hopelessly corrupt, as was demonstrated by the appalling brazen betrayal that culminated on October 3, 2008. Unlike that of 1929, our government will not hesitate to intervene, but it seems likely to do more harm than good.

    Another weakness we have, relative to the Thirties, is our higher degree of interdependence. During the first Great Depression, most people were prepared to survive without electricity or gasoline and many could grow their own food or at least lived close to a food source. Many people could get water from a well and relieve themselves in an outhouse. Those options are no longer available. Almost everyone now depends on fuel, electricity, and remote food sources, and the supply of these things depends on complex nation-wide industrial networks and financial arrangements. Even city water and sewage services are rarely locally self-sufficient. A failure of key industries would leave tens of millions of people entirely without food, water, sanitation, communications or transportation. Can you spell A-N-A-R-C-H-Y?

    I knew you could!

    So what is there to do? The usual borrow-and-spend-and-fix-the-interest-rates might postpone the landslide for a bit, but after the last couple of weeks it seems unlikely. Government actions so far even seem to have accelerated the panic (although that may only be because blatant corruption has destroyed whatever faith in government was left). It is too late now to avoid the Second Great Depression; there is no political possibility of undertaking the necessary reforms and there probably won’t be until things have gotten very bad – hopefully not to the point of complete meltdown, but this is a prudent time for gun ownership.

    Of course the situation could be remedied, if the political means existed. I could draw up a plan, but the essential element is just this: tax the rich and give to the rest. Would that be fair? Maybe not. Would it make the lackeys of the power elite in Washington and the media, and their Libertopian dupes, squeal like stuck hogs? Hell yes! But it would also restore the economy.

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