Archive for September, 2011

Our Central Economic Challenge

At this point everyone I talk to about this stuff knows I believe that the discipline of economics has failed in a catastrophic way. Remarkably, one can lay out the nature of this failure in very few words:

(First) What if you acknowledge that, when it comes to the nation’s total household debt, there are only three possible states? In all instances, the household debt must be (1) increasing, (2) decreasing, or (3) holding steady.

(Second) Even a brief glance at history will tell you that only one of these states is consistent with a healthy and expanding economy. Household debt must be increasing in BOTH real and nominal terms.

(Third) What if you recognize that real household debt cannot expand forever? Yes, debt is something we owe ourselves; but if you want to understand the world, you cannot lose sight of the fact that household debt is owed by borrowers (borrowers with limited real capacity to borrow).

In short, economies only run properly when household debt is expanding, but this debt cannot expand forever.

When framed in these terms, this formulation sounds both simple and obvious. However, if the above statement is true, then it means that mainstream economic theory fundamentally misunderstands how economies work. It also, by-the-way, means that America and much of the world need to rethink our approach to managing our economic systems.

If you accept the logic presented above, then you are forced to accept the notion that our economy must go through phases—phases of debt-expansion and debt-destruction. A debt-expansion phase can last a long time—more than 60-years in our last stint (1946 to 2008)–but they cannot last forever. Debt-destruction phases last a long time too, and when a debt-destruction phase comes to a large economy, those phases are called depressions, or in Japan’s current case, long periods of deflationary stagnation.

Here is how the system works:

  1. An increase in debt drives growth in demand. (We pledge more resources from our future to buy things today.)
  2. A decrease in debt diminishes demand.
  3. When household debt is growing, things feel good. Demand is strong. People are pledging future resources, creating purchasing power, and the economy has the fuel it needs to drive growth.
  4. But when debt stops growing and begins to fall, this is when things fall apart. The so-called paradox of thrift kicks in. Reducing debt means reducing demand. Decreased demand translates to decreasing employment and earnings for many Americans and decreased asset values. As a result, the burden of debt we are attempting to pay down becomes even heavier, putting even more downward pressure on demand.

What you end up with is a deflationary cycle where falling wealth and falling earnings for many households causes the entire economy to be crushed under the weight of outstanding debts.

To get a sense of how this works, imagine how crushing your current debts would feel if someone were to cut in half the value of your wages and the value of your accumulated wealth. And imagine how tough it would be to be a creditor in a time when many of the loans you made in past years are unlikely to be repaid.

In a nutshell, after a 60-plus year debt-expansion phase, the American economy has now entered into a necessary-but-painful debt destruction phase. As the chart below illustrates, our debt-destruction phase has just begun. And sadly, as many households know from harsh reality, the paradox of thrift outlined above has begun to play out. Since 2007, the median household has seen a decrease in their income; they have seen a decrease in employment prospects; and, with dramatic erosion in home values and in stock market indices, they have almost certainly seen a dramatic decrease in their overall wealth.

If the above is an accurate understanding of how the world works, the implications are astounding. It means you can take much of what economists have told you up to now and drop it in the trash. It means that, unless we face up to our reality and do something truly radical, we face exceedingly hard times for years (perhaps even decades) to come. It means that, in the long run, we probably need to rethink the proper economic stance on questions like income distribution, optimal tax levels and structures, and how governments should go about monitoring and managing our economic system.

In coming days and months, we will attempt to broaden and deepen our understanding of how the system works and what is going on, and we will begin to delve into theses far-reaching implications.

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