Tuesday, December 20, 2011

The World Economy is Out of Balance

Over the last several decades the rewards of productivity have gone to owners of capital, not labor. Automation has reduced the need for labor in manufacturing industries, driving down wages.  Producers have moved production offshore to reduce labor costs even further. At the same time, the financial sector share of GDP has tripled. This has happened not only in the US, but in other developed countries as well.

What has been forgotten is what Henry Ford knew at the beginning of the twentieth century, namely that a thriving middle class is the source of most of the demand in consuming countries. When wages stagnate as they have in the last several decades, middle class buying power is destroyed. This may be in the producers interest if they can find buyers in other markets. But, when it happens all over the world in developed countries that supply 70% of world demand, it results in a sustained decline in the world economy.

No amount of money sloshing around in the pockets of a few wealthy people looking for a place to invest it will solve the problem. The only solution is to rebalance world wealth and incomes to put more money in the hands of people who will spend it, not people who save to invest. Until producers realize that that they need the spending power of wage earners to create demand, they are planting the seeds of their own failure. It’s time to start paying workers that spend their income a decent wage to rebalance the need of demand with the need for capital. If producers won’t do it, governments need step in and increase taxes of capital and reduce taxes on labor.

Monday, December 19, 2011

The Underlying Cause of Depressions

There has been a lot of study of the cause of the Great Depression and now of the current Great Recession. But, answers are clouded by studying primarily what happens after banks get into trouble. This overlooks underlying causes which may be more important. Nobel economist Joseph Stiglitz and Bruce Greenwald of Columbia University have been studying the underlying causes. Stiglitz has presented the results in a recent article in Vanity Fair. It’s a good read.

The scenario goes something like this. Technology improvements take place which increase productivity. This, in turn results in less labor being needed to produce the commodity. Too much labor leads to low wages, lost jobs, and reduced demand. The rewards of increased productivity go increasingly to the providers of capital. As capital accumulates, the return on capital is reduced, so capitalists look for ways to increase it. This usually results in buying up assets that can produce a revenue stream. Asset prices escalate and seeing this, investors buy up more assets to take advantage of increasing asset prices. This is the beginning of a bubble in asset prices.

Seeing a chance to make easy money, more people start investing in the asset bubble. Financial institutions are making money hand or fist from the new lending and capital is freely available from increased productivity and asset investments. The opportunity seems a sure thing so leverage is increased to increase profits dramatically. These profits must be invested to earn income, so banks seek to place new debt with less credit worthy debtors, and so are willing to take higher risks, which they offset by buying credit default swaps, a form of unregulated insurance not fully backed by the assets. Eventually the bubble bursts when these risky investments start to fail and the whole economic system is put in jeopardy by the threat of bank failures.

Only now does the analysis of what happened start. The first place analysts look is why excessive risk was taken on and why not enough liquidity is available to prevent a collapse of the economy. Governments are looked to for bailouts of failing banks. And we know the story from that point on. It’s a battle between people who think government spending is needed to sustain the economy and people who think it all happened because people and governments were irresponsible and what is needed is austerity measures to teach the irresponsible a lesson. The underlying problem has been long forgotten in the process.

The Underlying Problem in the Great Depression

Prior to the banking problems in the great depression, the economy was largely based on agriculture. As technology advanced, farmers were able to produce more food with less labor and the same size farm, so farm commodity prices fell and fewer farmers were needed. But switching from farming to an industrial job was not easy. Most farmers had only an elementary school education, so they continued to do what they knew how to do, farm. With less income per acre, they needed more acreage and loans to buy the acreage. But, this just compounded the problem. More production meant even lower prices and now they had bigger loans to pay off. And a drought in many parts of the country made things even worse. So many of these farmers ended up losing their farms and ended up unemployed. The unemployment among farmers, a large segment of the economy at the time, meant reduced demand for products and service produced elsewhere in the economy, resulting in unemployment there. Banks foreclosed on the farms, but with more production than was needed, banks took losses on the loans. And, the excess of labor and lack of new projects to employ them meant a drop in demand for all goods and services, driving the economy into depression.

The Underlying Problem in the Great Recession

In our current recession the underlying problem was increased productivity in manufacturing, hence less required labor, and moving much of the manufacturing sector overseas where labor costs were much lower. Again the rewards of productivity increases went to capital and wage income stagnated. Capitalists, flushed with newfound wealth looked for places to invest. And consumers, whose wages had stagnated looked for other ways to make ends meet. Investment in land and construction soon supplied the answer.  Average homeowners soon saw the opportunity to increase their income by taking loans on the increasing equity in their homes, and banks, flushed with cash saw another opportunity to make a killing leveraging up on riskier and riskier loans and unregulated insurance. The rest is history, and we know who governments bailed and who is picking up the tab.

So, What is the Solution?

Stiglitz seems to think the solution is to put people to work by embarking on new projects to employ them and education to equip them for new jobs. Just as the war economy pulled us out of the Great Depression by creating new jobs for the unemployed, we can create new jobs for the current unemployed by investing in infrastructure which has deteriorated for lack of maintenance and in research on promising new transportation, communication, and energy technology. But, just as the war required massive government spending and increased government debt, we need to accept greater debt now to ensure a healthy future economy that can pay off the debt. And,  just as the economy after the war required higher taxes on those who could afford to pay them, the same will be required now from people who have profited handsomely from years of productivity rewards, the bubble and the ensuing bailout.