In a typical economic cycle, some businesses expand too rapidly. When these businesses recognize that they have grown too fast, they pull back on spending. Usually the businesses that must do this are grouped in a specific economic sector. If enough businesses are forced to do this or the particular economic sector is large enough, then the economy falls into recession. However, what we have seen since late 2008 is not your garden variety recession. Rather, it is a once in a lifetime economic collapse brought about by the rapid expansion of credit.
Since 1971, the U.S. and the rest of the world have functioned on a purely debt-based monetary system. This system requires the continual expansion of credit in order for the economy to grow (think of an exponential function). As the debt level expands, it allows businesses and consumers to spend more. In the short term, the increase in debt appears to increase demand in the economy, which looks to most people like economic growth. However, what the expansion of debt really does is pull demand forward from the future. At some point (when there is no longer enough income generated to pay for the increased debt load), there is no more demand to pull forward. Businesses and consumers stop spending. What appeared to be growth in the economy is then recognized for what
it is—a period of false prosperity.
Since the credit bubble burst (and the data clearly shows that it has), the government has continued to attempt to pull demand forward. All of the methods it has used to do this have focused on expanding the level of credit in the economy in hopes of “jump starting” the economy. Some of these programs appear to have worked. Consumer spending has rebounded, home sales increased immediately after the tax incentives started, and industrial production has improved.
But, a year after these programs were started, many are now ending. As these programs end, we see that they did not really work (home sales are falling back to their lowest levels and car sales haven’t been able to continue the growth seen during the cash for clunkers program, for example). They didn’t work because there is no more demand to pull forward. Business and consumers are tapped out on debt and trying to reinflate the economy through more debt (which worked in the early 1980s, early 1990s and early 2000s) will not work any longer.
Fixing the economy is a rather simple, albeit painful, process. Step 1 is stopping all of the government intervention in the economy. Government intervention distorts and stifles demand because business and consumers have no rational basis from which to make decisions. Step 2 is allowing the credit bubble to collapse, removing from the system all of the bad debt that cannot possibly be paid back. While this will be painful it is not necessarily a long-term process. Step 3 is increasing savings and capital accumulation. Increased savings causes production to grow (for an excellent explanation of this, read the book “Economics for Real People” by Gene Callahan). More production causes income to increase. It is legitimate for the manufacturing industry to be upset about work being sent overseas, but the anger has been focused in the wrong place. Instead of complaining about the actions of foreign countries, the anger should be placed on policies enacted by our government that have inhibited savings and capital accumulation in this country.
While the diagnosis seems simple to me, the likelihood of it being put in place seems doubtful. Government doesn’t seem interested in following the steps I have outlined for any number of reasons. In fact, government is moving in the opposite direction by increasing its intervention in the economy. As the level of intervention increases, it becomes more difficult for me and you to make a reasonable estimate of what will happen in the future.
Looking ahead, my hope is that the economy muddles along through a series of ups and downs as we work off the bad debt accumulated during the last 40 years. This will probably take 5 to 10 years and hopefully not end in a major world war. But, I’m not sure how likely this is. Ludwig von Mises, one of the 20th century’s greatest economists, stated, “There is no means of avoiding a final collapse of a boom brought about by a credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved.” Let’s hope he’s wrong.
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