Economist’s View links to an interesting article by Steven Gjerstand and Vernon Smith.
In this article they say that the high level of consumer debt in a number of countries is a concern – and indicates the possibility of a depression style contraction. This has the ring of truth. However, they also say:
The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate
I am not quite sure that this is the case. Ultimately, there is a distinct difference between the contraction caused by a tightening in the money supply and a contraction that results from the reallocation of resources in the global economy. The Great Depression faced both – thanks to central banks around the world we only face the issues associated with the reallocation.
I see the monetarist explanation as an explanation of some of the “policy errors” during the Great Depression – not a strict explanation of the pain experienced during that period. Lets have a little discussion:
Consumer debt, prices, employment
When we have a large amount of consumer debt combined with a sudden realisation that household’s expectations of future income streams were far more generous we have trouble – and this is exactly what has happened in a number of developed countries.
Now, when this happens it makes sense that households will cut back consumption and look at paying back debt – and on the face of it that sounds good. However, the allocation of jobs and capital in the economy has been set up to provide for more consumption based growth – and as a result, in the immediate term this transition forces an increase in unemployment, and lower household incomes.
The monetarist idea of just printing some money works by helping the economy reduce real wages. When we reduce real wages, we ensure that it is easier for employers to adjust wages to move workers around the economy (this presumes that wages are “sticky” downward). Given this, we reduce the impact on production – and ensure that the costly re-adjustment in the economy is less costly than it otherwise would be.
That is the key for me – monetarist type policies don’t prevent the pain that will occur with such a large scale re-adjustment in the economy. But they limit the impact by helping the labour market clear.
Consumer debt and costly adjustment
Now when we have large consumer debt in some countries there are large savers in other countries as well – lets not forget that. As a result, some people feel that the countries that have saved substantially could start spending on the things they make (hence why we need to price of a lot of goods to fall) – thereby rebalancing the economy.
The fact is though, that we need capacity to make this consumption happen – some countries have a lot of manufacturing capacity, while others have built consumption capacity. We need a period of re-adjustment, and a change in relative prices, to make the current production and consumption within countries consistent with the newly realised expectations of productivity and wealth growth.
Such a process does have a cost – a cost that can be reduced with increasing labour market flexibility (both within and outside of countries).
That is one of the reasons I don’t believe that we can have another depression like the Great Depression – labour markets and capital markets are more flexible, not just thanks to policy but thanks to technology.
In this explanation, high consumer debt and collapsing house prices are a symptom of underlying change – not the cause. As a result, I agree with the authors that the high level of consumer debt points to some underlying issues – but once we look at the issues I am not concerned about the current economic situation to the same degree as the GD would cause concern. Furthermore, I don’t think this observation defeats the explanation provided by monetarism – it just forces us to qualify it.