Consumer debt, monetarism, and depressions

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.

7 replies
  1. Sandip Sen
    Sandip Sen says:

    Hi Matt,

    Nice blog. Here are some differing views of the Milton Friedman who assessed the GD closely and clinically. It looks similar to the current
    day happenings.

    In the Chapter ” Anatomy of Crisis” of the Great Depression, Milton Freidman in his popular best seller ” Free to Choose ” clearly says that during the 1929-34 period
    ” the Keynesian revolution not only captured economics profession, but also provided an appealing justification and a prescription for government intervention.
    The shift in opinion of both the public and the economics profession resulted from a misunderstanding of what had actually happened. We now know, as few knew then , that the depression was not produced by a failure of private enterprise , but rather a failure of government in an area where the government had from the first been assigned responsibility —- To coin money, regulate the Value thereof and of foreign coin”

    Freidman goes on to say in the Book that wrong government intervention & “subsidising the inefficient policy” propped up “The Knickerbockers Trust company” and many banks in 1907 creating a Federal Reserve system that created arbitrary rules on restriction on withdrawal of deposits , that collapsed ultimately in 1929 to create a much greater and long drawn depression.

    The present day crisis has roots similar to the great depression.
    Once again it is probably the government intervention & “subsidising the undeserving policy ” policy that is precipitating the crisis. By propping up the security & mortgage arms of monolithic banks & insurers such as Citi & AIG it is putting pressure on the already distressed citizen tax payer. If Banking or Insurance operations and derivatives business are segregated the problem will largely dissapear from the core functions of these companies which could go about the daily business normally. The derivatives business then must be examined closely, one large part of which would be the subprime mortgages that have been securitized. This part must be either
    dis entangled and scrutinized or written off en block. It is illiogical to repeatedly try and sell these toxic mortgages as securities in the market knowing that they would mutate and collapse in future under the weight of their toxicity.
    The US Governments , the Fed & the Treasury’s persistance with the disposal of the sub prime housing mortgages first by securitization and now by the public private partnership is simply baffling and shall only prolong and deepen the crisis, by the next quarter.

    Investment Guru warren Buffet had predicted in 2002 that these derivatives are financial instruments of mass destruction
    More on the subject at , a recent
    blog on ecology and economy.

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    thomas says:

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  3. Evelyn Guzman
    Evelyn Guzman says:

    I am glad to read your perspective on the issue of whether or not we are going to undergo depression. I like the analysis you made of the situation and your belief that we are not going to have another great depression is most welcome. Yes it’s due to policy and technology but sometimes the latter is hard on the consumers as one sometimes can’t talk to a real live person in the customer service department.

    Evelyn Guzman
    Debt Challenger

  4. Matt Nolan
    Matt Nolan says:

    @Sandip Sen

    Hi Sen,

    Thanks for the comment.

    I am not sure I would completely put the responsibility for the depression down to government – after all, large recessions and booms were prevalent well before we had centralized monetary and fiscal policy.

    Understanding how monetary and fiscal policy fit in with economic ebbs and flows is important – and is an issue we still have work to do on. But I don’t think we can solely put blame down on a single institution.

  5. Sandip Sen
    Sandip Sen says:

    Hi Matt,

    You are right. You can’t blame one institution or the Government. Warren Buffet blamed the instrument itself. Way back in 2002 he famously predicted ” Derivates are the financial weapons of mass destruction”
    No body listened to the old man as they were too engrossed in making money. So much so that by 2005 the Banking industry was so swamped with demand that they began issuing the derivatives without even having time to do the background paperwork for the securitization. When things got out of control Tim Geithner, then head of Federal Reserve pressed the top 15 financial firms who were issuing the derivatives to build an electronic network for recording of these instruments which was completed only by the third quarter of 2006. By then the damage was done. Some details are available at on both
    Buffet’s opinion & Geithner’s role.

    The issue, as in the Great Depression, was a massive downcycle due to a multiple institution fault. Even in the GD it was the Bank failures of 1907 which created the crisis of 1929 largely due to improper regulation by the Government which Friedman points to. The Government as now failed to meet its only responsibilty that was primarily “TO REGULATE” . Surprisingly it fails to do so even today after the Sept crash. The farcial stress tests by Banks themselves without external auditing is another example of failure of the Regulator, that will only help prolonging the misery. The fact is that cyclic ups and downs are natural, but only when you artificially manipulate the up cycle the down cycle hits you harder.

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