August 4, 2010

(Updated) The Coming Great Depression (and how to avert it)

Unless nations that have large trade surpluses begin importing much more, we are heading into a global Great Depression.

I will illustrate exactly how with a short story of an economy much like ours. Some readers will recognize this story, but it also includes some new observations at the end.

Suppose you and I were young and loved the wilderness and by chance we both moved to a small, remote meadow where we lived in teepees not far from each other, bringing with us basic tools by which to get our living. Suppose not long after we arrived we found an old cache of golden stones in a nearby cave from prehistoric times, and divided them equally, so that we had 20 golden stones apiece.

Suppose you loved to garden and forage, and had tools and seeds, and that I loved to hunt and trap and fish.

Not long after we arrive, you might well begin to want some meat to go with your meals, and I would surely like to have some vegetables, fruits or nuts to go with my meat.

While the first time or two we might simply trade a few items in barter, soon it would likely happen a day would come when I had a large haul of fish and you might have only a few nuts and I might suggest that you simply give me 1 of your golden stones (a "goldie") as a token for future food which I might buy back from you on another day when you had more.

We would have an economy, not fundamentally different from the global economy, even with its exchange rates, central banks, factories and technology.

Soon we might well have typical prices for our goods. A fish might cost a goldie, and so might 2 potatoes.

Perhaps on an average day we'd exchange a goldie or two, and in a week, perhaps several would go back and forth. Eventually, seasonal patterns might show up, and over the years we might have habits of me buying more vegetables in the summer, and you more meat in the winter, so that in the summer you would have more goldies and by early spring I would have more goldies.

Now, suppose one day, after several years of a stable, productive economy, I decided I wanted to save goldies for the future. Suppose I went on a savings binge. To save, I begin buying less from you, keeping more of my goldies in the summer, and foraging some for myself.

At the end of the summer, when you would usually have had plenty of goldies to buy meat from me in the winter, you'd find you have much fewer.

You've experienced a big loss of income. And winter is coming on. You've been saving nuts and potatoes, but you know it's going to be a hungry winter.

In desperation, due to your reduced income you begin buying less meat from me during the fall.

Now my income is reduced also.

In sum:
a) I've had less vegetables than usual
b) your income was reduced
c) you are poorer, and now now must make due with less meat than usual
d) and therefore my income is now reduced also.

I saved, and no one borrowed that savings and put it back into the economy, and the result was an economic spiral downward.

You are hungrier. I am hungrier.

Unless I stop saving, or someone starts borrowing my savings and spending it, trade would decline week after week, as I withdrew more and more goldies from circulation. Most likely what would happen is that due to my reduced income, I would be forced to begin choosing whether to save another goldie or have vegetables to eat that week, or take on extra work to grow my own, so that I worked 16 hour days. Eventually, my savings rate would stall out and decline, in spite of my plan. Either I'd stop saving in order to get some rest and eat at least a few vegetables, or I'd stop saving because I no longer have any income left to save. Trade would either stop entirely or be maintained at a low, impoverished level.

This is ultimately the real thing that is behind the abstraction of the "worldwide savings glut" -- a great excess of global savings over the sum of global consumption and sensible investment.

It is economic decline, joblessness, even economic downward spiral.

The only difference between our meadow and the global economy that matters here is that in the global economy, the massive savers -- the Germans and the Chinese -- loaned their savings to the rest of the world into financial markets so that more money went into house-price bubble countries whose housing bubbles were driven exactly by those excess savings via easy-money credit (mortgage) bubbles.

This massive credit delayed the downward spiral a savings glut must cause, but only to make the shift more sudden as a confidence crisis finally came, so that the inevitable downward spiral was more like falling off a cliff (2009).

Unless the excess savers change course this will continue, deepening to touch everyone, and may well even slam those that have a lot of savings in every nation, because savings cannot earn interest or dividends of any significance unless the invested-into economies grow.

In nations like China, such investments can take many forms, including such basic needs as railways, health clinics, hospitals and schools. And in underdeveloped nations, investments could take almost unlimited forms.

Because we are afraid of the economic uncertainty, even those of us that wouldn't ordinarily hoard a great excess of savings are trying to save more rapidly now.

People in many advanced nations are demanding their governments reduce deficits at the same time that they themselves save more.

In other words, the savings glut is likely to grow again in proportion to the world economy. Conditions could soon be getting worse.

Conditions will soon be getting worse unless there is a reversal of the excess of global saving over global borrowing.

Unless good investments quickly ensue, the unused savings could indeed spiral the global economy, and that of most all nations (except command & control economies), down into a great depression.

There is no long-term solution to this more general new psychology of hoarding short of creating renewed confidence in most nations where fear of the future holds sway. For instance in China this would take many forms, including visibly increasing the future economic security of retirees so that Chinese households would feel more confident about spending part of their large savings now.

Around the world, changes are needed now, before our global crisis deepens.

These changes seem unlikely to happen soon.

Therefore, we are on the path of the 1930s. That path was a spiral into depression, which provoked a rising militant nationalism in some nations, which led to aggression, which led to world war, which led to massive governmental borrowing (war bonds), which ended the excess of saving over borrowing, which massively increased total spending, which ended the depression.

Of course, that path included tens of millions dying and the first use of weapons of mass destruction.

Is there any way to avert this Great Depression?

Yes. Two broad efforts are needed.

The most central problem is the overhang of debt that depresses household spending. The second challenge is reforming the unfair international trade that had been heretofore covered up by easy credit, which made us feel richer than we were.

First, we can escape this great depression by accelerating the reduction of debt, especially debt forgiveness. People often think foreclosures are to be avoided, but the reality is that most foreclosures give dramatic relief to household budgets which escape crushing mortgage payments. Foreclosures are often a far better family budget relief than a low interest rate or other small modifications of mortgages, when families are in a house that is above their means. Consumer bankruptcies are also a dramatic debt relief. Review of current bankruptcy law could reveal ways to allow easier bankruptcies for consumers who are against the wall financially. Finally, as a great depression makes itself obvious, we may need to let those that can pay their revolving debts get lower interest rates such as by federally regulating interest rates on credit cards.

Second, we must require actual free trade with trading partners. When a nation (China) subsidizes its exports and places tariffs against American goods by artificially holding down the value of its currency, it steals jobs from other nations. That isn't "free trade."

America should enter into limited free trade agreements. We don't need unlimited free trade any more than we need to allow some nation to intentionally steal our jobs away through a calculated effort. Actual free trade will prohibit currency manipulation. But further, we can reasonably designate that some kinds of goods and services must be domestic in origin, just as China does.

Nations that are willing to trade on a fair basis, freely, are sufficient trading partners for us. Everyone, including China, will be better off over time under actual fair trade.


  1. Hal. I'm still trying to find a flaw in your model because it seems to suggest that Americans as well as Chinese should be spendthrifts. However your conclusion is 100% correct. Vitually the entirety of the current economic calamity has resulted from free trade with China. We need to bang the Chinese right between the eyes with smothering tariffs and show them we can play hardball too.

  2. Well, normally in an economy, as households save money (spending less than they earn), then the savings are in turn borrowed by young couples buying their first house, businesses expanding or offering stock IPOs, local and state governments issuing water or road bonds, etc.

    In other words, normally in an economy all the savings are borrowed and then used. The interest rate would classically be set by the relative demand of borrowers -- more borrowers would lead to a higher interest rate.

    Right now, so many businesses and households are saving, *around the world*, that there is not enough borrowing to drive interest rates of US treasuries up much above zero. Instead, the federal government is able to borrow at near-zero rates short term from private investors, and at even historically low rates medium term (5-yr treasuries).

    We are in a Savings Conundrum, a special condition. It is rare.

    Normally savings are borrowed and used productively (building new houses, roads, furniture, schools, etc.) in the economy.

    When that normal equation breaks down, the economy breaks down.

    It is the Savings Conundrum illustrated in this post.

    At the moment, unless governments borrow the unused savings and invest that money in the economy there will be unused savings, and thus less net total income for business around the world. A downward spiral.