What Happened to America's Economy

cross-posted at Dagblog

We're always told that economics is a complicated science, which is true, but also that bottom-line practical economics is very simple. But the simple rules we've all learned seem to have landed us into an incomprehensible mess. Let me try to recap what's happened.

Obviously, every business needs to make a profit to survive. This is done by keeping costs lower than revenues. If you're selling something, you need to make more money selling it than you spend in making or buying the product and in paying your workers.

What every business would like to do is to spend as little as possible without cutting revenues. This makes sense. And for the last thirty years, the most popular way of keeping costs down has been to keep labor costs down. The fewer people you pay, and the less you pay for them (counting wages, benefits, and payroll taxes), the more profit you can make. This also makes sense. Every business owner wants to keep pay down and profits up.

Now, here's the problem. If you pay your employees less than all of your competitors do, but charge equivalent (or slightly lower) prices, you will make more money than all of your competitors. If you could spend 10% or 20% less on your workers than everyone else in the market spent on equivalent workers, you'd have a winning strategy. However, at this point everyone who's gone to business school for even a semester, and many people who haven't, have all been taught that the key to succeeding in business is keeping costs down. So nearly everyone is trying to keep pay as low as possible.

This becomes a big problem because ultimately the employees (not just your employees but all of the economy's employees combined) are also the bulk of the consumers in the economy. If you pay Bob Cratchit only two-thirds of the going wage, but everyone else pays their Cratchits the full wage, you will be on the cover of Forbes. But if everyone pays their Cratchits two-thirds pay, suddenly there will be a lot less money out there for people to spend on buying your patented Scrooge-o-matic this Christmas. And then your business is in trouble. You could just fire a few Cratchits to keep your profit margin up, but if everyone's firing Cratchits then there will be even fewer people buying Scrooge-o-matics. It's a classic game-theory trap.

The problem is that reducing overall employee pay (either by cutting their wages or cutting taxes and benefits that employees will have to make up out of their wages) reduces overall consumer buying power. There are some classic ways to reduce (if not avoid) the problem of reducing consumer buying power.

The first is by increasing your national economy's exports, so that you get revenue from customers outside your own workforce. The United States has actually gone the opposite route, importing more and exporting less, so that makes the problem worse.

You can innovate in ways that allow you to produce higher-priced goods with lower overhead even when you hold employee pay more or less stable. We have done some of this, but it's a marginal benefit, and it's likely been overstated. Technological innovation has helped stave off the moment of crisis when the customers run out of money, but not much faster than the trade deficit has been hurrying that crisis toward us.

And finally, you can count on consumption by the very rich to make up for the loss of the employees' buying power. This is the "trickle-down" theory, which proposes that making the top spenders in the economy even richer, even at the expense of the lower, middle, and upper-middle spenders, will eventually help everyone. And it's true that the consumption of the very wealthy is consumption and helps as far as it goes. But the question is whether Mr. Scrooge's increased consumption when he has ten times the money in his pockets offsets the loss of consumption from a large number of Cratchits that he's fired. The result of our current real world experiment seems to be "Not even close."

So at some point, the United States economy will reach a point when the ongoing reduction in worker pay has damaged the consumers' overall buying power so badly that people can't buy anything and businesses can't make any profit. When will we hit that point? About twenty years ago. Maybe twenty-five years ago, maybe fifteen, it's hard to say. But certainly that crisis point, when it was time to turn the ship around and plot a new course, is already many years in our past.

When American businesses neared the point where the customers run out of money, they took very careful steps to postpone that crisis without fixing the underlying problems. By that point, the principle that pay should be kept low was already fixed in business's mind as an immutable and nearly moral law. (In fact, the compensation-cutting has only accelerated over the last decade or two.) So the question was how to shore up consumers' overall buying power even while cutting their overall pay.

There were two basic short-term fixes that disguised the problems and solved them in the short term while making them worse in the long run. The first was to cut prices on lower- and middle-end consumer goods by producing them overseas and retailing them in discount chains such as Wal-Mart. People who worked for a living were making less money, but many things were cheaper, so it felt like they were more or less keeping pace. This solution seemed to work for a while, but it cuts prices by cutting pay even faster, moving manufacturing jobs offshore and cutting wages for retail sales people (like Wal-Mart's employees) as far as they could be cut. So the first part of the strategy eventually undermines itself, and ultimately makes the economy's basic problem worse by cutting the consumers' buying power even deeper.

The other short-term fix was to loosen consumer credit by an unprecedented amount and make up for the lost real buying power by allowing consumers to rack up debt. This also papered over the problem for a while. Even if consumers had less money, they felt like they had money, and more importantly from business's point of view they spent that money. Meanwhile, business (in the aggregate) made even more profit off the consumers, by charging interest on that debt. Profits grew even higher, but the consumers' real long-term buying power was cut even further by the unprecedented amount of and unprecedented interest rates on that consumer debt. All of those credit cards kept the economy's wheels turning much longer than the actual fundamentals of the economy would allow, but left it in a much, much deeper hole. It's fashionable in some quarters to blame the economic downturn on the spendthrifts with the credit cards, but this misses the larger point: American business as a whole extended ridiculous amounts of credit for nearly twenty years, far in excess of borrowers' overall ability to repay, in an attempt to maintain unrealistically high corporate profits. American businesses essentially put the whole economy on Mastercard.

Now, of course, things are much much worse than they would have been twenty or so years ago. That was when we reached the point where depressing wages begins to depress consumers' buying power and hurt profits. Now, enabled by two decades of smoke and mirrors, we've gotten a long way below that point. Why would the American business community conspire against their own long-term economic future in this way?

The answer is supply-side economics, which basically teaches that the most important thing for economic growth is the availability of capital for investment. (It is absolutely true that an economy without enough investment capital will do poorly. There needs to be enough capital to start new businesses and expand existing ones.) Therefore, the key to building the economy is imagined as business profits which can be re-invested. Supply-side, at least in the crude popular form which actually gets put into practice, doesn't worry so much about the problem of demand. It proposes that if there is enough money to invest in a good business, the market will make that business a success, and people will buy the business's product or service. Where will the customers come from? Where will they get the money? The motto of supply-side is "If you build it, they will come." The problem is that they will come without money to buy anything.

The result of supply-side thinking is a focus on making the economy good for business profits, rather than for workers. (And of course, there is such a thing as an economy where pay's too high and profit's too low. But ideological supply-siders deny that profits could be too high or wages too low.) The focus has been on keeping costs down, and we've developed a whole set of beliefs and assumptions that go along with that idea. Everybody knows that taxes are bad for the economy, and everybody knows that unions are bad for the economy, because those things cut into employer profits and increase employee's earnings and buying power. But everybody's wrong; the economy was going like gangbusters in the heavily-unionized, relatively-high-taxed boom years of the Fifties and Sixties. And while there is such a thing as taxes being counter-productively high and union demands being unreasonable, unionized workers who can count on government benefits also make pretty good consumers, and the economy misses them when they're gone.

An implicit assumption of supply-side economics, at least as practiced by American policy-makers, is that there can never be too much capital available for investment. It imagines a smooth line on a graph, where the more capital there is the more the economy benefits, with no point of diminishing returns and certainly no point where the free capital becomes counterproductive. But this is demonstrably untrue. At a certain point, you get more capital than there are good investment opportunities for it, and then problems start. Ultimately, large piles of investment cash without enough real things to invest in lead to speculative bubbles. When average workers and consumers have too much cash for the amount of things that there are for them to buy, you get price inflation. When investors have too much cash for the amount of profitable enterprises that they could buy into, you get bubbles. Lots and lots of that accumulated capital gets put into investments that are unlikely to pay off, but the act of buying those ill-considered investments pushes their prices up, so they look like a huge profit opportunity, until eventually people are paying a million dollars for a tulip bulb and there's a crash. That's where the tech bubble and the resulting crash came from; that's where the housing bubble and the resulting crash came from. When the amount of profit going to the investor class becomes excessive, those big piles of cash basically start to set themselves on fire, and the fire spreads to the rest of the economy.

The problem we're in now is keeping a sufficient amount of investment capital available to build the economy back up, while restoring the buying power of the people who do most of the working and paying and living and dying around here. It's not an easy problem, but that's what the problem is.

Happy Labor Day, all!