11/17/2008 05:12 am ET | Updated May 25, 2011

Depression Economics Explained, Part 2: The Credit Crunch

People are desperate for an explanation of the economy that actually makes sense. They're not getting it from the experts. My talks with "Norm" are a composite of recent conversations I've had with friends and family about what's going on with the economy. The first installment dealt with "speculative bubbles." Here we turn to the "credit crunch."

Norm: There are a few things I don't understand about this "credit crunch." I heard on the news that cities can't borrow the money they need to fix roads and build schools. The next day I heard a story that corporations are canceling projects because they can't borrow money anymore.

Zack: So what don't you understand?

Norm: This is what confuses me: We are the same people we were a month ago, when we were fixing those roads and starting those projects. How does all that change because of some numbers on some screens in some banks?

Zack: Norm, that's an incredible question. I wish some financial journalists would ask it.

Norm: So you have an answer for me?

Zack: I bet you already have the answer. Are you a different person than you were a month ago?

Norm: I'm not, but my bank thinks I am. They rejected me for a home equity loan to build a second bathroom on the first floor of our house.

Zack: You're getting at something really important about our economy. It's obvious, it's right in front of our faces -- but our (mis)understanding of the economy causes us to look right past it.

In our economy we have given control over decisions -- those roads, those projects and even your bathroom -- to banks and investors who extend or withhold credit. So while a city is physically capable of repairing it's roads, it can't mobilize the people and materials to do it without the banks' go-ahead. In the Soviet Union, the government's central planners chose what resources can be mobilized. In our system, we've essentially tasked the banks with that role.

Norm: So you're saying it's our fault: that if we just saved and lived within our means, that the city would be able to fix the roads and I'd be able to build my bathroom.

Zack: Well, before we get to the alternative, let's just make sure we're on the same page about how the current system works. Think about how the banks make the decision to lend or not...

Norm: They look at your income and debt and try to figure out whether you'll be able to pay them back.

Zack: Well, that's what they're supposed to do, but they didn't do it over the past decade, did they? They lent trillions to speculators whose business they didn't even understand. And they lent trillions to home buyers who had nowhere near the incomes needed to pay back the loans. (See Part 1: Speculative Bubbles.)

Norm: Yeah, for a while, they were giving everyone money for everything, no matter how stupid. And now they're doing the exact opposite and not giving anyone money for anything. I have a stable job, and my house is nearly paid off, but they won't lend me $20,000 to add on to my house.

Zack: Right. Because we rely on credit, and because banks and other lenders control credit, they have become the "central planners" of our economy. And it turns out that they're really bad planners.

Norm: Well, they're not "central" planners -- because there are thousands of different players in the market.

Zack: You're right, but they sure do seem to run in a pack, don't they? So the result is sort of the same. But you raise an important point: it's in the nature of packs that they sometimes act erratically.

Norm: And that's why the government now steps in as the central planner.

Zack: But the government didn't step in as a planner. That's what's fascinating. The government is just extending cash and credit to the lenders. They're feeding and sustaining the pack, hoping that it will turn around and run the other way. But there's no guarantee they will.

Norm: But if banks get an infusion of capital from governments, why wouldn't they start lending again?

Zack: Because, if they think the economy is going down the tubes, they want their money in cash just like you do. The banks are acting rationally by not lending. We covered in our last discussion. So the government can give them all the money they want, but it's still up to the banks whether they go back to acting crazy and lending money for everything and anything. They are still in charge of whether or not to mobilize our resources for fixing roads, or building your bathroom.

Norm: So you're saying we're helpless.

Zack: No, there's an alternative.

Norm: You mean saving and living within our means? Then towns and businesses could pay for their roads and projects -- and I could pay for my own new bathroom. You're saying that if we just saved, then we'd have control over our economic lives.

Zack: Well, it's not that simple actually. There are so many other things that could get in your way, even if you were the model of perfect frugality:
  • Inflation could rise and wipe out your savings.
  • The economy could contract and you could lose your job.
  • The U.S. dollar could crash and then all the materials for your bathroom would cost a lot more.
...just to name a few.

Norm: So your point is that we can never have control over our economic lives and that we have to roll with the punches.

Zack: I didn't say that. My point here is to show that, without even thinking about it, our whole society has taken this radical approach to managing our labor and resources: we rely on banks and other private investors to do it. And this isn't something from the last couple of decades -- this is how most of the world has managed its economic activity for the past few hundred years.

Norm: It seemed to work for a while, didn't it? And are you saying we should go back to feudalism when kings managed our resources? Or you think Stalinist central planning is a better model?

Zack: Of course those aren't better models. But I disagree that the current model has ever worked well or that it's the best possible model.

A lot of upper-middle class people and rich people were happy with the last couple of decades because they got wealthier. I'm all for people living better. But most people in America saw their real incomes fall or stagnate during that period. They also worked a lot harder and had less time for their families.

On top of that, our "planners" spent resources unsustainably. In other words, they trashed the environment which is another way of saying they made a huge mess that we and our children are going to have to work really hard cleaning up. And they invested in industry and infrastructure that now has to be totally dismantled and rebuilt if we're going to stop creating these messes.

Norm: Yeah, I understand all that. But what's the alternative?

Zack: I think we're going to have to get through a few more of the concepts underlying depression economics before we start thinking through an alternative. Until next time...