What is the root cause of the global economic crisis? Before there can be a solution, the root problem must be known and understood. Only then can solutions be proposed.
It is easiest to explain the problem by way of a chart. This chart is from any textbook used to teach Economics 101 like Paul Samuelson’s textbook Economics
Households and firms are the two agents in the economy. Your family is a household. Suppose you work in a factory that makes toothbrushes. The toothbrush company you work for is a firm.
Households supply the factors of production to the firms through the Factor Markets. Factors are are land, labor and capital which are the inputs for production. You supply labor to the toothbrush factory. Firms create demand for the production factors. For instance, they put out a help wanted ad for new toothbrush assemblers.
Firms also supply goods and services to the households in the Product Market. Households in the product market act as consumers. For instance, the market sells toothbrushes to consumers made in the factory that employs you. Consumers create demand in the Product Market.
Money flows in the opposite direction. Firms pay households for the factors through wages, interest and corporate profits. This money collected by households is National Income.
Households pay firms for the goods and services they consume. This revenue for the goods and services is the National Product, which is revenue to the firms.
National Income equals National Product, and everything is in balance.
Input & Output Flows are Now Out-of-Balance
The following imbalance has occurred since about the year 2000.
Technology improvements in two key areas, telecommunication and transportation, has allowed firms to outsource many design and manufacturing jobs to distant locations. The most obvious new technologies are the internet and container ships.
Most of the outsourcing of labor has been to developing countries, such as China and India, where labor costs are a fraction of the U.S. labor costs. A typically Chinese factory worker may earn just 70 cents per hour compared to $15 per hour for a comparable U.S. worker.
Also geopolitical developments like the opening up of communist China to the west starting in the 1970s and the collapse of the U.S.S.R. in 1990, have also played a role. As a result, China and other countries are supplying a portion of the production factors to U.S. firms that was formerly supplied by U.S. households. In the past two decades, factories closed in Ohio and North Carolina and opened in Shanghai and Nanjing making everything from autos to furniture. Money is flowing the opposite way from U.S. firms to China through the factor market.
The great imbalance arises because Chinese households are not closing the loop and buying goods and service from U.S. firms. Instead, they are hoarding most of the money, as much as 50%, and lending it to the U.S. Households. The U.S. households are then using the loans from Chinese savers to buy goods and services from the U.S. firms. From 2000 to 2008, U.S. Households increased consumer spending, without seeing an increase in their household income. The difference has been made up with borrowed funds. In the process the U.S. Households have been building up debt which is owed to the China.
Too Much U.S. Debt
In the short run, none of this appeared to be a problem. U.S. GDP continued to grow as U.S. consumers bought more goods and services. Household’s standard of living rose with higher consumption. But much of the consumer spending and GDP growth of the past decade has been with borrowed money.
This debt is in the form of credit card debt, auto loans and the big one, home loans, which were collateralized by the U.S. housing stock. In 2007 and 2008 when house prices start falling, U.S. Households were either unable or unwilling to keep up with their debt obligations and began defaulting on debts, meaning they stopped making interest payments and allowed the lender to take the collateral through foreclosure.
The fundamental problem is that the circular flow of Income and Output are out of balance. Why? Because Chinese households are selling their labor in the Factor Market, but are not buying goods in the Product Market.
For an economy to work, everyone must be both a producer and consumer. Henry Ford understood this well. His principle was that every Ford employee cold afford to own a Ford automobile. If you were ever in Detroit during the heyday of the motor city, every car in the employee parking lot was a late mode Ford. If you go today to a Ford plant in Shanghai or Nanjing, would you see the same thing?
Is There a Solution?
So there we have outlined the fundamental problem. As for a solution, that is more difficult. There aren’t always neat solutions. Exactly how the resolution unfolds and which government policies might be best may be unknowable. Some solutions and paths might be unpleasant for either the for U.S., for the Chinese, for both or for the whole world. However it resolves, the balance between National Income and Output will be restored.
The views expressed are those of the author and do not necessarily represent the views of Laguna Beach Bikini, its editors or any organization.
