How the village went broke

Many years ago I read a reference to a hypothetical economics problem--a Chinese village in which all the inhabitants made their living by taking in one another's washing. I just did a google search to try to find a complete version of it but came up empty, and therefore must try to work it out for myself. The idea always struck me as a reductio ad absurdum, that is, a logical exercise culminating in an absurdity, and thus refuting the original premise--in this case, that such a thing was possible. The problem, it seemed to me, was that washing was a luxury, not a necessity. If everyone was doing nothing but one another's washing, their per capita income would equal the cost of doing their own washing, and thus they would have no money for food, shelter, or even the original clothing to wash. Such a village, on the assumption that it was a self-contained, autarkic economic unit, would in reality have to grow its own food. The laundry owner, like the blacksmith, the carpenter, and everyone else who did not work the land, would have to buy food; that it turn would give the farmers the money they needed for the services of those tradesmen. And if the village were not totally self-contained, surplus food could be sold elsewhere, allowing everyone, eventually, to get a little richer and afford more services, including perhaps an occasional concert by a traveling pianist or a barnstorming sports team. But it seemed to me then, and it still does, that any sound economic structure had to rest at bottom on the production and sale of life's necessities. No village that did not produce some of them could survive on its own.
Yet it has occurred to me over the years that the American economy has been coming closer and closer to that mythical Chinese village. Laundering is a service, and we increasingly have a service economy. But critically, in the last few decades, we have taken yet another big step down the road to perdition. The purchases of goods and services that make the economy grow have increasingly been financed not (in the first instance) from the production and sale of necessities, much less from the sale of necessities to other villages, that is, in the real world, to other countries. Instead, from the top of the economy to the bottom, they have been financed by ever-expanding debt--by the creation, in effect, of new money. In principle that is nothing new. The expansion of the money supply began in the early modern period when the first banks began issuing new credit instruments which, they believed, the acquisition and sale at profit of new goods (such as products from foreign lands) would enable their borrowers to repay with interest. But as everyone gradually came to understand, that kind of expansion of credit and money had to keep pace with the expansion of actual production. If credit expanded much more rapidly than productive capacity, then eventually large numbers of creditors would be unable to pay their debts, banks would fail, and panic would result. The great panics of 1929-33 led to a sustained effort to regulate both the expansion and contraction of credit and the issuance of securities so as to avoid anything similar ever happening again--and that effort succeeded quite well for as long as men and women old enough to remember 1929-32 still exercised power and responsibility and cast large numbers of votes at the ballot box.
It is a cliche, but nonetheless a true one: the United States, at every level, has been living beyond its means. Sometime in the last ten years, I believe, our national savings rate fell below zero, and that despite the conributions that so many wage-earners make into various forms of IRAs. Hundreds of thousands, perphaps millions, of Americans hold maxed out credit cards. Hundreds of thousands of students have taken out tens of thousands of dollars of loans. All that, however, turns out to be chump change compared to the millions--perhaps trillions--of debt incurred by financial institutions as leveraging money to finance enormous transactions and continually inflate the prices of various kinds of securities. The expansion of debt has driven the expansion of income at the highest level of our society--and that, as we all know, as been where the greatest expansion of income has taken place, especially in the last eight years.
Imagine, in short, a Chinese village composed entirely of laundries that also has a bank. Somehow--perhaps through deals with banks in a neighboring village--that bank borrows money with which it buys futures on the profits of all the laundries from the laundries themselves. The sale of the futures allows the villagers to buy the food and services they need from neighboring countries. And because the whole world is flooded with credit, the local bank in turn can turn those futures into long-term securities and sell them to some one else. That, it seems to me, is how the American economy has been running for some time. We haven't been producing very much that the rest of the world needs to buy from us for quite a while, but as long as ever-flowing credit kept our service economy going and our financial giants profitable, we didn't care. But suddenly this bubble--which I think is certain to turn out to dwarf any bubble in human history--has inevitably burst. Huge financial institutions are failing right and left, university endowments (who have used a lot of leverage themselves) are dramatically eroding (see last week), and at some point, I predict, credit card terms are going to have to get much, much tougher.
I cannot be sure of my next point, but it seems to me that all this may make recovery considerably harder than it was--or than it could have been--during the great depression. Fiscal stimulus created a partial recovery from 1933 to 1936, but unfortunately, fiscal retrenchment led to a severe recession in 1937-8, and only war and vastly expanded production really got us out of the depression. (Paul Krugman, citing an older authority, recently argued that the New Deal actually provided only a very limited fiscal stimulus.) But in the 1930s the United States was awash in productive capacity in both agriculture and industry--and still protected by substantial tariffs. The problem was simply to get income into the hands of consumers who would buy farm and industrial produce. The problem now looks harder to me because we have given up much of that productive capacity (and the Republicans in Congress, apparently, would like to give up even more in Detroit). Money to buy goods has largely gone out of the country, and it has come back to buy American financial instruments that have now lost most, or all, of their value. We may need, literally, a new financial industry run on completely new principles, and I don't know where it's going to come from.
Nor is that the only problem. Economists from the 1930s through the 1970s seemed to grasp that a healthy economy depended on higher incomes for the mass of the people to allow them to increase demand for both goods and services. In the 1980s supply-side economics argued that allowing the rich to keep more money would fuel investment and expand production. Instead, we now know, it fueled irresponsible investment in assets that have turned out in the end to be worthless. American firms, which in the 1950s and 1960s focused on hiring more workers, now try to use as few workers as possible. That has created short-term increases in profit but long-term economic catastrophe.
Getting out of this will require sustained concentration, analysis, courage, and patience--exactly the qualities that, I would argue, have gone out of fashion in the last few decades, not least in my own academic profession. The Obama Administration will need to devise plans and they will take years to work. Barack Obama clearly has the rhetorical skills to sustain public confidence for some time, but it will challenge him to keep it going long enough. For younger generations, however, this is both a very difficult time to reach adulthood, and a time of great practical challenges. The Boomers had the opportunity to raise the nation's consciousness, and they did. The Gen Xers and Millennials must now address serious, concrete problems, and that, for them and for the country, will be just as important and just as satisfying, if they can do it. Tomorrow, if time permits, I will say something about our prospects in foreign affairs.