Wednesday, September 17, 2008

Forward into the Past: October 1929, Part 3 of 6

In the previous two postings we've examined what happened in 1929. There was no need for the Great Depression ever to have happened, so what did happen, and why?

All that was necessary in 1929 was for the productive sector — the industrial, commercial, and agricultural enterprises in the United States — to obtain sufficient credit for working capital and to put underused capacity to work. By making certain that all or most of the credit was extended in ways that ensured that the net income after debt service would be used for consumption, the economy would itself generate the required effective demand to take up the slack of underused capacity.

Effective demand could have been generated in two ways: 1. Raising wages, or 2. Sharing ownership and paying out all net earnings as dividends to workers who would use the income for consumption. Given the tax situation at the time — most people didn't pay income taxes — the most advantageous method to the businesses would have been to raise wages (thereby decreasing corporate taxation without increasing the workers' income tax burden), but in light of the economic situation, paying out dividends to workers would have worked better as optimal for both workers and businesses (not increasing fixed costs, thereby retaining comparative advantage in wage rates). If dividends paid to workers were tax deductible at the corporate level, the latter method would have been by far the best in all cases.

Instead, credit dried up and banks could not justify lending to businesses with falling share values and a customer base with rapidly diminishing disposable income. (Had capital credit insurance been available, the demand for collateral could easily have been met, but that was not the case.) Starved for working capital and long-term credit, businesses laid off workers and cut wages instead of raising wages or distributing ownership-sharing dividends, further decreasing effective demand - a vicious circle.

By 1933, an estimated 25% of the workforce was unemployed, and those who had jobs wouldn't spend a cent more than they had to for fear of being unemployed the next week without savings. Taking into account the unemployment and greatly-reduced consumption levels, effective demand may have fallen by more than 50% across the board, with the expected results on agriculture, commerce, and industry. The wave of protectionism (today called "anti-globalization") infuriated Germany and Japan, both desperately trying to rebuild or build an industrial capacity, for which they needed the support of international trade.

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