Proceeding with Caution: Determining How Careful We Need to be in Managing Our Debts Forrest Scott Brinkley Economics Major October 13, 2006 With the progression of the1920s, American consumers became more and more liberal with respect to their spending habits. Their wages had not increased in accordance with their spending habits, but financing durable goods had also come into play. Installment plans paid for much of what was bought in the 1920s. When this buying option was taken away along with the most Americans’ savings with the dawn of the 1930s, consumerism and the U.S. GDP died simultaneously. Today we have a similar situation, though we’ve added the concept of revolving debt. Given this new debt, are we headed toward the second Great Depression? While consumer debt has been rising and the GDP again relies rather heavily on consumer spending for its wealth, the scenario is not likely to repeat itself. We are safer because of the rules and regulations passed after the Depression, but a look back at the Titanic’s fate reminds us that we are never absolutely safe. We must continue governmental regulation of the credit industry in order to prevent future devastation.

I. Introduction

Americans are (and have been for some time) dependent upon credit. The consumer centric society we now live in is almost a mirror of the 1920s. During this decade, consumer credit as a system of buying and selling goods was used by the masses in the form of installment plans. We have similar systems today that are used almost as frequently. What portion of the U.S. population is currently in debt

(excluding mortgage debt) and what risk(s) are associated with this figure?

To determine risk factors in this situation where people are spending banks’ and lenders’ monies, one must look to history. In the years leading up to the Great Depression, there was a large supply of loans available from banks acting as middlemen to the consumer. When these smaller banks failed left and right after the market collapse in 1929, there was a reduced supply of low-cost loans to consumers.

Thus the price of loans rose, and fewer and fewer could afford to borrow. “Most affected were households, farmers, unincorporated businesses, and small corporations.” (Temin 1989).

Similarities between the Roaring ‘20s and contemporary times make the risks even clearer. In the

1920s, what had been considered luxurious prior to WWI was now commonplace. “The consumer economy evolved into a vast engine fueled by buyer demand.” (Klein 2001). Today, as in the 1920s, much of the economy is based upon consumers buying goods and services, with or without their own money. Approximately 71% of the 2005 U.S. GDP was based on consumer expenditure. (Carter 2006). (Billions of USD) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total Consumer Debt 1095.8 1183 1235 1301 1393.7 1534 1905 2013 2118 2233 2322 Revolving Debt 443.1 499.4 531.2 560.5 595.6 663 742.9 762.9 784.8 818.7 842.1 Real GDP 8031.7 8329 8704 9067 9470.3 9817 9891 10049 10301 10704 11049 Consumption Exp. 5433.5 5619 5832 6126 6438.6 6739 6910 7099 7307 7589 7841

Calculations Consumption's Role in GDP 67.7% 67.5% 67.0% 67.6% 68.0% 68.7% 69.9% 70.6% 70.9% 70.9% 71.0% Debt's Role in Consumption 20.2% 21.0% 21.2% 21.2% 21.6% 22.8% 27.6% 28.4% 29.0% 29.4% 29.6% Revolving Debt's Role in Consumption 8.2% 8.9% 9.1% 9.1% 9.3% 9.8% 10.8% 10.7% 10.7% 10.8% 10.7%

(Billions of USD) 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 Total Consumer Debt 26.34 26.46 22.85 27.29 33.67 35.76 41.94 45.27 45.68 55.35 63.2 Consumption Exp. 637.85 555.1 443 477.1 563.28 560.7 608.8 625.4 620.5 655.4 689.5 Real GDP 583.75 575 560.9 594.4 673.49 690.1 711.8 755.3 763.6 769.9 822.2

Calculations Consumption's Role in GDP 109.3% 96.5% 79.0% 80.3% 83.6% 81.3% 85.5% 82.8% 81.3% 85.1% 83.9% Debt's Role in Consumption 4.1% 4.8% 5.2% 5.7% 6.0% 6.4% 6.9% 7.2% 7.4% 8.4% 9.2% Table 1 Consumer spending and debt rose as the 1920s progressed.

Total Consumer Debt

70

D 60 S U

f 50 o

s 40 n o i l

l 30 i B

n 20 i

t b

e 10 D 0 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 Year

Figure 1: Data Source: Historical Statistics of the United States

Similarly, the

total debt has increased sharply over the past five years. Weekly and hourly wages have not quite caught

up with the times and, as a result, people are borrowing more. Much of those funds come from the value of consumers’ homes. (Eisinger 2006). Revolving debt has seen increases in the past few years as well.

Revolving Debt

900

D 800 S U

700 f o

600 s

n 500 o i l l

i 400 B 300 n i

t 200 b e 100 D 0 7 0 1 4 5 5 6 8 9 2 3 9 0 0 0 0 9 9 9 9 0 0 9 9 9 9 9 0 0 0 0 0 0 1 1 1 1 1 2 2 2 2 2 2 Year

Figure 2: Data Source: http://www.federalreserve.gov It seems like every American these days is spending instead of saving. 132 percent of American households’ disposable incomes have been dedicated to debts. (Greenhouse 2006).

II. Economic Model

What is inherently wrong with the present situation? One cannot guarantee the future, but he can always look into the past for clues. Much of the economic failure in the Great Depression’s earliest months came from the sharp decline in consumer spending experienced in America. In an economy so dependant upon consumer spending (over three quarters of 1929s GDP was from such expenditure), any significant drop in spending spells disaster. That is exactly what happened as 1930 progressed. The drop in consumption occurred because of a decade of record high consumer debt and severe default consequences. Although Americans did not stop spending all together in 1930, they slowed their expenditures to ensure repayment of their debts in uncertain economic times. (Olney 1999).

The sense of uncertainty and the resulting reduction of consumer expenditure twisted ‘round in the belly of the Bull the dagger that had been so violently stuck there in October of ’29. “The change was neither immediate nor pervasive, but as the sense of uncertainty spread, it fed the uneasiness of those who had already grown apprehensive about the economy.” (Klein 2001).

Would such a drop in spending be met with similar results in today’s economy? Today over 70% of the U.S. GDP comes from consumer expenditurei. Clearly it would be devastating if there were to be such a sharp reduction in spending. Yet there are differences between the 1920s economy and the contemporary economy that ought to calm all but the most pessimistic Americans. While there is a rather large proportion of the GDP that comes from consumer expenditure, the number is significantly lower than the figure right before the Great Depression.

Additionally, the U.S. government has significantly more power today than it did in 1929. “In 1929, federal expenditures accounted for a mere 2.5% of the GNP, compared with 22% in 1990. It employed only 579,559 people and operated no social programs.” (Klein 2001).

When the stock market crashed, the Federal Reserve System was legally independent of the credit market and thus had no ability to control it. The laissez faire attitude held by so many at the time viewed even this limited a government as too big. One might propose that the only similarities between the pre-Depression U.S. government and the contemporary U.S. government are the Constitution and the

Bill of Rights. The legal authority held by today’s government over the economy is much greater and, consequently, so is its ability to stop the next Depression.

Although Americans have been incurring an increasing amount of debt, the rules and regulations put into effect after the Great Depression will prevent the recurrence of any adverse economic effects, direct or indirect, that such debt had on the economy of the late 1920s.

III. Data Description

In analyzing the data supporting this hypothesis one notices two things. Firstly, when turning to a graph of consumption as a percentage of GDP (see Figure 3)ii, one realizes that today’s consumption is not as significant a factor in the U.S. economy. That is not to say that consumers are no longer a major contributor to the U.S. economy (in fact they are the largest), but rather that other factors are present.

Such factors could help stabilize the U.S. economy in the event of a modest drop in consumer spending.

The economy would not be healthy, but we would not be seeing a recurrence of the Great Depression, either.

Secondly, when one examines debt as a contributor to consumptioniii, he will find that the slope of the graph has become less steep in the past two to three years after the huge jump during the recession earlier this decade. People are still spending quite a bit of lenders’ monies, but they have apparently curbed this habit. 1920s consumers seemed to be increasing their debts without end. Simple visual analysis of the slopes gives one this impression.

The significance of these data becomes quite clear when comparing and contrasting the contemporary and 1920s U.S. economies. First of all, because of the Keynesian policies enacted during the 1930s and 40s, we now have a smaller percentage of the U.S. GDP dependant solely upon consumer expenditure. Consumer expenditure is still the most important part in terms of percentage, yet other components such as government expenditure are now present to stabilize the system.

Secondly, for one particular reason or another, the amount of debt people are incurring with the purchase of goods and services seems to be increasing at a slower rate. Indeed, it looks as if there will be a decrease sometime in the near future. Personal Consumption's Role in GDP

120.00% 100.00% P

D 80.00% Consumption's Role G f in GDP o

t 60.00% n 1920s Comparison e c 40.00% r ('19-'29) e P 20.00% 0.00%

Year

Figure 3iv Debt's Role in Consumption

35.00% 30.00% 25.00% Debt's Role in t

n 20.00% Consumption e c r

e 15.00% 1920s Comparison P Data ('19-'29) 10.00% 5.00% 0.00%

Year

Figure 4v IV. Conclusion

Given the evidence that there is less a proportion of the U.S. GDP dependant upon the consumer expenditure today with a slower increase in indebtedness related to this consumption, Americans are much less likely to experience another depression caused or aided by these factors. The Federal Reserve and today’s credit industry regulations are both sources of this increase in stability.

Credit scoring and government regulation on interest rates and minimum credit card payments are just a few of the differences between 20s credit markets and today’s. One source of stability today is the powers granted to the government by Congress in the 1930s and 40s.

The Federal Reserve, the BEA and other monitoring and regulatory agencies were all created and or strengthened after the Great Depression. Theoretically, at least, agency monitoring would detect instability. Congress could then make the necessary changes in government spending to curb the effects of any potential economic disaster. Just as the Titanic’s flood-safe doors were a deceiving safety feature, care must be taken when relying on Uncle Sam to keep tabs on the consumer credit industry and its effects on the economy. The government must be careful not to allow debt’s role in consumption to rise to unsafe levels. Consider an economy where 100% of consumer expenditures were made with lenders’ dollars. The Great Depression,

Part II would be a market panic away.

Not all government solutions work, either. The government essentially has two options at all times. Option one is to decrease spending through tax cuts. The alternative would be to funnel more tax dollar into programs aimed at recovery. Depending upon the type of problem with the economy, either option could be beneficial. Yet Congress is full of politicians who are susceptible to political forces, not economic forces. The right option can sometimes be very hard to determine under such biased conditions.

Fortunately as of now, Congress seems to have chosen the right option. According to BBC News, the U.S. federal deficit has fallen due to higher employment rates making more people eligible for taxation. No doubt, these same newly-employed citizens also have more cash to spend in place of the credited dollars they used while unemployed.

Americans and their government are now smarter than ever about the U.S. economy. They have learned from the Great Depression. Many of the factors that caused the market downfall in 1929 have now been outlawed. The U.S. economy is not perfect, but it is substantially more stable and than it was in the pre-Depression years. References

Carter, Susan B. Scott Sigmund Gartner, Michael R. Haines, Alan R. Olmstead, Richard Sutch, and

Gavin Wright, eds. 2006. Historical Statistics of the United States: Earliest Times to the Present.

Vol. 3. Part C: Economic Structure and Performace. New York, NY.: Cambridge University Press.

Eisinger, Jesse. Long and Short: Night of the Living Debt. The Wall Street Journal. 4 Jan. 2006.

Greenhouse, Steven. Borrowers We Be. The New York Times. 3 Sept. 2006.

Klein, Maury. 2001. Rainbow’s End: The Crash of 1929. New York: Oxford University Press.

Olney, Martha J. 1999. Avoiding Default: The Role of Credit in the Consumption Collapse of 1930.

The Quarterly Journal of Economics 114, no. 1: 319-335.

http://www.jstor.org. (Accessed September 30, 2006).

Tax Bonanza Helps Cut U.S Deficit. BBC News. 11 October 2006. http://news.bbc.co.uk/2/hi/business/6041460.stm. (Accessed October 13, 2006).

Temin, Peter. 1989. Lessons from the Great Depression. Cambridge: MIT Press. i See Table 1. ii See Figure 3. iii See Figure 4. iv Please see Note i. v Please see Note ii.