I can`t help but recall my first year economics class at Harvard when I think about the current economic crisis. Despite the fact that I hated that course, I became an economics major. Now, I see the wisdom in it. In my mind everything we need to know about how we got into this mess and how we can get out of it, starts with my Ec 10 course and a simple concept known as supply and demand.

I think by now, even Mom & Pop in rural Indiana know how we got into this mess: debt. Let`s analyze this in a simple supply and demand framework. Let`s say that basic wages and prices enabled Jim to consume $100 worth of goods each year. Because Jim could use debt through either credit cards or refinancing his appreciating home, Jim was now able to consume $150 worth of goods. Subsequently, companies increased supply in order to meet Jim`s growing demand. They built a $150 supply infrastructure to meet the $150 demand. Jim and his friends could now afford $4 per cup coffee shops on every corner; so, Starbucks built them.

Everything was fine as long as Jim could artificially fill the gap between his $100 real demand and the new $150 supply infrastructure with $50 worth of debt. Then the debt dried up. All of a sudden there was no way to fill the $50 gap. In fact, as the economic condition has deteriorated, the gap has gotten even larger. The combination of people losing their jobs and the fear of losing their jobs has caused Americans to do something they have not done for 30 years: save. Now, instead of demand being $100, it has shrunk to $80. Today the demand/supply gap is not $50, but $70. So how do you solve this problem?

Here is where I differ with almost every economic proposal coming out of Washington, both from the Bush and Obama administrations. All of their plans suggest that we try to fill this demand/supply gap by artificially stimulating demand. They call this an economic stimulus package. No one really knows what that looks like, but they all agree that it starts with trying to get people to consume more to meet the $150 supply infrastructure. This is just another form of financial engineering. It is the same type of engineering that got us into this mess in the first place, except that we called it leverage (e.g. debt). What ever you call it, it is artificially inflating demand. That is the wrong answer. The answer should not be how to artificially grow demand but how to manage the contraction of the supply infrastructure.

No one in Washington (or frankly America) wants to use the term "contraction of supply". We are a nation consumed by the word growth. Everything must grow -- all the time. We have gotten blinded by growth. What we fail to realize is that sometimes things must shrink (in this case dramatically) in order to grow again. Of course, there are two obvious and legitimate reasons why politicians are afraid of contraction: unemployment and deflation. Our bloated supply infrastructure employees a lot of people. It has also led to wage growth. The contraction of our supply infrastructure will put a lot more people out of work and it may force us to reduce wages. These are not good things and can / will put even more downward pressure on the economy. I do not advocate that if we manage the contraction of supply that we stand their idle and watch unemployment grow precipitously. In my mind, that should be the focus our the Administration`s efforts. We should allocate our brain power and money towards softening the blow to employment by allocating our trillion plus dollar bailout plan to job creation programs. This type of artificial stimulus can have huge positive long-term impact through infrastructure development and the creation of a more employable workforce. Every heard of line: Give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime. Giving Americans a $5000 tax credit versus re-training him for the workforce is the equivalent.

Even if we achieve the organic growth that I advocate, it will take time. I also do not believe we will be able to create enough new high wage jobs to fill the gap of those lost through this supply contraction. There is another aspect of this plan that needs to be adopted. It is a concept that few Americans are not prepared to address, but must address: contraction of expectation. As debt bloated our supply infrastructure, it also bloated our personal expectations and sense of entitlement. I was with my 19 year old cousin during Thanksgiving. She is in college and has no job, yet she has a $250 I-phone. So do all of her friends. We live in a society where unemployed kids not only have such luxuries but feel entitled to them. That must change. And, it is not just the kids. It is our entire society. Let me put this bluntly:
- Americans are not entitled to I-phones
- Americans are not entitled to more than one large flat screen tv in their homes
- Americans are not entitled to a new car every 5 years
- Americans are not entitled to retire by age 60 to a nice house in Florida on a golf course
- Single Americans are not entitled to live by themselves
- Americans are not entitled to not have multiple generations of their family live under the same roof

These are all things that we have taken for granted as Americans. We need to alter our expectations. Citizens in most developed countries around the world do not have the bloated expectations of Americans. If we do not change, the only answer is to artificially inflate demand which will lead to this same disaster happening again. Next time the result will be much worse. It will not simply be the bankruptcy of American homeowners. It will be the bankruptcy of America. And that, my friends, is game over.

So what is the answer? Stay tuned for that in my next post.