Preventing a collapse of the financial system is part of preventing a depression. However, the shorthand term for this--getting the banks able and willing to lend--is misleading. There are plenty of banks that can lend. The problem is the borrowers: Those that could be counted on to repay their debts are mostly uninterested in borrowing, and those who want to borrow probably can't afford to take on more debt. That's the truth about the fix we're in. There are, however, two ways to fix it.

Spend less

First there's the long slow fix: Everybody spends less than they earn and either saves or pays off debts. This can be done. In fact, it always is done--it's the way this sort of situation is always fixed. However, it takes a long time. It's painful and disruptive. It's also unfair, in the sense that the pain falls disproportionately hard on different people depending on where they live and where they are in their life.

The slow fix is slow simply because even pretty serious frugality only opens up so much room between income and expense. WIth the amount of debt that's already baked into the system, too many households simply have no daylight between their daily expenses (including debt service) and their income.

At the same time, each household that bites the bullet and puts itself on the the slow path to a sound balance sheet--expenses less than income, debt service a small fraction of their income, an emergency fund, some retirement savings--shrinks the economy a tiny bit. A smaller economy means fewer jobs, less wages, less profits--meaning that it takes even longer to dig ourselves out of the hole we're in.

There are other pieces to the long slow fix. Assets will be sold and the cash used to pay off debt. Sales of productive assets can help everybody--the seller, who gets cash to settle overwhelming debt; the buyer, who gets something valuable for less than it would normally cost; workers associated with the asset, whose jobs now depend on someone who's not so broke; and consumers, who get more stuff because the productive assets can start producing at full capacity. (Of course, it doesn't necessarily help everybody--a productive asset dismantled and shipped overseas might leave local workers less well off. But the exercise can be a positive-sum game, with everybody better off.) Another part of the same process is bankruptcies--some debts are never going to be paid back. (Short of bankruptcy, some debts can be restructured to make them affordable.)

But, put it all together and it's still long and slow.

The other, quicker fix would be to boost incomes.

Earn more

The government is trying to do a piece of that--reduce the depth of the recession by replacing some of the missing household spending with government "stimulus" spending. That may help ease the downward spiral of households cutting spending leading to businesses laying off workers leading to more households that have to cut spending. But it doesn't help with the fundamental problem that household balance sheets are so badly out of balance that even years of frugal living won't restore a proper balance--if we go that route, it's going to take decades.

If we can boost household incomes, though, the whole thing could be speeded up considerably. Of course, any particular household might just spend its extra income, but that doesn't really matter: the economy can handle some number of households that live beyond their means; it always has.

Where, though, would this extra income come from? It's not like we can just gin up some money. (Well, the government can--and, in fact, has been--but that's not real value. Money created that way just dilutes the value of the existing money.) No, the only way to boost households' real income would be to reduce someone else's real income.

To get us out of this hole faster, what would have to happen would be for a greater share of income to flow to the people whose balance sheets are most tattered--the poor, the working class, middle class home-owners, etc. What would have to happen would be to change the way profits are divided between owners and workers. (This works because the owners' balance sheets aren't so out-of-balance.)

Of course, it isn't as easy as that. The division of the receipts of the enterprise is partially a matter of markets, and tampering with markets is always problematic. On the other hand, lots of other things play into the affair. Customs and traditions matter--salesmen get commissions, executives get bonuses, etc. These traditions can change--few people get paid piece rates nowadays--but they matter.

At its core, though, the division of profits is always a matter of power.

During long swaths of time the power rests with the owners, who claim all the profits as their right, setting workers against one another in competition for bare subsistence wages. At other times the workers scrape together some power, refusing to bid down their own wages, and claiming for themselves a greater share of the profits of the enterprise.

The last couple of decades have been something of a golden age for owners and managers.  Globalization has let employers put their workers in competition with poor people all over the world, giving them a huge market advantage.  At the same time, some of the traditional "rules of the game" were gradually slanted in favor of owners (in the form of the decline of labor unions, growth in lower paid service jobs, and vanishing traditions of loyalty to employees and to communities). 

If you're interested in this aspect, you might be interested in Robert Reich's book Supercapitalism.  I wrote a review of it for Wise Bread last year.

The main point of Reich's book is that you can't really expect anyone to behave differently unless they are forced to.  No owner or manager will pay more than the market rate for labor--anyone who even tries will quickly be replaced.

Generally, the workers only come out ahead when there's a genuine labor shortage--when war or plague has cut the work force so much that there simply isn't much competition for jobs. Other things factor into it, though. A huge surge in productivity can swell wages simply because owners are making money so fast it isn't worth it for them to push down the earnings of workers. Local customs and historical traditions have a strong influence. And, of course, government rules have a lot to say about the matter.

In the United States, as the graph above shows, the relationship between compensation and business output was pretty steady all through the 1950s and 1960s. In the 1970s, though, and accelerating in the 1980s and 1990s, things changed: As output (i.e. income to businesses--shown by the blue line) surged, wages (shown by the red line) quit keeping pace.

Looking at the data another way, as shown in the graph to the right, the average share of national income that went to compensation in the 1950s and 1960s was 57.1%. In the most recent quarter it was just 53.4% (and that was an increase from recent lows). 

Wages and salaries in 2008 totaled $26.2 trillion (versus a total national income of $49.7 trillion). If the division of the profits of the enterprise returned to the situation that prevailed in the 1950s and 1960s, household incomes would have been $28.4 trillion--that is, households would have received an extra $2.2 trillion in wages and salaries last year. An extra couple trillion dollars a year would go a long way to recovering household balance sheets. (Data for Wages and Salaries and National Income from the Bureau of Economic Analysis via the St. Louis Fed.)

Of course, that income would have been lost to someone else. To some extent, it would have been lost to the very same people--the bus drivers and school teachers who were bringing home bigger paychecks would have seen smaller gains in their 401(k)s over the years, if more income accrued to employees and less to owners. But the bulk of the difference would have shown up in the investment accounts of the very wealthy (because that's where the bulk of the income ends up).

So, there is a path for getting to recovery quicker: higher wages and salaries for workers at the expense of smaller profits to businesses. And it would not be a radical shift--just a return to the traditional proportion of income that went to labor in my parent's generation.

Of course, getting there is another story. Owners and managers are not going to voluntarily give up any of the profits and workers lack the market power to demand a larger share. There are some moves to increase the power of workers--proposed changes in the rules that determine whether workers can form a union, for example--but they're pretty tentative.

But that's okay. There's still the long slow path to recovery.