Submitted by Charles Hugh-Smith of OfTwoMinds blog,

If you understand the difference between the first pair of shoes and the 25th, you understand why America's debt-dependent consumer economy is doomed.



Yesterday I explained Why We're Stuck with a Bubble Economy:

Now that interest rates are near-zero and mortgage rates are rising from historic lows, there is no more juice to be squeezed from low rates. Asset bubbles always burst, destroying collateral and rendering borrowers and lenders alike insolvent.

Without organic demand from rising real income and new households with good-paying jobs and low levels of debt, the consumer-debt based economy stagnates. This has left the economy dependent on serial asset bubbles that create phantom collateral that can support new debt, albeit temporarily.

The other critical dynamic is the marginal utility of additional consumption in a debt-dependent consumer economy. In an economy in which 49% of all residents (156 million people out of a total population of 317 million) receive a direct transfer of cash or cash-equivalent benefit from the central government, and millions of these people also receive cash and/or benefits from state and local governments (49% of Americans Get Government Benefits), poverty is relative rather than absolute for the vast majority of Americans.



The American economy is highly dependent on consumption. Household consumption accounts for about 35% of developing economies' activity--roughly half of America's 70% consumption economy.



As noted yesterday, with the earned income of the lower 90% of wage earners stagnant for four decades, America has enabled consumption by leveraging income and collateral into ever-rising mountains of debt.



The problem with debt, of course, is that it accrues interest, and that paying interest reduces the amount of income left to spend on consumption.



In this way, depending on debt to finance consumption is akin to the snake eating its own tail: at some point, the cost of servicing the debt reduces the income available to be spent on additional consumption to zero. Additional consumption becomes impossible without asset bubbles to temporarily enrich the households that own assets or "helicopter drops" of interest-free cash into household checking accounts.



This is how we have reached the point that a majority of U.S. households live paycheck to paycheck, as earnings are eaten up by essential bills and debt service.



Given that the majority of Americans already enjoy a considerable array of consumer goods and services, the only way to fuel more consumption is to entice consumers into buying more of what they already own or buy a replacement for a perfectly usable good or service. Let's illustrate the concept of marginal utility with shoes.



To those with no shoes at all (a common enough occurrence in the 1930s Great Depression), the utility of one pair of shoes is extremely high: the utility (i.e. the benefits) resulting from owning that one pair of shoes is enormous.



Now consider an aspirational-consumer (i.e. someone striving to look wealthier and more successful than they really are) of the upper-middle class: this consumer might own several dozen pairs of shoes, and his/her problem is finding space for more shoes.



The retailer attempting to persuade this consumer to buy a 25th pair of shoes must overcome the diminishing utility (i.e. marginal utility) of yet another pair of shoes. This is accomplished by offering a "deal you can't pass up" or appealing to the always pressing need to jettison last year's style in favor of this year's "new thing."



Here's the critical point of this dynamic: to the consumer who already owns so much stuff that he has to rent a storage facility to store all the surplus goods, the utility of any additional purchase is low. In practical terms, the utility has declined to the thrill of the initial purchase and the initial wearing/use of the new item. Beyond that, it's just another pair of shoes in the closet.



To the manufacturer/retailer/government dependent on more sales for survival, the value of the first pair of shoes sold and the 25th pair sold are the same. The manufacturer/retailer needs to sell more shoes just to stay in business, and the government living off sales and other consumption-generated taxes also needs more sales.



In an economy in which most people have the essentials of life--i.e. the first pair of shoes with the highest utility--all consumption beyond replacing a hopelessly broken essential is of marginal utility.



An additional $1 of debt adds the same burden to the household whether it is spent on the first pair of shoes or the 25th pair. Taking on debt might make sense for the first pair of shoes, or the first bicycle, but it makes increasingly less sense for each additional pair of shoes or replacement bicycle: the debt piles up but the utility derived from the purchase is increasingly marginal.



The $3,000 I could spend on a replacement bike for the perfectly serviceable bicycle I bought used 15 years ago for $150 is of marginal utility; the better-quality parts and lighter frame, etc.--all the benefits that would flow from spending $3,000 for a "better, more modern" bike are extremely marginal to me, even though I put well over 1,000 miles a year on my bike. All those improvements are too modest to matter. This is the essence of marginal utility.



If you understand the difference between the first pair of shoes and the 25th, and the increasing diversion of income to interest payments that results from debt-based consumption, then you understand why America's debt-dependent consumer economy is doomed.