The Solvency Crisis

Future historians are likely to look back on the final year of the Bush administration as a moment not unlike 1930, when government dithered while a financial crisis deepened. At every stage of this unfolding crisis, the official response has been too little and too late.

I'm not predicting another great depression. Happily, the people who kept insisting that private business could regulate itself did not repeal the entire New Deal. We still have deposit insurance, Social Security, (reduced) bank regulation, the Securities and Exchange Commission, and a Federal Reserve given much stronger powers in the 1930s.

And we still have a government capable of serious anti-recession spending -- if it so chooses. But as the credit crisis deepens, this particular government is still infatuated with free-market fables now thoroughly discredited by events. So we must wait another 13 months before a new government can begin digging out of a needlessly deep hole.

America now faces an economic perfect storm: a weakened financial system, diminished consumer purchasing power, a swooning dollar and rising inflation.

Until last summer, serious people were marveling that credit was cheap because the world, oddly enough, enjoyed a "savings glut," as Fed Chairman Ben Bernanke put it. Despite the huge demand for credit from China, India, private industry, American consumers and the U.S. government, unlimited credit was somehow on offer at low interest rates.

But now we know what really occurred. Banks were increasingly moving loans off their books by creating exotic bonds. By selling off those bonds, they could use the proceeds to make more loans.

In effect, the private financial system was printing money, operating beyond regulatory constraints (which limit the ratio of loans to bank capital.) Because these loans were sold, they were unlimited. But the newly minted "money" was only as good as its collateral.

Once investors began examining that collateral -- a murky stew of sub-prime mortgages, high-risk credit card debt, used car loans, and other exotic securities created to insure these dubious bonds -- they saw a financial house of cards. As confidence collapsed with falling housing prices, so did the credit system.

At each step, the Fed has been behind the curve; the Treasury has offered feeble "voluntary" solutions. But credit markets, traumatized by the junk at the core of this pyramid scheme, have remained substantially frozen.

A temporary liquidity shortage can be remedied when central bankers add cheap money to the banking system. But much harder is a solvency crisis. The whole financial system now faces the equivalent of a $400,000 mortgage on $300,000 house. Lower interest rates can't repair insolvent balance sheets.

Last week, an alarmed Fed made an unprecedented offer to exchange ordinary bank collateral for cash -- taking the first step towards nationalizing bank debts. Even that extraordinary move has not restored normal credit flows.

Meanwhile, consumer spending is falling. Wages have been flat or declining for most workers since 2000, and medical costs keep rising. American families have been using credit card debts and home equity withdrawals as emergency piggy banks.

Alan Greenspan recently calculated that about three percent of consumer spending between 2000 and 2005 was funded by home equity loans. But with housing values declining and credit standards rising, that trick can't continue.

The Bush administration's voluntary remedy to the sub-prime crisis will save only 15-20 percent of the two million impending foreclosures. That means a continued drag of depressed housing prices on consumer net worth and on homebuilders. Instead, government should legislate a mandatory refinancing program, as we did during the New Deal.

Adding woes, the Federal Reserve's response to the credit emergency -- lowering interest rates to levels otherwise considered unwise -- has weakened the dollar and increased inflation.

Foreign central banks, flush with the proceeds of our chronic trade deficit, had been happily buying America's Treasury debt. But now, skittish about the dollar and attracted by fire-sale prices, foreign governments have begun using their hoard of play money to buy real stuff -- pieces of banks, corporations, real estate. Still more dividend and interest payments will flow out of the United States.

Congressional Democrats are planning a recovery program in the $100 billion range, plus mandatory foreclosure relief. That modest down payment on what's really needed will doubtless be vetoed by President Bush.

Ours is a resilient nation. The eventual recovery will require a repudiation of free-market economics, as bold as the New Deal. But like so much else about the Bush legacy, recovery will be far more agonizing than it had to be.

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