America’s House of Credit Crumbles

With Wall Street rocketing up and down day after day, foreclosures and bankruptcies escalating, jobs evaporating, and Americans running plain scared, everyone is struggling to understand exactly how the American financial house came to be built with tumbling cards in place of once towering capitalism. The most simplistic, but honest answer is, we spent too much and what we spent was money we really didn’t have.

Approximately two-thirds of the $14 trillion economy in the United States is dependent on consumer spending. Unfortunately, the American consumer has nursed a twenty-year addiction to debt. Last year, total household debt in the nation added up to $13.8 trillion, a jump of 20 percent since 2005. At the same time, the level of savings for the average family ticked down to practically zero. Higher prices on everything from homeowners insurance ratings to a gallon of milk at the store are hitting people who have no reserve and whose credit has shriveled.

The dominant law of the land over these past two decades, both on Wall Street and Main Street, has been “leverage.” The first question was not, “Can we afford to do or buy X?” but rather, “I have X, how much can I borrow against it?” Recent weeks have shown, painfully, that the era of debt funded investments has come to an end, including mortgage-backed securities now commonly referred to as “toxic.” At the same time, the common man’s credit market for loans on homes, a new car, or high-end consumer electronics has contracted to the point of evaporation. Why? Financial institutions, desperate to build capital to repair their balances sheets, are reducing their debt load and lending less and less.

Was the debt load of these institutions significant? Figures show that the most hard-hitting investment banks borrowed $30 for every $1 of real equity capital they possessed. Now, they’re shooting for a ratio of roughly 12 to 1, a slimming down process that will be both painful and protracted. Executives can’t achieve that goal without eliminating loans at all levels with the logical result being an overall shrinking of an economy that has gorged itself on credit since the deregulation of the Reagan years and the essentially laissez faire tactics of Federal Reserve head Alan Greenspan.

For his part, Greenspan has already admitted to a congressional panel that he erred in believing the mortgage industry was best left to police itself. When the mortgage bubble burst on the heels of $4 a gallon gasoline this summer, consumers began to get frightened and pull back. It was only a matter of time until that pull back made its way to Wall Street. Bad economic news tends to breed more of its own, and, at some point, consumer fear becomes a real factor in and of itself.

Now the Fed is headed by Ben Bernanke, whose doctoral dissertation was an examination of the causes of the Great Depression. (He’s also extensively studied the Japanese economy, which suffered its own implosion in the 1990s from real estate and stock market bubbles bursting.) He, and Treasury Secretary Henry Paulson, albeit reluctantly, have made it clear that the government will have to spend, even if that spending means borrowing, because pouring money into the economy (reminiscent of the philosophy of “pump priming,” from the days of the New Deal) will be necessary to stave off complete economic collapse.

Bernanke is supporting a second stimulus package to help Americans suddenly confronted with a rapid shift to a cash economy and living within their means. The ultimate consequence of such measures will be rising government debt that will have to be addressed once a degree of stabilization has been achieved in the credit market. Earlier in the year, the Congressional Budget office forecast a “modest” baseline deficit of $407 billion for 2008. Now, tack on the $700 billion bailout of banks and financial institutions, and a staggering $1 trillion for next year now seems more probable than possible.

Comparisons to the causes of the Great Depression seem inevitable these days. Although the factors of the Crash are complex, most scholars agree that the buying of stock on margin in a runaway market was a central factor in the disintegration of Wall Street on Black Thursday, October 24, 1929. “Buying on margin” was the phrase of the day for what were essentially credit-backed investments. Seventy-nine years later, historians and economists are rightfully saying, “Here we go again.” While regulations and safeguards exist in our economy that were not here in 1929, the core cause in both instance was spending money that didn’t exist, on a corporate and personal level. The piper has played and now the piper must be paid.