America's Addiction to Debt Finally Crashes the System


We have to deal with the fundamental reality that Americans are addicted to debt. Debt today in the United States is at an all-time high in each of the three primary sectors: public, corporate and consumer debt. The national debt last week topped $9 trillion, up from approximately $5 trillion when George Bush took office.

To put this in perspective, the government of Bush & Co. has borrowed almost as much as the governments of all the other presidents of the United States combined. Consumer credit is now at scary levels almost: $2.5 trillion, and analysts are beginning to speculate that credit card debt could be the next bubble to burst. Corporate debt has reached astronomical levels through highly leveraged private equity deals, and no one knows just how how much froth is still in the system.

Central banks worldwide have reacted to the crisis by injecting over $700 billion into the global financial system. This is an astronomical level of liquidity, but it seems somehow to defy any human element. However, it has intensely human consequences that will affect each and every one of us. By pumping so much liquidity into the system, it ultimately inflates the currency. Put in human terms, everything is going to start costing us more. Even worse, this approach simply postpones the eventual reckoning.

For the average worker who is already struggling to make ends meet, this could have devastating consequences. Median family earnings of $48,201 in 2006 were 2 percent less than they were in 2000. So already people are running on the economic treadmill, like hamsters, spinning faster, working harder and making less.

For those who had taken some measure of financial solace from the appreciation of their homes, the game has suddenly taken a turn into a dark tunnel. Prices which had become divorced from reality, are now being corrected with a vengeance. Here's the rub for homeowners: When real estate prices go down, the debt associated with those assets does not go down. This induces a downward spiral of asset values induced by negative leverage. With a record high of 15.75 percent of all subprime loans now 30 or more days past due, many homeowners now are stuck with negative equity.

And this is where things really start to get dicey, because the stability of the entire financial system is at risk. In other words, the downward spiral of real estate assets puts the solvency of major financial institutions in jeopardy.

There was a fervent belief, spread with evangelistic zeal by many of the key players in the creation of the debt bubble that this was different from other lending cycles and it could continue indefinitely. The belief was based upon the contention that there was now more reliable information that enabled mortgage lenders to make better judgments about the credit worthiness of borrowers.

The evangelists argued that sophisticated algorithms enabled them to determine with precision exactly which borrowers were good bets and which ones were likely to default on their loans. This belief fueled the creation of an entire market for leverage in the form of CDOs (Collatoralized Debt Obligations), which were sold to major players such as hedge funds. Evangelists argued that these new financial instruments would diffuse risks throughout the financial system and that somehow, through financial alchemy, the entire system would become more stable.

That absolutist belief, like the debt bubble, has now been punctured. In the words of Warren Buffet, "Many institutions that publicly report precise market values for their holdings or CDOs and CMOs are in truth reporting fiction."

It turns out that many of the lenders were unable to verify the accuracy of income and asset information supplied by borrowers and still went ahead with the loans. Garbage in, garbage out. In other words, it is now much more difficult to know who is holding the bad debts. It used to be that banks could assess their portfolio and fairly easily identify the trouble spots. But now, we don't really know how far into the layered labyrinth of leverage the trouble goes.

And now that the absolutist belief in reliable credit information has been exposed as a false credo, fear has been spreading like a contagion through the flocks of worshipers. So we're back to the future where the old rules of skepticism apply. Bad loans are bad loans, and somebody is going to have to pay. The question yet to play itself out is how far and wide the doubts will spread. The Fed may have to make some tough calls on whether to bail out the miscreants in order to insure the short-term stability of the system.

Take a quick look at the financial pages, and you quickly get a sense that everyone is scrambling to keep their ship afloat:

  • Countrywide, one of the country's largest mortgage lenders, was unable to raise capital through its mortgage-backed securities and was forced to access a $11.5 billion line of credit, a sure sign of distress.
  • Sentinel Management Group, which oversees $1.6 billion in assets, halted investor redemptions, which exacerbated the selling. Other funds are said to have similar problems as they face withdrawal demands at a time when it has become difficult to value low-quality debt.
  • France's BNP Paribas froze three funds that invested in the U. S. mortgage market.
  • Goldman Sachs, arguably the most prestigious Wall Street bank, was forced to rescue one of its hedge funds with an infusion of $3 billion, after the fund lost 30 percent of its value in just a week.
  • Market volatility follows uncertainty, and the stock markets continue to gyrate widely and have lost 10 percent since their peak.

But, the people who will ultimately be hit the hardest are the ones living at the margins. Over half of mortgages last year were made with less than 5 percent equity and even a modest depreciation in the value of their homes puts their mortgage underwater. Since the United States today has a negative savings rate, cashing out of mortgages through refinance is no longer an option for most.

These are sobering facts, but the unknowns are of even more concern. How far into the general economy will the credit crisis extend? Will tighter credit drag down the consumer spending sector? How many of those who rely on revolving credit card debt will be forced into bankruptcy? Will this bring down major financial institutions? How effective will the Fed's efforts at stabilization be? How will the global economy react? Will Asian central banks start to move significant portions of their credit away from treasury bills? Is this a fundamental flaw in the our monetary system?

Amidst all the questions and the complexities, there is one simple truth that has to be addressed in a meaningful way before the system is stabilized. The root cause of all the problems is -- put simply -- for America, living in debt has become a way of life. Until we deal with that reality, we will simply be digging ourselves deeper into a financial morass. Our addiction extends from public debt to consumer debt and corporate debt. Subsequent credit crises will only become more protracted and severe, until ultimately the fundamental flaw in the monetary system has to be recognized and dealt with.

Since in a market-based economy, power and money flow to those who already have it, the people who live at the margins find it increasingly difficult to survive economically. In other words, our economic system as it is has exacerbated inequalities. The stability of the overall economy is threatened by imbalances when increasing numbers of people are marginalized economically.

The conventional wisdom holds that in an ideal society the imbalances can be mitigated either by governmental intervention or by the activities of the social sector. But the conventional wisdom breaks down when the private sector becomes so powerful that the public sector becomes captive of private interests. Suddenly the public sector can no longer act as a counterweight to the consuming self-interest of the private sector. This creates both economic and psychological imbalances that impair the functioning of the entire system, and markets become increasingly unstable. If this is not a fundamental flaw, then I don't know what is.

The endgame is unclear, but signs increasingly point to a resolution that undermines the United States' stature in the global economy. Benjamin Friedman, author of Day of Reckoning and chairman of Harvard's economics department, points out in my recent documentary Time-Bomb: America's Debt Crises, Causes, Consequences and Solutions that throughout history the patterns of a nation's decline are clear.

"When a nation becomes a debtor nation, this signals a fall of international stature, as evidenced by the fall of the Dutch Empire in the 1600s, the Spanish Empire in the 1700s, and the British Empire in the 1800s," he said. 25 years ago the United States was the world's largest lender nation by far. Today we owe more to other nations than the rest of the world combined. Almost 5 percent of our GDP flows into foreign hands every year, as reflected in our current account trade deficit of approximately $700 billion annually.

How bad could it get? The Fed will likely put it in a position where the only option is to monetize the public debt. Monetization is economist jargon for intentionally inflating the system. In the Time-Bomb documentary, Kenneth Rogoff, a Harvard economics professor and former chief of research for the IMF, puts it bluntly: "People who think that the government will never monetize the debt are just out to lunch."

The United States doesn't have to default on its debt. It can simply pay back lenders with dollars that are worth less than the dollars that were borrowed. And if this happens to the public debt, private debt will be similarly affected and the entire monetary system will be destabilized.

These are not happy scenarios to contemplate. But by pumping such massive amounts of liquidity into the financial system, the Fed has already started a process of increasing the supply of a commodity and thereby decreasing its value. This process is otherwise known as inflation. With the value of the dollar plunging against foreign currencies, the cost of everything we buy from abroad increases.

With America now addicted to foreign imports, it is unlikely that our appetite will go down significantly. Classic economics says it will, but a lot of pain will be felt along the way. So the American standard of living will decline and people living on the margins are pushed ever closer to the brink.

We are now officially operating in uncharted territory. The central banks today have less controlling authority today since we operate in a global economy; thus they may have less power to control crises. The fiscal irresponsibility of both public officials and private lenders are serving to compromise the integrity of the entire monetary system.

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