Another One Bites the Dust

September 15, 2008. Lehman Brothers, the giant Wall Street firm, declares bankruptcy. Merrill Lynch, the most famous stock brokerage company in the country, avoids the risk of eventually suffering a similar fate by being euthanized (i.e., bought and absorbed) by Bank of America. The Dow falls over 500 points. And how was your Monday?

It was just a week ago that the government announced that it was taking over the two government-sponsored mortgage agencies, Fannie Mae and Freddie Mac. Wall Street responded with a rally that lasted all of one day, before sobriety returned and it dawned on investors that Uncle Sam and the American taxpayer aren’t exactly in the proper financial shape to guarantee another $5 trillion of debt and to act as the nation’s largest de facto landlord and banker.

The Fannie/Freddie bailout did not cure what ails us, but simply postpones for a while the day of reckoning. The facts remain that housing prices continue to fall; mortgage delinquencies and foreclosures continue to rise; financial institutions’ capital continues to be vaporized by imploding financial instruments (mortgage-backed securities, structured investment vehicles, collateralized debt obligations, etc.) with a face value of a couple hundred trillion dollars, dwarfing our $14 trillion GNP.

I hope I’m wrong about this, but it seems to me that we are in the early stages of a major financial crack-up. The financial recklessness of major Wall Street firms; an irresponsible Federal Reserve that has generated both the stock market and real estate boom/bust cycles in the last decade; the excessive government, private, and corporate debt that we’ve incurred (see “America’s Debt Problem”)—these factors now combine to paint us into a grim corner from which there is no painless way out.

To me, the scariest event of September 15 was when Hank Paulson publicly declared, “The banking system is safe and sound.” The very fact that the secretary of the United States Treasury felt obliged to issue such a statement indicates how precarious the situation has become. And the fact that our government officials so often have denied the existence of a problem shortly before the problem became obvious to everyone fills me with dread. There have already been more bank failures this year than in the previous three years combined (11 vs. 3) and the FDIC, which is supposed to insure bank deposits, has less than a nickel for every dollar of deposits. In normal times, that is a more-than-sufficient reserve. But today? I wonder.

Please don’t shoot me—I’m only the messenger, and I’m not enjoying this any more than you are—but what economics teaches us is that financial distortions, such as those caused by spastic monetary policies and excessive use of leverage and debt, cannot continue indefinitely, but eventually collapse of their own dead, rotten weight. Economically, this can be seen as a cleansing process, washing away an old moribund financial mess, clearing the way for a new round of economic growth built on a sounder, more economically rational foundation. In real life, though, this process is wrenching and painful. Innocent people get hurt. And because the process of economic healing is wrenching and painful, politicians attempt to ride to the rescue and save us from the unfolding disaster. The irony, of course, is that government intervention can’t put Humpty-Dumpty back together again, but instead exacerbates and prolongs the misery. (See “The Next Great Depression.”)

You can bet that the Bush administration, including the Federal Reserve, will do everything in its power to delay the spread of the financial storm until after the election. If it succeeds, the next president will be in a most unenviable position. If he takes the laissez-faire approach and allows the markets to make the necessary adjustments, he will be pilloried as uncaring, incompetent, and worse. If he intervenes, he will gain popularity but aggravate the problem. It’s a no-win dilemma.

Let me close with the bright side (such as it is) of this unhappy situation: We will get through this financial storm. There is a difference between the real economy—buildings, machines, technology, infrastructure, human capital, etc.—and the more abstract financial economy. The real economy will remain intact even if numerous financial institutions fail and the dollar’s purchasing power declines.

Unfortunately, the two economies are not sealed off from each other. When financial institutions can no longer make credit available, economic activity slows, businesses fail, incomes fall, and jobs are lost. When inflationary policies debase the currency, the savings of the people are ravaged. This is a time for everyone to find a safe harbor in which to weather the storm that is upon us. Best wishes and Godspeed to you all.