We are now well embarked on year two of the great Credit Crunch. And, yes, this is the same crisis that, a year ago, Federal Reserve Chairman Ben S. Bernanke said might involve no more than $50 billion in losses, the same one Treasury Secretary Hank Paulson called “well contained.”

Like most experts, they were wrong, and the crisis still careens from disaster to disaster. In the summer, Fannie Mae and Freddie Mac went into federal receivership. (You remember them: earlier this year, Congress anointed them the saviors of the mortgage markets.) And, in the wake of the Lehman Brothers bankruptcy, Merrill Lynch’s sale to Bank of America, and the collapse of Washington Mutual, all in September, most of the rest of Wall Street lies dazed and bleeding.

The Bush administration—avowed opponent of welfare programs in all their spirit-sapping guises—has attempted to lavish at least $2 trillion of taxpayers’ money on rescue operations for the silk-tie set, including the $700 billion Paulson-Bernanke “Mother of All Bailouts” Bill, but no end is yet in sight. [As we go to press on September 30, the bailout bill is stalled in Congress.]

What went wrong, and why is it so hard to fix?

From 2000 through 2007, the United States Gross Domestic Product, or GDP, the sum of all goods and services produced, was $92.5 trillion. But over the same period, the sum of all goods and services purchased was $97 trillion. That’s a $4.5 trillion difference. When a country’s purchases exceed its production, the shortfall must be filled with products purchased from overseas. So our trade deficit increased by exactly the sum of the excess purchases.

How did we pay for the excess? We borrowed the money. Household debt roughly doubled, increasing by $6.8 trillion, almost all of it secured by home mortgages. From 2000 through 2005, average home prices roughly doubled. That had never happened before. Homeowners thought they were rolling in money.

Unlike bubbles in stock markets, housing-price bubbles quickly translate into higher levels of consumer spending, since banks flog home-equity lines designed to “make your housing value work for you.” Some $4.2 trillion, or about two-thirds, of the additional mortgage debt was not spent on housing, but on other stuff, like plasma TVs and SUVs. The near match between that $4.2 trillion in home mortgage-financed consumption and the total trade deficit is not a coincidence.

The countries that were the primary recipients of the excess spending of Americans—mainly China and petro-states like Saudi Arabia and Russia—kept the debt merry-go-round spinning by mostly investing their trade winnings in U.S. Treasury notes and bonds (“Treasuries”). The appetite for American bonds was partly a matter of habit—U.S. Treasury bonds are as safe as dollars and pay interest, so most countries’ central banks have long plunked any excess dollars into Treasuries. And it was partly because countries like Russia, China, and the Middle Eastern petro-states lack the modern banking systems that make it easy to lend to their domestic businesses.

Almost all those foreign-owned Treasuries were kept in U.S. bank accounts and swelled bank reserves, which allowed banks to keep on lending, so consumers could plunge into debt over and over again. One of the unhappy side-effects of the binge is that nearly $5 trillion is now in the hands of some of the most unsavory political regimes in the world, a few of which fund terrorist movements.

Where were the regulators? The Federal Reserve could have tamped down the asset boom, but it chose not to. Alan Greenspan, who was Federal Reserve chairman at the height of the credit boom, believes that prices in asset markets are set by the God of Free Markets, and are ipso facto correct. So he looked on benignly as the great revolving flood-wheel of credit drove interest rates lower and lower and house and stock prices higher and higher. Until it stopped.

Why is it so hard to fix? The novel feature of the current crisis is that as banks made riskier and riskier loans, they concocted new ways of selling them off to other holders. It turns out that European banks and investment funds may hold even more toxic U.S. mortgages than American banks do. The trick was to take risky mortgages, bundle them up in packages that look much like bonds, and pay “independent” rating agencies to give them an investment-grade rating. (Yes, it was actually that crass.)

Investors all over the world happily bought triple-A-rated U.S. bonds backed by mortgage loans to people who had no hope of actually making the payments. Low “teaser” initial interest rates, however, deferred the defaults for a year or two after the bonds were sold. So-called subprime mortgage defaults started to spike in 2007, and very high levels of defaults will continue at least through 2009 and possibly well into 2010. As the shock of defaults spread through the global banking system, home prices have been in free fall—by some 15 percent over the past year. That, too, has never happened before.

Home mortgages are merely the largest of the troubled asset classes spilling out of the American debt binge. Commercial mortgages, leveraged buyout loans, credit card-backed bonds, and auto loans are also suffering defaults that, collectively, may be about as large as the losses on residential mortgages.

What are the political implications? Through the first half of 2008, global banks and investment banks have absorbed some $500 billion in losses—without counting the hits being taken by Fannie Mae and Freddie Mac, Merrill Lynch, and Lehman. Losses at nonbank debt holders, like pension funds and hedge funds, are probably on the same scale. Total losses, therefore, are already well over $1 trillion, and the bottom is not yet in sight. Only a very small amount of these losses will ever be recovered. Banks have been able to cover some of their losses by raising new capital, but they have been forced to cut back sharply on new lending.

This is a watershed event. U.S. political history tends to run in roughly quarter-century cycles. The “Keynesian” dispensation, which was based in an intellectualist faith in the power of an elite to direct the flow of events, ended in the economic debacle of the 1970s. It was replaced by the Milton Friedman/Ronald Reagan paradigm, marked by its devotion to free markets and its mistrust of government. Although it was at first a welcome corrective to the excesses of Keynesian-ism, the Friedmanite/Reaganist cycle eventually succumbed to the gross excesses that have characterized the twenty-first century.

Paradigm shifts are always painful. The engine of growth during the Reaganite era has been a credit-based boom in consumer goods—including housing, cars, entertainment centers, and consumer electronics of all kinds—offset by a depletion of personal savings and an impoverishment of the public sector, especially in health care. Free-market advocates point to all the gadgets possessed by the lowest economic quintile, ignoring the pervasive insecurities of haphazard employment and the lack of health-insurance coverage.

Correcting that imbalance will require higher taxes, higher savings, and much lower consumption—on the order of about 5–7 percent of GDP (see Jeff Madrick, page 11). The financial sector will shrink radically. It will not be possible to accomplish a transition on that scale without a serious recession. Until the fall of Lehman Brothers, federal policy attempted merely to keep the financial/consumer hamster wheel spinning. The decision to let Lehman fail was a critical first step in the opposite direction.

The new administration that takes office just three months from now, regardless of party, will be tempted to revert to a bailout mode. That would be a major mistake. The role model should be Federal Reserve Chairman Paul Volcker’s radical purging of consumer price inflation from 1979 to 1982. It was a great episode of public service, but it was made possible by the unstinting political support of President Ronald Reagan, against the advice of Republican stalwarts who feared that Reagan risked becoming a one-term president.

The same kind of political courage will be required of the next president. A relatively short but very painful purging of the current excesses over the next couple of years could put the country on the path to a major economic transition. Temporizing, papering over the problem for fear of unpopularity, will merely ensure that the crisis drags on, like a chronic infection, for years.      

September 30, 2008

Related: Mark A. Sargent reviews Charles R. Morris's The Trillion Dollar Meltdown