Diagnosing the Eagle: the housing bust

Summary:  The first in a long series of posts about one of our most serious problems, one that results from other and deeper problems — which makes it difficult to fix.  Links to other chapters in the series appear at the end.

Something is wrong with America, rendering our society incapable of connecting effectively to reality.  The late USAF Colonel John Boyd described this as a process:  Observe, Orient, Decide, and Act.  For a description of the OODA loop see this; for a discussion of Orientation see this article by Chet Richards.   Who can tell what has caused this social illness, a form of cultural Alzheimer’s?  The symptoms appear in many aspects of our national public policy — collective action in critical areas such as energy, geopolitics, and management of our economy.

We find it difficult to recognize large problems until they are upon us, and to discern causes and effects.  Worse, often we cannot weigh the various short- and long-term factors to rationally decide how to respond, so we choose seemingly easy and fast solutions without bothering to perform the necessary research and analysis.  And, perhaps as a result of this flawed process, we frequently find ourselves unable to competently implement whatever course of action we choose.

Rather than provide a theoretical analysis, I’ll show a few case studies.  In Chapter I we will look at the housing cycle.  Just a normal business cycle, although driven to amazing heights by a combination of factors — all noted at the time, with these warnings ignored by both our ruling elites and the citizenry:

  1. artificially low interest rates (Fed policy),
  2. ambitious public policy seeking to increase homeownership (esp among minority and lower income households),
  3. irresponsibly slack regulation of lenders, and
  4. ill-considered financial innovations.

Now we face the downcycle, inevitably long and hard proportionate to the extraordinary upcycle.  Rather than take the time to assemble experts to do the necessary research and prepare recommendations, our activists and politicians immediately reach for quack nostrums — which almost certainly will have unpleasant long-term effects.  Rather than rehash all this, here are a few links so you can read and decide for yourself.

As usual in America,the important initiatives are bipartisan.

  1. Actions Taken and Actions Needed in U.S. Mortgage Markets, remarks by Secretary of Treasury Paulson at the Office of Thrift Supervision National Housing Forum (3 December 2007)
  2. Hillary Clinton’s Statement about Treasury Secretary Paulson’s Comments (3 December 2007)
  3. Edwards Unveils Bold New Proposals To Restore The American Dream Of Homeownership (5 December 2007)

The criticism by experts has come quickly and fluently

From “Subprime Bailout II” by the Institutional Risk Analyst, 6 December 2007 — a comment from a client:

“The Paulson proposal will paralyze the US housing market for years.  Who in their right mind will lend money for home ownership ever again if the contract can become null and void the second the hoi polloi start screaming to their elected officials?  Fannie?  Freddie?  {Profanity}, they’re bankrupt as it is and will only lend up to $417k which does nothing for either coast of the United States.  Everyone in a protected [guaranteed by the government or a government-sponsored enterprise] mortgage won’t ever leave ’cause they’ll never get a better deal.  Home prices will not reset to more sane levels.  The Paulson proposal is a {obscenity} for generations X, Y and Z.  Thank you very much.  If this continues, the US is going to be just like Japan in the ’90s.”

From Dennis Gartman, author of The Gartman Letter — one of the top sages on Wall Street (5 December 2007):

Are contracts no longer to be viewed as law, but rather are to be viewed as nothing other than mere whim?  If we are to allow mortgagees who are in trouble to stand down and have their problems taken up by taxpayers, what then of contracts anywhere?  Can we demand foreign governments, or foreign companies, or foreign individuals to stand by their commitments to Americans if Americans will not stand by their commitments to one another?

No one wants to see people put out from their homes.  No one wants to see the television photo-op of poor people pushed from their homes at Christmastime, or in the depths of winter.  No bank wants to take delivery of a foreclosed-upon home when it could be left in the hands of the former home owner, with the mortgage shortage to be worked out over time.  But to have the government step in and mandate that homeowners be allowed, under penalty of law, to remain in their homes and for banks to be forced to accommodate is legal and philosophical madness.

This is a country of law, which believes in the sanctity of contract agreed upon by those who’ve consented to the binding nature of that contract.  If the parties involved wish to change the contract, and if agreement can be reached to do so, then it can and should be done.  But to have government force the issue — and worse, to mandate the taxpayer funds be used to do so — is morally wrong, with implications that shall redound into any and all other economic concerns.

For a brief but more technical analysis, see Max Fraad Wolff’s article here.  There ar many sites with excellent coverage of the housing cycle, such as Calculated Risk.  For a valuable overview see this article.

The pattern shows the problem

If this cycle is like the commercial real estate bust of the early 1990’s, is that a big deal?  Fifteen years ago and now almost forgotten.  We bailed out the banks, with the cost just another load added to the Federal debt.

The pattern shows the problem.  We’re not talking here of 100 year floods, or even 50 year floods. It’s only 15 years and already face a broadly similar situation, perhaps worse.  We cannot do this every 2 or 3 decades!   Whatever fixes we implemented have proven inadequate.  Worse, the responsible institutions — both commercial and governmental — did not recognize the problem as it grew or even as the bubble popped.  Only months into the crisis have they responded.  This demonstrates a flaw in our national ability to collectively see, think, and act (our OODA loop).


We do not only have too many houses; we have too much debt incurred to buy the houses.  Solutions to excess debt come in four flavors.

1.  Growth:  given time and rapid wage growth, the debt burden becomes manageable.  We pay it off, ever more easily as incomes grow.  That was the dream solution to America’s high levels of household debt and large long-term government obligations.  It burst in 2000, and will not return in time to help us.

2.  Inflation, reducing the real weight of our debt.  This requires two things.  First, real growth in wages.  Second, either the cooperation or blindness of bond investors — they must either accept negative real after-tax yields, or remain oblivious to rising inflation.  (Note the low reported numbers of the government’s inflation indexes.)

3.  Debt can disappear the hard way, as debtors default on their loans.  Both recessions and declining home prices drive defaults (involuntary and voluntary, respectively).  This is surgery, resulting in bankruptcies, homelessness, decaying neighborhoods, bank failures, etc.  Also, many states have single option laws making mortgages on primary residences (only first’s, not refi’s or seconds) non-recourse to the borrower, so the lender cannot collect a deficiency from the borrower (when the mortgage exceeds the home’s net sale price).  This leads to “jingle mail” — keys mailed back to the lenders.


  1. They can legislate to direct change mortgage contracts:  reducing interest rates and payment terms, preventing or slowing foreclosures.  This spreads the debt burden from debtors to creditors.
  2. They can change the rules of the bankruptcy courts, with the same result as above — spreading the debt burden from debtors to creditors.
  4. They can nationalize the problem, taking direct ownership of the sector.

Socialization is the seemingly easy path.  Done well, we have reforms like those Solon instituted for Athens — laying the foundation for its future greatness.  Done poorly, we have increased moral hazard leading to another cycle of rising debt and speculation — except that the next crash will imperil a larger part of the society, or even all of it.  See this post for more about this solution.

It’s all about choice.  Every downturn gives us the opportunity to determine what America will become.  We weigh our fidelity to our principles, our history, our forebearers — vs. our ability to collectively withstand pain (financial, social, political).  Interesting times, indeed.

Other posts about the housing crisis



39 thoughts on “Diagnosing the Eagle: the housing bust

  1. One of the major problems with the entire housing/mortgage scenario at this point is very simple and is the key to the future: no one knows how deep this actually goes and how bad it will get. Mortgages are, resold, and resold time and time again. Ask your lender who actually owns your mortgage – chances are they will not be able to tell you because it has been placed on the global marker and it could be owned by a bank in Europe or Asia. If the US government bails out mortgages, it is actually bailing out the global economy to an extent. We’ve seen English, Frenc, German and American banks get seriously hammered over the last couple of months.

    This entire scenario is a result of an overly complex global finance system – and the more complex the system, the greater the chance for instability.

  2. It is true that many mortgages are resold in investment packages, which is the focus of the current Senate probe, but this debt is on the investment side of the bank. The retail sides have not made such mistakes, and they will be coming on strong with ads to gain new customers. The plus side is that the retail loans have more oversight, so they will not suffer the same consequences as the subprime loans in the news, and banks do not resell these mortgages.
    One of the big issues is that the constant barrage of advertising to obtain more credit, or the practice to increase credit limits on current cards to encourage more spending, will inject some money into the economy, but I feel that this will come at a cost to our nation. This tactic of offering more unsecured debt to those who cannot afford it is a great money maker to the financial industry, but hazardous to their clients.

  3. It doesn’t really matter what side of the bank is doing what – the banks are there to make a buck anyway possible (my father has been an executive in the banking industry for 30 years). There will be no ads if there is no bank. If the crises gets to be so bad where the government has to bail them out (which just occured in England with Northern Rock) the banks would fail – which is laissez-faire capitalism at its finest.

    Credit issuance is a major problem – I agree – and if the situation you describe comes to fruition, it’ll be just another example of the little Dutch boy putting his thumb in the leak of the dyke. The debt problem in the US has to be fixed one way or another – continuing to throw money we don’t have at debts doesn’t seem to be a rational way to fix any financial problem including this one. There are too many banks in the US anyway, a consolidation wouldn’t be the worst idea in the world. Somehow Canada only manages to have a dozen or so domestic banks.

  4. Regardless of the government of the day’s philosophy and beliefs, when the peasants are at the castle gates with the pitchforks the government will bend. Today the peasants are there with the torches and pitchforks. This debt will get socialized and this will be another step in the decline of Pax Americana.

  5. If this cycle is like that of the early 1990’s, is that a big deal? Fifteen years ago and almost forgotten, the cost just another load added to the Federal debt.

    The pattern is the problem. We’re not talking here of 100 year floods, or even 50 year floods. It’s only 15 years and we face a broadly similar situation, perhaps worse. We cannot do this every 2 or 3 decades! It demonstrates a flaw in our national ability to see, think, and act (what Boyd called the OODA loop).

  6. Hi Fabius, I thought I was going to hate this article, but in fact, on reading it I find that it is quite sensible actually. That is to say, the section on sub-prime debt is quite sensible, but the start of the article casts the government’s responses in terms of an existential crisis brought on by our incapability of “connecting effectively to reality”. Surely some kind of hyperbole. I don’t think that it’s ever been the case that America has been better at “connecting… to reality” (which is implied) or that other countries are better at this (which is also implied). At least, if you are correct, you could show responses to financial crises in the past that were much more measured and made better use of the OODA loop.

    Best… Vim

  7. Vim — what a great idea! I j did not think of it. The classic example is the Volcker era, with the US unable to rollover our debt in US dollars — our creditors wanted debt denominated in real money. His hard medicine laid the basis — much more than anything Reagan or Congress did, imho — for the following generation of US prosperity.

    Or look to the post-WWII shambles, in which America instituted the GI bill, the Marshall Plan, and the Bretton Wood agreement. Or go way way back to the founding, in which Hamilton laid the foundation for America by insisting that we pay off the war debt — not just default like everyone else does.

    Yes, our present behavior is not typical of America. Or of what America was. Future chapters will illustrate this in other contexts.


    I don’t think it is hyperbole. The author Bar Yam explains about much of what is happening. If you read some of the author’s work, I think you will understand what Fabius is talking about. The world has become too complex for any one to understand completely. These “bubbles” are real and brought about by potentials that are “unseen”, as if you can see potential energy, by most if not all of us. For more discussion on this try searching Zenpundit’s archives on this for author.

  9. Larry — great connection! I’ve glanced at Bar Yam’s work, but sounds like it deserves closer attention.

  10. Larry,

    I think you make an interesting point, but that’s not what Fabius said, or at least that’s not how I read it. The above article diagnoses an illness. It’s not that society has become too complex, but that we have become too stupid (“cultural Alzheimer’s”). Although, in any case, haven’t we become better placed to deal with complexity (see Flynn’s new book on the IQ “surge”)? Isn’t complexity part of a solution or a raft of solutions to problems of scarcity and allocation, which then gives rise to new problems (and new solutions (and new…))? It’s my opinion that this is less of an existential problem than the experience of a continual tension: how to keep all the plates spinning at once. And there are many more plates than there were in the past becaues we’ve got a lot better at it.

    So I wonder: has it ever been different? What about Smoot-Hawley? What about civil war? What about America’s contemporary peers (for instance, although Bush was spectacularly stupid in his response to the sub-prime crisis recently, Brown (previously known here as an ice-man or “Stalin”) beat him to it and handed over a £24bn loan to Northern Rock). I’m sure that with a vague enough description (“not connected to reality”), one could fit pretty much any regime from any moment in time to it.

    Why does America feed off the idea that it’s in perpetual crisis or contsantly on the edge of the void? That’s what I want to know. I suppose I don’t doubt that there are serious problems, just wondering what the nature of the problems are and how serious they have become. I’m sure further chapters will answer these questions.

    Best, vim

  11. Vim, I think your examples illustrate my point. Smoot-Hawley was an act of protectionism, which is not inherently foolish. States such as the US and Japan have employed it successfully for long periods. Like most powerful medicines, it can be applied in the wrong dosages at the wrong time, with ill effect.

    Ditto, Northern Rock. Individual banks, or groups of banks, have failed since banks were invented. Since the Great Depression governments have often bailed them out. Nothing systemic in that. It’s the normal March of Folly (Tuchman’s book).

    Ditto, civil wars. Some historical conflicts exceed average folks ability to resolve them with reason and heart. Just because something bad happens does not mean the folks involved were stupid.

    None of these events suggests that a society’s OODA loop is broken. Allowing household to insanely overload on debt, beyond any historical precedent, does suggest that. Letting one’s banks implode again, a little more than a decade after they did so on a grand scale, does suggest that. Allowing both to happen (over a decade) strongly suggests that. Future articles will describe other examples.

    These are things that common sense tells us is bad. Things we have done despite long and loud warnings. Hence the concern that there is an underlying social illness at work.

  12. Perhaps a bit off topic, but I wonder sometimes if corporations (and banks, in this instance) play on this cultural amnesia. AT my US university, I’ve noticed an exponential increase in the number of credit card offers to college students. Aside from the whole naive-and-unused-to-credit issues, these potential cardholders also have no real memory of what happened economically in the early nineties, much less the 70s and 80s (when the US economy really went to hell, IMHO).

    As the unknown client above quote, Generations X and below are getting shafted by their predecessors….

  13. Fabius,

    Actually, I think your examples illustrate my point! Or at least they are contentious. Smoot-Hawley might not have been systemic, but it is also popularly held (by certain economists, e.g. Cato Institute types) to be one of the causes of the Great Depression, or if not a cause, then something which only served to entrench not alleviate the depression. Perhaps someone could have written a similar post then.

    Protectionism is not an evil in ande of itself, but it can also be the wrong response to a difficult situation. For example, the rise of protectionism in the late 19th C obviously fed the Great War (and autarky frequently requires conquest to sustain). Removal of protectionist constraints has led to the growth of India’s economy. No longer do we talk of the “hindu rate of growth”. Communism killed millions of people, but still proved a popular economic choice. These things happened. Yes, the current levels of US personal debt are unsustainable and not sensible from an economic perspective, but I still don’t believe that this is “worse” than anything that happened in the past / happens around the world, or that this represents an existential crisis, or that this crisis is particularly unusual in its strength or character. Financial instruments leading people to imagine their position is stronger than it is — it’s not that significant. Is it?

    Looking forward to further posts…

  14. Protectionism is not an evil, in that it often works. So Smoot Hawley was clearly wrong, but not insane. Current economic dogma to a large extent just ignores this, just at ignores Ricardo’s statement that free trade benefits all parties only when the factors of production are immobile (which is obviously not true today).

    As for the debt crisis, look at my posts on the end of the post-WWII economic regime. Not proof, but I think indicates that our behavior is irrational.

    Nor have I said that this is “worse than anything that has happened in the past.” In those posts I said the opposite, in that foolish behavior leading to regmine failure is historically common. Our failed OODA loop might become just another example in future textbooks.

  15. Sorry, I took that to be your point re the Volcker era and the original post, i.e. that the situation is worse than at any other time in the past and than in other states in the contemporary era.

    Will look at your post-WWII posts as I think there’s probably something there that I’m missing.

  16. PS: Don’t know if current dogma ignores the dangers of free trade (such as they are), so much as over-emphasises the benefits relative to other important factors (being institutions) in arguments with protectionists and economic populists. The inherent problems in free trade and shifting comparative advantage are well known, IMO. Two excellent contemporary treatments are Paul Samuelson’s paper, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization”(1) and Jagdish Bhagwati, Arvind Panagariya and T.N. Srinivasan’s semi response, “The Muddles Over Outsourcing”(2).

    1. http://econ-www.mit.edu/faculty/download_rp.php?id=50
    2. http://www.columbia.edu/~jb38/Muddles%20Over%20Outsourcing.pdf

    I think that the new institutional economics of North and Rodrik etc would agree that free trade is not everywhere and by necessity a good thing, but that given the right preconditions it certainly is.

  17. Vim, The purpose of an OODA loop is to destroy complexity; I would think this would be the first place to look for a disease.

  18. Vim — yes, the series about “the post-WWII regime is ending” establishes a context for this.

    The two articles you cite I think fit the “pretty much ignore” the preconditions Ricardo established. Bhagwati et al test for internal consistency of the theory, but in the wider context we’re discussing their conclusions result from their narrow assumptions (which they clearly state). Their discussion at the end of mal-effects from outsourcing are so much hand-waving. Samuelson’s paper is similar. For example, as he states at the end this assumes zero net capital movements — hardly representative of current globalization. It is a very narrow defense of current preferences for open trade flows.

    I will probably do a post on globalization and trade in the next week or so.

  19. Of course you destroy complexity by action. Most of the time the type of action is unimportant except to generals, philosophers, or diplomats. Action itself, to the single OODA loop is a simplifying process. This is true even though that action can, and most likely will, create other complexity.

    And to be sure, action will happen in the housing crises, Iraq, Iran, China, peak oil, and any number of series Fabius is discussing here. So Action is not the problem.

    It could be our Decisions. But we arrive at our decisions by the observations we make and how we orient ourselves to those observations.

    So maybe the problem lays between our Observations and Decision making. That would bring it to our Orientation (democracy.) If you feel your oreintation is democratic and that there is nothing wrong with democracy then the problem doesn’t lay there.

    If democracy is not the problem, then it might be in how we observe the world. Maybe the world we observe is too complex for our orientation and our orientation is no longer valid for the complexity of our observations. On the other hand, it could be that our orientation will serve the complexity, but has been corrupted. As an examble, maybe our leaders don’t represent the people anymore, just special orientations? This would mean we would have to go in and tweek our election system a little to correct the situation, thus destroying, at least a little part, of the complexity. This would be a revolutionary action, which is the movement across the gap between two complex observations. I think one of our founding fathers said we needed one every 20 years, he could have been correct.

  20. Larry — That is a very helpful analysis. Somehow our orientation — not just of our leaders — has decoupled from reality. I’ll have to re-read Chet Richards note on Orientation.

  21. The best analysis I’ve seen so far the of Paulson plan is this post from Mish’s Global Economic Trend Analysis. Excerpt follows, the money quote:

    This plan will benefit homeowners who meet ALL of the following requirements {should say “conditions”, not “requirement”}.

    The homeowner has at most 3% equity
    The homeowner is not hugely underwater on current loan to value.
    The home is in an area where home prices are not apt to plunge over the next few years.
    The freeze will permanently prevent foreclosure.

    It takes all four conditions before homeowners will benefit. The plan has negative benefit for nearly everyone in the small select group of people that meet the carefully crafted eligibility requirements.

  22. The current disaster is simply the culmination of 30 years of mismanagement after Bretton Woods collapsed and the US went off the gold standard (largely due to unsustainable expenditure on the Vietnam War and a relative decline in manufacturing).

    The problem was that the US remained the ‘reserve’ currency (in which much of, particularly raw materials including oil, international trade is denominated in US$). This created an irresistible opportunity for the US (people, companies, Gov’t, etc) to live above their means by utilising almost free debt simply by increasing the supply of US$.

    The dangers of this were warned about at the time. To be fair, as a short term ‘fix’, to buy time for the US to clean up its house, it was acceptable. Trouble was that there was no ‘clean up’, instead the trade deficit steadily increased as its own resources became depleted and its manufacturing base started declining in absolute terms.

    Gov’t (State and Federal) and corporations jumped on the bandwagon as well. As the volumes of US$ steadily increased the financial industry adapted and changed. Deregulation increased the capacity of the industry to issue debt.

    Eventually, by the early-mid 90’s the entire financial system had become a mechanism to recycle US$.

    Here’s a very simple example of how it works:

    A US company buys (say) oil. Oil is paid for in US$. The company goes to its bank, which has sufficient $ available (thanks to the Federal Reserve creating, them through the wonderful multiplier of the financial system). The US$ are transferred to the (say) Saudi organisation. This will use some of them to buy other things it needs from other countries, but is still left with a surplus of US$. What can it do with them?

    Multiply this up by US imports from all over the world (EU, Japan, China, etc) and it doesn’t take too long for mere billions to become trillions.

    For along time this was reinvested in US Treasury bonds, the US stock market, corporate debt, property, etc. This demand also allowed the US Govt to issue more bonds, to cover its deficit. Banks could take these deposits and re-lend them (multiplied up of course, in some cases by as much as a 10:1 multiplier), much of that domestically. This was made worse by deregulation of the finance sector, which allowed banks to set up subsidiaries that could issue more debt than the actual bank would be allowed to do (due to reserve and liquidity requirements), then 10:1 multipliers became 100:1 or more.

    So the US financial system was sitting on the capacity to issue tremendous levels of debt on very small reserves. However lenders need borrowers. Fortunately for them cheap money always finds a home.

    This funded the various stock market ‘booms’ over the years, as well as corporate takeovers, private debt explosion, et al. It also funded the US Govt’s deficits, since there was always demand for Govt bonds.

    But as each ‘bust’ happened’ the investors of US$ became more reluctant to invest in ‘risky’ investments. More ever, the US consumer started to become tapped out, overloaded by debt with negative net savings.

    This is where the current mess started. The US financial system was awash with money thanks to the Federal reserve pumping even more money into the system after the dot com collapse and 9/.11. Thanks to the trade deficit this was exported throughout the world.

    Trouble was all those organisations with large amounts of money had fewer, high earning investments available. Putting their money into safe bonds, with their low earning rates would simple depress earnings and get the CEO fired.

    Then came the ‘bright idea’. Securitise debt, lump them into packages and sell them off, with higher earning potential. Good debt got mixed in with bad debt, risk and values were ‘invented’ by complex equations. Soon everyone got in the act.

    Back to the US consumer, always ready to borrow to consume and ever optimistic about the future. Banks (and huge numbers of other organisations) got into the last bastion of consumers assets, housing. Cheap loans, allowing people to ‘draw down’ on their existing mortgages (ie turn their house into an ATM), investment loans, etc, etc. As competition increased (and the flow of funds needing a home) lending standards went down, way down.

    This debt was then packaged, given a ‘rating” of how good it was and then sold off. Many holders of US$, looking for a high earning safe home flocked to them all over the world, as well as those people and organisations in the US that actually had some money.

    This made things worse, as many financial companies then realised that they could buy this stuff, and then borrow against these ‘assets’ and issue more debt in other packages. Then debt multiplier ratios started moving to 1000:1 or more (oh those miraculous hedge funds). At this point it had taken on a life of its own, but the Federal Reserve still kept pumping money into the system (pouring more petrol on the fire).

    And so it went on, not only in the US. The UK for example has total debt (private and Govt) now greater than its GDP (if it was a company it would be put into receivership).

    Politicians loved it, war with Iraq, issue more debt, boondangle to a favoured group, issue more debt. At a stroke of a pen the US Govt could add 100, 200 …. billion $. $700 billion for the Iraq war , stroke of a pen. Hit the Govt debt limit, change it. Cut taxes to the rich, stroke of a pen. A new corporate tax dodge lobbied for? Give it and add more debt.

    Consumers loved it. You could borrow more on your house. But because there was so much money around housing prices exploded (this is called hyper inflation). So the value of your house kept growing as fast, or even faster, than you could borrow on it. Flat screen TV, buy it, new car, buy it, etc.

    Business loved it. Consumers spent and spent. Money for takeovers abounded. Share prices went up. More importantly senior executive pay and bonuses went up even more.

    Of course there is always an ending and all Ponzi schemes always collapse in the end. What is called the ‘sub-prime’ crisis was just the match that lit the fuse. What is actually happening now is that all packaged debt is looking toxic

    The problems right now are the incredible volumes of debt and the packaging and re-packaging means that no one now knows what they are worth. So there is now a de-facto credit freeze going on as people who have money are scared to lend it out and those who need it are getting desperate.

    The multiplier effect both multiplies gains and losses. If you are an organisation that has a trillion $ in debt issued and it loses 10% of its value then you lose $100 billion. Some organisations have already gone under and even some of the big banks are looking very shaky. Citibank and some others could conceivably lose all their capital reserves, at which point it shuts down. Have a look at the Hedge Fund Implode-meter and The Mortgage Fund Implode-meter (http://hf-implode.com/?source=cmailer and http://ml-implode.com/?source=cmailer) for a day by day list of who’s going under.

    There are simply too many US$ around in the world, this means they are losing value. Other creditor countries are now facing the horrible situation of either dropping off the $ as a reserve currency, letting it going into free fall and lose a lot of money, or ruining their own economies by the inflationary effects of too much money. China and Saudi Arabia are caught right in this cleft stick at the moment. Eventually they will have to drop it.

    Could this have been avoided, sure. If the US had voluntarily stopped being the reserve currency in (say) 1980, after managing to put together a reasonable basket of currencies replacement. The subsequent financial discipline required (such as actually having to earn foreign currency to buy something) would have concentrated minds acutely. If debt had been sucked up into real, wealth generating investments (infrastructure, industrial investment, etc) instead of consumption. Et al.

    But greed, stupidity and short term thinking won out as they unfortunately often do,

    The 2 trillion $ question is, can it be unravelled without the worlds’ financial systems collapsing and a world wide depression? Maybe. But we can say with certainty:

    1. The US $ will no longer be the reserve currency.
    2. It will be stuck in a long recessionary period, possibly with stagflation.
    3. Large amounts of US assets will pass into foreign hands.
    4. There will be collapses of major corporations (think GM, Ford or Citibank, etc)
    5. Taxes will have to rise and spending dropped (note raising taxes to discourage private consumption as well as stabilise Govt debt is actually a good thing in this situation).
    6. The US standard of living will drop markedly, how this pain is spread (equitably or concentrated in just the middle and lower classes) will be critical for the US’s future.
    7. Military spending will decline unless the US turns into a dictatorship (even then actually).
    8. Forget the F-23, new destroyers, 1,000 foreign bases, etc, etc. There will be no money to pay for them. Hard decisions will have to be made (and soon).
    9. The US will leave Iraq, sooner than most people think, with Afghanistan not much later, due to the financial strain.

    From a longer term perspective this is not all bad. With deft and clever handling the pain can be turned into an opportunity for re-building and revitalisation, with the US coming back in (say) 20 years a lot wiser and in many ways a lot stronger. Taking just one simple example, if the US has to actually earn foreign currency to pay for oil, energy efficiency will improve. New domestic energy alternatives will become attractive, whole new industries could come into being.

    Then again if it is stuffed up …..

  23. >Are contracts no longer to be viewed as law, but rather are to be viewed as nothing other than mere whim?<

    Here in Oregon, certain factions of state government recently managed to whip up a public scare about the projected future indebtedness of the Public Employees’ Retirement System, then persuade the legislature to abrogate legal contracts with public employees. The state supreme court upheld. From this I induce that legal contracts with governments are binding only insofar as governments choose to honor them.

    The government may bend for peasants at the castle gates, but before it does, it’s a lot more likely to call in police and tear gas, or machine guns. However, we have seen repeatedly that the government readily bends for money interests, especially those who have tended to provide campaign funds. The Golden Rule applies.

  24. This is all more interesting with the sub-prime melt down and bear crash. I have written a few articles in {snip}.
    Fabius Maximus replies: discussions about investments are off-topic for this blog. If you have a specific article of relevance, you may post a link to that article.

  25. “Something is wrong with America, rendering our society incapable of connecting effectively to reality.”

    Quite possibly. When Batman and the Joker become national obsessions, we might be out of touch with reality.
    Fabius Maximus replies: I disagree, although your view is a commonplace throughout history. Probably there were those in classical Athens who said the same about their obsession with the theather and olympics. The Batman stories are reflections of the groundlessness of mondern society, inevitable fears since Rousseau and later (and more profoundly) Nietzsche destroyed the intellectual foundation of our values. All that remains is committment, decisions made in the absence of faith.

  26. One thought on why we’re less equipped to deal with reality these days, people are really heavily medicated, and more here than anywhere else in the world.
    Fabius Maximus replies: A powerful observation, and worth considerable thought.

  27. Since debt is, indeed, a huge part of the problem, it’s surprising that so few are noting the problems of tax deductions of mortgage payments. Currently you can only deduct the interest, the debt portion. This should have changed long ago to be a clear 35% or 25% tax credit on the whole house payment, with a lifetime maximum.

    The sickness in America is the addiction to OPM — gov’t benefits to be paid in tax by Other People’s Money.

    You also fail to note the biggest delusion of housing investors: ‘house prices always go up’. This was generally true since … Volker! crushed inflation in the 80s, but careless lending based on this assumption kept giving better returns (and bonuses) than prudent lending.

    Oldskeptic’s long rant was pretty good, but I don’t believe in a long recession as much as a long slow US growth, little real asset growth phase, while BRIC countries (Brazil, Russia, India, China) increase their share of the world’s economy.
    Fabius Maximus replies: I believe the rise in real prices of US residential real estate began in the 1970’s, from a combination of inflation (rise in price of real assets) and demographics (baby boomers forming households increased the demand for housing) — esp in areas with net in-migration (i.e., the Southwest).

    Volker crushing inflation would, all other things being equal, decrease the attractiveness of real assets like housing. House prices began their metoric rise after Greenspan expanded the monetary base after 2001 (the recession and 9/11).

    Economic forecasts are not like guessing which horse will in the third of Belmont. They requrie massive analytical work, complex models — and even then are probably wrong.

  28. A society is itself complex, so what is referred to as “our OODA loop” is actually the result of many OODA loops, from many constituencies and sub-groups within the society. The difficulty is that there must be robust mechanisms in place (political, legal, cultural) to:
    a) ensure that the aggregation of rational, but divergent OODA loops will result in a globally rational one;
    b) prevent a few powerful individual decision making processes to predominate to the detriment of all the others.
    The current situation, as insane as it is, may therefore not necessarily be caused by a “disconnect from reality”, but by skews in the overall OODA loop (as larrydunbar suggests).

    Much has been made of people “foolishly” entering appealing but unsustainable mortgage arrangements. Was there anything to rent corresponding to their socio-economic level? Private operators are usually not very keen on renting houses to low-income or minority wage earners. And the availability of low-budget public housing from HUD has been decreasing for years.

    On the other hand, some top sharks made fortunes during the bubble expansion, lured rescue capital from sovereign funds on what now appears to be advantageous terms, and are being bailed out at taxpayer’s expense early, when conditions are still acceptable. Not such a bad OODA loop after all, and astutely (if cynically) connected with the institutional and economic reality.

    By the way: the failure to balance individual OODA loops into a coherent and harmonious whole reminds me of comments in another FM thread (‘The War Nerd discovers van Creveld’s “power of weakness”, and demography’), which revolve around the loss of cohesion in societies — though the problem considered here has nothing obvious to do with birthrates, immigration or war.
    Fabius Maximus replies: Yes, speaking of “America” in anything but the most limited sense is to abstract or simplfy for easy discussion of complex things.

    As for people “foolishly” buying homes on credit, I have seen no evidence that rentals were either scarce or unusually expensive (both should go together). In fact the low cost of renting is one of the factors keeping the CPI low during the early 2000’s. As the number of surplus housing units (nationally) expanded above levels ever seen since WWII, rents were depressed.


    Too much intellectualism is being read into the new Batman movie by reviewers and critics. It is escapist entertainment. The Dark Knight is fiction. It is fantasy. It is not real. Neither Batman nor the Joker would last long in our real world. Both of them would end up dead or in prison in very short order. Their scripted Gotham City is a much safer place for them than our unpredictable real world.

    In the Time magazine review of The Dark Knight, the reviewer compared the Joker to Osama bin Laden, which is an insult to the victims of 9/11. To put escapist entertainment on the same level as real-life tragedy is indeed caused by a “disconnect from reality”.
    Fabius Maximus replies: I wish I had thought of these comments in Freshman literature.

    “Prof, Hamlet and Antigone are fiction, as neither would last long in our real world. Ditto for Don Quixote, King Arthur, and Robin Hood — obviously just escapist entertainment. None of these works will stand the test of time.”

  30. “Ditto for Don Quixote, King Arthur, and Robin Hood — obviously just escapist entertainment.”

    King Arthur and Robin Hood are not completely fictional. They are at least based on real people if they are not real themselves. And things can stand the test of time by being reiterated and recycled. The King Arthur legends have been rewritten numerous times during the centuries. And Batman plus Robin Hood equals DC Comics own Bat-Clone – the Green Arrow.
    Fabius Maximus replies: There is speculation that the character of King Arthur has some basis in fact (not much like the legend, however). And even less basis for speculation about Robin Hood. A thousand years or more from now folks might speculate about the basis for legends about Batman.

    Only with the passing of time do we see what future generations considered to be classics. that speak to the fears and dreams of people. We see this even with movies over even a few generations. For example “Casablanca” was considered neither a great movie nor classic upon its original release (Wikipedia: “The film was a solid, if unspectacular, success in its initial run”).

    Note that the Batman saga has been re-invented several times since its origin in the 1930’s.

  31. “Note that the Batman saga has been re-invented several times since its origin in the 1930’s.”

    Yes. Possibly the best re-invention being the one done by Dennis O’Neil and Neal Adams in 1969 that would last until the mid-1980s. Not silly like the campy period before and not melancholy like the dark period after. Serious but not dark. A good balance.

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