The FT's Martin Wolf explains the real reason we're in this financial mess. Hint: It's not a liquidity problem. It's a solvency problem.
The aggregate stock of US debt rose from a mere 163 per cent of gross domestic product in 1980 to 346 per cent in 2007.
Just two sectors of the economy were responsible for this massive rise in leverage: households, whose indebtedness jumped from 50 per cent of GDP in 1980 to 71 per cent in 2000 and 100 per cent in 2007; and the financial sector, whose indebtedness jumped from just 21 per cent of GDP in 1980 to 83 per cent in 2000 and 116 per cent in 2007 (see charts). The balance sheets of the financial sector exploded, as did the sector’s notional profitability. But leverage, alas, works both ways.
Since US net international debt was 39 per cent of GDP at the end of 2007, virtually all of this debt is an asset of another domestic entity and would net out to zero. But when the gross debt stock is huge and economic conditions difficult, the chances that many entities are bankrupt is high. When people fear mass insolvency, lenders stop lending and the indebted stop spending. The result can be the “debt deflation”, described by the American economist, Irving Fisher, in 1933 and experienced by Japan in the 1990s.
Given the recent explosion in leverage, the challenge is unlikely to be one of mispricing of the toxic mortgage-backed securities alone. Many people and institutions made leveraged bets that have since gone sour. Their debt cannot be repaid. Creditors are responding accordingly.
If the government doesn't deal with the crisis by turning the dollar to toilet paper (one possibility), we may get to experience that "debt deflation" again real soon. So let's hope they get that bailout right. (Looking better last time we checked, but still not looking good.) Here's Martin's story in pictures:
Can't afford it? Just leverage up!
The point? The point is that buying a few hundred billion of crap assets off the balance sheets of sad-ass banks won't likely fix the problem. See Martin's better bailout ideas below.
See Also: Two Better Bailouts
