The Economy

Lehman gone, Merrill sold, AIG tottering . . . . Quite a weekend.

Neither candidate displays the slightest understanding of what's going on. Seriously, zero. Our financial institutions have funded themselves with short-term funds borrowed on mortgage-based collateral, in part to fund the acquisition of mortgage assets. Those loans were all made on the assumption of rising house prices, which were fueled by years of declining interest rates and the extension of mortgage credit to marginal borrowers. The former was the initial and primary driver, with the credit extension first justified by the price increases from the rate reductions. But as banks crowded into the trade the proportion of credit extension grew to be the primary driver. Relaxed lending standards based on price increases driven by further relaxation of lending standards is a tautology that even Wall Street will eventually notice.

The markets now have to reprice those assets for sustainable housing values, which we're still discovering and which depend in part on the financing available, which of course depends on those assets. The markets also have to adjust to reductions in leverage available, as mortgages are no longer good collateral. That is exaggerating financing difficulties beyond their long-term levels, and will probably depress housing prices somewhat below those long-term levels. These are interdependent variables and it will take some time for everything to shake out.

There were other excesses in lending standards as the securitization model was extended to items like credit card debt and corporate securities, all initially justified by lower interest rates. The contraction of those structures is also hurting the supply of liquidity and the demand for debt assets. The overall debt environment was also supported by the recycling of dollars by exporters (Asian manufacturers and oil producers) who were reaching for yield.

These financial events reach the real economy through consumer spending and housing construction. Less mortgage finance means reduced housing demand and reduced housing construction. Housing price increases fueled consumer demand directly through home equity loans, and indirectly through increased consumer credit as credit card debt was tacitly protected by the borrower's ability to reach that increased home equity. The wealth effects of higher housing prices made consumers willing to use that newly available credit. Lower financing costs also probably helped business investment at the margin.

The dislocations and anxiety we're feeling is the logical adjustment to all this. We should worry, because we've lost the security on which we depended for the past ten years, and the reduction in consumption is the necessary and logical consequence of those worries. That security was always financial and exaggerated. The productivity of the American economy hasn't changed, but yes, we will have to focus a little more on what we actually need. It's disturbing but not terrible.

The pain is worst for those in marginal jobs and industries, but their position was never well founded to begin with. No government action will bring it back. We were mistaken to focus on anything but the core productivity of our workers and our economy, and we would be mistaken to focus on anything else right now.

I don't hear any of that from the candidates, probably because they don't understand any of it.