This Sucker Could Go Down

"This sucker could go down,” declared President Bush, after the White House leadership summit failed to reach agreement on a bailout plan for the financial services sector. The President is one of the last to recognize how bad the economic situation really is. But the U.S. economy has been tiptoeing on quicksand for years, and the current problems will not be solved quickly, even with an infusion of $700 billion, as the President proposes.

The root of the problem is this: the U.S. has been living on borrowed money for an entire generation; this debt has been serviced internally by a mushrooming but shaky financial services sector, and externally by foreign governments (especially the Chinese); and now both of these sources are evaporating. Whether or not the bailout package is approved, the U.S. economy and American consumers are going to take a bit hit.

First--the borrowed money. Both government and consumers have been spending beyond their means, almost continuously, for two decades. The federal government has had huge budget deficits every year since 1980, except for a few years during the Clinton presidency. The deficits have built the federal debt up to some $10 trillion, accounting for two-thirds of GDP, compared to only one-third in the 1970s. Next year’s budget deficit will add almost $500 billion to that debt. The bailout package will probably add another trillion dollars. Just the interest on the federal debt is one of the largest items in the federal budget, draining over $400 billion annually.

Government profligacy is matched by consumers: the household savings rate in the U.S. has been declining for two decades, is the lowest among all developed countries, and in 2005 fell below zero for the first time ever. Credit card and mortgage debt are both at record levels, as are bankruptcies and mortgage foreclosures. Most Americans, even those near retirement age, have almost no retirement savings. The Social Security and Medicare “trust funds” are actually unfunded, to the tune of some $41 trillion. The government is unlikely to find resources to meet these liabilities, which will put further strains on seniors.

Consumer spending now accounts for two-thirds of all economic activity in the U.S. This growth in spending has been possible only by borrowing. The consumer spending and borrowing binge has been fueled by the growth of the financial services industry, which has increasingly replaced manufacturing as the mainstay of the U.S. economy. Banks, mortgage companies, loan agencies and credit card companies make their money by making loans, and they are constantly seeking new customers and encouraging existing ones to borrow more. It is this symbiotic relationship between binging consumers and profit seeking financial companies that has created the piles of consumer debt and subprime mortgages.

All of this is starting to unravel now. People borrowed more than they could afford; the mortgage crisis undercut their ability to repay loans and mortgages; the banks and loan agencies faced mounting defaults and declining profits and stock prices. Banks are increasingly unable or unwilling to extend loans to businesses or individuals, which will crimp both consumer spending and economic growth, accelerating the economic downturn.

The U.S. government is not really in a position to rescue bankrupt companies, because it is itself bankrupt. And just as the financial industry has been an enabler of consumer deficit spending, foreign governments have enabled the U.S. government to spend more than it brings in, by buying up U.S. debt. Over half of U.S. debt is now owned by foreigners—compared to just 5 percent that was owned by foreigners twenty years ago. The biggest outside holder of U.S. debt is the government of China. Holding such debt only makes sense if you are sure you can redeem the funds when you need to. As you can imagine, foreign governments and banks are increasingly worried about this, and have already started shifting such investments to other countries, and other currencies, especially the euro. This is one of the reasons for the sharp drop in the value of the dollar, to record low levels against the euro and other currencies.

So this $700 billion bailout, as large as it is, will only scratch the surface of these multiple dimensions of debt and economic weakness. We cannot continue to grow, based on borrowing against the future. The domestic financial pot is empty, and our foreign enablers are wising up. The economy will contract, our standard of living will decline, and more people will join the ranks of the poor and unemployed. This sucker could go down. The U.S. is in for tough times.