What Lies Beneath: the little depression that could


by Rich Broderick, September 16, 2008 • Ever have one of those moments when you are just dozing off and you dream that you are coming down a stairway and step into – empty space?

Something like that sensation is afflicting the investment community and is now rapidly spreading throughout the banking system. Only it’s not empty space they’re stepping into, but the nightmarish prospect of something economists call “debt deflation.”

Debt deflation refers to a situation in which the value of an asset falls below the amount of money borrowed – the debt incurred – to make the purchase and that is still owed to someone. As consumers, we experience debt deflation all the time on depreciating assets like cars and household appliances. But we don’t expect to be able to sell our four-year-old Ford Focus for as much as we paid for it nor does our economic solvency depend on being able to do so.

Debt deflation becomes a serious problem when it affects what should be appreciating or at least stable assets – stock portfolios, for example. Or the house we live in. And the more we borrowed to purchase an asset like this at what turns out to have been an inflated price, the bigger the headache.

How big? In a nutshell, debt deflation is what set off the panic that followed the stock market crash and the subsequent credit crunch that ensured that the economic downturn would rapidly escalate into the Great Depression.

In 1929, debt deflation chiefly involved stocks. In the run-up to the crash, investors were borrowing money hand-over-fist, using it to purchase equities in the belief that as stock prices continued to skyrocket it would be possible to pay back the borrowed money from the proceeds of stock sales and still realize a tidy profit.

In this early forerunner of the “no-doc, low-doc” fiasco of the housing bubble, investors in that time of nearly unregulated trading were borrowing as much as 100 percent of the price of stocks they purchased. When the market crashed, they were stuck with the bill for the money they had borrowed for stocks that now in many cases were worth absolutely nothing.

No wonder there was a wave of suicides on Wall Street.

Today the focus of debt deflation isn’t the stock market (though as the effects of the housing market collapse ripples through the economy, there is debt deflation taking place there, too) but in housing. An untold number of Americans who took out not just sub-prime or ARM mortgages but also minimum down payment mortgages over the past four or five years now owe more than their house is worth – or likely to be worth for the foreseeable future.

But the situation is much worse than that. Why? Because the problem is not confined to the two million or so American families who now are in, or at risk for, foreclosure and/or bankruptcy or the millions of other families who suddenly find themselves with a mortgage that is larger than the market value of their house. Debt deflation has also ravaged the huge shadow banking system that has been allowed to grow unchecked – and mostly unregulated — over the past decade.

Unlike regulated banks whose loans must be underwritten by deposits – i.e. actual cash — this shadow banking system has been underwritten to a large extent by so-called “collateralized debt obligations,” made up of, among other things, mortgage notes “bundled” into “equities.”

As long as the housing bubble continued to grow, those collateralized securities kept the shadow banking system afloat. Now that it has burst, it’s taking the shadow banking system down with it. And as the investment firms, hedge funds, and other entities that compose that system go down, defaulting as well on money they borrowed from regulated banks, they threaten to drag the entire financial system into the black hole of another Great Depression. In turn, this giant Ponzi scheme could take all of us down with it.

At the moment, private debt in America stands at more than $40 trillion — and counting. Until the past few months, it was possible to believe that this staggering sum represented assets worth at least $40 trillion or more. Today, such faith is no longer tenable. No one knows precisely what the assets purchased by that $40 trillion are really worth – just that it is less, perhaps much less, than the money that we collectively owe.

Yes, it’s true that there are mechanisms in place – like FIDC insurance on bank deposits of up to $100,000 – that place some kind of floor under a collapse, as well as a willingness on the part of federal officials to intervene in the markets in a way Herbert Hoover would never have countenanced. But one of the things that has the financial system so scared is the knowledge that, because of the reckless profligacy of the Bush Administration, the federal government is now broke and itself living on borrowed money — some $5 trillion during the past eight years.

Meanwhile, though it’s tempting to blame Bush for the mess we are in, the truth is that, like the military-industrial complex or stupid imperial adventurism, responsibility for the heedless deregulation of the financial system has been a bi-partisan affair. It began under Reagan and proceeded apace under Democratic and Republican presidents despite the S&L crisis (also precipitated by lack of regulatory oversight) the dot.com bubble and now the housing crisis.

The fact is, no matter who is elected this fall, Obama or McCain, neither is going to be able to provide a quick fix for the contraction already underway. And by the time the next President is sworn in this coming January, we may well be into the kind of financial panic that could trigger another depression.

Even if the coming downturn will likely never reach the depths or match the duration of the Great Depression, it will be bad enough. And who knows? Maybe even bad enough for us finally to realize Phil Gramm’s fond vision of America as a “nation of whiners.”