Now Comes the Hangover

The story about the challenges with the Bear Stearns hedge funds that were tied to sub-prime mortgages is probably the tip of the financial iceberg. The American economy may be the 21st Century Titanic that has already made contact with the mega-sized chunk of ice, but only shows minor damage. As Al Lewis writes, Wall Street deserves a fair share of the blame for sowing the seeds of the sub-prime mortgage meltdown.

However, the Fed, Fannie Mae and Freddie Mac are also partially at fault. After 9/11, the Fed lowered interest rates to rock bottom levels and encouraged Americans to borrow and buy as much as possible - especially real estate. Freddie and Fannie are GSEs (Government-Sponsored Agencies) that purchase and/or securitize mortgages made by others. Even if a Washington Mutual or Wells Fargo made a shaky loan, after they offloaded it to a GSE, it wasn't their problem anymore.

Here's yet another case of where government intervention in the free market has caused and will cause more financial calamity in the US. If the mortgage lenders were forced to bear the risk of making these questionable loans, the problem would have been minimized, and the financial hangover would have been shorter and less painful. Unfortunately, that's not the case.

The US economy in the early 2000s was heading downward because of the dot-com bust, and other factors. But instead of letting the economy run its course, correct, and have consumers 'retrench' (i.e., cut back on spending), the government had to step in and 'do something.' By lowering rates to all-time low levels and encouraging borrowing out the wazoo, they created the residential real estate bubble and delayed the inevitable economic downturn.

The American economy is similar to a drinking buddy you probably had in your college or 20-something days. It's 2 AM, your friend is three sheets to the wind, and really shouldn't be drinking alcohol anymore. But instead of giving him water or Coke to drink (and starting the recovery process sooner), you give him four more shots of Jagermeister. He's feeling even less pain, but doing more damage to himself, and delaying the onset of the hangover and recovery.

America's debt party has been a rip-roaring one for sure. I hope that all the borrowing, spending and fun were worth it. In the next few years, I'll think we'll see a drastically different attitude towards borrowing. It may take longer than I think, but eventually debt will be considered dumb, and cash will be king. After the financial dust settles, people will look back on this time in American financial history and wonder what the heck people were thinking.