Fundamental problem with the bailout.

You may have read or heard about the idea of moral hazard in the past few weeks (maybe even right here on this blog).

Moral hazard is the tendency for those that are insured to take on more risk. Big banks were "too big to fail" so they destroyed the financial system by taking on too much risk, knowing that the government (or the Fed) would bail them out if things went bad. Those with a long term perspective won't get caught up in this game, but the short run profits are so huge that many did.

Fannie and Freddie were "implicitly" guaranteed by the government. This allowed them to raise a lot of cheap money to buy up a lot of mortgages and mortgage-backed securities (MBSs). That is how they became so large and it was basically a self-fulfilling prophecy as they were taken over last month. Again, they made a lot of bad decisions - bad for the taxpayer, bad for the long term prospects for themselves, bad for stockholders - because they could get away with it, earning many millions in compensation even while doing their part to destroy the financial system.

There's plenty more on this issue (people that bought too much house, mortgage brokers that profited by selling these horrible mortgage products to people that couldn't possibly understand how they worked, banks that originated and sold the mortgages, etc. - all basically expecting someone else to bail them out when the tide turns), but let me just say that the fundamental problem is not moral hazard. This is part of the explanation of why some people behaved the way they did, but it is not the fundamental issue.

Many alternative plans have been proposed, some sound pretty good, but virtually all are fundamentally flawed because they are just creative (in most cases anyway) ways of reflating the economy (meaning, getting people/companies back to the lending trough). Lending/borrowing just for the sake of increasing consumption cannot be the solution to the problem. That is the problem.

Economists have referred to the past twenty-eight year time period as the great moderation. That is, a time when the economy was generally strong and inflation was generally not a problem. Many feel that we have basically conquered the business cycle, particularly with adept use of monetary policy to control inflation and limit downturns in the economy. This is an illusion built on the expansion of money and credit over this time period.

Everything produced in the United States (overall output, GDP) is categorized into one of the following: Consumption (C), Investment (I), Government spending (G) or Exports (NX - Net exports). Consumption in the U.S. has grown from around 62% of GDP to around 70% of GDP. Think about how much of that consumption growth was driven by access to easy, cheap credit. Consumers are tapped out and the tide is slowly turning. Unfortunately, the economy has to go through a hard recession in order to effect the changes in attitudes that will lead to a stronger economy with some real long-term potential ahead of it. This would have been much easier on everyone if we'd just dealt with the problem 10 or 15 years ago, and that should be the primary lesson coming out of this economic crisis.

I'm going to spend a lot of time refining this line of thinking over the next couple of years. Whether or not you agree with me, your comments on this will be greatly appreciated.

President Bush famously declared that this country was addicted to oil just a couple of years ago. There may be some truth to that assertion, but I contend that this country has a much bigger monkey on it's back with its addiction to credit.