Commentary

Where did America’s Wealth go?

Where did America’s wealth go? That is the question being asked from Washington state to Washington DC. The Federal Reserve reported yesterday that U.S. household net worth plummeted by $11.2 trillion, equivalent to a loss of close to 18 percent, during 2008. Household net worth – which is assets owned minus liabilities owed – of Americans now stands at $51.47 trillion, the lowest level since 2004. And, even with this week’s Wall Street rally, stock prices are still in the basement compared with the lofty heights witnessed eighteen months ago, and real estate prices are still declining.

The Federal Reserve, under former chairman Alan Greenspan, provided the kindling that ignited the credit boom, fueling the housing bubble and the stock market’s meteoric rise. The Fed decided to keep interest rates artificially low for far too long after combating a mild slowdown in the U.S. economy resulting from the dot-com bust of 2000 and the terrorist attacks of September 11, 2001. This coincided with an evaporation of lending standards, the explosion in debt securitization and a glut of savings from exporting nations, which ultimately funded our spendthrift ways. It should be no surprise that the wealth generated during America’s debt-fueled orgy of home building and consumption is disappearing now that the global credit market has all but shut down. All that remain are the liabilities we have yet to pay. The Fed reported that by the end of 2008, outstanding household debt stood at $13.8 trillion.

The destruction in wealth occurred in assets that were supported by the accumulation of debt. The prices of real estate and shares of publicly traded financial companies soared to unsustainable levels, kept aloft only by a shaky pyramid of IOUs. The inflation of home prices and financial shares during the bubble years spanning 2004-2008 is now but a painful memory. But, it is important to note that these outrageous prices had nothing to do with the fundamental economic value of the underlying assets. Homes were selling at ridiculous multiples to incomes, and bank shares were trading at prices far beyond what the actual businesses were worth, completely detached from the risk these enterprises were engaging in.

The problem for American households is that assets will continue to fall; yet the level of debts owed will remain steady, and may actually grow for those late on their payments. This week’s stock market rally was due in large part to faint whiffs of profitability at Citigroup and Bank of America, but the economy is still shedding jobs. This is sure to put bank assets backed by credit card debt and auto loans at further risk in the months ahead. And the real estate market still struggles with a supply overhang as credit tightens and more homeowners are falling behind on mortgage payments, increasing the chance of foreclosure – all of which will continue to push home prices lower. This means that asset prices are still in the grips of deflation, and could experience more price declines as the economy continues to weaken.

The federal government is in a similar bind. The giant stimulus packages, costly financial bailouts for struggling financial and auto companies, the record number of people filing for jobless claims, and the mass retirement of baby boomers is adding worrying amounts of debt to the American government’s ledgers. This unprecedented explosion in expenditures has increased total public debt to $10.9 trillion.

I have been arguing that the Obama administration – and Congress – should focus more on restructuring and selling off the mountains of current debt sitting on the balance sheets of the nations’ banks. (The government is helping homeowners restructure mortgages, which is a good start, but even more needs to be done to stem the flow of foreclosures, which continues to drive real estate prices lower and in turn creates more problems for the nation’s banks.)

Last year I criticized a proposal by former presidential candidate Hillary Clinton, who suggested freezing mortgage interest rates, because it introduced political risk to American financial markets. But, due to the scale of the problems facing the banking industry and homeowners, I think there is no other way out of this mess. I read a recent piece by Niall Ferguson, an author and a columnist for the L.A. Times, in which he argued for the U.S. government to focus on restructuring private sector liabilities instead of piling on more public debt through Keynesian economic stimulus packages. Ferguson argues this will lead to currency devaluation or default. He sees the problem, as I do, as one of excessive debt. The way out this financial nightmare is to reduce debt levels, not add to them. (He must be so relieved to know that I share his views on this topic.)

Fixing the financial crisis means that all parties involved will have to make sacrifices, some of them will be quite painful. Investors who own bank shares have already been pummeled due to government equity infusions, now bank creditors must absorb losses as loans to these institutions are restructured. Renegotiating mortgages, resetting them to lower rates and possibly longer terms, will also create losses to those who hold them as investments, but this is still far better than millions of homeowners walking away from their current obligations.

In the end, confronting the slide in asset prices will do more to help both lenders and debtors. It will also keep the federal government from wasting hundreds of billions, if not trillions of dollars, on restarting the economy through stimulus packages aimed at increasing consumption and credit flows. This activity risks igniting inflation and increases the possibility of sovereign default. The continued abandonment of fiscal responsibility may help goose the economy in the short term, but will surely lead to a bigger disaster down the road.

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