03/12/2008 08:04 am ET Updated Dec 06, 2017

The U.S. is Choking on Debt Financed Expansion

From Marketwatch:

There is a marked difference between economic growth and debt-induced demand. Instead of letting the market take its medicine and enter recession in 2001, the powers that be injected fiscal and monetary drugs to dull the pain and induce stock gains.

The Federal Reserve understands the market is the world's largest thermometer and the driver of a finance-based economy. On the back of the tech bubble, in the aftermath of 9/11, following the invasion of Iraq and into the election, they administered stimulants with hopes that a legitimate expansion would take root.

Is this a conspiracy theory from tin-foil types sitting on a grassy knoll? The only difference between intervention and manipulation is communication, as we're apt to say, a fine line that's been all but erased in recent years. Hank Paulson recently highlighted The Working Group as a policy tool, an admission that effectively exposed the wizard behind the curtain. See article

While government policy set the stage for the underlying imbalances, our immediate-gratification mindset exacerbated them.

Consumers bought goods with no money down and financed those obligations at zero percent.

Many used homes as collateral and flipped into adjustable-rate mortgages at the urging of Alan Greenspan.

Total debt in this country rose to more than 400% of GDP as societal spending habits lost all semblance of consequence.

As Americans raced to keep up with the Dow Joneses, seeds of discontent percolated under the seemingly calm financial surface. All the while, the cumulative imbalances grew as society chased the bigger, better thing.

Let's start with this chart from the Census Bureau:

Notice the real (inflation-adjusted) median income is lower now than at the beginning of the expansion. That means overall income gains have been stagnant for this expansion.

Let's add a graph of the savings rate into the mix:

Notice the savings rate is hovering near zero and has been for some time. It's important to remember how we get this number. The savings rate is gross income less all expenses and expenditures; essentially it's the money that's left over after we pay for and buy all of our stuff.

So, pay has been stagnant and we've been buying more and more stuff so that essentially, we're spending literally everything we make. But notice that despite the fact that pay has been stagnant and we're spending everything we make, retail sales still increased this expansion:

Also note that real (inflation-adjusted) personal consumption expenditures also increased.

So, let's sum up.

1.) When this expansion started, US consumers were already spending just about everything they made.

2.) Median income has been stagnant for this expansion.

3.) Yet, personal consumption expenditures and retail sales increased at strong rates.

Where did the money come from?

This whole expansion has been financed by debt acquisition. Americans have clearly gone deeper and deeper into debt to keep on spending.

Now we are paying the price. All of that debt has to go somewhere. Over the last 7 years, the financial industry has been very busy buying up all of the debt, carving it into various bonds and selling it to the highest bidder. They have used a process called securitization which has been around for about 25 years and in general has been used very successfully.

Problems start to occur when people start to fudge the numbers.

Federal investigators probing the business practices of Countrywide Financial Corp. are trying to figure out what Countrywide knew -- or in some cases didn't know -- about the incomes and assets of thousands of its borrowers.

The investigators are finding that Countrywide's loan documents often were marked by dubious or erroneous information about its mortgage clients, according to people involved in the matter. The company packaged many of those mortgages into securities and sold them to investors, raising the additional question of whether Countrywide understated the risks such investments carried.

Countrywide, long the No. 1 mortgage company in the U.S. in terms of dollar value of loan originations, also was considered among the most aggressive in finding ways to make home loans to consumers whose qualifications couldn't be proved or seemed questionable, mortgage industry executives and analysts said. The Federal Bureau of Investigation has begun looking into its practices in pursuing such business, according to people close to the matter.

Now we're paying the price for these policies. And it's going to take awhile to work the problems out.