Monday, March 2, 2009

Shared Sacrifice Will Ease the Credit Crunch

Shared Sacrifice Will Ease the Credit Crunch

Is the U.S. heading for another Great Depression? Probably not—but we are about to go through a period future generations may call the Great Repudiation.

The root cause of today's crisis lies not in the housing market but in America's foreign debt. Over the past four years the U.S. private sector has borrowed an astonishing $3 trillion from the rest of the world. The money, directly and indirectly, came from countries such as China, Germany, Japan, and Saudi Arabia, which ran huge trade surpluses with America. Foreign investors trusted their funds to U.S. financial institutions, which used much of the money for mortgage loans.

But American families took on a lot more debt than they could comfortably afford. Now no one is sure how much of that towering sum the U.S. is going to pay back—and all the uncertainty is roiling the financial markets.

The Washington bailout debate boils down to this question: Who is going to bear the burden of the $3 trillion mistake? Will low- and middle-income borrowers have to cut back on spending to pay their mortgage bills? Will taxpayers have to chip in big bucks to pay for defaults on those debts? Or will Washington act in a way that imposes large losses on foreign investors—in effect, repudiating some of the debt? The best outcome is shared sacrifice among borrowers, taxpayers, and foreign investors—but that result may be politically difficult to achieve.


Since mid-2004, American households have taken on a bit more than $3 trillion in mortgage debt. The official statistics are very fuzzy, but it looks like at least one-third of the debt, and perhaps half, was financed with foreign money. As a result, foreign investors are sitting on an enormous mountain of mortgage-related securities.

The value of those securities, though, depends on both economic and political factors. Real wages have dropped for most U.S. workers since 2004. To make good on their mortgages, many low- and middle-income families would have to sharply cut their spending, hurting both the domestic economy and countries that export to the U.S.

A better solution is for borrowers, U.S. taxpayers, and foreign investors to share the burden of the excess debt. The question, though, is finding the fair division of pain. So far the U.S. government has taken over Fannie Mae (FNM) and Freddie Mac (FRE), a move that provides a taxpayer guarantee to investors, many of them foreign, who own securities issued or backed by those companies. The Paulson bailout plan, too, would devote up to $700 billion of taxpayer money to buying up bad securities, with non-U.S. investors some of the major beneficiaries.

Given the hostility to the Paulson plan, however, it's unlikely we will see more money to prop up the prices of securities. The next step in Washington could be legislation to benefit homeowners—say, by allowing bankruptcy courts to reduce mortgage debt, which they cannot do now. Alternately, the government could let more homeowners default and more financial institutions go under. In either case, the value of mortgage-related securities would drop, with foreign investors taking much of the hit.

The global response to such a move depends a lot on how it's presented by the leaders in Washington. It's unseemly for the world's richest country to refuse to pay some of its debts. That's especially true since much of the money came from poorer countries such as China. In the worst case, the losses by foreign investors would lead to an unwillingness to invest in the U.S. while fueling anti-American sentiment around the world.

U.S. politicians are accustomed to playing to a domestic audience. But in the end, making the case for shared global sacrifice may be the biggest task facing the next President.

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