The Two Problems
September 30, 2008, 06:15 PM
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Let me suggest a conceptual distinction to make things clearer.

Economically, we face two related but distinguishable problems.

First, due to post-modern financial engineering, Wall Street has created vast upside down pyramids of leverage that are so intricate that nobody is sure what financial instruments are worth anymore, with frightening implications for the whole system, which could cause a lock-up of all lending.

Second, we have a fundamental problem, which is that a lot of those highly leveraged complex instruments really aren't worth much because the basic assets they balance on top of have declined sharply in value. Essentially, in this decade home prices (primarily in a small number of states, most notably California, Nevada, Arizona, and Florida) inflated to absurd levels, generating trillions in new wealth on paper. Those gains are now gone and won't come back for decades because they were always stupid: there was never enough human capital in California to earn enough money to pay for those houses.

Now, that doesn't sound so bad: easy come, easy go. For some homeowners in California, the nominal doubling and subsequent halving of their home values had no effect on their economic behavior. My family took our vacation in a tent in pre-bubble 2001 and again in bubblicious 2007. Unfortunately, lots of Californians spent their increased paper wealth on crud, like fancy rims. (And the salesmen who sold the rims purchased fancier tattoos. And the tattoo artists ...) And now the economy and standards of living are going to have to contract as this orgy of real world spending of paper profits is slowly paid off.