"Debt Deflation?" Krugman points to a problem of the overall economy

The government has nationalized Fannie Mae and Freddie Mac! The economy is Saved!!

The first statement is true. The second? We wish. Krugman applauds the government takeover of the two mortgage institutions that currently handle about 70% of all American mortgage loans. It had to be done, and Bernanke and Paulson did it rather well.

Why did it have to be done? Krugman explains "Debt Deflation."

...when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a “stampede to liquidate” is a severe economic slump.

That’s what’s happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged — their assets were mainly bought with borrowed money. As Paul McCulley of Pimco, the bond investor, put it in a recent essay titled “The Paradox of Deleveraging,” lately just about every financial institution has been trying to reduce its leverage — but the plunge in asset values has nonetheless left these institutions with more debt relative to their assets than before.

What's happening now is that highly leveraged financial players are trying to eliminate debt by selling assets to pay it off. But the collapse in asset values is forcing them to sell at lower prices.

Leverage is the amount of debt held compared to the value of assets held. If a financial player owned assets worth one million dollars, they might borrow another million and get the profit from controlling two million dollars, paying in exchange the interest on the borrowed one million dollars. That is, they would have two million dollars in assets working for them and owe one million dollars. That's 50% debt.

Keep in mind that Bear Stearns had a debt ration of 33:1. For every dollar of their own, they had borrowed $33 more and had $34 in assets. Those assets were in - among other things - high-paying sub-prime real estate mortgages. When enough real estate mortgages went bad so that the lost, say $2 of that $34, they had only $32 for every $33 they owed lenders. No lender was going to lend them more money for fear of not getting it back.

So the highly leveraged financial players couldn't sell assets fast enough to pay off debt to bring their leverage down. In fact, their efforts to sell assets all at the same time caused the value of all of their assets to drop.

Banks and financial institutions which do not have any capital cannot loan money to others. When Bear Stearns had lost all of their own money and were losing borrowed money, they could no longer buy mortgages. Plus, no lender was going to lend them more money to buy mortgages. They were literally losing money on every transaction they made. So they went out of business - to be bought by J.P. Morgan. The U.S. treasury sold Bear Stearn's good loans (assets) to J. P. Morgan and kept the bad ones essentially for the taxpayers to pay for.

Unfortunately, the entire banking industry is highly leveraged. They thought they could get away with it because everyone knew that mortgages were the safest kind of loans. Now they know better and they are all scrambling to sell off loans and get to a more sustainable level of leverage . As they try to sell off assets (loans) to lower their leverage, the value of all such assets is dropping rapidly. Since they are trying to sell loans, they can't make new ones, which is why the credit crunch that has been happening this year has happened.

The absence of credit is causing business of all kinds to contract, including credit cards, leading the the layoffs and lack of hiring that has been happening all year. The layoffs and the shortage of consumer credit are hitting retailers. Steak and Ale and Bennigan's are gone now.

Silver State Bank reportedly failed because of bad construction and real estate loans. I don't know for sure, but Nevada has been one of the areas, like California and Florida, where real estate values were highest. The builders were building to take advantage of those high prices, but since the mortgage lenders have largely shut off mortgage lending this years, they haven't been able to sell what they have already built. Back in Texas in the early 80's (the Reagan Era) a similar thing happen because of the S&L crisis.

Builders couldn't sell what they had built, so Banks loaned them more money to keep them building and stay in business until the economy turned around - only it took to long for the economy to turn around. Then the builders did finally go bankrupt and took the banks with them. Every town in Texas had new retail stores sitting empty for several years because there were no businesses that could make enough money to fill them.

So we come to Krugman's conclusion:

...the effort to contain the financial crisis seems to be failing. Asset prices are still falling, losses are still mounting, and the unemployment rate has just hit a five-year high. With each passing month, America is looking more and more Japanese.

So yes, the Fannie-Freddie rescue was a good thing. But it takes place in the context of a broader economic struggle — a struggle we seem to be losing.

So how long will it be until the economy turns around again? That depends on how long the current debt deflation continues, and THAT depends largely on how soon and how effective action it taken by the U.S. Congress to stimulate the economy. Tax cuts to the wealthy are useless since this is a recession caused by inadequate consumption. Effective action has to get more money to the consumer to spend, and that will mean more and better paying jobs for the consumer. Tax cuts will not restart the economy. Tax cuts, even for consumers, will be like a gas-powered mower that gets just enough gas to pop once or twice, but won't start running. This economy isn't going to be restarted by handing out checks. It has to have jobs, which will mean government and government-created jobs.

Only after consumers can start increasing purchases will the private market be able to start a comeback. And that will be ... who knows? It's against conservative ideology.