Memo to President Obama

First, let’s clear up a misconception. The economic crisis is not about house prices, credit or the stock market. The crux of the matter is the U.S. consumer, the main force driving the global economy. Without reviving U.S. consumer spending, the world faces a depression, defined as an open-ended downturn from which the economy cannot emerge on its own, without structural changes imposed on it from outside the economic system.

Even if another source of demand were found soon, economic dislocations would still be severe and adjustment to the new reality extremely painful.

The U.S. consumer won’t be easy to replace. Since the early 1990s, U.S. consumption increased 2.5 times and provided half of overall U.S. growth. In current dollars, annual consumption increased by $4.2 trillion, or 7 percent of global GDP. (By contrast, China’s domestic stimulus plan, unveiled in November, measures less than $600 billion over the next two years.)

U.S. imports have more than quadrupled during this period. Today, we import $2 trillion more per year than in 1991. This consumption binge enriched foreign exporters and provided an enormous multiplier effect for global economic growth. Our external gap, measuring $800 million, provided plentiful funds for local consumption and investment.

Runaway Debt

But disposable income has been growing much slower than consumption. The savings rate went down from 8 percent in the early 1990s to less than 1 percent in the past four years. The gap between consumption and incomes has been bridged by borrowing, as consumer loans and home equity credit increased by $1 trillion over this period. Consumer credit outstanding rose by nearly $2 trillion. The overall consumer debt burden has been growing even faster, accelerating sharply since 2000.

While the consumer borrowed directly, Washington also borrowed on his behalf. After cutting taxes, the “conservative” Bush Administration then increased spending, so that gross federal debt jumped by more than $6 trillion, despite a period of fiscal surpluses in the late 1990s.

The market economy is cyclical for a reason. Periods of growth are interspersed with recessions because the cycle plays a key moderating role in the economy. Recessions allow the economy to self-correct, working out excesses and imbalances accumulated during boom years.

The Federal Reserve is supposed to end expansions by curbing credit whenever the economy overheats. In the words of one former Fed chairman, its job is to take away the punch bowl just as the party gets going. It is a highly unpopular job, which is why the Fed has remained an independent, non-political entity outside the control of the legislative and executive branches.

However, after the painful corporate restructuring of the early 1990s, the Fed embraced recession-avoidance as a key goal. Global competition, the emergence of China and new technologies kept consumer prices at bay, providing Fed chairman Alan Greenspan with an excuse not to tighten monetary policy.

But rising consumer prices are not the only sign of overheating. Asset price inflation is equally dangerous — if not more so, because assets are used to secure borrowing. If the price of the underlying asset is inflated, the owner of that asset can borrow more than the equilibrium price of that asset. When asset prices decline, the system is hit by widespread defaults.

In a conventional recession, overextended debtors go bankrupt — dragging along imprudent lenders as well — but after the slate is wiped clean the economy is primed for renewed growth.

In the second half of the 1990s, U.S. consumers kept borrowing against the rising value of their investment portfolios. But when the tech bubble burst, the expected recession didn’t occur. The Fed slashed interest rates and allowed the credit-financed consumer binge to go on — except now consumers shifted to their rapidly inflating houses as collateral.

Without the salutary effect of a recession, bubbles tend to inflate everywhere — in commodities, fine art and professional sports, for instance. Worse, if the collective memory of mass bankruptcies fades, lenders and borrowers forget prudence and go in above their heads.

In fact, when the Fed started to tighten in mid-2004, it gave a boost to the credit bubble. Since unrealistic real estate prices already underpinned debt, borrowers didn’t care when rates went up. They expected rising house prices to bail them out.

Blame the Messenger

During the election campaign, both candidates attacked “greed and corruption on Wall Street.” But the real culprit in this crisis is the American consumer, who wanted to keep buying flat screen TVs and gas-guzzling SUVs even while living well beyond his means. Finance professionals merely allowed the consumer to squeeze every last dollar of credit from his assets, but the borrowing spree started with the consumer’s willingness to pawn his last asset.