There Is a Silver Lining

The whole country has been complicit in a great fraud. As economist Jeffrey Sachs points out, "We've wanted lots of government, but we haven't wanted to pay for it." So we've borrowed our way out of the problem. In 1990, the national debt stood at $3 trillion. (That sounds high, but keep reading.) By 2000, it had almost doubled, to $5.75 trillion. It is currently $10.2 trillion. The number moved into 11 digits last month, which meant that the National Debt Clock in New York City ran out of space to display the figures. Its owners plan to get a new clock next year.

"Leverage" is the fancy Wall Street word for debt. It's at the heart of the current crisis. Warren Buffett explained the problem in his inimitable way on "The Charlie Rose Show." "Leverage," he said, "is the only way a smart guy can go broke ... You do smart things, you eventually get very rich. If you do smart things and use leverage and you do one wrong thing along the way, it could wipe you out, because anything times zero is zero. But it's reinforcing when the people around you are doing it successfully, you're doing it successfully, and it's a lot like Cinderella at the ball. The guys look better all the time, the music sounds better, it's more and more fun, you think, 'Why the hell should I leave at a quarter to 12? I'll leave at two minutes to 12.' But the trouble is, there are no clocks on the wall. And everybody thinks they're going to leave at two minutes to 12."

If there is a lesson to be taken from this crisis, it's a simple and old rule of economics: there is no free lunch. If you want something, you have to pay for it. Debt is not a bad thing. Used responsibly, it is at the heart of modern capitalism. But hiding mountains of debt in complex instruments is a way to disguise costs, an invitation to irresponsible behavior.

At some point, the magical accounting had to stop. At some point, consumers had to stop using their homes as banks and spending money that they didn't have. At some point, the government had to confront its indebtedness. The United States—and other overleveraged societies—have now gotten the wake-up call from hell. If we can respond and change our behavior markedly, this might actually be a blessing in disguise. (Though, as Winston Churchill said when he lost the election of 1945, "at the moment it appears rather effectively disguised.")

In the short term, all the solutions to the current crisis require that governments take on more debts and larger obligations. This is inevitable and necessary. But that doesn't mean we should, as some noted economists advocate, stimulate the economy with more tax cuts. That would be only one more way to keep the party going artificially—like asking a drunk to go to AA next year, but in the meantime to have even more whisky. A far better stimulus would be to announce and expedite major infrastructure and energy projects, which are investments, not consumption, and therefore have a much different effect on the country's fiscal fortunes. (They are not listed separately in the federal budget, but that's just bad accounting.)

In the medium and long term, we have to get back to basics. Households, for instance, should save more. Governments should put incentives in place that make such savings more likely. The U.S. government offers enormous incentives to consume (the deduction of mortgage interest being the best example), and it works. We have the biggest houses in the world, the thinnest flat-screen TVs and the most cars. If we were to tax consumption and encourage savings, that would also work. Regulations on credit-card debt should be revised to ensure that people understand the risks and costs of these instruments. Moving in this direction would be good for families and for the government as well.

Wall Street will also need to change. Paul Volcker has long argued that the recent spate of financial innovation was nothing of the kind: it simply shuffled around existing resources while contributing few real benefits to the economy. Such activity will now be reduced significantly. Boykin Curry, managing director of Eagle Capital, says, "For 20 years, the DNA of nearly every financial institution had morphed dangerously. Each time someone at the table pressed for more leverage and more risk, the next few years proved them 'right.' These people were emboldened, they were promoted and they gained control of ever more capital. Meanwhile, anyone in power who hesitated, who argued for caution, was proved 'wrong.' The cautious types were increasingly intimidated, passed over for promotion. They lost their hold on capital. This happened every day in almost every financial institution over and over, until we ended up with a very specific kind of person running things. This year, the capital that remains is finally being reallocated to more careful, thoughtful executives and investors—the Warren Buffetts … of the world."