On this date four years ago, Oct. 9, 2007, the Dow Jones Industrial average reached its highest mark ever, rising to 14,164, or more than 25 percent higher than where it is today. The national unemployment rate stood at 4.7 percent, roughly half of where it stands today.
Although the nation's economy has struggled back from the abyss, the seeming prosperity of 2007 appears irretrievably distant, especially sitting in the dark shadow of the ongoing European sovereign debt crisis.
We believe, however, that there is a direct but difficult path forward to lasting prosperity. That path requires the orderly restructuring of our massive debt.
The stock market stalled in its upward march in Oct. 2007 as the reality of broad declines in the housing market began to ripple through financial markets. As housing values fell, myriad financial transactions built on the back of that overpriced and overbuilt market began to fall apart.
The carnage that followed included the collapse of mortgage-backed assets, the freezing up of credit, failing banks, unprecedented government intervention and the loss of millions of jobs.
It was a classic speculative bubble: too much credit had been extended to individuals, companies and speculators purchasing assets related to housing, and housing carried far greater downside risks than most imagined.
Consequently, the balance sheets for households, companies, banks and governments held far too much debt.
Since the financial crisis, there has been significant unwinding of that debt by companies. Through operational and financial restructuring, American corporations have dramatically deleveraged their balance sheets. This has cost jobs, but American businesses have generally reemerged more productive, profitable and competitive.
But far too many households, banks and governments have yet to restructure their debts, leaving households and banks with a joint negative equity problem that has yet to be resolved.
The negative equity problem simply refers to families saddled with mortgage debt that exceeds the value of their homes. By some estimates, there is close to $800 billion in negative equity in the housing market. This is a joint problem for homeowners and for banks because banks continue to carry all that questionable value on their books.
This joint negative equity problem, that leaves banks not lending and households not spending is what Nobel Prize-winning economist Vernon Smith calls "the root of our economic distress."
Bankruptcy and foreclosure provide blunt instruments for deleveraging this market. But they are probably too blunt, often resulting in a lose-lose-lose scenario where borrowers, creditors and adjoining landowners all lose more value than what might occur if there were some more nuanced and orderly system to write off a portion of the value of the unpaid principal. The challenge is how to do that without destroying creditors' rights or creating perverse incentives for those who are not in distress.
This crisis began and continues because of too much debt in a lackluster housing market. Accordingly, lawmakers should have spent significant effort thoughtfully amending bankruptcy and foreclosure law to address the biggest financial issue of our day. We happen to be partial to the ideas of University of Chicago economist Luigi Zingales, which would allow for contingent write-downs coupled with equity sharing. But there are many other creative ideas for reform to facilitate orderly deleveraging that can avoid the lose-lose-lose scenario of foreclosure.
Sadly, our broken political culture is incapable of identifying and solving such fundamental problems. Government itself keeps borrowing and refuses to restructure its own long-term obligations.
Under a new generation of leadership, American businesses went through the painful steps of deleveraging. In order to repair the balance sheets of our households, our banks and our governments, the nation needs a new generation of political leadership that will pragmatically solve the vexing root problems of our time. The fundamentals of lasting prosperity depend upon it.
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