Washington DC, October 2, 2007 --  

The popping real estate bubble is putting financially responsible citizens at risk from the behavior of the irresponsible masses.

Walk down the H Street corridor in one of the rougher parts of this town, and you'll be inundated with solicitations for acts of financial irresponsibility. Check cashing stores offer fast money through payday loans with punishing interest rates. Retail outlets offer instant gratification: merchandise now and no payments for the first year. With few banks around, the main investment vehicle comes from DC Lottery tickets sold at corner liquor stores.

Relatively speaking, these are but minor temptations on the road to financial ruin. With America's housing bubble deflating at an impressive clip, casualties from much bigger mistakes are beginning to litter the roadside.

Many Americans bought homes at the peak of the bubble with interest-only or adjustable rate mortgages. A disproportionate number of these creative loans went to high risk "subprime" borrowers. These mortgages gave buyers low payments at first, but counted on home prices continuing to rise so the loans could be refinanced later. This was essentially a pyramid scheme -- only the thick-headed could have expected this to continue indefinitely.

The chickens are coming home to roost for this financially irresponsible behavior. American home prices in 20 metropolitan areas fell 3.9 percent in the year ending July¹, a decline which will likely continue for years. Many Americans facing balloon payments on adjustable rate mortgages can no longer afford their homes and face foreclosure. Other Americans are locked into interest-only loans, and stuck overpaying to live in houses they can't sell without taking a huge loss.

Yet there is no room for smugness by those of us who weren't irresponsible enough to take the real-estate equivalent of a payday loan. Defaults have caused a financial liquidity crisis to emerge across the world², forcing the U.S. Federal Reserve to pump money into the system. The Fed even lowered the federal funds interest rate by half a percentage point last month in an attempt to ward off a recession.³

Much like printing money, these actions by the Fed have increased the money supply, creating serious effects for the greenback. The U.S. dollar has repeatedly hit one record low against the euro after another, and amazingly, it has even dropped below the value of the beleaguered Canadian dollar. You know all those Canadian quarters that American shopkeepers wouldn't accept? Now they're worth the same or more than their American counterparts.

Indeed, the past year has seen the decline in the dollar against every world currency tracked by the Economist magazine, save such basket case currencies as the Argentine peso and the Pakistani rupee.⁴

For most people, the main consequence of a flagging dollar is the higher cost of imported consumer products. The effects to date have been mild, largely because America's main suppliers of imported goods (China, Japan, and oil producing countries) have currencies pegged or at least closely tied to the value of the U.S. dollar. But this is bound to change, as countries stop exposing themselves to risk by accumulating massive portfolios of American IOUs.

China, for example now holds about a third of its $700 billion in foreign currency reserves in U.S. Treasury Bills, and another third in other dollar-denominated bonds.⁵ Yet the country has decided to abandon its currency's peg to the dollar in favor of a basket of currencies. If other countries abandon their ties to the dollar, Americans will experience a significant rise in the price of imports -- and ultimately serious consumer product inflation.

Former Federal Reserve Chairman Alan Greenspan predicts we will soon see high inflation and double-digit interest rates, due largely to rising costs of products from globablizing economies such as China and India.⁶ He doesn't blame the inflation on those who created the housing bubble -- to do so would to cast blame on himself for not working to stop its rise. But it is true is that plenty of other irresponsible financial behavior has contributed to the decline of the dollar, too.

For one thing, American voters keep electing people who engage in massive deficit spending on entitlements and pork projects. American involvement in the pointless war in Iraq has also wasted $100 billion per year in deficit spending for the past five years. And most Americans continue to spend far beyond their means, racking up credit card and household debt that many people can never hope to repay.

Such destructive collective behavior is exactly what makes free-market systems run into trouble. Once a critical mass of irresponsible people creates a disruption in markets, even the responsible people suffer. Like a mob of village idiots in a horror film, those who can't manage their finances are enveloping the rest of us in the consequences of their actions.

This idea is well known to residents of Latin America, where savings accounts have been repeatedly wiped out by successive waves of currency devaluation. Fortunately, America is not at that point yet. A corrective dose of financial responsibility is what's needed to keep us from heading there.

Related Web Columns:

Spending Away the Dollar, December 7, 2004

Money Out the Window, October 29, 2002

Notes:

1. Bloomberg News, U.S. New-Home Sales Drop, Prices Fall Most Since 1970, September 7, 2007

2. The Montreal Gazette, Credit Crisis Strikes UBS, Citigroup, October 2, 2007

3. Bloomberg News, Fed Lowers Rate to 4.75 Percent, First Cut Since 2003, September 18, 2007

4. The Economist, Economic and Financial Indicators, September 29, 2007

5. Washington Post, China Pledges Not to Unload U.S. T-Bills, September 10, 2007

6. USA Today, Greenspan Predicts Double-Digit Rates in Coming Years, September 15, 2007