In Hock (a caption attached to the graph from The Economist below)
Given the rapid plunge in the stock market, the closure of many funding paths for businesses and households, and the pervasive uncertainty regarding the future of the U.S. economy, a coherent analysis of the state of our economy that can be understood by the person on Main Street (or College Avenue) is definitely in order.  
In the United States, we have been living on borrowed time.  The loans have come due. We all know what happens when individuals, businesses, governments, or other organizations carry too much debt; no one will loan more to them.  This time is not different or escapable.  At some point, debt must be reduced; balance sheets rebalanced; and reduced consumption and investment take place during the transition.
Despite the wishful thinking of many economists and policy makers in the 1960s and again in the late 1990s that we had a “recession-proof” economy, recessions and downturns are not optional.  The greed and fear cycles of Wall Street match the optimistic and pessimistic views on Main Street.  The severity of these cycles in both time and depth, however, can be moderated by prudent policy making, not one of its characteristics in the United States in recent years.
The current cycle, similar to most of its predecessors, arises from too much credit relative to the income that can be generated by it. The graph below provides one glimpse of the recent boom in credit expansion which began in the early 1980s, took a break in the mid-1990s, and turned markedly upward after the millennium.  The graph displays U.S. total debt – both public and private – as a percentage of Gross Domestic Product, the most commonly cited measure of our nation’s income.  All sectors have participated in this credit boom; it’s not just federal spending that is out of control.  Between 1990 and 2008, for example, household sector debt as a percentage of personal income rose from 75% to 130%.  
Furthermore, all domestic debt is not captured in this graph.  We have too little transparency in our financial statements to capture all borrowing in audited balance sheets. These accounts do not include many credit default swaps, which have been recently estimated to exceed $55 trillion, an astonishing four times U.S. GDP.  In 2004 the Securities and Exchange Commission ruled that brokerage units of investment banks with $5 billion or more in assets would be exempt from regulations that restricted the amount of debt they could accrue.  Consequently, these institutions leveraged (borrowed against) their existing assets to purchase various combinations of mortgage backed securities and credit derivatives.  By mid-2007, the five largest investment banks averaged 27 dollars of debt for each dollar of equity capital that they held.  This average exceeded that existent at Long Term Capital Management in 1998 before its bailout was arranged.  When income is rising rapidly, these debt instruments yield huge returns for the equity holders, but the equity holders can become drunk on other people’s money.  I call this the Opium (for Other People’s Money) principle: why risk your own money when you can risk someone else’s money, especially if you do not have to be accountable for paying it all back when income falls far short of required debt service payments.
In contrast with previous credit booms in the United States, the effects of the current debt addiction have been spread worldwide.  Total foreign assets and liabilities have risen to 450% of GDP for advanced countries and 250% of GDP in emerging markets. Specifically, in this decade, over 80% of U.S. federal borrowing (not including Freddie Mac and Fannie Mae bonds) is held by entities outside the U.S., especially the governments of China, Japan, the United Kingdom, and the oil producing countries.    I suspect that they have had their fill.
All addictions have their consequences, and the more flagrant the addiction the more potential damage that will be done before a sustainable economic growth path can be reached.  Advances in financial mathematics have led to the creation of a wide variety of new financial instruments that proponents judged to have moderate or low levels of risk.  Such financial calculations, along with high returns on equity investment in recent years, led to trust and confidence in these complex instruments.
Of course, explosive events, such as chains of defaults spurred by the inability of lenders to pay off their loans in one sector (e.g. subprime mortgages), can and do take place.   Nassem Talib, essayist and mathematical trader as well as professor at the University of Massachusetts at Amherst, calls these events “Black Swans.”  Despite numerous reports over a six month period about the potential demise of Lehman Brothers – one investment bank loaded with a complex concoction of these debt instruments- financiers world wide continued to hold Lehman Brothers bonds and commercial paper (money market securities.) As a result, on September 14th when Lehman Brothers declared bankruptcy, both money market and bond markets seized.  Confidence was gone, and no interbank lending would take place.  The wheels had come off the debt wagon.
So what’s the route from here to economic stability? Clearly, businesses, households, and governments need to replenish their balance sheets, which in simple terms means save more and spend less.  Such a contagious act of prudency, however, leads to a stagnant economy and recession.  British economist John Maynard Keynes (1883-1946) called this the “paradox of thrift.” How bad might the recession be?  Our only guides come from the economic history of the 20th century.  Of all the post World War II recessions in the U.S., the 1973- 1975 and 1981-1982, which both lasted 16 months, were the worst; GDP dropped by 3.5% in the former and 3.0% in the latter.  The unemployment rate rose to 9.0% in 1975 and 10.8% in 1982.  On the world stage, credit-related recessions in the past forty years have featured GDP losses of 18% in Japan (1997) and 31% in Sweden (1992). According to a recently constructed IMF database on financial crises between 1970 and 2007, the average loss of GDP was about 20%.  My conjecture is that the U.S. recession will be at least as large as those we endured in the mid 1970s and early 1980s and possibly the GDP loss will be as much as 10%.
Aggressive use of monetary and fiscal policy can lean against these recessionary tendencies to prop up demand for goods and services and thus generate income.  The Federal Reserve Bank (FED), in its exercise of lending authority under provision 13(3) of the Federal Reserve Act – a provision not used since the 1930s - has made more liquidity available than anyone thought possible. Estimates of loans, loan guarantees, and equity infusions now surpass $8.5 trillion. But FED provision of funds does not mean confident lending to businesses and households.  Stated differently, if lenders do not believe that they can lend money relatively safely, then even cheap money will not induce more loans.  Expansionary fiscal policy will be the hallmark of the first days of the Obama administration.  The anticipated increase in spending and reduced taxation will inevitably induce income growth which should help renew confidence in the financial markets.  When such confidence returns, however, given the huge amount of liquidity forced into the economy by the Federal Reserve, we may have a hard time controlling spending growth.
So where will these aggressively expansionary policies take us?  Although, they probably will generate short term growth in the U.S. economy and some return of confidence to the financial markets, they probably will not assist us in addressing our debt addiction.  A reflated economy that remains deeply in debt without major changes in business, household, and governmental savings and investment behaviors, and without prudent lending, puts in jeopardy a sustainable, long term path to improving the standard of living for Americans.  Given the impending retirement of the “baby boom” generation with its attendant huge entitlement commitments for Medicare and Social Security, we have our work cut out for us.  As the famous Pogo cartoon in the 1960s opined “We have met the enemy and he is us.”
Merton Finkler, Ph.D.
John R. Kimberly Distinguished Professor in the American Economic System
December 9, 2008