Painful Path To More Realistic Growth

At some point the federal government had to say no. It could not continue saving every major investment corporation from its own bad decisions. That's not how a free market system works.

When it came to underwriting a plan to save Lehman Brothers, the government finally drew the line. Whether that line comes too late or too soon is impossible to judge until the current crisis plays out. And crisis is the right word.

After failing to engineer a government bailout or get help from fellow bankers, Lehman Brothers filed for bankruptcy Monday. At the same time Merrill Lynch, also on the point of collapse, agreed to sell itself to Bank of America for roughly $50 billion.

Combined with the demise of Bear Stearns earlier in the year, three of the five giants of Wall Street, the major independent brokers, will soon be gone, leaving only Morgan Stanley and Goldman Sachs. The carnage is unprecedented, the economic fallout incalculable.

Despite dramatic and controversial steps by the Treasury and Federal Reserve to address the crisis, it continues to escalate. The Fed took on billions of dollars in risky investments to make the sale of Bear Stearns possible before it collapsed. It has opened its discount window ever wider to provide liquidity to financial institutions, and lowered standards for the collateral it would accept. More recently the Treasury Department effectively nationalized the troubled mortgage finance companies Fannie Mae and Freddie Mac, leaving U.S. taxpayers essentially owning the bulk of the nation's mortgage market, and not a healthy market at that.

But the waves of institutional failures continued to crash on shore.

The government has done all it can, and arguably too much, to try and stop the current downward spiral. It appears the time has come to let the situation play out and find the true bottom.

Over the past decade the real wages of the middle class, when measured against the cost of living, have declined, yet consumer spending showed steady growth. Credit, combined with diminished savings, made that mathematical equation work. Growing home prices, and the credit derived from the resulting equity, provided the illusion that increasing purchase power without increasing wage growth was sustainable. Income and buying became disengaged.

Long-accepted standards for responsible lending and borrowing became passé. No longer did borrowers have to have sufficient income and a healthy down payment to obtain a home mortgage. This easy credit fueled housing sales, which drove up prices, which fed more reckless borrowing. But then the bubble burst. Housing sales plummeted, as did prices. Equity evaporated and foreclosures soared. And now the debt that backed all those derivatives, hedge funds and leveraged arrangements is not getting paid back and seeming untouchables, such as

The reaction of the stock market Monday was predictable - the Dow Jones industrial average sinking 504 points, the biggest single-day loss since markets reopened after the 9/11 attacks in 2001. With each prior bailout announcement the markets had risen, as if the need for government intervention was good news. On Monday it was as if a day of reckoning had arrived.

The resulting convulsions will likely lead to even tighter credit as commercial banks and securities firms seek to preserve capital and limit risk going forward. Tighter credit will likely slow the economy and deepen the recession.

Painful as that may be, the result will be a more reality-based economy, with purchasing and borrowing habits again tied to income.

Both Wall Street and Main Street are getting a tough, but inevitable, reality check.

It should also be noted that the government has already back peddled and as of last night decided to buy back 50 billion in government bonds to shore up the stock market.