The Month When Reality Invaded

September 2008 will go down in the history books as the month in which the bulls finally looked like losers. It took eight and a half years. March 2000 marked the end of the Reagan stock market boom, although the supposed experts did not see this at the time or thereafter. Even after the NASDAQ had declined 80% by 2003, they still told people that the best strategy is to buy stocks and hold them long-term. They still believed that the stock market was going to produce 15% per annum returns for the foreseeable future. September 2008 and he ended that mantra. On September 3, the Dow Jones Industrial Average was where it had been at its peak in 2000: 11,700. The Standard & Poor’s 500 index was lower: 1280 vs. 1529 (close). Subtract from that over 20% price inflation.

The experts on CNBC on September 1 still clung to the illusion that there was no recession, the boom was still in force, and everything would work out just fine. By the end of September, all that lay in ruins. There is no optimism on CNBC today. There is a kind of stiff upper lip determination not to panic.

It should have been obvious in August 2007 that the end of post-2003 stock market recovery was over. Bernanke had tightened money from the day he took over as chairman of the Board of Governors of the Federal Reserve System in February 2006. Real estate was the driving force of the expansion, and real estate was in decline. It was obvious to me in late 2005 that the bull market in real estate was over. I said so at the time. It was surreal estate. A handful of us saw this coming, but it seemed so far-fetched at the time that virtually nobody paid any attention. They now pay attention.

Real estate from 2001 to late 2005 was the largest bubble in American financial history. It dwarfed the bubble of the stock market in the 1920s, because that bubble had involved only a tiny fraction of American investors. The residential real estate bubble involved two-thirds of the population, all of whom owned homes. The other third were affected because of rising rents.

People thought that they were going to get rich with leveraged real estate. Instead, something in the range of 40% of all mortgage debtors in the United States will be under water in their mortgages by the end of 2009. People were told by the experts that “this time it’s different.” It wasn’t different. It was just more extreme. The consequences will be felt over the next decade.

In September, confidence was at long last shattered. At the beginning of the month, Secretary of the Treasury Henry Paulson was still assuring people that the banking system was perfectly sound. On Sunday, September 7, he unilaterally announced the Federal government was taking over Fannie Mae and Freddie Mac, along with their $5 trillion of mortgage debt. He did not ask Congress. Congress did not complain. That act ended anything resembling a free market in housing.

Falling equity takes away the credit that Americans need to borrow money to live the good life. They will soon feel betrayed. A widespread sense of betrayal is dangerous for politicians.


We are living in a time in which the fundamental religion of our era has been faith in the redemptive power of the State. Whenever there is a crisis, citizens call upon the State to bail them out. They are convinced that the State has a separate existence which enables it to intervene into the affairs of men, thereby improving the life of almost everyone under its jurisdiction.

This religion of State redemption has been fading in recent years. It gained almost universal acceptance during the Great Depression. The fundamental purpose of the State is no longer seen as justice, but rather to serve as the source of guidance for the free market, without which the economy supposedly cannot sustain long-term economic growth. There is enormous faith by the public in the ability of bureaucrats to collect data, interpret data, make accurate predictions, establish incentives that encourage growth, and enforce these incentives without bias. People generally do not believe that God intervenes into the economy with the same frequency and reliability that the State does.

The great redeemer since 1987 has been Alan Greenspan. He had the power of the printing press behind him, and he used it. People concluded that in an economic crisis, under Greenspan’s guidance, the Federal Reserve System would be able to overcome all economic setbacks. This faith escalated from 1987 until his retirement in January 2006.

We are now seeing the undermining of this confidence in the ability of the Federal Reserve System to compensate for the downturns in the markets. People are beginning to figure out that Bernanke is in over his head, and the Federal Reserve System seems impotent to overcome the worst economic crisis since the Great Depression.

It is significant that this assessment, namely, that this really is the worst financial crisis since the Great Depression, is now becoming widespread in the media. The assumption that the Federal Reserve, when assisted by the U.S. Treasury, and funded by an extra couple of trillion dollars of Federal debt, will be able to deal with any crisis is now becoming shaky. There are whispers of discontent. Some people are saying that this crisis is more fundamental than what Paulson admitted in the week of September 15.


Paulson would have officially agreed with this optimism prior to September 15. He reiterated again and again that the financial system is fundamentally sound, that there is no threat to the banking system, and that people should not panic.

On September 15, Lehman Brothers Holdings declared bankruptcy. Merrill Lynch had become a subdivision of Bank of America the day before.

On September 16, at 10 in the evening, the Federal Reserve announced an $85 billion bailout of AIG, the nation’s largest insurance company. The FED was buying AIG’s about-to-be worthless stock. This was the first time the FED had ever publicly bought equity in a company — a dying company.

On September 18, Paulson clearly panicked. He told Congress that it had to pass a $700 billion bailout of the financial industry. The banks had loaded up on mortgages that are going bad, and this threatens to topple a highly leveraged series of dominoes all over the world. None of this was visible to him the week before. If it really was visible, then he was lying through his teeth, as high government officials are expected to, when he assured the public that there was no fundamental threat to the economic stability of the American economy. So, he was revealed as either a liar or a completely ill-informed high official. He is supposed to be second in knowledge only to Bernanke, but the two of them have imitated a pair of drunks, staggering home in the dark, arms wrapped around each other, each hoping that the other will not fall.

When I see Bernanke on television, he looks like someone who has been hit over the head by a frying pan. He really looks dazed. He does not communicate any sense of optimism. Yet his function, as the senior representative of the fractional reserve banking cartel, is to exude confidence at all times. He no longer does.

As for Bush, he looks washed out. He really is a shell of a man. He can see his legacy going down the tubes. He is now visibly revealed as a man out of touch with reality. He is going through the motions. He is visibly the lamest lame-duck President since Herbert Hoover.

Paulson exudes lots of confidence, but unfortunately that confidence hit a brick wall on September 18. We now face a situation which he did not think we would be facing, or least pretended that we would not be facing, prior to September 15. We are facing a loss of confidence in the Treasury Department and the Federal Reserve.

This loss of confidence now centers in Congress. Congress is hearing from constituents, and most constituents are either opposed to the bailout or else they are not certain that the bailout will work, and offer the pollsters no opinion. The number of people who oppose the bailout is significantly higher than the number people who favor it. The taxpayers are beginning to figure out that they are going to be saddled with an enormous debt, and the main beneficiaries will be bankers. This does not sit well with them.

We are now seeing a significant decrease in confidence regarding the reliability of the government with respect to financial crises. This has not happened in a long time. I do not recall that has ever happened on this scale in my lifetime. It happened from 1929 to 1932, but it has not happened since then.

This new outlook has blindsided the Federal government. All the assurances coming down from the Secretary of the Treasury prior to September 15 are seen in retrospect as blowing smoke. The critics who said that the crisis would get beyond the ability of the government control now appear to have been correct.

Bernanke and Paulson are fighting mightily to persuade Congress to have faith in the proposed bailout. But the resistance of Congress turned out to be greater than either of them thought it would be. The foot-dragging upset their plans. But there was not much they can do about it.

The financial markets are still intact. This indicates that investors are not really convinced that this crisis is so great that they must be saddled with an additional $700 billion of debt in order to bail out bankers.

This has the government in a dilemma. If things get worse, Congress will capitulate to Bernanke and Paulson. It will write a blank check. But if things get worse, the recession will accelerate, Federal tax revenues will decline, and the deficit, even apart from the $700 billion bailout, will call attention to the fact that the American economy is in a crisis.

I think we have moved beyond a tipping point in American economic history. I think the investing public has begun to sense that whatever may be wrong with the financial markets, the Federal Reserve System and the Treasury Department are at wit’s end in dealing with the crisis. This sense of uneasiness has not yet reached the general public. Such issues as central banking, the federal funds rate, and derivatives will never penetrate the thinking of the general public. The public simply trusts in the leaders. The public thinks that the leaders know what is going on, and can take active steps to solve any problem when it occurs. This confidence is being tested severely today.

My sense of the matter is the general public is still not anywhere near panic mode. In fact, if I were to assess it one way or the other, I would say that Paulson and Bernanke are closer to panic mode than the general public is. The public is not convinced yet that there has to be this gigantic bailout of the banking system with taxpayers’ money. In the past, taxpayers have grumbled when there have been tax increases. They have paid very little attention to the Federal debt. But this bailout is big. Paulson says that it is important that it be executed rapidly. But the public finally has some sense of the magnitude of the crisis that is facing the financial markets, and the magnitude of the debt burden that is going to be placed on their backs. They do not like this message.

I, for one, am all in favor of this message. The message is that the Federal government, even when backed up by the digital printing presses of the Federal Reserve System, is facing a crisis in the financial system that may be more than it can handle. If the public loses confidence in the system, and if people begin to move their assets out of shaky banks into the large ones, the number of bank failures is going to increase. As these bank failures increase, even though these are small banks, a sense of instability will begin to pervade the financial markets. It will have the effect of the series of shoes dropping in a shoe closet larger than those of Imelda Marcos and Tammy Faye Bakker combined.

It is the drip, drip, drip of busted banks that threatens the public’s confidence in the ability of the Federal government to deal with the problem. Pain has not yet afflicted most Americans. They have not lost their jobs. They do not have a savings program, so they are not all that worried about a falling stock market. They hear about the falling stock market, and they see the talking heads on television who tell them not to panic, but since most of them are running negative budgets anyway, imitating the Federal government, they don’t care. What they care about is whether or not they can meet their payments next month. The Federal government does not worry about this because it can sell debt to foreign central banks, to investors who are moving out of the stock market in fear, and ultimately to the Federal Reserve System. So, the Federal government really doesn’t worry about red ink. Voters do.


Voters now see that their futures are going to involve a level of debt that they had not planned on. They have heard that deficits don’t matter, and so far, deficits have not hurt them personally. But, at some point, either the debt level must cease outrunning economic growth, or else it is going to be funded by fiat money.

Voters do not understand how the Federal Reserve System works, but they do understand that if they continue to roll up debt, month after month, at some point they are going to have to pay the piper. They are going to get calls from the credit collection agencies demanding that they pay what they owe. They defer this day of reckoning, just as the Federal government defers its day of reckoning. The average guy in the street perceives the Federal government as being in the same situation he is, but on a much larger scale. The worse it looks for him personally in terms of his growing debt burden, the more he is going to make the same assumption about the Federal government. This assumption is correct.

The average voter looks at his own budget and concludes that this cannot go on forever. This doesn’t mean that he is going to stop going into debt. Forever is quite some time away. Until then, he will continue to spend more than he earns after taxes. He does not want to go through the pain of balancing his budget. Americans are borrowing against their futures. They no longer save. Yet they do sense that this is going to cost them in the future. They are not going to live in a comfortable retirement. Their children are going to inherit debt from the Federal government, and this will not be compensated by any inheritance left to them by the parents as people grow older. They see that they have fewer reserves, they are supposed to change their behavior. They are supposed to go into panic saving mode. But the people have not done this. Why not? Because they have been told that deficits don’t matter. They have also been reassured, time after time, that the Federal government will intervene and bail them out if they ever get into a major problem. They look to Social Security, Medicare, the FDIC, and all of the other Federal regulatory agencies, and they conclude that they are safe. Yes, they may go through some hard times, and they may miss a few payments, but they will not be reduced to bankruptcy, and even if they are reduced to bankruptcy, someone will still send them a credit card application a month later. So, they really don’t worry about the future very much. They have a nagging sense that something is drastically wrong, but they don’t try to fix it. They don’t want to begin to think about fixing it.

All of this is a threat to the Federal government. It is a threat because people will eventually come to understand fully that the Federal government is not fundamentally different from an individual household. It runs deficits. It can sell Treasury debt to the Federal Reserve System. But, at some point, it either balances its budget or else it goes under. How? By inflating. It ceases to be able to send out checks denominated in money that buys anything. The average guy looks at his own situation, and he concludes that at some point he will run out of maneuvering room. He has some vague awareness that the Federal government is in the same predicament. On the one hand, he is seen that the Federal government always seems to evade a crisis. On the other hand, he knows that he has done the same thing, and time is running out for him. Why should we believe the time is not running out for the Federal government? Time really is running out for the Federal government. The question is: When? It may be 10 years away. It may be 20 years away. Or, if the bailout doesn’t go through, and Paulson was not crying wolf, it may begin in the next six months. The crucial factor is the direction of the trend.


I think the investing public has finally figured out that the stock market is not going to go back up above what it was in March 2000, plus 20% to compensate for higher consumer prices. The number of people on tout TV who talk about a new boom in the stock market being just around the corner, with highs in the range of 20,000 or 30,000 on the Dow, is zero. “Dow 36,000” is a matter of ancient history.

This shift in perspective is going to make it much more difficult for the government to persuade the voters that it has any more rabbits in its hat. Every time it pulls out a rabbit these days, there is a large price tag on it. The rabbit is then handed to the taxpayers. The government has no viable answers. It has only programs to delay the inevitable. As this sense of the inevitable increases, people’s willingness to invest in the stock market and the bond market will decline. Capital will become more expensive for private entrepreneurs. I don’t think the rate of economic growth will reverse on a permanent basis, or even on a five-year basis, but it will be reduced. Our lives will be worse off as a result.

October 4, 2008

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2008