This Week's Clue: House of Cards

The following essay is designated as This Week's Clue, for our 10th anniversary issue, March 5, 2007. (The first issue went out March 3, 1997.) Enjoy.

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What forced people 40 years ago toward Nixonism was Lyndon Johnson's policy of guns and butter.

It couldn't be sustained.

The central domestic battle of the first Nixon Administration was over the budget. It was Nixon who created the Office of Management and Budget, in 1970. Mostly he cut butter, killing much of the Great Society. This defined his conservatism, because on other issues -- the environment, worker safety -- he dramatically expanded the reach of the government.

I mention this because our present policy forces the same choices on us. We're deep into the 1967 Game. The difference is several orders of magnitude.

The current budget deficit is a lie (your Social Security taxes fund Iraq), our trade deficit is unsustainable (China has to put on the brakes or it will overheat), our dollars are becoming worthless (118 to the Yen, $2 to the pound, $1.30 per Euro) so cutting interest rates are out of the question, and the housing bubble is popping.

It is this, and not some magic pony plan, that will force our hand in Iraq. We are leveraged to the hilt, the bills are coming due, and their nukes (the ability to dump our currency rendering it worthless) are more powerful than our nukes (which are just bombs that blow things up).

This is why some real economists (not Jim Cramer, people who've actually studied the subject) like Nouriel Roubini (left), are now predicting a "hard landing." The fall in housing we've seen so far is just the tip of the iceberg. Roubini estimates as many as half of all mortgages today are "junk" -- that is, they might not pay off.

Not only is our economy tied closely to housing, so is our tax system. Property taxes are local taxes. Property taxes can't be collected if everyone is defaulting on their home. This is a substantial portion of the tax burden. And you can't make it up in sales taxes because foreclosures mean no one is buying stuff.

It's the U.S. economy that will force us out of Iraq.

The size of any market collapse is directly proportional to the leverage and excess in that market. We have a housing bubble, a Chinese stock bubble, a budget bubble, all interconnected, all ready to pop at once.

China can't bail us out of it. The Federal Reserve can't bail us out of it. What has to happen is that values go to market, actually a little below. And it's this economic pressure that will end the war in Iraq. The world's going to just take away our credit card.

The only question is when all this will happen. The Bush people are pretending they can string things along until they're out of town, and the media has a bias against bearishness -- especially the financial media.

But let's check in on Jim Cramer's magic pony plan to avoid all this, which is a simple cut in interest rates. Here's what happens in that case:

1. The dollar falls in value.
2. Money leaves our stock market, because even gains become losses when the underlying currency declines. 
   
3. Market interest rates, for things like mortgages, actually go up.
4. Housing defaults accelerate.
5. The spiral accelerates, because the Federal engine doesn't work any more.

Managing this process so as not to take the rest of the world economy down will be a complex business, and this is where things get interesting.

Chinese bankers (that's the head of China's central bank at left), backed by Japanese and European bankers, will tell the U.S. government it must drastically cut its budget deficits in order to keep the currency afloat. Otherwise the foreign exchange markets will continue dumping dollars, at an accelerated rate.

The quickest, and by far the most popular, way to start doing that is by pulling out of Iraq. The implied threat from the bankers is that if we don't, the economic pain will get worse, and fast. As Tom Wolfe wrote in his Atlanta novel, A Man in Full, the "honored customer" becomes "the son of a bitch." This is the kind of torture that makes what goes on in 24 seem like child's play.

The sooner this process starts, frankly, the better for the world as a whole. Letting Bush slide until after January 2009 will only make the problem infinitely worse for all of us. Including the bankers.