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The debt-price link, or the consequences of balancing the books.

|Includes: SPDR S&P 500 Trust ETF (SPY)

Virtually everyone recognizes the American economy is loaded with debt.  Public debt, private debt, we've got a lot of it. We'd like to get rid of it, or at least some of it.  Everyone agrees on this even if they disagree on the timing.

What people seem to recognize less is that debt levels sustain asset prices and asset prices sustain debt levels.  Every dollar of debt creates a dollar of nominal wealth and that nominal wealth parks itself somewhere - in houses, in the stock market, in exotic derivatives, in the present value of a stream of future wages, etc.  And there is a feedback loop between debt and asset prices.  Money generated by debt gets invested in assets.  As assets get bought up their prices rise and they can collateralize more debt.

Now, this doesn't have to be an unsustainable cycle.  To the extent debt-created money is invested in assets that generate real wealth - real technological innovation (stuff that lets us be more productive, not stuff that is simply entertaining) or development of human capital or infrastructure - there is a sustainable base for the next round of borrowing. 

But to the extent debt is used to pull future consumption into the present, we've got a problem.  The next round of borrowing is based on the inflated prices of assets that are not productive like houses, consumer goods, or exotic derivatives.  If this sounds like the setup for an economic Looney-Toons gag, it is.  The economy runs itself off a cliff and the only question is when it's going to look down and realize there's nothing beneath its feet but a lot of empty air.

And that's where we are now.  Policy makers have taken a peek and felt around with a toe and they're pretty sure that what's about to happen next is a long drop followed by a sudden stop and a halo of little tweeting birds.  But their response to finding out there is no more hill has been to try even harder to run up it.  That's what the stimulus is - an attempt to re-inflate asset prices and debt levels to the levels that were maintaining economic growth even though that growth is unsustainable with the real productive assets we have to work with.

I'm in favor of stimulus, don't get me wrong.  There is a real humanitarian case for providing relief from what would otherwise be a plunge into ruinous poverty for many Americans.  But that palliative spending has to be coupled with an orderly process of recognizing and resolving bad debts and deflating asset prices or we'll on the hook for ever-larger infusions of printed cash far into the indefinite future.

With that in mind I'd propose the following measures (disclaimer: I have no more idea how to do any of this effectively than anyone who might actually be in a position to do it, but that at least puts me on a level playing field with our policy makers).

1) Nationalize the largest banks and announce a timetable for marking assets to fair value and recognizing bad loans.  Repeal mark-to-fantasy and other regulations that allow financial institutions to out-and-out lie about their financial state, but provide an explicit guarantee of support during the resolution process.  Fire senior managers (or put them in prison.  Or dump them in a depressed neighborhood with a lot of foreclosures and have law enforcement look the other way for a few minutes)

2) Cease extraordinary liquidity support for financial markets.  No more plunge protection team, no more free money through the discount window that flows into the markets.

3) Create a specific resolution regime for mortgages that allows people to stay in their homes but trades away some of the upside should they sell.  The objective here is not to rescue housing prices, though.  It's just to stop massive write-downs of housing prices from throwing people out onto the streets.

I didn't get to 12 steps, but people much smarter than me could take the ball and run with it.  I'll focus on the first one - the only one bloggers are really suited to - getting people to admit there is a problem.

Disclosure: No positions or assets with which to take positions.