President Bush has admitted that Wall Street got “drunk”. Bill Bonner says that sounds about right. But who provided the free booze?

The Fed has been laying on a lavish party for American consumers since 2002 with its relaxed monetary policy. This created the idea that house prices would rise forever, encouraging households to borrow and spend. Now house prices are tumbling, consumers are cutting back, and the government is nearly $0.5 trillion in the red.

The party is over. Now it’s time for the mother of all hangovers…

Yesterday we reported Merrill’s $5.7 billion in write-downs. Even with the smartest people on Wall Street running things, the firm couldn’t avoid big losses. And last week, Fannie (NYSE:FNM) and Freddie (NYSE:FRE) had our attention. The twin mortgage lenders had been playing the game with a deck stacked in their favor; still, they couldn’t seem to win.

How could this be? What would cause seasoned businessmen to go so wrong? For once, the president of the United States of America seemed to have it right. He said Wall Street had gotten “drunk.” The party got a little out of hand, he might have added. Some lamps got broken, and a fight broke out in the parking lot. And now the financiers needed to “sober up,” continued the president.

The metaphor is as good as any. But if we were filling out a police report, we’d still have some questions. We’d want to know who supplied the free booze…and why. No one asked us, but in the following paragraphs we provide the answer anyway.

During the last two decades, the percentage of the U.S. economy devoted to consumer spending went up and up and up – from 67% of GDP to 72%, a huge increase. Consumers got a taste of excess spending – and they liked it. Then, they were urged to drink more by the same people who provided the alcohol – the feds. In a consumer economy, they reasoned, growth came from consumer spending. If consumers didn’t spend enough, growth slowed. So, in order to boost GDP growth, it was sometimes necessary to “stimulate” consumers to spend more – by giving them more of what they least needed, more Jim Beam-style credit.

A particularly stimulating environment following the mini-recession of ‘02 produced a particularly thrilling party. The Fed knocked down its key rate to 1% – and left it there for a year. Extremely low lending rates caused house prices to soar. Consumers found that they were not only able to borrow against the inflated values of their houses, but to “take out” equity, believing they would never have to put it back. As it developed, householders were able to borrow an additional $6.8 trillion, of which $4.2 trillion was spent on consumption.

But everyone thought house prices would continue to go up. In today’s news, for example, we discover that IndyMac (OTC:IDMC) – which just went broke – used mortgage finance models explicitly based on ever-rising house prices.

The whole consumer economy functioned in much the same way as Wall Street. Profits were booked when sales were made – not when the item was paid for. Whether the consumer bought an eggbeater or a split-level in the suburbs, the salesman gave himself a bonus when the deal was signed. Someone else would have to worry about collecting!

Case/Shiller report that house prices fell 15.8% in May, from a year before. Now, the collateral for mortgage finance is falling in price and buyers are not settling up as expected. (Of course, we haven’t seen any real estate agents offer to give back their commissions or any appraisers returning their fees…)

And now that the collateral is falling in price, the poor consumers are getting a little sore. Unless some new scam is found that will keep them spending money they don’t have, they’re going to have to cut back. In fact, as house prices go back whence they came, it seems likely that consumer spending as a portion of GDP will too. And guess what? If consumer spending were to go back to 67% of GDP, it would mean a drop of about $700 billion in spending per year – enough to wipe out all “growth” completely.

Meanwhile, New York City says it’s facing a budget gap of $2.3 billion. And the Bush administration is leaving a deficit of nearly half a trillion dollars for the next person fool enough to want to live in the White House.

And we know what you’re thinking, dear reader: criticize, criticize, criticize…that’s all we do here at The Daily Reckoning.

“What can be done about his situation?” asked one earnest listener at the Vancouver conference last week. “What would you do if you were elected president?” she went on.

“I would ask for an investigation of the voting machines,” was our reply. “Besides, there’s no solution for some problems. When you borrow too much, you’re going to suffer when you pay it back; that’s just the way it is.”

Source: Every Party Has a Pooper