Small Matters: Overborrowing is the culprit; now, who pays the piper?

I am often told that the cost of living has risen so much that it now takes two workers to support a family that in the "good old days" could be supported by one. Inflation is the villain.

But a fallacy is embedded in that belief.

Suppose you are a farmer growing tomatoes and you sell 100 at $1 each. Your income is $100. Then, food prices increase, so $100 buys less - except that your income increases identically since it is equal to the quantity of tomatoes you produce multiplied by the now higher price of tomatoes. Income = quantity sold x price. So, in simple terms, incomes increases with inflation.

The problem with inflation, of course, is that not all incomes increase proportionately (such as those on fixed retirement incomes), so inflation redistributes incomes, one of the reasons we don't like it.

So, the reason that it "takes two workers" today isn't so much because of the rising cost of living, since nominal incomes, collectively, keep pace with inflation. Rather, it is because we want it all now, not later. We buy the biggest house we can, buy the neat car, the wide-screen television, stuff we used to wait to get until we could afford it. And we use debt to do it.

Making those payments becomes the driving force of daily life and, if anything happens - illness, accident, recession - and incomes are reduced, payments are missed, and a financial crisis results.

The use, or misuse, of credit has been growing as credit has been "democratized" - made available to higher-risk people. Consumer debt in the United States rose to 150 percent of aggregate income, $14 trillion, before the recession began in 2008.

This has happened to governments as well. Governments have borrowed excessively to finance paying for promises they were unwilling to ask taxpayers to finance. Federal debt is now as large as Gross Domestic Product (national income). And we just authorized the addition of trillions more by lifting the debt ceiling.

Other developed countries have done the same. Greece is in crisis because it promised goodies to its people and borrowed from German, French, and other banks to finance it, using its "sovereign" debt. When it became apparent that Greece could not repay the debt, the crisis was triggered. If Greek government debt is no good, then the banks that lent money to Greece are threatened.

Irish banks are in trouble because they financed too much housing speculation, far in excess of what was needed (and far worse than our excess building). Those loans went bad, and to save the banks, the government backed the loans - much like our Federal Reserve buying mortgage-backed securities. The government of Ireland borrowed from other European banks, and now the worry is that Ireland cannot raise taxes or cut spending enough to repay the debt.

Other governments face similar problems.

There is no easy way out of this. We have to decide who the winners and losers will be. In the case of Greece, will German savers lose the money they lent, or will Greek citizens have to experience reduced government services and lower pensions than promised.

Our housing market crisis has the same problems. Some people borrowed too much because they paid too much for the house, and now they can't repay. They are losing their investment (if any was made) and they can't escape their obligations unless they declare bankruptcy, which imposes the losses on investors who provided the funds (through the banks that represent them).

The paperwork fiasco is making it hard to figure out who owns many of the houses, and the government keeps inventing programs to try to keep debtors in their homes. The housing sector will not recover until we declare the winners and losers. The advantage in the busting of the dot.com bubble was, we knew who were the winners and losers.

Perhaps the major source of today's high unemployment is the fact that housing starts are about a million units below where they would have been had we not overbuilt in the 2003-07 boom. Most of our houses are built by small businesses across the country. We can't start building new ones until the excess supply is used up.

Many schemes will be suggested to "solve" the problem, including forgiving debts for owners in homes with mortgages larger than the house value (a hard thing to determine), having the government buy homes to take them off the market, arranging for underwater owners to become renters of their homes, cheaper interest rates on troubled mortgages and more.

The bottom line is, somebody has to win and somebody has to lose before we can move on. The process of making all this happen, for individual consumers and for major governments, is not going to be pleasant.