Grim

I am not just referring to current financial market conditions, even though by all accounts the credit market is facing severe distress. The gap between Agency MBS and Treasury spreads feels a bit like the gap between on and off the run 30 year Treasury bonds back in 1998.

Agencies aren’t quite Treasuries (though Ginnie Mae bonds are quite close). But it is hard for me to see the US government walking away from the Agencies right now. Not when the Fed is more and more willing to accept Agency MBS as collateral. Not when the Congress is counting on the Agencies to mitigate the impact of the fall in private demand for mortgages. Not when the world’s central banks already own $900b billion of Agencies (see the Fed Flow of Funds, L107, line 13) -- about 12% of all outstanding Agencies (counting Agency MBS). America’s creditors wouldn’t be happy if the US walked away from its implicit guarantees ...

That though is a political judgment, one quite independent of the actual health of the Agencies’ individual balance sheets. And right now investors seem to care about the actual health of the Agencies’ balance sheets.

Nor am I just referring to former Secretary Summers’ assessment of the current conjuncture:

"I believe we are facing the most serious ... economic and financial stresses that the US has faced in at least a generation, and possibly much longer. .... We are in nearly unprecedented territory with respect to financial strain."

Nor am I just referring the apparent state of risk management at many of the United States (and Europe’s) leading financial institutions. Hat tip, Thoma.

Rather I am referring to the fact that the credit extension the fueled the most recent boom didn’t generate any real income gains for most Americans. Times weren’t all that good for most Americans even before the credit bubble burst.

For a variety of reasons that economists only partly understand — including technological change and global trade — many workers have received only modest raises in recent years, despite healthy economic growth.

The median household earned $48,201 in 2006, down from $49,244 in 1999, according to the Census Bureau. It now looks as if a full decade may pass before most Americans receive a raise.

Back in 1998, the rise in swap spreads and on the run and off the run spreads indicated real trouble in the financial markets. But the US economy was fundamentally healthy. American households could pay their debts. Median real wages were rising. Private demand for the dollar-denominated financial assets was strong.

The trigger for financial trouble in 1998 was financial trouble elsewhere in the world, not trouble in the US.

The fact that median household income wasn’t rising should have been a signal that the rising indebtedness of the household sector was a potential problem. An awful lot of money was bet on the assumption that median housing prices could continue to increase faster than median household income (or, put only a bit differently, on the assumption that housing prices never fall). An awful lot of money was also bet on the proposition that macroeconomic volatility has disappeared, making a higher level of financial leverage appropriate through out the economy.

For households.

For financial institutions.

And for the US itself, with its rising international debt balanced by the rising value of the its foreign equity portfolio.

And, sadly, it is likely both that median income will fall during the now almost certain recession and that the median family will get stuck with at least some part of the bill for cleaning up the financial sector.