Sebastian Mallaby: The real estate crisis is nothing compared to our long-term debt addiction

There are two views of the financial crisis. The first is that we face the bursting of a real estate bubble. The second is that we face the bursting of that bubble plus a terrifying long-term one that has been building since the Reagan era. This second bubble is the product of a quarter-century expansion in borrowing, excessive confidence in the dollar and an overblown faith in markets. Between 1950 and 1980, total lending in the United States inched up slowly relative to the size of the economy. Then, in the early 1980s, it took off. Every dollar of capital was "leveraged" aggressively: Private equity wizards loaded firms with debt; hedge funds bought securities on margin; banks lent prodigiously on thin cushions of capital. All this leverage boosted rewards in good times, because a thin capital cushion means fewer shareholders to divvy up the profits. But a thin capital cushion has the opposite consequence when a shock comes. There are fewer shareholders to absorb losses and still repay lenders. Bankruptcy beckons.

Why have Americans gorged on debt? First, because it has been available. The dollar is the world's reserve currency: Holding a dollar-denominated bond or bank deposit has been thought of as the safest way to store savings. So whenever Americans have wanted to borrow more, the world's savers have been happy to provide the capital.

The second reason Americans gorged on debt was that it didn't seem too risky. Whenever a really big bankruptcy loomed, regulators staged a rescue, cutting the risk of lending to the top players. Without the Fed's intervention, people who lent to Bear Stearns or bought its fancy securities would have been hit with nasty losses. But thanks to the Fed, Bear was the latest in a long line of episodes in which creditors escaped relatively unharmed.

Financial economics has overestimated the efficiency of markets and underestimated their tendency to swing viciously. Along with the authorities' successive rescues and savers' confidence in American assets, this error kept the debt party going.

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