America starts to come to its senses

Economic contraction is unpleasant. Generally it's a thing to be avoided, when possible. But that isn't always possible.

Economics is characterized by cyclical patterns, rise and fall, rebound and retreat. The desire to avoid the downturn at any cost, which has been the overriding theme among America's economic leaders for years, can wind up extracting a far heavier price than if economic nature had been left alone to do its thing.

Like a military retreat, an economic retreat has to be managed properly to avoid unnecessary casualties. Military leaders know that defeat in one battle doesn't mean the war is lost. A commander who manages the retreat well is left with forces to fight another day, and perhaps vanquish the enemy. But a panicked retreat, with one's forces scattering pell-mell in every direction is all too likely to cost a leader the war.

My faithful readers already know that I'm a history buff. I'd rather watch the History Channel than a reality show any time. So let's take an example from history that demonstrates the importance of an orderly retreat.

Everybody knows that the Allied invasion of Normandy, in June 1944, marked the beginning of the end for the Nazis. But as Churchill himself said, who knows if that day would have come if not for the orderly retreat from Dunkirk, which extracted the British forces from French soil back to their home island, four years earlier.

The same goes for an economic retreat. Downturns will happen, and if a retreat isn't properly managed it can turn into a genuine crisis. Don't believe it? Think the markets should be left completely alone, allowed to do their thing without management? Watch the History Channel.

In an economic retreat, market forces will probably, eventually, correct what needs to be corrected. But that outcome will only follow years of crisis. Proper management is the key. Here at home, look at the bank-shares arrangement of 1983, or the economic stabilization program of 1985 that tamed hyperinflation. Those are excellent examples of proper management of a retreat.

Naturally, it would be nice to avoid crises altogether, but once they arrive, a government can't just sit back twiddling its thumbs and wait for the storm to go away. If you will allow another historic moment, that's what the U.S. government did when the Great Depression began to unfold after the crash of 1929 - it did nothing, which made the crisis and its aftermath much longer and far worse.

Today the American economy is at a very delicate point. It's pretty clear, including to people who denied there was a crisis at all mere months ago, that Washington's efforts to deflect a crisis didn't work. The question now is whether the retreat will be panicky or organized.

That is the prism through which we have to look at last week's events, culminating in the nationalization of the Fannie Mae and Freddie Mac mortgage organizations. Flouting its own declared ideology, Washington brutally intervened in the marketplace, hoping to prevent the economic retreat from turning into full-blown meltdown.

Naturally, the federal government's intervention triggered a bitter debate between proponents and opponents as to whether it was really necessary to seize control of the two mortgage giants. But the argument is specious, really. Under the circumstances, the government didn't really have a choice.

There are some bright sides to the events taking place in America. I know that may sound strange as the blows continue to land, but the darkness we see is the consequence of having observed the world through rose-colored glasses beforehand.

The roots of the current crisis lie in developments over years and years. The good news is that we're starting to see signs of remorse, acknowledgement that for years, America had been on the wrong track.

Don't confuse the symptom and the disease. Today's crisis isn't the disease, it's the symptom. The disease is the fact that America spent years and years living beyond its means.

Fannie Mae and Freddie Mac were the poster kids of the disease. They emblemized it: They were the great enablers in the American economic fireworks show. They helped an entire nation consume more than it produced, based on America's good name - namely of being the richest nation in the world.

Fannie Mae and Freddie Mac were the arm that raked in cash from the investors of the world by issuing bonds. The investors of the world were happy to invest in their debt because they assumed that Washington would back it in full. Which wasn't actually the case, formally, though it has turned out to be perfectly correct.

Fannie and Freddie were a financial golem that turned on their maker. They had been established for a noble purpose: to resolve the liquidity problems of a market that had been wracked by crisis. But over time they turned into monsters that created credit from nowhere, through wonders of financial engineering. As they staggered toward their demise, they enabled millions of Americans to live well beyond the level of other mortals on the globe, even as their production gap with the rest of the world narrowed and narrowed.

From that perspective, the nationalization of Fannie Mae and Freddie Mac, the gradual winding down of their credit portfolios (lending) - is good news. It's news that Washington is coming to its senses.

New mindset

The first, essential step in curing the American economy is to recognize that the American standard of living must drop. Americans have to relinquish the concept, which many believe with all their hearts and being, that their way of is their natural right - meaning, that their consumption levels be higher than those of any other nation.

It wasn't long ago that Washington decided to give the citizens a stimulus, in the form of tax refunds designed to get them spending. That imbecilic attempt to intervene in the natural course of events to avert recession is in utter contrast to the decision to nationalize the mortgage companies. The tax refunds were an aggressive move to avert the inevitable recession, which is why their effect was so short-lived. The battle was doomed from the start, and achieved nothing but to consume precious resources.

The decision to seize control of Fannie Mae and Freddie Mac shows that there's been a change in mindset, acknowledgement that crisis has arrived and needs to be managed. There is no point in trying to prevent slowdown: It is inevitable.

This is not the last change in mindset that America needs. But it's the first step in the right direction.

The author is the chief executive of Compass Investments, a member of the Psagot group.