With all of the trouble on Wall Street, is it the end of the world as we know it?

BY busadmin  September 24, 2008 at 6:45 PM EDT

A Lehman Brothers employee on the floor of the stock market; AP Photo

Paul Solman: As Lehman was melting down on Sept. 14, I wrote the following “answer,” which remains my best effort to explain what’s been going on. We’re going to keep it as the lead item on this page for awhile and you can find my answers to several of your questions in the posts below.

Anxiously scanning the Business section of nytimes.com on Sunday, I came across this headline: Amid Potential Chaos, a Light-Hearted Break. Below was a subhead: “For those who need a little bit of levity on a tense day, we present some mood music.” If you clicked on the video box below, a song began to play, its lyrics flashing on the screen in various colors: REM’s “It’s the End of the World as We Know It.”

It did bring me a smile – at 11:30 p.m., no less – but also a question from my wife, Boston Globe language columnist Jan Freeman: “IS it the end of the world as we know it?” she asked.

My shot at an answer is today’s entry.

Of course, I have no idea what’s going to happen in the next few hours, days or weeks. No one does. Global markets will decide the near-term fate of the financial system as we know it. Those markets are made up of millions of investors, including you and me, changing their minds.

Do you know what you’re going to do with your money? Where to put it? How to protect it?

No? Welcome to the club. And if you don’t know, and I don’t know, why expect anyone else to, especially the “experts” who have brought us to this pretty pass?

When you see and hear talk of a “panic,” that is, it’s both the experts and us commoners, all becoming pessimistic: losing faith in the system at the same time, and trying to protect our future by selling our “risky” investments for cash, maybe gold — whatever we think is safest at the moment.

But remember: when more people want to sell something than buy it, the price goes down. When there are way more sellers than buyers, the price goes way down. That’s the fear for stocks today: the world over, all because stocks are risky.

OK, but that’s the effect of what’s been happening. My wife wanted to know the cause, as simply as possible. Try this:

Any financial system more sophisticated than Robinson Crusoe’s is built on credit: “I’ll take your promise to pay me tomorrow in return for the use of your wealth today.” That’s how a farmer gets money for his seed corn before the crop comes up. That’s how the high-tech firm rents its offices and pays its workers when its new software is no more than a gleam in its eye. That’s how traders in Mesopotamia sent yarn across the desert around 2500 B.C. (The credit terms were pressed into clay tablets that still exist.)

More than 4,500 years later, the world economy is awash in IOUs. And not just from farmers or techies or the weavers of Ur. Every company in the world borrows money against its future earnings. Most consumers (in the U.S., anyway) borrow against their future earnings via credit cards. The U.S. government borrows against its future earnings (our taxes) by selling Treasury notes, bills and bonds. And just about every country in the world does as the U.S. does.

Sometimes, in borrowing for a mortgage or equity loan against the value of a house, you know there’s collateral. Often, there isn’t.

And the debts/IOUs/forms of credit above are just for starters. There is more and more credit built on credit: pools of mortgages and corporate debts and credit-card debts and government debts, used as collateral to borrow even more, creating more credit, more debts, more promises to pay back in the future. (See our piece on the subprime market from last year for a primer on how it was done with mortgages.)

Let’s face it: even money is nothing more than a promise. It used to be backed by “collateral”: gold at Fort Knox (remember the movie “Goldfinger”) or five floors underground at the New York Fed (think “Die Hard with a Vengeance”). But U.S. dollars haven’t been worth anything beyond the world’s faith in them since FDR took us off the gold standard in the 1930s. That’s why the dollar fluctuates so much in value.

Credit comes from the Latin credere, “to believe.” I repeated this chestnut for the umpteenth time last week, on this occasion to one of my sons-in-law.

“Credibility,” he said. Right he was. Because that’s the mot juste in this crisis.

In plain English, if you doubt that the farmer will pay you back (won’t plant the corn, will run off with your money), you won’t lend. If you doubt the techies or the seamstresses of Ur – for whatever reasons – same story.

That’s the pessimism, the loss of credibility, that’s happening right now. Except instead of “corn farmers,” substitute “Bear Stearns”; instead of the sisters of Ur, the brothers of Lehman. (I mean no sexism regarding Mesopotamia; I’ve just been trying to set up this gag.)

Bear and Lehman are “investment banks.” They take money from investors and say they will invest it better, earning enough to pay back their investors and have plenty left over for a chateau or more in the Hamptons.

A key way they increase their earnings, for investors and themselves alike, is by borrowing money to augment the investment capital, so they can make bigger bets. Indeed, they can borrow at one price, “invest” by lending the money at a higher price, and the game can just keep going until…well, in Lehman’s case, until today. (Lehman was actually listed on eBay Monday morning, but the “offer” was soon removed.)

What has happened is simple: Lehman became the sleazy corn farmer or the pie-in-the-sky techie or the Ur weavers who got lost in the Tower of Babel — a borrower with no credibility. To stay in the game, Lehman would have to pay more and more for its loans. That would eat into its capital – its investors’ money. The less capital it had, the more collateral it would have to plunk down for the money it had already borrowed. And if it tried to sell the loans it had invested in, those loans would crash in value, making the situation worse. QED. RIP. The best you can say about the firm now, to paraphrase Descartes, ‘subsido ergo ero”: I sink therefore I was.

And this is also what happened to Fannie Mae and Freddie Mac. It’s not that the mortgages they held or guaranteed weren’t going to pay off someday. For the most part, they pretty much steered clear of subprime and other toxic loans. But would you lend money to Fannie or Freddie without demanding a premium for the added risk of doing so, given all you were reading in the papers and hearing on the NewsHour?

In fact, you wouldn’t. You didn’t. Investors like you (and me) kept demanding a higher and higher interest rate in order to keep lending to F&F. They’d lost their credibility. As a result, they couldn’t get credit at a price low enough to keep them in business. To bolster confidence in them, Treasury Secretary Henry Paulson had announced the government would take them over if necessary, precisely so that it wouldn’t be necessary. But that didn’t work.

So now the world’s debt is shrinking. “Bad” loans are being written down time and again, everywhere. They’re “bad” for one reason: investors no longer believe they’ll be paid back. The borrowers have turned pessimistic, have lost their credibility and the loans are therefore losing their value.

This happens again and again in capitalism. I’ve seen the great Pennsylvania Central Railroad tank around 1970; New York City default on its debts (1974, was it?); much of the so-called “Third World” do the same in the ’80s. There was Russia and Mexico in 1998. And you can go back the Medici and Fuggers – the earliest bankers in history – and find the same story: kings and princes no longer able to service their debts; the bankers, defunct.

What’s different in 2008 is that the whole world is not only watching, but interconnected. Thus the failure of Lehman means it won’t be fully honoring its debts, just what investors have been afraid of. (See our domino metaphor and explanation from March.)

It’s a self-fulfilling prophecy, you could say. Will the “lenders to Lehman” now be bankrupted in turn? The cliche we no longer use at the end of TV pieces is the right one: Only time will tell.

But we can safely say one thing. A few years ago, the world was, in effect, betting on an ever-more bounteous future: everyone would pay back what they’d borrowed; homes, collectibles, and all sorts of other collateral would be worth more and more as time went on. If the world’s total wealth was the sum of its current prices and future debts, wow. It not appears that maybe the world wasn’t worth that much, which means those of us holding those assets, debts and, yes, dollars, aren’t as wealthy as we’d thought. And that it’s going to be harder to borrow in the future, i.e., a “credit crunch.”

Let me conclude with a paragraph from the great English economist J.M. Keynes, who wrote this in the midst of the Great Depression:

“Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation….our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits of a spontaneous urge to action rather than inaction….Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; though fears of loss may have a basis no more reasonable than hopes of profit had before.”

I don’t mean to be that pessimistic. The world would seem to have grown tangibly richer – far richer – since Keynes published those words in 1936. And I’m not suggesting this is the 1930s redux. It’s just that optimism and credibility matter. And right now there’s precious little of either – perhaps for good reason. But that’s what’s helping cause the problem.