How Real Was the Prosperity?

We're just beginning to figure out how much of the nation's recent growth was the result of a credit-induced frenzy. Here are some guideposts

Mark it down. Clear the slate. Get it all behind us. That's what the big banks are trying to do now. With their massive write-offs, Citigroup (C), Merrill Lynch (MER), and the other big financial institutions hope to take all of their pain at once. In toto, Wall Street firms have taken roughly $100 billion in losses on their investments.

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But the underlying problems that ail the markets and the economy cannot be waved away by the Fed's magic wand. In truth, we're at the beginning of a long, arduous process of figuring out how much of the post-tech bubble prosperity was real and how much was the result of a credit-induced frenzy.

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Way Beyond Housing

The housing markets, of course, overshot as too many buyers took out subprime mortgages they couldn't afford. The outcome will be a decline in home values, with prices in some areas already down.

But the economic writedown is likely to go far beyond housing. Household spending, consumer debt, financial sector profits: All may need a retrenchment, sudden or gradual, to get back to sustainable levels.

There may even be a reassessment of whether recent productivity gains were fueled by excess credit.

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There's no way to tell yet how much of the gains of recent years will have to be written down—how much we will have to reduce our expectations for the future.

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Some of those apparent productivity gains also may be illusory. If the economy was artificially boosted by excess borrowing, that would show up as higher output and, presumably, higher productivity. The implication is that once borrowing recedes to the historical average, actual underlying productivity growth might be lower than we thought.

The outcome won't become clear for a while. But if productivity growth is slower, then the economy's "speed limit" —the maximum growth rate that doesn't push up inflation— would be lower. Presumably, a slower-growing, less productive U.S. would become less attractive to foreign investors.

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These are sobering questions to consider. One consolation: The American economy can produce pleasant as well as nasty surprises. Many foresaw the tech bubble of the 1990s bursting; few predicted the housing boom that followed. Maybe a new force will emerge to propel the economy forward and keep spending robust. Right now, that's what everyone wants to know.

Business Week