Reply #7: How Real Was the Prosperity?

[ozymandius]

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. Yet investors around the world are still remarkably skittish. On Jan. 21 they sent markets in Asia and Europe plunging. The decline was halted—perhaps temporarily—by the Federal Reserve's 0.75 percentage point surprise cut in rates the next morning, and the promise of more to come. It's possible the combination of Fed rate cuts and quick fiscal stimulus from Washington could keep the U.S. economy out of recession. The Fed originally was created to deal with just this kind of financial crisis, and it's capable of pumping enormous amounts of money into the financial system if needed. "I have a basic faith in the Fed," says Christina D. Romer, an economist at the University of California at Berkeley. "We don't make the kind of mistakes that we used to."

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. The answer will determine what we can expect.
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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. That's bad news for investors and the global economy, which still depends heavily on U.S. consumption for growth.
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Personal Spending. The rule for a prudent individual is simple: Don't spend more than you make. For a long time, the U.S. economy obeyed that rule. As far back as the 1960s, personal spending, adjusted for inflation, has basically tracked the overall growth of the economy, as measured by gross domestic product. Sometimes consumers would get ahead of the economy for a few years, and sometimes fall behind, but never for very long.
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Where did we spend the money? On housing and health care, of course. But outsize gains also came in clothing, furniture, recreation equipment, motor vehicles, and consumer electronics—all areas where prices have fallen and imports have surged.

http://www.businessweek.com/magazine/content/08_05/b4069000016691.htm?chan=top+news_top+news+index_top+story