If we consider the latest moves in response to the financial crisis by the treasury departments of all of the major industrialized countries, it all essentially comes down to this: having deregulated their way to the brink of an international financial meltdown, they are now going "all in" on the greatest "double down" bet in human history wherein all of the major governments in the world are betting that they have the financial capacity to make good on the bad bets of all of the major banks in the world.
I don't claim to be an world-renowned expert on these things, but I have worked in the financial sector as an attorney, and I do have a morbid fascination with the doomsday scenarios that seem to be unfolding such that I've read quite a bit about it. So here's my take using my own brother-in-law as a real world illustration...
My brother-in-law owns a small business that generates a piss-poor profit -- maybe a couple of thousand dollars a month at best. But, with easy credit availability and a borrowed down payment, he was able to acquire a house in 1996 in an area of California experiencing rapidly escalating housing values.
He was never really in a position to make the payments on this house particularly given his propensity for impulse purchases of coveted toys such as a big-screen TV, a speedboat, and a sweet 1974 Corvette. But the value of the house was rising faster than the amount by which he was short on the payments. So, no problem, a few more loans from friends and family and within a year of buying the house, he had refinanced it and paid back the bank and everyone who loaned him money (including myself!).
The only problem was that after the refinance, the payments became even less affordable. But again, with housing values rising upwards of 20-30% per year, the process just repeated itself over and over: he staves off default with loans from friends and family long enough to refi the house and pay everyone off. This actually went on for years, because the value of the house kept rising faster than the sum of his debts. Somewhere off in the distance, however, was this rapidly escalating principal balance, but nobody worried about that, not him and definitely not the banks.
As the rate of escalation of principal exceeded the rate of increase in the property value, the refi's became ever more exotic adjustable-rate mortgages with interest only or "option" payments. This helped in the short-term, but ultimately it only increased the speed by which his loan principal was outstripping the value of the house. In desperation, his mother's previously bought and paid-for house was brought in to collateralize the ever-rising loan amounts.
Of course, the eventual collapse in housing values was a brick wall standing in the way of my brother in law's financial fortunes. When $600,000 listings in the surrounding neighborhoods literally dropped to $300,000 overnight, no bank in the world was going to roll over the $800,000 that people typically owed on them, particularly when the only other collateral on the loan (income) remained in the sub-$2000 a month range (as was the case for my brother-in-law). Thus, the foreclosure of not only his house, but his mother's as well (yeah, that really sucks).
The world financial system basically operates on the same principle that my brother-in-law did. The level of debt has exploded even as incomes have stagnated. But the stagnation in incomes has been masked by rising asset values, which allowed all of the debt to be continuously rolled over. As long as assets values continued to rise, there was no need for a reckoning.
The froth of this bubble, like my brother in law's, was when the banks were so desperate to roll over the debt that they were willing to fund loans to anyone with a pulse, so long as they agree to buy at these incredibly inflated values. The worst of the loans were outright fraudulent, and in many cases not one single payment was ever made. The bubble popped, and the only question was how big the losses would be and who would suffer them.
Now, we are over a year into an asset value reduction trend and the crisis keeps getting worse and worse because the more the values drop, the less the banks are able to roll over their debts. The last hope now is that governments all over the world collectively still retain sufficient borrowing capacity to roll over this debt.
In a way, governments are playing a similar role for the banks that my brother-in-law's mother played for him. Like the federal government, his mother was the only party left with still-unencumbered assets, and like the federal government, she had limited revenue potential. She was able to bail him out in the short term because of her asset (the house), but in the long term both of them went down because neither had the income to actually service the debts.
In the case of the government, its capacity to service this debt is dependent on their taxing authority. This whole house of cards then rests on whether or not you and me can generate enough income to pay the taxes that will be required to service the debt. After eight years of stagnating incomes, and decades of deindustrialization, not to mention the very real ecological limits on growth that we are increasingly confronting, the odds on this bet seem questionable at best.
Further complicating things is that our governments are in some ways even worse off than my brother-in-law's mother: they have been for decades engaged in the exact same kinds of Ponzi financing schemes that have brought down the private sector banks. Does anyone really think that the U.S will ever actually pay off our $10 trillion national debt? Even in the best of budgetary times, we might've shaved a couple of hundred billion dollars off of it at most, and with a $2 trillion dollar deficit facing us this year, and a deepening recession, we are quite a ways off from the best of budgetary times. Many other countries are no better off.
So, I guess it's time to grab the popcorn and get ready for the big show: the Great Double Down Bet of 2008!