Laura Rowley Money & Happiness

It's clear that the economy is in for a rough ride over the next two years -- and possibly longer. As unemployment rises and the credit markets tighten further, consumers will rein in their spending, leading to more layoffs and another downward cycle. Housing prices may continue to slide, and lines of credit shrink further.

This tumultuous week, amid the Lehman Brothers bankruptcy filing, Bank of America's takeover of Merrill Lynch, and the AIG bailout, Treasury Secretary Henry Paulson suggested a bright spot in the mess. The federal bailout of the government-sponsored entities Fannie Mae and Freddie Mac will make mortgage credit more widely available, he said, which could help stem the housing slide.

"The root of the problem lies in this housing correction, and until ... the biggest part of that is behind us and we have more stability in housing prices, we are going to continue to have turmoil in the financial markets," Paulson said. "That's why the actions we're taking with Fannie and Freddie are so important...that is the key to turning the corner here."

Where It All Began

Well, if we're defining the root of the problem, I'd go back a little farther than that. The root of the problem is a cocktail of debt with a chaser of pathological optimism, and many Americans got drunk on both. Awash in credit offers, they bought homes, cars, and lots of other stuff they couldn't afford, and hoped for a best-case scenario, in which their home values and rising salaries would take care of it.

There were plenty of foolish, crooked, and greedy intermediaries who played key roles in the meltdown -- from the Federal Reserve, which held interest rates too low for too long; to mortgage brokers who defrauded borrowers; to the investment houses that securitized and sold toxic mortgage derivatives; to those who aggressively pushed for deregulation, insisting the free markets would naturally behave themselves. Like, say, a compulsive shoplifter let loose in the Mall of America.

But what happened on Wall Street this week was fundamentally linked to the decisions made on Main Street to borrow like crazy and hope for the best. The reality is, lots of responsible people did not accept the invitation to get in over their heads during the boom. (I wrote about that in this column in February 2006, in which I predicted the Fannie and Freddie takeover. Four months later, Fed Chairman Ben Bernanke was still suggesting that U.S. households were "managing their personal finances well.")

The Worst Case Scenario

And now, in a worst case scenario, the price of living a leveraged life becomes abundantly clear -- and its effects go well beyond cash-flow issues.

Debt hurts, physically: Twenty percent of people with moderately high or high levels of debt stress also report more incidents of mental and physical health problems, according to a recent survey by AOL Health and the Associated Press. Their ailments range from back pain to migraines, ulcers to heart problems.

The leveraged life also changes your character and your relationships. I recently received an email from a reader who paid off three credit cards and an auto loan after committing to using software to track and restrain his spending.

"Debt not only costs money, but it also forces you to sacrifice who you are as an individual," he wrote. "Debt has made me stretch my morals so that I feel I have to hold my tongue or temper my opinion in my profession. After all, my debt required I stay employed. It has cost me time with my family because I had to work to make the payments. As a result, debt cost us a balanced life."

A Founding Father Debtor

And debt can make you feel wretched, as was the case for Thomas Jefferson, who in 1787 wrote to his friend Nicholas Lewis, "The torment of mind I endure till the moment shall arrive when I shall not owe a shilling on earth is such really as to render life of little value."

That moment never arrived; he died with $107,000 in debts (about $2 million today). Jefferson shared similar traits with modern-day debtors, in that he took big risks, was overly optimistic, and remained deeply in denial when things turned against him, says Barnard Professor Herbert Sloan, a historian and author of "Principle and Interest: Thomas Jefferson and the Problem of Debt".

Jefferson's trouble began when his father-in-law died, and he and his brothers-in-law quickly divided the estate before its debts were settled. It made each of them liable for the whole amount due -- which turned out to be more than they expected.

Debt Through the Centuries 

"People were aware in Virginia in the 1770s that this was not the smartest way to go, and that people who did this often got into trouble," says Sloan. "But it was risk-taking on his part. He was a little too optimistic about what would happen, and he got caught. As a result of things he could not have foreseen, he got badly burned and suffered for the rest of his life, because he was never able to feel [financially] secure."

Jefferson sold land before the American Revolution to pay off the debts, but by the time he received payment, the paper money was worthless amid the skyrocketing inflation of the war years. Cornwallis ravaged Jefferson's plantation during the war, and British creditors resumed their collection efforts when the conflict ended. Jefferson was burned again when he co-signed notes for a relative who reneged on debts in the financial panic of 1819. Only Jefferson's public stature prevented creditors from seizing Monticello and selling it out from under him during his lifetime.

"He's got this optimistic outlook, a kind of sign of his failure to face reality," says Sloan. "Even after everything has collapsed, in 1823 he's drawing up these plans: 'If only the following 25 assumptions work out, I'll be debt free by...' You can see him playing these games with himself."

Jefferson's experience with personal debt reinforced his views on the evils of public debt. "Loading up the nation with debt and leaving it for the following generations to pay is morally irresponsible," he wrote. "Excessive debt is a means by which governments oppress the people and waste their substance. No nation has a right to contract debt for periods longer than the majority contracting it can expect to live."

Elements Beyond Our Control

And that's the rub. Because I'm debt-free (except for a fixed-rate mortgage) and save regularly, my short-term financial life isn't disturbed by the immediate crisis; I plan to stay the course, avoid debt, build up cash, and watch closely for investment opportunities. (I distinctly remember the dirt-cheap, one-bedroom co-op I passed up in Manhattan in the early ‘90s crash. This time I'm prepared.) But it's the elements I can't control that are troubling.

American taxpayers have had an unprecedented financial obligation dumped in their laps in the Fannie/Freddie bailout. William Poole, former president of the Federal Reserve Bank of St. Louis, told Bloomberg Radio that the two entities have $6 trillion in liabilities. If just 5 percent of the loans on their books go bad, the cost will be $300 billion.

The government has made a two-year, $85 billion loan to insurer AIG, which will supposedly be paid back with interest. Gee, how many of you think that will go as planned? Then there's the $30 billion tab to bail out Bear Stearns back in March.

What sort of oppression -- as Jefferson put it -- will these decisions bring? Will savers regret putting money away all these years (rather than living it up on borrowed funds) if the federal government prints money like crazy to pay for the mess and inflation continues to soar? (I really don't need to know first-hand how Jefferson felt.) How high will income taxes go? Will the "permanent" tax breaks on vehicles like 529 plans and Roth IRAs eventually become not-so-permanent?

I asked Sloan how Jefferson would feel about the bailouts.

"Awful," he said. "All the [founding fathers] are turning in their graves."