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A Chance to Find Balance

A focus on education, infrastructure, and R&D could spur new growth

Are we safe yet?

In the short term, no. More financial institutions will collapse, in the U.S. and elsewhere. Many workers will lose their jobs. Consumers will have to cut back on their spending, in some cases deeply. And the government is going to have to lay out big bucks to keep the economy and financial markets afloat.

But for the medium term—say, two or three years down the road—economic and financial prospects look considerably brighter. The long housing and consumption booms sucked resources out of more productive sectors. If companies, investors, and workers don't get completely spooked, this crisis can evolve into an opportunity rather than an unmitigated disaster.

For now the current crisis is going to get deeper. How deep? The underlying problem is over-borrowing by financial institutions and households, which have greatly increased their debt over the past 10 years. So the turmoil won't end until these sectors pare down their debt.

A rough calculation suggests that households have borrowed $2 trillion to $3 trillion more than they should have, based on historical patterns. Much of that excess debt—taken for homes, cars, other consumer goods—will not be paid back, because many borrowers don't have enough income. This overhang of bad debt is what brought down Bear Stearns, Lehman Brothers (LEH), and AIG (AIG), and it's likely to hit several other big financial institutions before the crisis is over.

As bad loans get written off by the financial sector, the debt burden on households is lessened but not eliminated. American consumers will have to tighten their belts to pay back whatever excess debt is left. That means reductions in consumer spending, leading to widespread job cuts.

So where's the bright spot? The U.S. has had a distorted economy since 2000. Money flowed into housing and consumer goods, while business and infrastructure investment got short shrift. In other words, productive assets had to go to the back of the line.

Now that emphasis could change. Businesses and state and local governments still have room to borrow because they didn't leverage up as much as households and financial institutions did. The resulting retreat in housing and consumption will leave more resources to devote to building real wealth for the future, including spending on education and research and development.

This crisis could become a chance to reevaluate our priorities as a country. Rather than stressing homeownership and consumption, we should focus on investment and innovation, which have a bigger long-term payoff.

This upbeat view, of course, depends on whether the government has the will and the ability to keep the financial system from collapsing completely. One piece of good news: Adjusted for inflation, the federal government did not add much debt over the past decade, so it has plenty of borrowing power. The Federal Reserve, too, still has ammo left.

In many ways this crisis is like a forest fire. If left unchecked, a fire can devastate thousands of acres. But it can also clear out old brush and set the stage for a new round of growth. With any luck, that's where we will end up.

Mandel is chief economist for BusinessWeek.

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