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It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions. (from Ben Bernanke’s Aug. 31 speech)

The Chairman is exactly right, and I’d go a step further: It is also not the responsibility of the taxpayers to protect lenders or investors.

As I’ve mentioned, one of my core beliefs is that true adulthood and maturity are the result of learning to accept and deal with the consequences of our own decisions. More importantly, it’s learning to consider the consequences before we commit to a decision, not just whether “I want it.”

Giving others (our children, our spouses, entitlement recipients, Katrina victims, subprime borrowers, Citibank, Long Term Capital Management, the United States Congress) the freedom to make decisions without having to consider the consequences does nothing but induce a spiral of more and more irresponsible behavior.

It is our job, as parents, friends, citizens, fellow humans, to maintain the connection between Freedom and Responsibility. That’s how they become independent and self-sufficient, instead of mewling, manipulative exploiters unable to control themselves and always needing someone else to bail them out.

The Problem With Subprime Defaults: The Deflationary Shock

Unfortunately, the consequences materializing from the actions of irresponsible lenders and borrowers don’t affect just them. Otherwise the solution would be easy- let the bums feel the sting! Trouble is, that sting is like a firecracker under a butane tank, the butane tank which is our entire economy- and those consequences would snowball into something that seriously hurts all of us.

You see, due to the way our fiat money system works, debt is money. Banks create money by loaning their excess reserves (how much excess exists in the system at a given time is one way the Fed exerts its influence). These loaned dollars (someone’s debt) are in turn deposited by the recipient, and the bank gets to count that money on its balance sheet, and turn around and loan most of it back out, which is then re-deposited somewhere else, etc.

This multi-generational money creation machine (think biblical- “10 dollars begat 9 dollars which begat 8 dollars…”) is how a few billion dollars added to the system can balloon into many many billions of new dollars floating around our economy in search of a product to purchase (or a 3BR, 1.5BA w/ 2CG and WBFP).

Now the ugly flip side: It works the same way in reverse. Drain a few billion dollars out of the system, and it results in many many billions fewer dollars floating around, since the cornerstone of the pyramid has been removed.

Fewer dollars chasing the same products- that’s also known as deflation, and as it ripples through the economy it affects us all. A deflationary spiral occurs when such a ripple adversely affects other borrowers (deflation makes debt more expensive and harder to pay off with future earnings), and those borrowers begin to default, which removes more money (debt) from the system, which compounds the problem and makes the deflation worse, and on and on…

Eventually the system can contract so much that massive defaults begin to occur even in “prime” loans. If we get that far, we’re in another Great Depression.

How To Prevent The Losers From Triggering A Depression - Refinance

As with your kid who’s been arrested for getting caught smoking pot naked in the back seat of the Lexus with the preacher’s daughter… it’s a little too late to go back and say, “DON’T DO THAT, YOU IDIOT!”

What we’re faced with is a choice between the lesser of evils. To do nothing and “let the bums feel the sting” is to do great damage to our own financial future through the mechanism of debt-deflation.

To write hundreds of billions of dollars of taxpayer-funded checks to the banks and relieve the bums of their responsibility is even worse. As I described above, that would just encourage more of the same behavior, from the bums and from the banks.

As much as possible and although we hate it, we need to prevent the bums from defaulting, but we need them to continue to carry their debt and make payments on it. The answer? Some type of refinancing solution. In this scenario, the banks take a little hit, the taxpayers take a hit (the refinanced loans would doubtless involve some type of government backing, which means it would cost us… but significantly less than actually taking on the debt itself), the irresponsible bums keep their loans at a lower rate which (hopefully) they can make payments on. The debt-money stays in the system, and we have a much better chance of weathering the coming recession. Oh yeah, did I mention that?

I believe this is why Chairman Bernanke is encouraging banks and legislators to pursue a refinancing solution, as in his letter to the honorable Chuckey Schumer:

The federal banking regulators have encouraged banks and thrifts to work actively with troubled borrowers to modify loans or to refinance as needed to avoid default or foreclosure…

and

It might be worth considering at this juncture whether the private and public sectors, separately or in collaboration, could help the situation by developing a broader range of mortgage products which are appropriate for low-and moderate-income borrowers, including those seeking to refinance. Such products could be designed to avoid or mitigate the risk of payment shock and to be more transparent with respect to their terms.

In short, there is no easy way out of this mess. There’s painful, and there’s more painful. Those are our choices, our consequences for allowing a system which rewards greed, immediate gratification and irresponsibility.