People seem to act irrationally when they have nothing to lose. Often we observe in wars that the losing side expends more blood and treasure after its position becomes hopeless.

The American South sustained most of its casualties in the Civil War after July 1863, when the dual defeats at Gettysburg and Vicksburg made its position untenable. Athens suffered its worst casualties in the Sicilian gamble at the end of the Peloponnesian War.

The Spanish ruined their empire and depopulated their core provinces during the second half of the Thirty Years War of 1618-1648 rather than cede dominance to France. Germany took most of its casualties after Stalingrad. Japan was prepared to absorb an arbitrarily large number of casualties after Okinawa, and its resistance was terminated only by nuclear attack.

Some aspects of the apparently suicidal behavior observed in great wars may be at work in the present budget stalemate in Washington, where the Republican right and the Democratic left yet may undo a compromise. I do not think this will happen – yet. But the extremes of polarization in the American body politic are different from anything I have seen in my lifetime.

If the Tea Party wanted most of all to govern, it would declare that a split government cannot accomplish the agenda on which its members were sent to congress, and that the 2012 presidential election would become a national referendum on America’s future. It would then agree to an interim compromise on the debt ceiling.

The trouble is that both the Tea Party and President Barack Obama have existential reasons to force a crisis. Obama, as I wrote two weeks ago, faces probable defeat with a becalmed economy, and may benefit from a crisis in which he casts himself as savior-in-chief (see Obama could stir a Tea Party crisis, July 19). The Tea Partiers may conclude that no compromise will benefit them, and decide to take the system down in revenge.

There is an underlying economic motive for this confrontation: the cure for the American economy is not necessarily a cure for the majority of the American middle class. The only recovery thus far (and the only recovery possible under the circumstances) has occurred in corporate profits and equity prices.

But this benefits only the small minority of wealthy American families who hold financial assets. The majority of Americans hold most of their wealth in real property (mainly their own homes). They have had no recovery and have no prospect of one. And the quickest path to recovery is one that offers few benefits to them.

The home price bubble drew on a flood of foreign investment in American mortgage-backed securities and other assets; Americans saved very little, because foreigners shipped their savings to America.

After the crisis, savings rose sharply, and the current account deficit shrank by half. That is just what was supposed to happen; from a macroeconomic viewpoint, that was the reason a crisis was necessary in the first place.

Savings stagnated as current account deficit widened
– and reversed after the crisis

Source: Bureau of Economic Affairs

The savings of the rest of the world, in short, invested in an already overbuilt American housing market that has few prospects for recovery. The toothpaste can’t be squeezed back into the tube. America needs to compensate for its years of under-saving, and the normal way to do that is to export more to other countries and save the proceeds (or, correspondingly, to import less). The reduction in the current account deficit is the correct outcome, particularly as it is driven by a jump in exports.

US exports of goods and services

Source: Bureau of Economic Affairs

Only a tiny proportion of the American labor force, though, contributes to the rise in exports. Manufacturing in the US is so capital-intensive that a substantial increase in output has a negligible impact on employment.

America is exporting and saving. An increase in savings is the same thing as an increase in demand for assets. But the asset of choice of the late 1990s and 2000s, namely housing, continued to suffer from declining demand.Source: Bureau of Economic Affairs

Home prices (30 major metropolitan markets)

Source: S&P Case-Schiller Index

Housing faces a demographic headwind that may last indefinitely, as I showed in a May 2009 study for First Things entitled “Demographics and Depression.” As I wrote:

America’s population has risen from 200 million to 300 million since 1970, while the total number of two-parent families with children is the same today as it was when Richard Nixon took office, at 25 million. In 1973, the United States had 36 million housing units with three or more bedrooms, not many more than the number of two-parent families with children – which means that the supply of family homes was roughly in line with the number of families. By 2005, the number of housing units with three or more bedrooms had doubled to 72 million, though America had the same number of two-parent families with children.

This will get worse, not better: The Virginia Tech economist Arthur C Nelson predicts that American households with children will comprise just a quarter of the total by 2025 compared to half in 2010 as the Baby Boomers retire, and that demand for large-lot single family homes will fall by 40%.

That leaves most American households deeply in the hole: according to the Federal Reserve’s most recent survey of personal wealth, American households’ real estate is worth about a third less than it was in 2006, that is, $16.1 trillion compared to $22.7 trillion. The problem is that most Americans approaching retirement age in 2007 had most of their net worth in non-financial assets.

Apart from real estate, the next-largest component of middle class wealth was in the form of equity in small businesses. Small business has had no share in the recovery. A rough gauge of small business income is non-farm proprietors’ income as reported in the gross domestic product (GDP) tables.

As the table below indicates, corporate profits have soared to a record, but proprietors’ income remains below the pre-recession peak. Judging from the surveys published by the National Federation of Independent Business and other organizations, small business remains in a slump. That is not surprising, for reasons spelled out in a recent study by New York Federal Reserve economists. Most small business growth during the past decade followed the housing bubble.

Corporate profits surge while proprietors’ income stagnates

Source: Bureau of Economic Affairs

As corporate profits rose, so did stock prices. The trouble is that the top 10% of American households by net worth own roughly 80% of all the stocks owned by households. That does not take into account corporate pension funds, to be sure, the vehicle through which the less affluent usually participate in the stock market.

Nonetheless the vast majority of American households concentrated their wealth in housing during the decade before the crash, and for apparently good reasons. With home prices rising at 10% a year and banks demanding a 10% down payment or less for most mortgages, the rate of return on equity for a homeowner on such terms was often 100% per year. No other asset class offered a fraction of the returns available to the general public.

America’s path to recovery lies through exports. There is no way around this. The growth rate of emerging nations with young populations struggling to enter the modern world far exceeds that of mature economies, including the United States. Americans need to save, and exports generate income to be saved. But the kind of exports at which America excels, including farm products, employ a tiny fraction of the workforce. And the financial benefits to the turnaround – in the form of higher equity prices – accrue mainly to the top 10% of American households.

The Tea Party reflects the frustrations of the middle class, especially the middle-aged middle class in places where you can’t sell a home, maintain a business, and fund a retirement. It believes that cutting the deficit is the problem, and a balanced budget is the solution. They are half right. The federal deficit is the monster that gobbled up the credit markets. The growth in federal borrowing corresponds almost exactly to the decline in mortgage borrowing.

Mortgage borrowing collapses while federal government borrowing surges

Source: SIFMA

Eliminating federal borrowing (which at present would mean reducing government payments equivalent to 10% of GDP) would not, however, lead to a recovery in mortgage borrowing, but an economic crash on the scale of 1933. The notion that a balanced budget would solve America’s problems has the stench of a millennial cult. America is spending far too much, and needs to restore its finances.

But that requires economic growth and rising tax revenues, and a massive cut in spending would bring about neither. For that, America needs deregulation and tax cuts – and that means living with a deficit for a while longer. It was Ronald Reagan who shocked conventional wisdom in the early 1980s by telling the country not to worry about the deficit while his tax cuts restarted the economy.

The Tea Party has the chance to become a catalyst for fundamental economic change. But it remains at risk of becoming the Ghost Dance of the American housing bubble, a millennial movement inspired by sinking circumstances, like the pathetic resistance of the defeated Plains Indians after 1890, or the New Guinea Cargo Cults of the 1940s. The economic cure America requires will benefit the beleaguered middle class slowly, and too late to prevent misery for many of them.

If economic fundamentals leave the middle class in the cold, they have put the core constituency of the hard left into the deep freeze. The welfare state is collapsing because the money isn’t there to support it. State and local governments have eliminated 400,000 jobs since August 2008, and are cutting spending at a 2.4% annual rate. That eviscerates the so-called public service unions, the core of the Democratic Party’s activist constituency.

The poorest and least-educated Americans, moreover, have seen no recovery at all. High-school dropouts have a reported unemployment rate of 13%, while Americans with a bachelor’s degree have an unemployment rate of 4.5%. The discrepancy is much worse, because the labor force participation rate of high-school dropouts is only 46%, against 77% for college-educated workers.

Neither the middle-class Republicans who support the Tea Party, nor the core Democratic constituencies who elected Barack Obama, have much of a stake in the outcome of the budget debate. That explains why the debt ceiling has turned into a cliffhanger, to the consternation of financial markets.

I do not think America will go over the brink this time. The Tea Partiers ultimately will accept the argument that they have to keep some dry powder for the 2012 presidential election. But the polarization of American politics will get worse, not better, and the crisis of American governance will be delayed but not defused if congress and the president reach a budget agreement this week.