The way out of the credit crunch

In hindsight, once the herd has dispersed, it always seems as if these investors were simply dumb. After all, who could now believe that an "undertaking of great advantage but nobody to know what it is" could be a reasonable investment? Probably no one. However, at the time that quote refers to -- the South Sea Bubble of 1720 -- quite a few investors figured just such an investment made really good economic sense. Seriously.

4. How did we get from credit expansion to a crunch?

Because credit expansion distorts capital investments and spending by creating the illusion of prosperity, when the time comes to pay back what is borrowed, investors and lenders discover they have misallocated their capital. This leads to losses because the only way to turn a misallocation of capital into a gain is to sell it at a higher price to someone who still believes it will go up.

This loss of capital creates risk aversion. Lenders suddenly find they are not being repaid, say, by subprime borrowers who are defaulting on their mortgages. These lenders in turn find that because they used the expected repayment of these loans as collateral for other loans they took out to "malinvest," they are suddenly unable to repay some of their own debts. The lender's lender is in the same boat, as is the lender's lender's lender.

So, what do these lenders do? They "de-lever." In other words, they sell whatever they can, whatever is still liquid -- U.S. stocks, for example -- in order to raise capital to repay loans. This pressures asset prices.

We then have a situation in which the fear of not having money (U.S. dollars) to pay down debt spreads. This deepens further risk aversion.

Time preferences shrink. Lenders in many cases cannot, or are no longer willing to, extend credit beyond the very short term, for they fear not being repaid.

5. What's next?

If we are in a credit crunch, how do we get out of it?

The Fed can make even more credit available, a monetary response. This may temporarily relieve tight credit conditions among financial institutions, but so far, despite an array of special lending programs, the creation of weird acronyms and the opening of access to the Fed's discount window to broker-dealers, the monetary response has been weak, largely because of the size and impact of housing inflation and the leverage involved.

When monetary policy is insufficient to stop the credit crunch, the government can step in and create any number of mechanisms to essentially bail out lenders and borrowers, a fiscal response. We are seeing this happen now with Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs).

Markets are too large for any central bank or group of central banks to control for long. And, ironically, the more they act to try to prop up or even slow the decline in asset prices, the larger the market becomes. By targeting asset prices and attempting to "manage the economy," the Fed creates the conditions for a market that is too large for it to control. As a result, crashes, collapses of speculative bubbles, become more devastating and affect far more people in the real economy.

What happens on the other side of that is what we need to be concerned with now. One consequence of the credit crunch will be sweeping increases in the balance sheet of the government. This will likely take the form of increases in public-works projects targeting infrastructure, as well as increases in military spending and other government programs to help Americans deal with the transition from boom to bust and back again.

In some weird, perverted sense, this couldn't happen at a better time, something we first noted more than a year ago in our Five Things column. Our view, at that time, centered on a report released by the Urban Land Institute and Ernst & Young projecting a U.S. deficit of $1.6 trillion through 2010 for basic infrastructure repairs and maintenance. We viewed that shortfall as good news.

How could a $1.6 trillion shortfall in infrastructure spending possible be good news? Easy.

During economic depressions caused by malinvestment and magnified by intervention and the perversion of the normal business cycle, the ensuing widespread layoffs create vast societal upheaval as displaced workers, while former homeowners turn desperate in order to feed their families and get by.

Fortunately, this deteriorating infrastructure is perfect for government-paid public works projects.

This article was reported and written by Kevin Depew. He writes "Five Things You Need to Know Today" for Minyanville, from which this was adapted.

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