With the collapse in the price of sub-prime mortgage backed securities and credit derivatives, the credit boom has moved into the crisis phase. This is the place in the cycle where it becomes clear to the market the investments made possible by unfunded credit were mal-investments and they are re-priced.Reisman agrees, and he fingers the culprit as the massive credit expansions facilitated by central banks. In The Housing Bubble & the Credit Crunch he says:
The situation today is essentially similar to all previous episodes of the boom-bust business cycle launched by [central bank] credit expansion. The only difference is that in this case, the credit expansion fed an expanded demand for housing and, at the same time, most of the additional capital funds created by the credit expansion were invested in housing. Now that the demand for housing has fallen, as the result of the slowdown of the credit expansion, much of the additional capital funds invested in housing has turned out to be malinvestments. In most previous instances, credit expansion fed an additional demand for capital goods, notably plant and equipment, and most of the additional capital funds created by credit expansion were invested in the production of capital goods. When the credit expansion slowed, the demand for capital goods fell and much of the additional capital funds invested in their production turned out to be malinvestments.The prognosis is not pretty, says Reisman, and the latest knee-jerk credit expansion is just adding more fuel to an already out-of-control fire.
In all instances of credit expansion what is present is the introduction into the economic system of a mass of capital funds that so long as it is present has the appearance of real wealth and capital and provides the basis for sharply increased buying and selling and a corresponding rise in asset prices. Unfortunately, once the credit expansion that creates these capital funds slows, the basis of the profitability of the funds previously created by the credit expansion is withdrawn. This is because those funds are invested in lines dependent for their profitability on a demand that only the continuation of the credit expansion can provide.
In the aftermath of credit expansion, today no less than in the past, the economic system is primed for a veritable implosion of credit, money, and spending. The mass of capital funds put into the economic system by credit expansion quickly begins evaporating (the hedge funds of Bear Stearns are an excellent recent example), with the potential to wipe out further vast amounts of capital funds.
...the likely outcome will be a future surge in spending and in prices of all kinds based on an expansion of the money supply of sufficient magnitude to overcome even the very powerful impetus to contraction and deflation that has come about as the result of the bursting of the housing bubble.Explosive expansion of central bank credit has been going on for the last decade or more, and it's like having a tiger by the tail--it gets harder all the time to let go of that tail. But there is a way to extricate ourselves from the mess. In response to recent injections of credit by the Fed, Reisman concedes "the only thing that can prevent the emergence of a full-blown major depression is the creation of yet still more money."
Another outcome will almost certainly be the enactment of still more laws and regulations concerning financial activity. Oblivious to the essential role of credit expansion and of the government’s role in the existence of credit expansion, the politicians and the media are already attempting to blame the present debacle on whatever aspects of economic and financial activity still remain free of the government’s control.
But that new and additional money does not necessarily have to be in the form of paper and checkbook money. An alternative would be to declare gold and silver coin and bullion legal tender for the payment of debts denominated in paper dollars. There is no limit to the amount of debt-paying power in terms of paper dollars that gold and silver can have. It depends only on the number of dollars per ounce.And there is a difference in the latest $38 billion central bank intervention that John Paul Koning points out. Instead of buying treasury bonds and bills its been buying mortgage-backed securities at a furious rate, meaning in just 3 short days the Federal Reserve has effectively become one of the major real estate owners in the USA.
To be sure, this is an extremely radical suggestion, but something along these lines will someday be necessary if the world is ever to get off the paper-money merry-go-round of the unending ups and downs of boom and bust, accompanied since 1933 by the continuing loss of the buying power of money.
UPDATE: Fran O'Sullivan offers a robust local view.