How Do You Cure a Credit Bubble?

I'm a bit puzzled by some of the underlying thought processses behind those proponents of a massive government bailout of some sort of the US housing industry. On one hand, they seem, for the most part, to be agreeing with the premise that the state of the US balance sheet, whether our private (consumers) or our public (the government) is at minimum unsound and in the long term creates extreme risk. On the other hand, they seem to be saying that the only way out of our current difficulties is to continue to expand credit. Huh?

Via Financial Times (a fine paper in many respects, but can't say I agree with this particular opinion):

Moreover, the US has structural vulnerabilities that Japan did not have: low household savings, untested derivative markets, and a large current account deficit.

But there may be a conflict between the private interest of the banks and the public interest in continued credit expansion.

So, were financially unsound and its in the public interest to become more financially unsound? Continued credit expansion, the so called "hair of the dog" approach is really what we need? When does it reach the point where it's time to enter a good detox center (managed credit contraction) instead? So, levering the entire world's output and the entire worlds stock market capitalization at over 10x thru derivatives alone isn't enough (estimated size of derivatives market $516 trillion divided by $48 trillion world GDP or by $51 trillion world stock market capitalization)? Keep the frat party going as long as possible, keep misallocating far too many resources into financial engineering and real estate?

Then of course, there are those within the "We'll fix our balance sheet by borrowing and leveraging some more crowd" who want to "fix" our situation via some sort of upside down Nixonian price controls, i.e. price floors. So is the thought process something along the lines of "Just because temporary price controls were a disaster doesn't mean temporary price floors won't work out just wonderful"? This via the Senate banking committee chairman (Chris Dodd):

What we're trying to do here, in addition to providing assistance to the homeowner, is to create a floor...

So what is the right price to set it at, i.e. the floor? Is it better set by free markets or by government subsidies? Furthermore, what if Chris Dodd and the like were to actually to "succeed" in putting a floor on house prices (doubtful but lets just play "what if"). Is having housing prices artificially subsidized at levels far above long term trends actually in the long term best interest of our economy? Further, is it in the best interest of those looking to buy a house both now and in the future to not only have to pay some of their tax money subsidizing the cost of housing, but to overpay once more in buying an artificially overpriced house?

It seems to me that trying reflate the bubble in some way shape or form is about the worst thing we can do. The only viable long term solution is to attempt to deleverage / contract the credit cycle to a market driven level of balance, but given the magnitude of the rise, to do it in some sort of managed fashion. As to the particulars of how best to manage it? There are plenty of arguments to be made on each step of the way, sure to provide plenty of fodder for discussion. Some of my own thoughts are here, including perhaps the less conventional belief that it may be time to consider putting away the interest rate tool after this coming week.

Comments

[Johnc]

You are right but the devil is in the details. As an American who lives in Asia, I understand but am constantly amazed by the household balance sheet carried by most of my upper middle class friends in the US. How do we get the deleveraging without collapsing the whole system? The Austrian School is right (and crowing about it) but it will take years to reeducate the average American consumer to see the benefits of saving and productive investment. And with the likely tax regime under the next administration, I fear we will move further away from a simple and flattish tax policy that would point the way towards the deleveraging you correctly identify as the cure for our (US and global) ailments. Reverse Nixon price controls...very nicely put. History rhyming but not exactly repeating.

[dickjanine]

Another one of the Critics who doesn't have even One answer.

[capitalist54]

There is no need for a government backed taxpayer bailout. By keeping the prime rate low, and sinking, the treasury rates go up due to the bond prices sinking under inflationary pressure. The result of this is increasing spreads for the financial instituitions. Not instant gains, but a large cash flow.

The problem, which Bush, Bernanke, et all seem immune too is that this will keep downward pressure on housing due to the mortgage rates staying high.

And of course we have oil at $110 a barrel, and wheat at over $10.00 per bushel. But food and oil don't count in inflation statistics, so we really don't have inflation. yea right.

[Mr Pasadena]

If our government just butt out then people will realize that the last few years real estate growth is unrealistic to maintain. Most Americans do not have an upside down mortgage. They just think their asking price is real but don't want to accept the fact that the kind of money that made this bubble happen is no longer available. When they finally realize it, they will sell at historical average pricing. That will re-ignite the real estate industry. But if every home owner wants to wait for the bubble price, they the real estate industry have a long, long wait for a recovery.

[bylo]

Exactly what I've been yammering about for the last three months, i.e., you can't fix too much debt with more debt! Is there an easy answer? Not that I can see. Only pain until housing values and mortgage amounts come back into some sort of balance.