Credit Crisis

The front page of the WSJ today had an article titled "Credit Crisis Strains Government's Options". It posed this question: "Why haven't the steps taken so far calmed the system? What can policy makers do next?"

There are many aspects to this crisis, but I want to focus on three, very specific issues: consumer deleveraging, bank regulation, and housing prices.

Consumer deleveraging
Deleveraging, or shedding debt, is a process that both corporations and individuals go through at times. It's not necessarily unhealthy, just as borrowing money (leveraging) isn't necessarily unhealthy. The key to deleveraging, though, is that it takes a long time. People can't just immediately shed loans. The process of, say, moving to a different house, selling a house, or selling other assets and paying off debts, can take months. So, although the housing price drops started affecting people as much as a couple of years ago, we are still feeling the aftershocks of deleveraging adjustments.

Bank regulation
I will leave the broader question of whether we have too much or too little bank regulation alone, but I am going to argue that in some very specific ways the regulation scheme is causing a problem. Banks, right now, are having a hard time raising money. There is a lot of money out there, though, so why can't banks get it?
1) People are unsure how to assess risks right now, because the various bond rating schemes and whatnot clearly did not protect investors (such as foreign sovereign wealth funds) as much as was expected in the last year or two. Regulators are causing a further moral hazard by bailing companies out, which makes risk hinge as much on the likelihood of a bailout as on the inhereny stability of a bank's finances.
2) Hedge funds and private equity are restricted by rules that cap their ownership of banks at 25%. It's understandable that banking regulations should apply to companies that own banks, even if they don't refer to themselves as banks, but right now, that means that places like Lehman can't get any more money from Blackstone.

Housing prices
A lot of imaginary wealth was created in housing prices. Housing prices are only fundamentally affected by a few factors: population, construction costs, availability of land (and zoning) and incomes. Housing prices in most places rapidly ran away from the fundamentals. When I offered my old landlord $625,000 for a house that he thought was worth $900,000, I was probably still offering too much. I'm saying that many of these houses were overvalued by 50-100%. That's a lot. As that funny money evaporates, individuals and corporations feel poorer. In a sense, they are. There is no way for that adjustment to occur without the prices continuing to fall and people continuing to adjust their finances to compensate.

Furthermore, both banks and individuals need to be punished for what they did. Banks shouldn't have been loaning money so freely, and consumers CERTAINLY shouldn't have been bidding the prices of houses up so high. Unpleasant as it sounds, the quickest way to get back into equilibrium is probably to let banks and individuals suffer quite a bit because of their bad investment decisions.

Right now we have uncertain interest rates, uncertain credit availability, arcane financing rules, uncertainty about further bailouts and uncertainty about further stimulus packages. It's impossible to make these things certain, but the Fed and the Treasury should take a line like this:

We'll keep the interest rates as low as we can, but we're going to hold non-energy, non-food, non-mining products inflation constant. We're not going to bail anyone out unless it's imperative for the economy. People who made bad decisions are going to have to adjust to the way prices are now. We're going to find a way to let the money that's out there flow into the banking system to help equilibrate things and support loan prices. And, in the future, the banking and financial insurance industries are going to be rationalized to have less regulation that works better.