Thursday, August 16, 2007

When Credit Collapses

Much of the economic turmoil of the last few weeks is explained by the monetary policy of the last few years.

As the Federal Reserve lowered interest rates, the lower cost of borrowing encouraged many business projects and investment decisions that would not normally make sense. The result was what some economists call malinvestment.

Malinvestment looks very much like growth, at least for a while, just like a gambler on a winning streak looks prosperous. Then something happens. Luck runs out. Business hits an unexpected problem. First someone, then many someones can't make the payments on their loans. The problems expand, credit contracts, and growth stops.

The Fed knows this. That's why its been trying to raise interest rates after pushing them to historic lows after 9/11. It's trying to reload the monetary gun after using nearly all its bullets.

The most important question of the next few weeks is, how will the Fed respond? Will it cut interest rates to keep growth going a little longer, or will it sit back and let businesses and individuals suffer the consequences of decisions made under conditions of the Fed's own making?

Either decision leads to problems. If the Fed lowers rates, then it merely postpones the reckoning. If the Fed holds rates fast or raises rates, it creates an angry mass of voters susceptible to ambitious political rhetoric affixing blame and promising solutions.

Unfortunately, angry voters and ambitious politicians rarely blame the right people or deliver the right solutions. That might be the biggest risk of all.

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