The Underlying Problem was Never Illiquidity
The credit markets may have been melted loose by the Fed’s pouring salt on the ice, but the overall weather conditions remain the same.
True, they can keep adding salt, but if it remains cold outside, there is a much more fundamental problem going unaddressed. The Fed can crow all it wants to about having done something, and it can jawbone bank executives about the need to make more loans to get the economy moving again.
The government can mail out moderate stimulus checks or even cough up a $1 trillion ditch – digging program and a middle-class tax cut, but as long as consumers, businesses, and financial institutions remain highly leveraged, they will prefer to use their incremental cash flow to reduce what they owe.
Imagine you are a bank CEO, and you were leveraged 15-to–1 before the crisis. Over half of bank loans are real estate related, and that asset class has fallen about 25 percent from the peak.
The Fed extends a guarantee, swap, or loan to your bank, so now you may be liquid. But from the perspective of the marketplace, you remain insolvent — that is if your depositors pull out, you will be left holding the bag as long as the Fed expects to see this money extended from its temporary facilities back someday. So you don’t make any more loans, and your customers wouldn’t want to borrow more, even if you did press them to do so.
What does this mean? It means that the underlying problem is not illiquidity. (But the drying up of funds is a very important intermediate mechanism of a marketplace that is trying to sort out problems by forcing liquidation.)
It really indicates that insolvency is the problem, and it was caused by both the private and the public sectors borrowing too much relative to their income. What if you say their equity seemed adequate at the top? Indeed it was, if everyone in the world could have transacted assets at that price and deleveraged at precisely that moment, an impossible and totally theoretical feat.
In reality asset prices were pumped up by a credit boom, so the income those assets generated to justify their dear prices was dependent upon ever-increasing waves of lending to produce growth, or a perpetual excess of demand over supply, however you want to look at it.