More debt: A curious solution to a credit crisis

A nagging question haunts U.S. government efforts to revive a dormant financial system: Can a crisis that started because of excess credit be solved with more debt?

The typical answer from economists is a qualified no. That is, No, more credit will not make the problem go away. But yes, the government should do its best to restore bank lending to prevent an even worse economic outcome.

Yet the refrain out of Washington places a lot of credence on the ability of debt to revive the country's economy.

U.S. Treasury Secretary Timothy Geithner was only the latest to proclaim what has now become an official mantra. Without credit, which he and others call the lifeblood of the economy, you can kiss recovery hopes goodbye.

Federal Reserve Chairman Ben Bernanke, justifying the massive help the central bank has offered to financial institutions, made his own case: This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit.

Detractors of this view argue that it offers an overly convoluted approach. The problem, they say is much simpler.

We need to get jobs and incomes flowing, not credit, said Randall Wray, research director at the Center for Full Employment and Price Stability, in Kansas City, Missouri.

INSECURITIZATION

That is certainly not the prevailing view among policy-makers.

Indeed, a huge part of the Treasury's economic rescue plan is based on reviving securitization. This is the process by which everything from real estate and auto loans to credit cards and student debt gets repackaged into bonds and is then sold on to investors in a secondary market.

This worked wonders during the boom of the past couple of decades, leading to rapid capital formation that underpinned a huge rise in lending. But when the music stopped, many investors were left looking for an empty chair as these products of financial innovation proved ruinously difficult to value.

Given this history, Wray, also a senior fellow at the Levy Economics Institute, said asset-backed bonds are the problem, not the solution. We need to kill off securitization and go back to banking -- loan officers and underwriting.

This is not to say that government policies have no role in ameliorating the economic conditions generated by the crisis.

Indeed, experts widely agree that the public sector must enlarge its role during a time of crisis to ensure that the underlying momentum of the economy does not screech to an abrupt halt.

But many believe this greater involvement is best undertaken at the fiscal level, by enacting policies that directly boost employment rather than hoping for the onward flow of credit to eventually trickle down into the labor market.

Helping the banks may also be just too damn expensive. Goldman Sachs estimates that, in order for the Fed to effectively counter the downturn, it would have to expand its balance sheet to a shocking $10 trillion. That is more than five times the current level, and more than 10 times its pre-crisis size.

On Wednesday, the Fed announced it would begin outright purchases of U.S. debt, the first such move since the 1960s. They also vastly expanded their purchases of mortgage-backed and agency securities, remnants of a real-estate sector gone wild.

SPEND IT, IF YOU GOT IT

Prudent lending is a good thing. If creditors have cut back, it is because the risks associated with an environment of turbulence dictate that they should.

In truth, not all economies run on credit. In a legitimate economy, it is not credit that fuels spending and investment, but simply income and savings, said Peter Schiff, president of Euro Pacific Capital in Darien, Connecticut.

That American families now routinely rely on credit to make every-day purchases is a habit that needs to be broken and not encouraged.

James Poterba, the MIT economist who now heads the influential National Bureau of Economic Research, agrees that there is some inconsistency in the advice given by experts.

As economists, the policy prescription we're making is to say we need to get people out there to spend and to help boost the economy, he said. At the same time, I know personally, I feel it is a good time to be saving more and to be trying to be rebuilding some of those assets.

Defenders of securitization say that the baby, spoiled as might seem, should not get thrown out with the bathwater. Done right, in a simpler, more transparent form.

There's nothing wrong with securitization per se, said Eugene White, economics professor at Rutgers University in New Brunswick, New Jersey. The problem emerged because of these 'exotic' developments whereby the owner of the final product had no clue as to the underlying assets.

Still, it remains to be seen whether the appetite for such bonds will even exist in a world where risk-aversion is so pervasive. The burden of proof will be with the camp that says a system that so miserably failed the test of time can still be made to work somehow.

Moreover, even if these loans do become available, the current crisis is affecting consumers so deeply that it may lead to a prolonged -- and perhaps wise -- reluctance to take on new debt.

The reason is right out of Economics 101: supply and demand. The current debacle is, at its core, a problem of oversupply, of housing, cars, plastic toys, and debt itself. Adjusting to that glut will take time, lots of it.

We're going through an epic credit collapse, said David Rosenberg, chief North America economist at Banc of America Securities-Merrill Lynch. It's going to be very difficult to fight this thing with demand-led policies.

(Additional reporting by Diane Craft)

(Reporting by Pedro Nicolaci da Costa)