More debt: A curious solution to a credit crisis

By Pedro Nicolaci da Costa - Analysis

NEW YORK (Reuters) - 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.