updated 9/17/2008 11:56:38 AM ET 2008-09-17T15:56:38

There is not enough room on page one of the nation's newspapers for all of this week's news. Any of the major business stories — the Lehman bankruptcy, a sale of Merrill Lynch, AIG capital needs, plummeting oil prices or new Fed lending facilities — could be above-the-fold headline news.

The U.S. is moving through its deepest set of financial market difficulties since the banking and savings and loan crises of the 1980s and 1990s.

The key thing to remember here is that the emphasis belongs on the word financial. The economy is not the problem; lousy lending standards and the excessive use of leverage are the problem. Gales of punitive destruction are knocking down one investment bank after another, while gales of creative destruction continue to move the economy forward. In fact, real gross domestic product (GDP) has grown 2.2 percent in the past year and accelerated to a 3.3 percent growth rate in the second quarter.

As in the 1980s and 1990s, the roots of our current financial market problems reach back to a period of absurdly low interest rates. In the 1970s, when the Fed held interest rates too low for too long, banks made similar mistakes with their balance sheets — borrowing at short-term rates to make longer-term loans in inflation-sensitive assets.

In this decade, by cutting interest rates to 1 percent, the Fed caused investment banks to overuse leverage-based strategies. Borrowing short and lending long turned so lucrative that many financial market players could not help themselves. Wall Street based its business model on leveraging up the most leveraged asset on Main Street — housing.

When the Fed pushes interest rates below their "natural" level, mal-investment always occurs. And in the current case, the mal-investment was a double whammy. Not only did Main Street gorge on real estate, but Wall Street ate it up too. This double set of leverage has blown up because the housing market became overbuilt and housing prices stopped rising.

Mark-to-market accounting exaggerated this process by allowing firms to mark up assets above true fundamental value when the market was strong but is now forcing firms to mark down assets, to below true fundamental economic value.

The good news is that this financial hurricane is unlikely to change the economic climate. The bad loans made earlier this decade did not create a widespread economic boom, and the realization of how bad some of these loans are will not create an economic bust.

The non-housing economy, which is roughly 95 percent of total U.S. economic activity, has been remarkably stable. In fact, non-housing real GDP growth has accelerated, growing 3.2 percent at an annual rate in the past three years, versus a 2.7 percent annualized growth rate in the three years since March 2005.

This is not that hard to understand. Consider a bad loan made to a home buyer. Clearly that allows the borrower to spend more than he had earned. But every dollar of this cash came from someone else who had to spend less than he earned. The lender is buying less. Even when the loan money comes from abroad, that means fewer dollars available to foreigners to buy U.S. exports. Is it any wonder that the trade deficit was booming when capital was readily available for mortgage loans on easy terms, and that the trade deficit is falling rapidly now that mortgage credit has slowed?

Remember, lending and credit expansion, by itself, is not the equivalent of printing money; it simply shifts the pocket in which the money is located. Credit contractions come and go, but only credit contractions caused by government policy mistakes lead to widespread recession. This is why the current financial market problems are unlikely to spread to the economy as a whole.

There have been no major increases in tax rates, no sudden lurches into trade protectionism, and no prolonged period of tight monetary policy, with a federal funds rate persistently above the trend in nominal GDP growth. In fact, tax rates are still relatively low, and the Fed is holding interest rates at extremely accommodative levels.

It is difficult to gauge when the financial market upheaval will finally come to an end. However, as long as policymakers steer clear of tax hikes, tight money and protectionism, the economy should remain resilient. After all, 2,747 banks and savings and loans failed between 1983 and 1994, but real GDP continued to expand at a 3.5 percent annual rate.

It was "gales of creative destruction" (Joseph Schumpeter's phrase to describe the role of new technology in creating growth) that kept the economy growing during the 1980s and 1990s. And even as hurricane-force gales of punitive destruction buffet the financial and real estate markets, the gales of creative destruction continue to push the economy forward today.

© 2012


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