A market patiently gets its payback

I've always been somewhat amused at pundits who think that the free market, like some magic wand, will automatically right all wrongs in an economy without some severe consequences to those who played by the rules. Of course what they don't consider are things that have more to due with human failings than simple theories of supply and demand, such as greed, deliberate secrecy and politicians (and their appointees) looking the other way because doing so means re-election and/or continued paychecks. In other words, "it's all about me." So does that make me a cynic? Writing in USA Today, David Lynch (not the director) might not think so:

This is no ordinary economic crisis, and it won't be over anytime soon. In fact, problems are multiplying. A year ago, the financial virus seemed confined to subprime mortgages, defaults on loans given to those with less-than-perfect credit. Now, much of the banking system appears rickety, and the U.S. economy has slowed to a crawl. But thanks to robust demand from still-growing countries such as China, the prices of commodities from oil to food have soared — hitting Americans from the gas pump to the grocery checkout...

For nearly a decade, consumers grew accustomed to the idea of ever-rising home prices. Housing-related prosperity boosted consumption, as consumers tapped home-equity loans for cash to pay for everything from new cars to college for the kids. As the boom roared on, regulators stood on the sidelines, convinced that the magic of the market would sort out any problems.

"It seemed too good to be true, and it was. Absolutely (today) is payback," says Rogoff, former chief economist of the International Monetary Fund...

The combination of galloping prices and stagnant activity leaves Fed officials with a tough call on future interest rate moves.

If anemic growth were the only problem, the Fed could cut interest rates to jump-start economic activity. Likewise, fast-rising prices alone would argue for higher rates to cool off the economic engine. But an economy poised to tumble into recession, even while prices are steaming higher, leaves Bernanke in one-armed paperhanger mode...

The economy is going through what analysts call "deleveraging," a fancy way of saying debt repayment. During the housing boom, Americans and their financial institutions borrowed way too much money. Now the bills are coming due — economywide. And that's what is making things so tough in so many different ways.

"It's not like your standard business cycle recession. … The trouble with this deleveraging recession is it's self-reinforcing. … I don't like to be pessimistic, but the relentless flow of bad news is just something we're going to have to get used to," says George Magnus, senior economic adviser for UBS in London.

How bad might it get? Perennial doomsayer Nouriel Roubini, who calls this "by far the worst financial crisis since the Great Depression," predicts stocks will fall 40% from their peaks. That translates into a Dow of 8568 — a level not seen since 2003...

But it's the banking sector that likely will see the most significant activity. The housing crisis has left financial institutions with deeply wounded balance sheets, as the mortgage securities they hold have turned out to be worth far less than once believed.

Major global banks now need to reload by raising money — lots of it. Even after scraping together $350 billion over the past 12 months, the U.S. and European financial systems remain undercapitalized, says Mohamed El-Erian, co-CEO of Pimco in Newport Beach, Calif. He calls the current predicament "a crisis at the core of the global capitalist system" and likens the banking sector's woes to a car running desperately short of oil.

At the White House, in a question that seemed to echo Franklin Roosevelt's day, a reporter asked Bush if the banking system is in trouble.

"I think the system basically is sound," Bush replied.

Yah. Uh-huh. SURE it is....

One thing is clear: Government involvement in the financial system is expanding in ways that even the most fervent socialist could only have imagined one year ago. This week's federal proposal to help mortgage giants Fannie Mae and Freddie Mac, including opening the door to future government ownership stakes in the firms, is an "earthshaking event," Rogoff says.

And not an isolated one. It comes after the Federal Reserve has stretched its legal mandate and found creative ways to grease the financial system's levers. In March, the Fed midwived the sale of investment bank Bear Stearns to rival JPMorgan Chase in a bid to head off broader problems.

An era marked by regulators' light touch is at an end. "The system got carried away with financial innovation or financial engineering," El-Erian says. "Regulators didn't recognize how quickly things were moving. Now they're catching up."