Krugman explains the credit crunch in plain language

Paul Krugman's explanation of the credit crunch and the current market problems lays out both the problem and the reasons quite clearly. Certain statements are especially important:

• The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole.
  
• ...liquidity has been drying up.
  
• “What we are witnessing,” says Bill Gross of the bond manager Pimco, “is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”
  
• The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one.
  
• Behind the disappearance of liquidity lies a collapse of trust: market players don’t want to lend to each other, because they’re not sure they’ll be repaid.
  
• ...what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried.
  
• How did things get so opaque? The answer is “financial innovation” ...
  
• Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs.
  
• policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.
  

The problem has the bankers scared, because they simply don't know how bad it is, nor what risks they have taken when they invested funds. The various new types of alphabetical investments were supposed to diversify away risk while keeping the high rates of income normally associated with greater risk in investing, but what those investments really did was just hide the risk so it could be ignored. Then many of the the investment institutions have leveraged themselves to make even more money, thinking that they were working with safe investments. Now they are finding that leverage not only magnifies earnings, it also magnifies losses, and the investments weren't safe at all.

So the economy has already lost home building and home buying as net positive sources of jobs and incomes. If the credit markets freeze up and cease to function, then business investment will join the housing industry and the economy will start losing even more jobs.

The job losses may have already started. The Commerce Department has just revised their second quarter 2007 report to say "personal income from wages and salaries grew at an annual rate of 1.6 percent in the second quarter, far below the 4.5 percent that had previously been estimated." As Kevin Drum reports, this is probably a result of revised estimates. It's not surprising that they got the estimates wrong, since the many banking innovations have created a set of financial markets that no one currently understands.

I have yet to see any reports on the credit crunch and the economic reactions that would even suggest a positive outcome in the near future, so I continue to expect a severe recession beginning early in 2008.

Let's not forget who brought this financial disaster down on us. See my Saturday post laying out Who's to blame for the credit mess. The collapse of the subprime loans, ARMs and poorly underwritten mortgages triggered the rest of the credit crunch, because mortgages were supposed to be a safe investment and the rest of the credit structure was built on the belief of that low risk investment.