How Do You Cure a Credit Bubble?

I'm a bit puzzled by some of the underlying thought processses behind those proponents of a massive government bailout of some sort of the US housing industry. On one hand, they seem, for the most part, to be agreeing with the premise that the state of the US balance sheet, whether our private (consumers) or our public (the government) is at minimum unsound and in the long term creates extreme risk. On the other hand, they seem to be saying that the only way out of our current difficulties is to continue to expand credit. Huh?

Via FT (a fine paper in many respects, but can't say I agree with this particular opinion);

"Moreover, the US has structural vulnerabilities that Japan did not have: low household savings, untested derivative markets, and a large current account deficit."

"But there may be a conflict between the private interest of the banks and the public interest in continued credit expansion."

So, were financially unsound and its in the public interest to become more financially unsound? Continued credit expansion, the so called "hair of the dog" approach is really what we need? When does it reach the point where it's time to enter a good detox center (managed credit contraction) instead? So, levering the entire world's output and the entire worlds stock market capitalization at over 10x thru derivatives alone isn't enough (estimated size of derivatives market $516 trillion divided by $48 trillion world GDP or by $51 trillion world stock market capitalization)? Keep the frat party going as long as possible, keep misallocating far too many resources into financial engineering and real estate?

Then of course, there are those within the "We'll fix our balance sheet by borrowing and leveraging some more crowd" who want to "fix" our situation via some sort of upside down Nixonian price controls, i.e. price floors. So is the thought process something along the lines of "Just because temporary price controls were a disaster doesn't mean temporary price floors won't work out just wonderful"? This via the Senate banking committee chairman (Chris Dodd);

"What we're trying to do here, in addition to providing assistance to the homeowner, is to create a floor..."

So what is the right price to set it at, i.e. the floor? Is it better set by free markets or by government subsidies? Furthermore, what if Chris Dodd and the like were to actually to "succeed" in putting a floor on house prices (doubtful but lets just play "what if"). Is having housing prices artificially subsidized at levels far above long term trends actually in the long term best interest of our economy? Further, is it in the best interest of those looking to buy a house both now and in the future to not only have to pay some of their tax money subsidizing the cost of housing, but to overpay once more in buying an artificially overpriced house?


It seems to me that trying reflate the bubble in some way shape or form is about the worst thing we can do. The only viable long term solution is to attempt to deleverage / contract the credit cycle to a market driven level of balance, but given the magnitude of the rise, to do it in some sort of managed fashion. As to the particulars of how best to manage it? There are plenty of arguments to be made on each step of the way, sure to provide plenty of fodder for discussion. Some of my own thoughts are here, including perhaps the less conventional belief that it may be time to consider putting away the interest rate tool after this coming week .