Resident Fellow  Desmond Lachman

Leo Tolstoy mused that happy families are all alike but that every unhappy family is unhappy in its own way. The same could not be truer of credit crunches. And the very different nature of today's credit crunch from those which immediately preceded it, should now give the Federal Reserve pause before taking too much comfort in its relative success in having defused earlier credit crunches.

Painful and sudden as today's credit crunch might seem, it is hardly without precedent. Indeed, over the past twenty years there have been three separate occasions on which the Fed has had to resort to extraordinary policy intervention to defuse a seizing up of the financial system. First, in 1987 following Black Monday, when the New York Stock Exchange plunged over 25 percent in a single day; second, in August 1998 when Russia's default triggered the Long Term Capital  Management crisis; and third, in the immediate aftermath of September 11, 2001 when the US banking system virtually froze.

On each of those three earlier occasions, the Fed deservedly earned credit for its swift and successful response in restoring confidence. By speedily pumping large amounts of liquidity into a frozen banking system and by aggressively cutting interest rates, the Fed succeeded in restoring more normal financial market conditions while at the same time avoiding a deep recession.

The key question that the Federal Reserve now has to address is whether the present credit crunch is in principle little different from its predecessors or whether it has characteristics that might make it less amenable to the quick fixes of the past. If it turns out that the present credit crunch is mainly a liquidity problem caused by a transitory loss in confidence, the Fed will be proved right in its measured approach to the present crisis. If not, the Fed will be judged to have done too little too late.

Among the variety of reasons to suspect that the present credit crunch is of a more virulent nature than those of its predecessors is that it would appear to have more to do with the deflating of asset bubbles, rather than simply with a sudden and dramatic loss of confidence in the financial system. Putting the matter differently, we would appear to be dealing with deep solvency issues arising not simply from the re-pricing of credit risk from historically low levels but also from the deflating of a major housing bubble.

The immediate fire that the Federal Reserve is now trying to extinguish is a dramatic loss of confidence in the financial system as reflected in a stampede to the safety of Treasury bills. The principal underlying cause of that loss of confidence is a heightened degree of uncertainty as to how large and as to where in the financial system the losses on asset backed securities might be.

Yet as the Fed battles to restore confidence, there is every prospect that the bursting of the US housing bubble now in full evidence continues apace. This is bound to highly complicate the Fed's task of restoring financial market confidence in a qualitatively different manner from earlier credit crunches. For not only does the continuing housing market bust with its attendant fall in housing prices increase the odds of a consumer-led recession. Rather, it also increase the probable size of the financial system's eventual losses from sub-prime mortgage lending to somewhere of the order of US$200 billion, or approximately double Chairman Bernanke's US$100 billion estimate of the mortgage problem.

Further complicating the Fed's task in defusing the present credit crunch is the very different nature of today's financial sector with its very many more players than in the past. Over the past thirty years, there has been a steady erosion of the importance of the banks in the US financial system from around 50 percent of total financial assets in the early 1980s to barely 25 percent at present. Instead, an ever larger part of the US financial system is now represented by hedge funds, mutual funds, insurance companies, and pension funds. Gone are now the days when the Fed could resolve financial market problems by seating a relatively few but important players around a table to resolve a credit crunch as it did in the 1998 Long Term Capital Management crisis.

Making the Fed's task even more difficult is the veritable explosion of financial innovation over the past decade. By increasing the distance between lenders and borrowers, the pervasive securitization of loans makes it extremely difficult to execute an orderly workout of troubled loans. More important still, the massive resort by banks to complicated credit derivatives to pass on risk to the rest of the financial system could be found to be very wanting should the rest of the financial system come under real pressure.

As the Federal Reserve ponders its next move, it might want to focus on the very different circumstances of the present credit crunch from those that preceded it. Maybe then the Federal Reserve will come to appreciate how urgently lower interest rates are needed to avert the very real risk of recession.

Desmond Lachman is a resident fellow at AEI.