Bubbles and busts are inevitable, as is the panic that follows the bust. During these downturns, the government must always increase its spending to counterbalance the contraction of the private sector’s balance sheet. The challenge in the coming years will be to find ways to shrink back the now greatly-inflated government balance sheet.

Resident Fellow Alex J. Pollock

The bubble was huge and we are mired in a terrific bust. Is this unprecedented? No. The basic patterns repeat throughout financial history.

"Leveraged financial institutions are inherently prone to crisis," as James Grant reminds us. A mere two decades ago, the 1980s bust brought us not only the collapse of the savings and loan industry, but the failure of 1,500 commercial banks and also the government bailout of the Farm Credit System.

That notable theorist of financial cycles, Hyman Minsky (whom I knew well), liked to say that "stability creates instability." By this he meant that a period of financial success convinces financial actors that higher leverage and increasing use of short-term debt are safe--so both go higher, and so do prices of assets bought with debt. In the resulting "fragile" state, the debt can be repaid only by selling the asset at a yet higher price, which requires even more debt from some optimistic lender. The bust, remorse, and the bailouts follow.

Why should this keep happening? Don't we learn from experience? Doesn't economic knowledge increase? And how about having computers, lots of data and information, and new mathematical models to guide lending and investing decisions?

Well, the idea that improved knowledge will keep us out of trouble is also not new. There was a major bust in England in 1825 (including the first Latin American debt defaults). According to the financial historian Edward Chancellor, "Disraeli had asserted that the boom of 1825 would not turn to bust because the period was distinguished from previous ages by superior commercial knowledge."

Our 21st-century housing bubble, now deflated, was inflated despite--indeed partially because of--amazing computer power, reams of data, and sophisticated models operated by exceptionally bright analysts informed by Nobel Prize-winning financial theories. These computerized models created a sense of security, just as did the "superior commercial knowledge" of 1825.

Now we are in the panic phase. As David Ricardo wrote two centuries ago, "On extraordinary occasions, a general panic may seize the country, when every one becomes desirous of possessing himself of the precious metals [now: cash and Treasury bills]--against such panic banks have no security on any system."

This lack of security in a funding panic "on any system" is what triggers government deposit guarantees ("insurance") and also government bailouts.

It also triggers "deleveraging"--financial firms urgently trying to pay off debt, reduce the ratio of debt to equity (with equity depleted by losses), and correspondingly shrink their balance sheets.

Clearly any one firm can shrink its balance sheet by selling assets to someone else. But ask yourself this question: How is it possible for everyone to deleverage at the same time? Imagine the combined balance sheet of all the financial firms--all the balance sheets thought of as one big balance sheet. How is it possible for this aggregate balance sheet to shrink?

One way would be a generalized asset-price collapse and widespread default on debts of all kinds. This is a "debt deflation," the outcome no one wants, to say the least.

The only other way for the aggregate private balance sheet to shrink is for another balance sheet to expand: the government's balance sheet. In other words, we have a kind of yin and yang of two big balance sheets: the aggregate private balance sheet can deleverage only by the expansion of the government balance sheet.

And this is of course what is happening. Since the beginning of the financial market panic in August 2007, the Federal Reserve banks have expanded their combined balance sheet by about $1.3 trillion, or over 150%, looking ever more like a risk-taking commercial bank. The Federal Reserve System is now intermediating the risk between mortgage securities, loans to financial firms, and commercial paper on one side and its own rapidly escalating deposits on the other.

What is the alternative in a panic? According to Walter Bagehot, the father of central banking theory, none. Therefore, in Bagehot's celebrated dictum, in a panic the Bank of England, or in our case the Fed, must "lend freely." Both of them today, with a housing bust and a financial panic in both countries, are certainly doing so.

Not only the central banks, but the treasuries of many countries are now expanding their balance sheets and using the public credit to keep the financial sector solvent. This makes possible the private deleveraging.

When we are finally past the bust, we will have to shrink back the greatly inflated government balance sheet.

That will be the challenge of two years or so from now.

Alex J. Pollock is a resident fellow at AEI.