Current economic situation explained from Austrian perspective

Oh, I understand what you are saying jzneff, but you must realize that when the extended that money through the fractional reserve system, creating it through a loan, that money entered the economic pipeline at the time of lending. It has been spent, based upon the principal amount extended in the lending process. That money has worked through the economy flow patterns at the time it was extended. The bank balance sheets are bascially comprised of future earnings from those loans, principal and interest obligations. When they write off those loans, the original money that was basically created out of thin air in the first place has been utilized by paying this person or that person, this supplier, that builder, the land owner, etc. The balance on the banks books take the form of the future earnings off that mortgage. The actual losses are as much a fiat entry as the money that was extended in the first place when a borrowed signed it into creation through a mortgage or loan instrument.

Now, since it is very rare that a bank hold its own paper and usually pools the loans into tranches that are sold to various investors, including other banks the only transaction would then be the discounted cost of those tranches and the future earnings they represent. The only change came when those tranches could not longer be considered assets, but were transformed into liabilities. The bank balance sheet then takes a hit based on the amount of liability represented by those bad tranches of MBSs.

Say a bank bought MBS tranches at a spread of 2.5% and later in the year some, but not all of those notes come due, then its portfolio will increase by the amount of the spread on those notes producing at any given time or they will decrease by the amount of the non-producing notes at any given time if there are losses. It is the reason banks and investors bought into MBS because they provided what was thought to be safe and secure future earnings. The losses to the bank would be the initial investments in those securites, money that the bank had on hand as either part of their reserves or assets. These were called structure investment portfolios because they are based on extended returns not present returns.

Now some banks were able to avoid sub-prime MBS write-offs they were holding by quickly buying into GBS with higher spreads and while they had losses within their portfolio of MBS, they made up for it with short-term securities in government backed instruments such as those issued by FannieMae or FreddieMac.

The liquidity of an instrument determines just how close it is to real money, the more liquidity an instrument has the more it operates like real money on the books of a bank; counterwise, the more illiquid an instrument is the less it acts like real money. The investments made by banks into MBS were not very liquid, in fact they were traded as discount instruments because of the fact that they were relatively illiquid instruments representing furture earnings instead of present earnings. Of course, as the markets contracted away from such instruments the less liquid they became to the point that no one would trade them because they had no discernable evaluation as to actual worth.

Now, if you are talking about bonds as part of a banks portfolio then you are talking about something that is very close to real money however, in most cases, unless they are short-term, those bonds are also structured for future returns.

So, what money are you talking about?

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I would remind you that extremism in the defense of liberty is no vice! And let me remind you also that moderation in the pursuit of justice is no virtue. Barry Goldwater

I see where you're coming from, but feel the monetary response to the crack has been vilified more than it deserves. Had abrupt reversal in credit expansion been the only official response (or non response) to the 1929 crack, I doubt the downturn would have been long lasting enough for any of us to be speaking of it today. Capital owners would have gotten ravaged, but assets would have been written down, liabilities written off, and people would much more quickly have been able to start from a blank slate. Savings would of course have taken a pummeling, which would have meant delayed retirement for many.

It was, at least as I see it, all the other, non monetary responses that made the depression so 'great.' It opened up possibilities for an entire cottage industry of economic quacks and other charlatans to send public money and works in their, or their clients' direction.

And while, in isolation, I am sure you are right that cutting of credit now, would be about as bad a timing as possible, not doing so will inevitably lead market participants to (correctly) guess they will be bailed out next time as well, leading to even more excesses later.

That being said, if policy makers really did as you advice; ease credit until the worst is over, and then immediately go about credibly reducing or eliminating their own ability to do so in the future; that would likely be the best of all worlds. I just feel that, regardless of how deep and long lasting this downturn turns out to be, policy makers will claim it would have been even worse without them intervening. Hence, we should use the current mistrust in the fed and economic interventionism to reduce their role, even if now may not be the exact optimal time to do so.