The main emotional impetus behind the housing bubble was the prospect of a “free lunch.” Appreciation of the house not only allowed money to be withdrawn to make the payments on the house, it provided a life of luxury and the prospect of a well-funded retirement. It is a basic, but erroneous, principle of the Keynesian economic delusions under which we labor that such free lunches exist. The Keynesian idea is that the consumption engendered by deficit spending results in real investment to satisfy the demand for goods. Which investment then generates improvements in productivity, which in turn allow the debt to be repaid as output rises sufficiently to both cover demand and investment.

In order for this to work out for house owners, house prices had to rise much faster than general price inflation indefinitely. People saw how this could work. With interest payments near zero as a result of teaser rates or negative amortization, no principal amortization, and no down payment requirements, house payments became nearly independent of purchase price. This meant that almost anyone could afford to pay almost any price for a house. Stated income didn’t matter because income didn’t matter. So long as lenders believed and kept lending to finance ever-higher prices, it would work. And it did work for quite a while.

The consumption that this flood of lending encouraged did, in fact, lead to a huge surge in capital investment and the associated improvement in productivity. The trouble is, the investment was in China, India and other countries around the world where lower labor costs made the prospective returns on that investment much higher than in the US. So the investment didn’t result in any increase in real incomes in the US, although arguably the low cost imports did help to keep consumer prices down in the US and slow down the erosion of real incomes in the US. However, as the dollar continues to weaken this effect is diminishing and even reversing.

But a sizable minority wasn’t satisfied with a good thing and wanted more. So some speculators took advantage of the belief of lenders and defrauded them. Poster child Casey Serin showed how - take cash out on closing, then don’t pay. Foreclosures rose and lenders started to look at deals more closely, because foreclosures not only cost money, they make the lender look bad. This, of course, was the beginning of the end because when confidence starts to crack, it rapidly turns to mistrust. As lending tightened up, sales slowed, inventories rose and prices began to fall as lenders demanded higher payments, and buyers with marginal credit were removed from the pool of prospective buyers. Defaults then began to rise rapidly as fraud turned out to have been much more widespread than most, especially the lenders, had imagined.

House owners are, of course, dismayed by the loss of their free lunch. Consumption that was funded by rising house prices is rapidly disappearing and recession looms. Their dismay is immediately relayed to the political class, which responds with its promise to reinstate the housing free lunch or provide another, different, one.

The problem that faces the political class is necessarily that of rebuilding confidence. The Keynesian miracle hasn’t occurred, incomes have not caught up to consumption. Americans have spent more than they earned because they have had confidence that a “free lunch” will provide for their futures. Lacking such confidence, they will probably reduce their spending and resume saving a portion of their income for investment in their future. The inevitable result of this will be recession, because the economy is geared to provide goods for consumption, not for investment. It will take time to shift the economy, and output will be reduced while the shifting occurs.

First up is Mr Bernanke. He has acted first of all to preserve the illusion that the Federal Reserve can effectively deal deal with the crisis, and secondarily to convince the public that the problems with housing and credit will not impact economic growth. He has tried to do this by supporting the stock market with specifically-timed monetary policy actions, aggressively lending money to banks and broker/dealers, and by outright purchase of bad debt that was jeopardizing one of the Wall street firms, Bear Stearns. Rather than simply print money, he has acted to provide liquidity for bad or shaky assets by swapping it for cash or Treasuries. He has been successful to a considerable degree, but as he pushes the limits of his powers and regulatory remit he is increasingly seen as panicky, which is not helping confidence.

While the crisis was largely rooted in bad monetary policy, it is a mistake to believe that the solution lies in monetary policy. Especially not by repeating the policies of the past - cutting interest rates and pumping liquidity. The housing and economic problems are now real, and independent of monetary issues. Real in the sense that the housing stock is much larger than needed, and as a result much of it will be vacant for the foreseeable future. “Saving homes” is not the issue. Families will have homes regardless of whether they rent or own, there is more supply out there than demand as shown by soaring vacancy rates. Preserving “homeownership” by reducing foreclosures will simply have the effect of reducing rental demand still further. The issue is the “free lunch.”

The political class is enormously committed to free lunches already, with unfunded commitments to Social Security and Medicare that dwarf any realistic estimates of future revenues. It realises that Bernanke’s stopgap measures are simply protecting Wall Street  and that more is needed to reinstate the citizenry’s faith in the free lunch. After all  the promise of free lunch is what keeps them in office. The various proposals brought forward by the political class at this point are mostly about government, i.e. taxpayer, purchases of mortgages and mortgage securities. By various magics, the payments on these mortgages would be reduced so that existing homeowners would be able to afford them, and thus avoid foreclosure. Of course, this results in both immediate and future losses and the schemes differ in how they allocate these losses to lenders, security owners and taxpayers. But at the end of the day, new Federal debt would replace large amounts of mortgage debt, which would be held by some modern-day version of the Resolution Trust Corporation or the Home Ownership Loan Corporation. The idea is that this would then free up private capital to resume lending, providing support to the housing market and thence to credit markets in general. However there is no chance that private lenders will go back to the kind of reckless lending that was fueling the rise in house prices, so it is more or less inevitable that expanding the role of direct lending from government agencies will be the next step.

Even so, oversupply in the housing market will stall any price recovery for years. The political class will have to look elsewhere for the next promise of the free lunch. There is really only one place to go, and that is fiscal policy. The Bush administration has already started down this path in a small way with the $600/$1200 checks soon to be in the mail. But this is clearly announced as a  one-time thing and that will not make people change their longer-term intentions. So the government will have to start sending regular checks, assuring that they are reliable, in order to get consumption fired up again. They can’t just print the money, even Mr Bernanke knows that is the way hyperinflations get going. So they’ll have to borrow it. Will people lend?