WHEN the inability of a few overstretched homeowners to meet their mortgage obligations results in the firing of the chief executive of Bear Stearns, the forced bail-out of a German lender, the suspension of three asset-backed funds by France’s largest bank, and the cancellation of several private-equity deals, attention must be paid, as Arthur Miller warned about his troubled salesman, Willy Loman. Nobody listened, and Loman committed suicide.

Market watchers and traders have not reached that point yet, but market volatility has led them to bite their fingernails in a way hitherto seen only by friends of Gordon Brown. And not only in America. The old saying that “when America sneezes, Europe catches a cold” seems to be apt today.

President George Bush took to the airwaves to assure us that “the fundamentals of our economy are strong, there is enough liquidity to enable markets to correct, and we are headed for a soft landing”. Unfortunately, this only prompted memories of similar assurances by Herbert Hoover, and failed to ease fears that problems in financial markets will bring down the “real economy”.

One trader says that until now all he worried about is what he didn’t know. But the BNP Paribas discovery that it could not determine the value of some of its funds came only a few days after its chief executive, Baudouin Prot, assured the markets that the bank’s exposure to the problems of the sub-prime mortgage market was “absolutely negligible”. So traders now worry about what the people who should know in fact don’t know.

In this atmosphere, almost anything the authorities do is taken as a sign that the situation is even worse than it seems. The European Central Bank (ECB) injected a whopping €140 billion (£95 billion) of liquidity into the banking system, and the Federal Reserve Board added $20 billion of liquidity to its usual seasonal injection. The ECB action led lenders to worry what problem the central bank has uncovered.

Main Street is not as convinced as Wall Street that the world is coming to an end. A majority of Americans say that recent movements in share prices have had no effect on their views on the nation’s economic condition, and 77% say that the recent decline in house prices had “no impact either way” on their own financial situation. To which many economists are saying, “just wait a few weeks”.

As they see it, there is more going on than a mere correction of too-loose credit. Companies that were planning to sell high-yield bonds to finance expansion have found that there are no takers. In July, only $2.4 billion of these bonds were issued, down 90% from $22.4 billion in June. More ominous, high-quality, investment-grade bond offerings from companies with impeccable credit fell from $109 billion in June to $30.4 billion last month. Unable to expand, these companies cannot create the jobs and rising incomes that a growing economy requires.

Consumers who want to buy a home – and there are some – are finding that banks are reluctant to lend them money, even if they have unblemished credit records. Worse still, adjustable-rate mortgages on some 2.5m to 3m homes will be “reset” next year, meaning that interest rates on some $700 billion of mortgages will rise, and with them defaults or, at least, a further contraction of consumer spending power.

Banks are finding that they can’t determine the value of many of their assets, which makes them illiquid. The observation of the great 19th century essayist Walter Bagehot that a banker has “no special means of judging” the creditworthiness of “people not his customers” has been ignored. In addition, American banks find themselves unable to syndicate – are stuck with, in plain language – some $200 billion of loans they have made to private-equity players. Not knowing what their balance sheets will look like when the current turmoil settles down, they are turning down many potential borrowers whom only a few weeks ago they would have showered with money.

Switch now to the real economy, or, as some would have it, economic fundamentals. The job market remains strong, with unemployment at a low 4.6%. Inflation is low. Stores such as Saks, JC Penney and Nordstrom are reporting strong sales, with expensive handbags and such items “flying off the shelves”, according to retail analysts.

Meanwhile, all eyes are on policy-makers. Larry Lindsey, the economist who crafted the tax cuts that the president last week credited with the $1,900 billion economic expansion since he moved into the White House, says the important distinction is between liquidity and solvency. Only if the liquidity crisis drives banks and other businesses into insolvency will the current troubles result in a recession.

That can be avoided if the Fed does what it is designed to do, act as the buyer of last resort for the assets that are now illiquid. That does not mean it should arrange a bail-out, for it is important that imprudent lenders feel pain, lest they repeat their errors sooner than they otherwise will. Bagehot urged central banks faced with a credit crunch to “lend freely at a penalty rate”.

Fed chairman Ben Bernanke might end up doing just that. So far, he has not been panicked into triggering a massive purchase of dicey mortgage-backed securities. Which is just as well since, even after the recent blood bath, share prices remain above last year’s levels.

This is really the first test of Bernanke’s skill and nerve since he succeeded the fabled Alan Greenspan. Scholars who blame the prolongation of the Great Depression of the 1930s on mistaken decisions by the Fed are hoping that monetary policy-makers get it right this time.

Irwin Stelzer is a business adviser and director of economic policy studies at the Hudson Institute

stelzer@aol.com

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