I spent a good amount of time studying economics before I moved to Birmingham to study theology. I was a pretty strong advocate of the modified classical/monetarist economics employed by the Federal Reserve under Chairman Greenspan and now Bernake. However, the more I have seen about the current economic crisis the more I am questioning those traditional models of economics.

According to the classical/monetarist model, the economy manages itself by money-flow. This is supply and demand at work- if more people demand a good, then more money flows to that market and the supply increases to match the demand. So the greatest way to encourage economic growth is to expand the amount of spending that is going on. This has to be carefully monitored though: we can’t just dump money into the system, all that will do is create inflation with little or no growth. To keep this balance, the Fed plays a back and forth game with the money supply by buying and selling bonds to the major banks, thus controlling how much money they have on hand to lend out.

Which is where the irony begins. Our managing of the economy has been based very largely on the credit industry. If inflation is getting out of hand, we try and cut back on the amount of loans banks make. If the economy is slowing down, we try to encourage them to make more loans. Our growth is sustained by credit.

What we seem to be realizing in the current economic crisis is that this pattern isn’t sustainable in the long-run. Our economy is now experiencing a huge credit bubble that has collapsed. The bubble was sustained not just by lots of housing loans, but by loans from bank to bank and credit agency to credit agency. Then, to make things really complicated, those loans were turned into securities and sold to other companies/agencies, who bought them using more loans. Now the bubble bursts. My company fails because others can’t pay back their loans, which means I can’t pay back my loans, which means another company can’t pay back theirs, and the cycle goes on. Since all this growth was based on money that no one actually had, the current collapse creates a massive domino effect in the order of a few hundred billion dollars!

This is ironic because the very thing that we have been relying on to sustain our economic growth is now the very thing that is causing a massive economic contraction.

Now, in a sense, that’s how a bubble usually works. An industry booms for a while, and then something goes awry and that industry collapses. What makes this especially interesting, though, is that its not just any industry. This is the industry which underwrites our whole economic system that is being shaken.

I see basically two options for the capitalist system: The first is the classical option- do nothing and hope the economy will fix itself. Given, however, the nature and the extent of this contraction, this will almost certainly result in a widespread, long-lasting depression that could lead to major social and political instabilities. Which might, in another twist of irony, bring us closer to the playing out of Marx’s predictions about the collapse of capitalist society than we have ever been.

The second option is to try and salvage the economy through a bail-out (what we have been doing) similar to the New Deal. The difficulty is that in the long run this just perpetuates the problem. This problem exists because our economy is built on credit, which means it can’t absorb the shock of a market failure like the one we are currently experiencing. Dumping more money into the system to try and stimulate more growth is like using the medicine that made us sick to try and treat the symptoms. Even if it works in the short run, in the long-run we still have the same root problem: an economy built on credit with no shock-absorbers and no way to sustain growth without more credit.

The end result of this second option could be a falling back into the first. This is a kind of worst case-scenario: arriving at the point where we literally cannot do anymore to stimulate the economy, so we are forced to do nothing and let the economy run its (almost certainly disastrous) course. I don’t foresee that happening in the major Western nations anytime soon, but there are concerns it might happen (or already be happening) in developing nations.

A complete solution to our foundational economic problems is going to require some sort of radical change to the underlying structure of our economic system. I’m not sure how we get there (at least without it being a very painful transition), but we have to move away from a dependence on credit and adapt to a more long-term, sustainable system of economic growth. Which is not to say that we need to abolish credit as a means of economic expansion. Credit is important in a lot of ways. People generally buy a house or a car via credit. I (along with most other students I know) am at least partially financing my education through credit. However, what this economic crisis is showing is that we cannot depend on credit as a primary engine of economic growth, which may mean a fundamental change in the way we manage the economy. What that probably looks like is a much smaller economy on a whole and maybe much more simple life-styles. And for a lot of industries that simply cannot be sustained without credit (for instance, the medical industry), there may be a need for socialization.