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While most of our neighbours to the south were still recovering from their overstuffed Thanksgiving birds and Black Friday shopping bruises, U.S. equities were finishing off their worst week since 1932, a time when the Great Depression was living up to its name and panic was driving investor decisions.

Europe's worsening debt woes have been taking most of the blame for kindling the current market jitters. Friday, we had the Greeks suddenly demanding that bond investors accept not just haircuts but a complete shearing, Europe's leaders still trying to kick the can down the road and the Belgians getting hit with the latest credit downgrade. Which should not come as a surprise at this stage.

But the news closer to home was no more comforting. After several years of shedding debt and rebuilding depleted savings, U.S. consumers are still in no mood to rescue the economy. Sentiment has plumbed lows typically seen in serious recessions. That meshes nicely with the prevailing attitude of their banks, which are too worried about a surge in mortgage defaults, loan losses and other risks to be courting a lot of new lending.

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The Tea Party crowd won't like it, but if conditions get any worse, the best fix lies with a more activist Federal Reserve and a third round of quantitative easing, insists Paul Kasriel, the veteran chief economist with Northern Trust in Chicago.

Mr. Kasriel argues that the key to avoiding another recession and putting the U.S. economy back on a sounder footing lies in more credit creation. And if the banks can't or won't do it, the Fed must step in.

In the wake of the sub-prime fiasco and the near-collapse of the financial system in 2008, U.S. banks became extremely reluctant lenders, an economy-crippling condition that has only recently been showing signs of improvement.

Gone are the days "when mortgages were granted to anyone who could fog a mirror," Mr. Kasriel says. Today, even people with jobs, relatively clean credit ratings and enough cash to make a down payment are being turned away. One reason is that mortgage defaults and foreclosures are still rising, and banks worry they will be saddled with more losses. Similarly, small businesses with long-standing banking relationships have had trouble getting loans renewed.

Banks are still "holding lots of underwater loans on their books that they and the regulators know they're going to have to write down at some point," Mr. Kasriel says. "So they can't use their capital to support new lending, because they're pretty sure they will need it as a buffer against future losses in a year or two. They are concerned about their future capital adequacy."

Tight credit conditions have eased of late. And if U.S. banks continue to increase available credit, at an annualized rate of about 7 per cent – the level of the past 13 weeks – then QE3, as yet another round of quantitative easing would inevitably be dubbed, probably won't be necessary.

But what if the euro-scare and worries about their own capital cushions prompt U.S. banks to batten down their hatches again?

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This, Mr. Kasriel says, is where the Fed has to step in as the creator of credit that would otherwise be provided by the financial sector in normal times.

He offers a mercifully simple explanation of how this intervention might work. Suppose the Fed bought a Treasury bond through a dealer selling on behalf of a pension fund. The fund gets the cash, which appears "like manna from heaven. It didn't come out of somebody else's account. So there's net new cash in the system. The Fed, in effect, printed it, and the pension fund is probably going to look for some other security to replace the one it just sold."

That could come from a corporation issuing bonds to finance, say, technology purchases. "In that case, we have a net increase in credit that essentially came from the Fed and was created out of thin air. That's the essence of quantitative easing."

Critics complain that the previous two rounds of Fed intervention did more to inflate equity assets than aid the economy. And they fret over what further easing would do to long-term interest rates and inflation.

Mr. Kasriel argues that QE1, which ran from late 2008 to March, 2010, would have worked if the Fed hadn't reduced other sources of credit at the same time and if the banking sector hadn't also been cutting back drastically. "During that first quantitative easing [period] banks contracted credit by over $300-billion (U.S.). You have to look at Fed credit plus banking system credit. There was a net contraction."

In the next QE2 phase, from November, 2010, through the following June, bank credit remained essentially stable, and the Fed's credit injection added about $600-billion. The result was a pickup in domestic demand, he said. "So it worked."

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Fed chairman Ben Bernanke has no internal consensus supporting a more activist role. And Republican leaders have sternly warned against further intervention.

But failure to act could lead the U.S. down the same blighted road to nowhere as Japan. "That is the risk," Mr. Kasriel warns. "The encouraging thing is that our banks are lending now. But if they stop lending – if this is just an isolated 13 weeks – and there's political opposition to rational quantitative easing, that will be the outcome. Especially with what's going on in Europe."

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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