One of my favorite readers raises a question about the Zingales-Posner approach to addressing underwater mortgages.

Zingales’ solution is classic Chicago, and it assumes away all the real problems. Yes, we need modification programs in one way or another. But the core reason his idea hasn’t gotten traction has to do with the particulars of mortgage holdings. Banks are holding second liens on their books at hugely inflated rates; to modify or writedown these losses to reasonable levels would effectively destroy the top banks. Of course this highlights the insanity in hoping that TBTF banks can limp along with better regulation. But it’s this, combined with the various agency problems associated with how MBS pools work, that are real problems. Banks should be picking up on this stuff on their own and offering solutions. Most are not.

He also adds a sobering thought:

It’s sad, but the housing crisis has actually dramatically increased the role of the federal government in housing and banking subsidies. Fannie and Freddie have been pushed to originate horrible mortgages. The bailed-out banks have scaled up operations; confident that future bailouts will eliminate any risk. Government modification efforts are pushing huge subsidies towards banks. Under this environment–banks may go easier on credit. We may end up with an insane situation in which the government–through the Fed’s Consumer Agency–tries to get people to avoid cheap credit products; and in which banks continue to offer more and more credit aided by government-supplied loose money and credit guarantees.

Part of this issue has to do with a troubled global environment. As long as America imports a ton of oil and it remains a huge dumping ground for foreign capital; it’s currency will be cheap and non-tradable goods financed through credit will always be attractive.

One wonders what the appropriate mix of public policies is to tackle this potentially volatile set of circumstances. There is broad agreement that the global economy would profit from “rebalancing,” with the big next exporters consuming more and the big net importers consuming less. Yet for the big emerging markets, a strong net international investment position is a powerful form of self-insurance against an economic crisis. Substantive international cooperation is difficult to achieve in this environment.

Perhaps one could seek to directly influence the difficulties posed by oil imports by, say, electrifying the economy and relying more heavily on nuclear power. This, however, is a massive and expensive undertaking that would require a more far-sighted, effective government than the one we have or are likely to have.

Frustratingly, the government-supplied loose money and credit guarantees our loyal reader describes are also preventing downward pressure on housing prices that might aid cash-strapped families. And this is leaving aside the implicit cost to taxpayers — many of whom are those same cash-strapped families, who are likely to face higher net taxes in the future as we put in place broad-based consumption taxes and benefit cuts to deal with the coming public debt explosion.