Prepare for the credit crisis to spread 

Münchau claims that "financial operations do not lend themselves to innovation", describing all historic bubbles as being "accompanied by a sharp rise in leverage". Meanwhile, the emergence of innovative financial products is a "salient feature" of modern bubbles and such innovations offer "significant potential for contagion" in a crisis, he adds. 

The "sheer size of the market" and the "euphoria" of the boom contribute to the exceptional size of the credit bubble, believes Münchau – adding that house prices are likely to be affected as well as the financial sector. 

Münchau claims that governments - rather than central banks – will be the main actors in the rescue operation, because the banks are currently less able to cut interest rates than during the last recession. 

This credit crisis cannot easily be stopped by "a few hasty rate cuts or bank bail-outs", warns the author. Stating that a positive interest rate could not bail you out "if your subprime mortgage exceeds the value of your house by 10 per cent […] and the monthly payments exceed your income", the only hope is "some serious debt relief", he adds. 

Münchau believes that the subprime market is not the only "unstable" part of the "very deep" credit market, warning that a crisis in credit card and car finance collateralised debt obligations (CDOs) may be to come, as well as similar problems with loan obligations. 

For Münchau, debating whether this is a crisis of liquidity or solvency is irrelevant, warning that bailing out banks is going to be insufficient and may not even be necessary. The fiscal and monetary authorities should assume that this is a solvency crisis and be ready to support the economy "if and when needed", he adds – most likely through lower interest rates and fiscal policy. 

The author is "convinced" that the US Federal Reserve and the European Central Bank will lower interest rates soon. Another concern for the banks is what Münchau terms "moral hazard", as markets expect central banks to bail out the financial sector during a crisis. He warns that for such a strategy to work, central banks must include asset prices in their policy frameworks. 

Münchau concludes that bailing out the financial system will become "unavoidable", though should be accompanied by structural policy changes. Tighter financial regulation, a new role for ratings agencies and changes to the monetary policy frameworks of central banks are all required, he adds.