Are we facing the worst financial crisis since the Great Depression? If so, why?

The simple answer is “probably.” And we are facing that crisis in no small measure due to the actions that are taking place in Washington D.C. and not in the financial centers of New York.

The credit crisis of today has been brewing for a long time; more than a year ago you could read about the “credit crunch” hitting markets and businesses and of you need to go back years to find the root causes for the housing bubble.

But the problems of even a year ago did not have to become the crisis of today. Wall Street has weathered serious problems in the past without massive government intervention and without causing journalists and politicians to begin reminiscing about the 1930’s. What turned this particular problem into a financial disaster were the remarkably maladroit actions of policymakers in Washington D.C.

First, let’s acknowledge that imbalances in the market are at the root of the current troubles. There is no doubt that a housing and lending bubble formed, and that the popping of that bubble has helped lead us to where we are today. Others have shown how lending rules set by politicians and monetary policies set by the Fed helped distorted the market for housing, but even without those prods this or another asset bubble could easily have formed. Markets are not infallible.

The popping of bubbles are invariably painful, and it is no surprise that policymakers jumped in to avert as much of that pain as possible. In doing so they unwittingly helped transform the credit crunch into the current credit crisis.

Ironically, Washington’s initial attempts to stem the bleeding transformed the painful but necessary correction into today’s market rout. As in 1929 and the early 1930’s, it was government intervention into the workings of the market that turned a serious problem into a crisis.

In the 1930’s the government helped create the Great Depression by making a number of blunders that helped destroy the underlying financial system. In particular the Federal Reserve stood by as bank failures led to a massive contraction of the money supply, drying up credit and leading to massive deflation that destroyed the American economy. This time around nobody can accuse the Fed of being stingy with money.

So what did Washington do this time that was so damaging?

From early this year the Fed and Treasury seem to have been following what I would call a “reverse Goldilocks” strategy, doing both too much and too little and getting the policy just wrong.

It’s hard to date when exactly the financial crunch transformed into a full-fledged crisis, but a convenient starting point would be the bailout of Fannie Mae and Freddie Mac. It was at that point that it became abundantly clear that any chance of simply muddling through the credit crunch was not going to be possible. If the companies holding nearly 70% of America’s mortgages were on the verge of bankruptcy then just about any company might follow.

The Lehman Brothers bankruptcy followed closely the demise of Fannie and Freddie, and the AIG bailout came just a day after the government let Lehman fail. Continued...