It’s pretty clear to everyone that the financial industry is not doing what it normally does, which is to extend credit and lend money. Just as clearly, the decline in new credit formation leads to deflation in risk-bearing financial assets, and a sharp contraction in overall economic activity.

Less clear are the implications for policy and for business forecasting.

Businesspeople are simply confused about the future direction, and waiting for signs of a bottom.

But policymakers are seeking to deny reality. They imagine that the financial system is just hitting a bump in the road, and that it’s somehow possible to return to the world of 2006, but with better regulation.

There are two fundamental factors which are reducing the amount of credit being extended by banks and other financial intermediaries: the end of the housing bubble, and the end of highly leveraged financing models. Both effects are permanent rather than cyclical.

It’s simply impossible to lose so much value from housing, and not feel the effect on the balance sheets of lending institutions. It’s been estimated that total losses from housing-related assets (including mortgage-backed securities) may reach as high as two trillion dollars.

Those losses get taken by the equity capital of the banks and other institutions that supplied the credit that enabled the housing bubble. Until that capital gets replaced, a long slow process, credit formation will be severely curtailed.

The other critical effect is that leveraged, short-term finance, as practiced over the last several years, probably won’t come back. Leveraged financing models, like the ones used by Bear Stearns and other investment banks, depend on being able to borrow huge amounts of money at reasonable interest rates every single night. The borrowings are used to finance portfolios of longer-dated, higher-yielding assets, like mortgage-backed paper.

It all works beautifully. Until the night comes that for one reason or another, you can’t roll over your financing. That’s how Bear Stearns got killed. And the end of the leveraged financing model eventually took the rest of the Wall Street investment banks with it.

The two that (for now) remain independent, Goldman Sachs and Morgan Stanley, have converted from investment banks to bank holding companies, a structure which subjects them to much tighter regulation. But in return, they’re now permitted to take deposits from the public, which is a much more stable source of funds than overnight borrowing in repo or money markets.

The overall problem for the global economy comes from the fact that these two permanent effects are combining to sharply reduce the amount of capital available for extending new credit.

Losing two trillion dollars in equity has an obvious impact. The leverage situation is more subtle. People are no longer able or willing to participate in financing structures with leverage ratios as high as 30-1 or more. And that puts a much lower limit on the amount of assets they can buy. Since those assets are the means through which credit becomes available to businesses and consumers, it follows that overall credit formation is far lower.

In essence, we’re moving to something much closer to a “real-money” economy. This takes a lot of the speed, innovation, and risk-taking out of the global economy, because the people who are making credit decisions are the ones with actual money to put to work. (In the more leveraged model, the slow-moving traditional banks would lend money to hedge-funds, private-equity firms and investment banks, who would then make the riskier investment decisions.)

Another way to look at this, is that the “shadow banking system” has gotten much smaller, and will remain permanently smaller. To people who blame financial deregulation for the current crisis, this is a very good thing. But again, it means that most of the speed and innovation will go away. And financial innovation is a big part of what has been increasing prosperity and reducing poverty around the world for two decades now. To lose so much innovation is by no means an unmixed blessing.

Another consequence is that the value of all financial assets (including equity, which is based on the value of corporate earnings streams) will be permanently reduced. This effect looks and acts a lot like deflation, although it arises from the fact that less capital is available with which to buy the assets.

We could conceivably address this problem by re-enabling the high-leverage financing models. That would make more dollars available to buy the existing pool of assets, and therefore pump up their prices. But there are two problems: first, the regulators will have none of it.

Second, and far more importantly, the markets will have none of it. We all learned in this crisis that our risk-management models are far too fragile to trust at really high gearing ratios.

So what should we do about all this by way of policy?

In terms of the reduction of housing values, policymakers (first and foremost at the FDIC) are seeing the problem in political rather than economic terms. Their paramount goal is to keep individuals from losing their homes to foreclosure.

To this end, FDIC chief Sheila Bair (who by the way is among the very few senior officials being carried over from the Bush to the Obama Administration) has been pushing a set of policies designed to prevent mortgage foreclosure at all costs. This misbegotten plan is having all kinds of perverse consequences, such as encouraging distressed homeowners to literally quit their jobs (because they get more assistance if their mortgage payment is a higher percentage of their income).

But the biggest perverse outcome of all, is that the housing market is not being allowed to clear. The goal of policy is to deny that houses have lost value, and to try to pin them (and their mortgages) at an artificially high value.

This is like trying to push water uphill. Eventually you get wet, but the longer you try to keep that from happening, the more time, energy and money you waste. In this case, the waste appears as a continuing misallocation of economic resources to housing. The FDIC is madly trying to keep the housing bubble pumped up.

The other way that orthodox policymakers are trying to deny reality is by misreading the cause of the current deflation. The hope is that we can counteract deflation by engineering a huge pulse of inflation through the expedient of fiscal stimulus.

This would basically divert a lot of money from foreign central-bank reserves into the US economy. We’re going to replay the experiment of the mid-Thirties, using fiscal deficits rather than higher taxes as a funding source.

There’s no doubt that this will increase measured GDP somewhat, and may even reduce unemployment somewhat. What it WON’T do is relieve the deflation of financial assets, because it does nothing to address the reasons for the deflation. Those reasons, as I’ve said, are capital losses and reduction of leverage.

The world economy simply has to settle at a lower overall price level. That doesn’t mean there will necessarily be less economic activity over the long term. It does mean that overall returns to capital will be lower than in the past. Trying to deny this reality will result in real waste and real pain.