The current credit crunch was caused almost exclusively by faulty government policies, as follows:

• Beginning early in the Clinton Administration, an elaborate network of federal agencies, state agencies, tax preferences, regulatory requirements, and other programs encouraged and subsidized housing, raising housing prices and enabling people to acquire homes they couldn't afford. With Democrats controlling both the Administration and Congress, the entire federal government put massive pressure on banks and mortgage originators to grant more mortgages to minorities and the poor. Beginning in 1992, Congress urged Fannie Mae and Freddie Mac to increase their purchases of mortgages for low and moderate income borrowers. In 1996, the Department of Housing and Urban Development (HUD) required F&F to supply 42% of their mortgage financing to borrowers with income below the area's median. In 2000, the target was increased to 50% and in 2005 to 52%. For traditional banks, the Community Reinvestment Act provided similar goals. First passed in 1977, the Act was "strengthened" in 1995, causing an increase of 80% in the number of bank loans provided to low and moderate income families. All these demands enabled the government to increase home ownership among poor people without counting the costs in the federal budget. Over time, mortgage requirements were eased. Borrowers could pay less than the interest owed each month, with the shortfall added to the principal balance. (Those loans are recalculated periodically. Hundreds of thousands of them will be recast in the spring of 2009, probably causing a wave of delinquencies. Even more will be recast in 2010 and 2011.) Homeowners were encouraged to borrow even the downpayments. With no skin in the game, they can readily walk away and let the bank foreclose. Mortgage companies were encouraged not to check the income and financial statement of borrowers. "Alt-A" mortgages, sometimes referred to as "liar loans," were obtained by people with middle income. Exaggeration of income and net worth among this group was particularly widespread. For mortgages originated in 2006 and 2007, when lending standards were loosest, delinquencies will be especially high.

• For several decades, Fannie Mae and Freddie Mac borrowed money at very low rates, because everyone expected the federal government to support them if worst came to worst, as indeed it did. But homeowners didn't receive low rates; no, F&F charged regular rates. Wide profit margins resulted, which were paid to F&F executives, federal legislators, and liberal organizations. (One of the most favored organization, ACORN, engages in fraudulent electoral practices to maximize Democratic votes.) In the past decade, F&F paid more than $170 million for lobbying. In 2003 and 2004, Fannie and Freddie engaged in egregious accounting scandals. Following this, to curry favor with Congress, they committed even more heavily to the financing of "affordable housing." Subprime and Alt-A mortgages rose from less than 8% of all U.S. mortgages in 2003 to over 20% in 2006. After 1996, Congress enabled F&F to take ever more risks, and committee chairmen restrained regulators from preventing it.

• Congress has foolishly given the Federal Reserve Bank a dual mandate: to keep prices stable and maximize employment. These goals conflict. Following the dot.com bust (for the cause of that problem, see my column dated 3/3/03), the Fed flooded the world with an excess of dollars in an effort to prevent unemployment. This helped carry real estate prices to record highs. (The European Central Bank has only one mandate: to keep prices stable.)

• A few months ago, the Financial Accounting Standards Board, looking in the rear view mirror at the Enron scandal, required banks and other institutions to record their financial assets at current market values. This is all very well for liquid assets, like Treasurys, but it's disasterous for illiquid assets, like bonds and derivatives based on mortgages, which are likely to pay off in the long run but have inactive markets in the short run. Since the mark-to-market rule is enforced by the SEC, financial companies have marked down these illiquid assets almost to zero. When asset values fall, institutions required to maintain constant leverage, as many are, must liquidate assets to enable them to reduce their loans. This causes asset prices to fall all the more, and the process repeats. (As a general rule, government regulations on financial markets cause more harm than good.)

• Sophisticated financial instruments and ever-more capable computers enabled companies placing mortgage loans with homeowners to subsequently sell them to investment bankers, like Lehman Brothers, enabling the originators, with their coffers replenished, to sell additional mortgages. The investment bankers pooled mortgages of similar types and sold them in the form of bonds. All major parties in mortgage financing created derivatives, which transfer the risk of mortgage defaults to other parties in the derivative transaction. This entire process, called "securitization," spread mortgage risks throughout the world. Until the 1990s, banks generally retained ownership of the mortgages they sold. But after securitization, no single party owns a particular mortgage. The risk of default is spread among many parties, which caused most people to disregard risk. Securitization turned mortgages into liquid securities, but unfortunately, these were generally financed by short-term debt, making the holdings vulnerable to market changes. In 2008, the sudden appearance of risk caused short-term markets to freeze, making the mortgage bonds and derivatives unsaleable. (No one should expect regulators to have prevented any of this. Government regulators can do no more than confront the last problem, not the next one.)

Consumer debt has risen too high in relation to disposable income, from 100% in 2000 to 140% now, and house values are no longer available as ATM machines. Bank loans are being less available. Unlike investment banks, whose money is invested in financial assets, bank loans tend to be invested in real assets. As bank loans decline, the real economy will be affected, causing problems among prime mortgages, consumer debt, student loans, auto loans, money market funds, auction-rate securities, and corporate loans, especially commercial real estate loans.

In the last quarter-century, global financial-sector debt has risen five-fold in relation to the world's GDP. A global recession seems likely, lasting into 2009 and possibly 2010, during which time the world's financial sector will return to normal levels.

The Federal Deposit Insurance Corporation (FDIC) has only $53 billion of funds. This is too low, because, in the 1990s, when conditions were favorable, the government foolishly reduced the insurance premiums charged to banks. Almost 15% of FDIC's capital is being used to bail out IndyMac alone. Banking experts estimate that at least 8% of U.S. banks (about 700 of them) are in serious trouble. The FDIC's watch list now contains only 117 banks. (Indy-Mac wasn't on the list until just a month before it collapsed.)

The IMF estimates total credit losses of $945 billion. Goldman Sachs estimates $1.1 trillion; UBS $1 trillion. Hedge-fund manager John Paulson estimates losses of $1.3 trillion, and Bridgewater Associates estimates $1.6 trillion. The banks have written down only about $300 billion of subprime debt. The recession is likely to be nasty. Although I'm bullish for the short term (something like a few months), I look for the Dow eventually to fall to approximately 8500, meaning that the bear market is about half over.

In the eventual recovery, thrift will replace leverage and capital will be invested more productively. I expect recovery to be most rapid in emerging nations, especially China and India. The world economy will become more balanced in the future, relying less on the U.S. Accordingly, in the portfolio suggested in this website, I have increased foreign ETFs to 35% and cut U.S. ETFs to 25%.

What you should do about all this depends on your knowledge and personality. As a test, imaging that you held cash during the recent panic selling. Could you see yourself investing that cash right in the thick of the pessimism and uncertainty? If not, don't raise cash now, because you're likely to delay reinvesting until the problems seem resolved. But by that time, prices will probably be higher than they were when you sold. Fewer than 1 percent of people with investments have the knowledge and emotional makeup to engage in market timing consistently and successfully. Ride through the storm. Eventually, the sun will shine again.