Tomorrow’s paper in America will tell us what the Fed is up to. But whatever it does, the answer to the ‘what happens next’ question depends on where you are; if you are at the beginning or the middle of a credit expansion, you get one answer. If you are at the end, you get a much different one

If there is one thing you can count on it is that developers, bankers and farmers will over-do it. They all go bust every 10 years or so. What is hurting the banking industry now is subprime lending. But don’t worry. We live in an age of Zoo Capitalism, and the keepers are supposed to make sure the animals don’t get hurt.

Credit, it turns out, soon reaches the point of diminishing returns. During the entire period up until 1980, it took about $1.40 worth of extra credit to produce a single extra dollar of GDP. Since then, the ratio has deteriorated. And now we seem to have passed the top of the credit cycle, with the credit industry unwilling to pony up more cash and output falling.

The fall in the value of subprime-linked securities has boosted a group of funds which spotted the problems in advance. The decision to use derivatives to short, or bet against, low-quality U.S. home loans taken by a select group of hedge funds last year appears to have become the most profitable single trade of all time.

Isn’t it wonderful how government can make things better by decree? By edict! By passing a law! Spend too much money? Running a little short? Don’t worry about it; we’ll print up some more. Who says government can’t be a positive force?

A second devastating wave of writedowns from major banks has rocked confidence. To add to the gloom there are mounting fears that the problems could engulf other types of American debt – credit cards, car finance and unsecured loans.

Banks typically borrow short and lend long. But when short rates are so high, how can they make any money lending for long-term mortgages? They can’t. So they stop lending. And without ready mortgage credit, buyers stop buying houses. And when buyers stop buying houses, house prices fall.

The 10-year note already yields less than 4%. Bonds have been falling since June. They are just another of the many signs of deflation – of a draining away of credit, cash, liquidity – from the markets. Now the Fed is no longer driving inflation; it is trailing along behind deflation, trying to keep up with it.

“Pushing on a string” is an expression that describes what happens when a deflationary spiral gets out of control. The financial authorities can offer more money on better terms, but the banks and the borrowers are already having trouble paying off the debt they’ve got; they don’t want any more. Besides, they’re not too sure that others will be able to pay their debts either.