We’re all aware of the well-established economic theory that higher interest rates choke off borrowing and economic activity while lower interest rates fuel borrowing and economic activity. There are numerous critical assumptions that support this contention but one, in particular, is quite interesting.

• Perfect knowledge prevails in the economy, i.e., all players possess – or can quickly acquire – perfect knowledge about any economic or financial event, which helps assure the free and unimpeded flow of goods and services in response to changes in market conditions and events.

And if this assumption doesn’t hold up, what would we expect to see?  Likely very much what we are, in fact, seeing today – a massive reluctance to open the credit spigots regardless of how far the Federal Reserve pushes down interest rates.

Obscurity, not perfect knowledge, is the present operative force in the financial and credit markets.  As the CEO of Bank of America recently commented “…none of us know what inning we’re in…” underscored by a further remark that the extent of future write-downs for collateralized debt obligations (CDOs) is “…unknowable…” If these sentiments are at all applicable beyond Bank of America, banks don’t know themselves the extent of the potential disasters in their own portfolios, let alone the extent of potential disasters in the portfolios of banks they would otherwise lend to.

But there is always the consumer, whose spending accounts for 70% of gross domestic product (GDP).  As much as 10% of consumer spending was financed by home equity loans of one variety or another as housing prices accelerated until the middle of 2006.  That translates to about $250 billion per quarter in cash withdrawals against home equity values.  In the third quarter of 2007, however, the cash withdrawals decreased to about $170 billion, reflecting more stringent credit standards and falling equity values.  By one estimate, if housing prices fall by 20%, almost 14 million homeowners will be confronted with negative home equity, i.e., the debt on their property will exceed the property’s market value.  Could housing prices possibly fall by 20%, given that they have already decreased by 5% on average?  Possibly, since housing prices at their peak in 2006 were 30% above the historical relationship between housing prices and rents or income.

There is another problem with consumer lending.  Critical ultimate investors in consumer debt – such as pension and investment funds that bought billions of dollars of packaged residential, automobile, and credit card debt – have lost their voracious appetite for bundled consumer debt in the wake of the mortgage-backed security debacle.

We can hope that lower interest rates may help alleviate these credit problems.  But the more likely resolution to the current credit crunch is increasing transparency and better knowledge – better knowledge about bank portfolios and better knowledge about consumer credit quality – which will be slow to emerge.  As the chief economist at Lehman Brothers recently suggested “…the housing shock is a slow moving shock.  It’s not like a spike in energy prices…”