Seven Suggestions for Dealing with the Banking Crisis

The global credit market sickness and the knock-on impact on the broader economy is, I'm afraid, far from over. The world's largest economies binged on leverage to bid up asset prices and spend beyond their means. Following the sacking of this regime of false confidence, the supply and demand curves for credit have both reset at sharply lower levels. And with each passing day providing ongoing evidence of collateral damage ricocheting around the global economy, I'm increasingly suspicious that a depression-like collapse of asset prices, economic activity, and employment levels might represent the inevitable outcome. The cooperators--especially Asian and Middle Eastern countries with large export surpluses--that provided financing and cheaply priced goods seem no better off as the profligate old ways of their customers rapidly fall away.

Ignoring political reality for a second, there are two choices available to the United States. The first is to let the system reset without massive government intervention in the financial sector. If the bleak scenario above holds true, then the government shouldn't be risking the all-in bet it is currently making. By taking massive credit risk based on current cash flows and asset prices, the losses in a collapse scenario are guaranteed to be stupendous and will simply be transferred from the private to the public sector. Government officials instead bear a tremendous responsibility to defend the federal balance sheet in order to act as the (discriminating) provider of credit, spending power, and humanitarian aid of last resort during the tough times ahead. This approach need not mean blindly employing a hard-headed approach of laissez-faire capitalism. It would still make sense to--following the most basic lessons from the Great Depression--continue to insure bank deposits and provide for an orderly wind-down or sale of failed financial institutions in order to prevent panic regarding bank savings and the payment system at large.

The obvious result of the minimalist approach would be a wave of cascading financial and corporate failures (even if orderly), massive wealth destruction from deflating real and financial assets, and a resounding loss of confidence. Many would argue that all of this will happen anyway--and they've got a point. After all, it's unclear what the massive intervention so far has actually prevented. Others, including myself, would point out that many sound banks and corporations would fail merely due to the domino effect (subsequent failures of the weakest and then the next-weakest bank, etc.) and the lack of perfect information among counterparties during a period of extreme uncertainty, needlessly amplifying the damage.

But the first option--the minimalist approach--is really a moot point. To put it simply, we've already crossed the bailout bridge and it's difficult to go back. Politically, it would be a near impossibility. So, enough with the Monday morning quarterbacking, let's take up the second approach--the activist one--and ask how should we proceed if we are to continue with our activist bent, choosing hope over fear?

I'd offer that we need a comprehensive and coherent package of action plans that are self-reinforcing, rather than being expedient with one hand and populist and self-defeating with the other. What's more, let's give up the reckless dream of rapid reflation, releveraging, and relief from anything that resembles responsibility. If the root cause of our current plight is overleveraging and overspending and the immediate symptoms are busted loans and rapid asset price deflation, let's instead work to make the transition toward increased savings and thrift as orderly as possible.

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