There's More to Fear Than Fear

No, we haven't turned the corner on the banking crisis—we can't even see the corner. What's needed is a bold, massive jolt to the system.

Franklin Delano Roosevelt's first inaugural address is now known for only one sentence: "The only thing we have to fear is fear itself." But the audience at the time paid little attention to that line and the newspapers buried it in their reports the next day. As Jonathan Alter recounts in his book "The Defining Moment," the words that got the greatest applause were something more specific. "I shall ask Congress for the one remaining instrument to meet the crisis," FDR said, "broad Executive power to wage war against the emergency, as great as the power that would be given to me if we were in fact invaded by a foreign foe." The next day's headline in The New York Herald Tribune was FOR DICTATORSHIP IF NECESSARY.

We are not in 1933, and no one would advocate or encourage any such power grab today. But President Barack Obama will have to quickly start planning for a set of more extraordinary measures to pull the United States out of its current, unsustainable economic condition. The president has understandably focused his first few days on important campaign promises—ending torture, closing Guantánamo—but he will now have to tackle the biggest challenge facing the country. The American economy is entering its sharpest economic contraction since 1974—a recession that is likely to be the longest since the Second World War. But that's not the worst of it. The American financial system is effectively broken. Major banks are moving toward insolvency, and credit activity remains extremely weak. As long as the financial sector remains moribund, American consumers and companies—who collectively make up 80 percent of GDP—will not have access to credit, and economic activity cannot really resume on any significant scale. We have not turned the corner. In fact, we can't even see the corner right now. In Washington and in the media, we have all stopped thinking about the rescue of the financial system—that was last year's story—and moved on to the automobile bailout and now the fiscal stimulus. Debates have begun as to whether programs represent pork or investment, whether tax cuts should be preferred to government spending. But despite the injection of hundreds of billions of dollars, and the promise of many billions more, banks are still not lending. Without a functioning financial system, even a massive stimulus will not restore the economy to a normal growth trajectory. Japan tried to jump-start its economy with the world's largest fiscal stimulus in the 1990s. It did nothing for long-term growth in that country.

What about the actions taken so far? The $700 billion TARP, the various federal guarantees, the Federal Reserve's extraordinary actions? The outgoing administration has plausibly claimed that these have worked—in the sense that the financial system has not imploded. Paul Krugman, no fan of the Bush administration's approach to the crisis, acknowledges, "Without the bank bailout, the whole system would have collapsed." But the bailout has not solved the problem; banks are still buried under mountains of bad assets. And while the Bush administration has made mistakes—most of them clearer in hindsight—the Obama economic team knows that there is no simple answer to this extraordinarily complex situation. Britain, which was widely lauded for its first set of bank bailouts, appears to have stumbled in a second set of policies last week. This might be the time to recall screenwriter William Goldman's cardinal rule about Hollywood: "Nobody knows anything."

And yet the government has to do something. President Obama faces a terrible dilemma. He needs to act quickly and on a massive scale. Part of what has unnerved markets has been the incremental nature of the government's response. Will it bail out this bank or that one? On what terms? A broad systemic approach commits the government to one course—one solution—and does not allow for experimentation. It is also enormously expensive. And yet without large-scale action, the financial system will keep bleeding. The politics of this are even worse. The American public believes that we have already spent far too much money on bailing out the banks. But the economic fact is that we have not spent enough. Without several hundreds of billions of dollars, these organizations will remain zombies and the economy will remain paralyzed. Speed is also crucial. In U.S. policy-making circles in the 1990s it was customary to deride the Japanese government for its weak response to the bursting of Japan's real-estate and stock-market bubble—which led to more than a decade of economic stagnation. In fact the Japanese took drastic action: they injected capital into their banks, lowered interest rates and undertook a massive fiscal stimulus. But they waited for a couple of years before confronting their problems and that made the measures far less effective. The Federal Reserve has learned its lesson and has moved much faster than did the Bank of Japan. But will the American political system move any faster than the Japanese political system?

There remains a spirited debate over what should be done now. But at its heart everyone seems to agree with former Treasury secretary Hank Paulson's original diagnosis—the problem is that banks have huge amounts of bad assets (related to mortgages) on their books. These assets are "toxic" because they infect the rest of the banks' balances, making it difficult for them to operate. These assets must be disclosed, written down and quarantined for the financial system to start functioning again.

Some now argue for a national "aggregator bank" that would buy up all the toxic assets, still others for a set of government guarantees and insurance, others still for outright nationalization of the worst-off institutions. Paulson's January rescue of Citicorp seemed to use TARP money in an effective way, getting a large bang for the buck. Each policy has its merits and drawbacks, and I am not expert enough to judge which is the right approach. But it does appear crucial that the government's response be systemic. Ideologies need to be suspended in this period of crisis—we don't hear much about "moral hazard" anymore. We might temporarily limit practices that are causing a downward spiral—such as "marking assets to market," the practice of forcing banks to keep lowering the price of securities (even those that they do not intend to sell), which then forces them to raise more capital. Overall, the government must send markets a clear signal: it is futile to bet against us; we have unlimited tools at our disposal and will use them; and in the end we will win.

Tackling the banks will not be the end of these problems. As President Obama has often pointed out, until the housing market stabilizes, the crisis will continue. Housing is what underpins many of these toxic assets. If prices continue to fall, the assets will only become more toxic. A veteran investment banker, Thomas Patrick, has circulated an innovative proposal that would have Fannie Mae and Freddie Mac close out the securitizations and then refinance all the underlying mortgages, thus dispensing with the toxic paper and stabilizing the mortgages in one swoop. No matter what course is taken, the United States will run trillion-dollar deficits for years, the Federal Reserve will accumulate trillions on its balance sheet, and the American financial and mortgage system will have been semi-nationalized, whatever the euphemisms used to disguise that fact.

This current crisis has resulted in a deep erosion of American power that we have not fully understood. Even in the depths of the Iraq War, when much of the globe was enraged by George W. Bush's unilateralism, people everywhere believed that the United States had the world's most advanced economy and that its capital markets in particular were the most sophisticated and developed. American officials, businessmen and economists lectured far and wide on the need to copy the American system. That system is now seen across the world as a sham, a casino game in which highly paid participants mismanaged risk and highly respected regulators cheered them on. I have traveled to Europe, Asia and the Middle East in the past three months and am writing this from Canada. The attitudes of officials and businessmen range from shock to rage at what they see in the United States.

When he began his run for the White House, Barack Obama thought he could restore American power and leadership by righting our foreign policy, winding down the Iraq War, closing Guantánamo, ending torture. These are all important policies, and I am glad that he is pursuing them. But right now, the most important way for him to restore America's credibility and influence in the world is to rescue the American model.

Obama's rhetoric suggests that he understands this issue. But does Congress? Can the American political system rise to the challenge? The United States will have to enact extraordinary measures, many of them unpopular, run up huge deficits, then just as quickly start to unwind these guarantees and commitments, get onto a path of strict fiscal prudence, reform entitlements and bring our financial house in order. If we don't, the world will talk not of American power but weakness. America will be a model, all right, but of pride and its fall.