A Prescription for Radical Surgery

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Even before the Treasury has spent a single dollar of its $700 billion fund, the markets have pronounced Paulson’s bailout as dead on arrival. All of the criticisms are right: the original proposal was too arrogant, delaying passage; the target should have been building bank equity, not buying bad loans; the Fed already had adequate authority to handle the bad debt problem, and so on.

But they also all miss the core point. Unwinding the excessive securitization and runaway use of leverage is too large and complex a problem for the technicians. Since there is no way to reverse engineer what regulators had allowed to happen, there is no way—at least within the parameters of government-as-usual—to avoid the catastrophe being generated as hedge funds (among others) liquidate their portfolios at any price in order to meet obligations. It is causing market prices to wildly overshoot, thereby causing yet more damage.

What is individually rational is producing collective madness.

Letting the downward spiral run its course as central bankers and finance ministers launch more bailouts and liquidity programs would be the modern equivalent of Hooverism. It isn’t working and could actually be making the problem worse.

It’s time for a New New Deal.

Instead of a bank holiday, we need a market holiday. Instead of closing banks, we need to close hedge funds. Only those that are solvent should be allowed eventually to reopen under federal regulation and guidance. We need to nationalize and liquidate the credit-default swap market, using the federal government’s power (and threat) of eminent domain as necessary. Instead of stretching out mortgage maturities, we need to rework interest rates and payment schedules to keep people in their houses and cash flowing to service the mortgages. That will take extraordinary action—as it did after 1932—and extraordinary caution to ensure that contract law is not permanently undermined.

And, of course, we need a profound revision of the financial regulatory system, from one based on rules to one based on principles. A rules-based system has proven too easy for smart financiers to manipulate, with disastrous results.

That amounts to radical surgery, but the patient is already on the operating table, and in cardiac arrest.

Designing and managing such a solution would take a president with a strong political mandate—but also a strong Congress and Judiciary to provide checks against the abuse of such concentrated economic authority. Are either McCain or Obama up to playing FDR?

- Alan Stoga