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We're battered and bloodied and hanging on the ropes for survival as a result of the current financial crisis. Alas, nothing we've tried so far has helped all that much in protecting us from the barrage of devastating body blows.
We've bailed out Bear Stearns, Fannie Mae (NYSE: FNM ) , Freddie Mac (NYSE: FRE ) , and AIG (NYSE: AIG ) , and that didn't bring much relief. The Fed has cut interest rates several times, and that hasn’t been terribly effective either. We even stood aside and let Lehman Brothers go bankrupt. And that really, really didn't go very well.
Despite all of this activity, credit markets remain clogged and equity markets are being gutted -- some blue-chip companies like UnitedHealth Group (NYSE: UNH ) , Alcoa (NYSE: AA ) , General Motors (NYSE: GM ) , and Merck (NYSE: MRK ) have seen their share prices decline by more than 50 percentage points so far this year. On Tuesday, Oct. 14, the government detailed a promising plan to inject $250 billion into America’s banks, but much more needs to be done. Over the past few weeks, economists have put forward some bold new ideas for getting us out of this mess. Let's consider what they have to say.
The dismal science strikes back
Among the economists making the rounds lately have been recent Nobel laureate Paul Krugman and Nouriel Roubini -- whose prescient forecasting of this catastrophe has earned him the nickname "Dr. Doom." Here are three policy prescriptions that have been put forward by these and other economists:
- Recapitalize the banks.
- Stabilize the housing market.
- Increase aggregate demand.
An overall strategy that pursues all three of these aims simultaneously might be most effective, according to some economists. Unfortunately, the gathering global recession will only make it harder to make headway on all of these fronts at once.
Many economists recognized early on that we needed to recapitalize our banks. Under this approach, the government injects cash directly into the banks in return for an equity stake in these institutions. To many commentators, this seemed to be preferable to the aim of the original bailout plan, which was to buy up toxic assets. Treasury Secretary Henry Paulson has finally been won over to the policy of “sticking capital into the banks,” as evidenced by the new rescue plan that was announced last week.
It is hoped that this policy will eventually unclog the credit markets, though it's likely that a lot more than $250 billion will be needed for this. And there are worries that the banks will hoard the cash, thereby undermining the intent of the program.
Getting our housing in order
The current financial crisis started as a result of the collapse of the housing bubble, and it's unlikely to be resolved until the housing market stabilizes. Roubini has called for “a temporary freeze on all foreclosures,” a policy which Sen. Barack Obama also supports. For his part, Sen. John McCain wants the U.S. Treasury to help refinance troubled mortgages.
Addressing the housing problem directly makes perfect sense according to Luigi Zingales, an economist from the University of Chicago. In his Plan B, he notes that “if homeowners continue to default and walk away from their houses, the banking sector will continue to bleed and additional equity infusions will be needed.” Zingales proposes that Congress pass a law that allows eligible homeowners to renegotiate their contracts with lenders. His argument is very compelling, though one wonders about the daunting logistics of implementing such a policy.
The final strategy to be considered hearkens back to John Maynard Keynes, who felt that increased government spending was necessary to pick up the slack in aggregate demand caused by a depression. Both Roubini and Krugman propose that generous public spending on infrastructure projects, unemployment benefits, and tax cuts to lower-income households should be implemented to counteract the deflationary pressures of a global recession. According to Krugman, we need to spend boldly and not worry about the deficit at the present time.
Keynes once suggested that it would be a good thing in recessionary times for the government to bury bank notes, and then let the private sector literally dig them up. He added that it would be preferable to build useful things, but that buried money would be better than nothing. And at a time of record deficits and a mounting national debt, the call for additional government spending might meet stiff resistance from voters and politicians in the coming months.
Will any of this work?
There are a lot of great ideas out there, but so far there is very little reason for optimism. Any solution will require a lot of trial and error, and every citizen will be required to evaluate the latest theories being floated by the economists. There's no need for ordinary folks to be intimidated by all that learning, though. Ben Bernanke, who has been at the wheel as this bus veered into the ditch, was a scholar of the Great Depression before becoming the chairman of the Fed. How's that for irony?
Have some better ideas? Add them to the comments box below.
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