Investors have been disappointed by the Obama administration's lack of specifics regarding its "bad bank" plan to remove soured assets from bank balance sheets. This week, Federal Reserve ex-Chairman Alan Greenspan added his voice to the debate, when he recommended that the government consider wholesale bank nationalization, Greespan calls it "the least bad solution." And he's right.

"When the facts change, I change my mind -- what do you do, sir?"
Like Greenspan, I'm a free marketeer, yet I accept the idea of nationalization under extraordinary circumstances. When the facts change, you're better off imitating Keynes and changing your mind. For one thing, nationalization is already upon us. The government has seized control of mortgage giants Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), as well as troubled insurer AIG (NYSE:AIG). Furthermore, if we exclude a muscular response from the government on troubled banks, the outlook for an economic recovery is pretty bleak.

The Japanese gave us a blueprint of what not to do in the 1990s: dither about, and ignore the reality that important parts of the banking sector are insolvent. That approach gave Japan a "lost decade" of economic stagnation. We are now faced with the same situation: As Martin Wolf pointed out in the Financial Times, the fundamental problem of the U.S. banking sector is not one of liquidity, it is one of solvency -- i.e. where the liabilities of certain banks exceed their assets.

Dealing with the three categories of banks
In that respect, I'd rather salute Greenspan's pragmatism than criticize him: It would be foolish to maintain a rigid free-market stance when you are faced with distressed institutions that are "too big to fail." (To be fair, free marketeers would resist letting any institution become too big to fail from the outset.) Institutions in that category -- Citigroup (NYSE:C) certainly comes to mind -- should be nationalized and recapitalized before being broken up, with the separate units eventually privatized.

The institutions that don't pose a systemic risk and are insolvent must be allowed to fail. Finally, those that are reasonably fit, such as JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), and US Bancorp (NYSE:USB), should be left to go about their business without undue interference from the government.

Let's not turn Japanese
There is no room for "zombie banks" if we wish to pull the ailing U.S. economy out of its morass. Failing that, we need only look at Japan's experience to get a glimpse of the disastrous fate that awaits us; yesterday, the broad-based Topix stock index in Japan came within 5 points of closing at a 25-year low.

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