With his recent rate cut to just about 0%, Federal Reserve chairman Ben Bernanke has run out of bullets. Upon firing that last round, he predicted that the economy would remain weak for quite some time.

It's a pity he feels that way, especially since there's a simple, four-step plan that will do wonders to help get our economy back on track.

Step 1: Restore the Rule of Law
Perhaps the most devastating part of this financial crisis took place when Washington Mutual collapsed. When it handed WaMu's assets over to JPMorgan Chase (NYSE:JPM), the FDIC trampled on the very important bankruptcy concept of "Absolute Priority." By shafting debt holders' claims in the deal, the government sent a very clear message that it was a bad idea to loan any money to companies that needed the cash.

It's no coincidence that the lending market froze shortly after the WaMu seizure, and it hasn't completely recovered since. For there to be any chance for the debt market to recover, whatever laws enabled that fiasco need to be rewritten to assure bond investors' due process rights to company assets in bankruptcy are protected. Otherwise, private interest rate spreads will remain high, no matter how much cash the Federal Reserve gives away.

Step 2: Protect the Innocent
That being said, the reason the FDIC acted the way it did was because its insurance fund was at risk of being depleted. It's certainly not the insured depositors' faults that the FDIC neglected its primary responsibility of assuring its insurance fund was adequately capitalized. Insured depositors rightly thought they had a government-backed guarantee on their savings.

If there were any legitimate use for bailout cash, it'd be to temporarily backstop the FDIC's insurance fund to assure insured depositors could be made whole. Even then, the bailout wouldn't have needed to be permanent. In bankruptcy reorganizations, liquidations, or court-supervised sales, the FDIC could have stood in line ahead of other creditors to be made whole.

Step 3: Restore Banks' Willingness to Lend
As part of its rescue attempts, the government has stopped foreclosures when it takes over failing mortgage lenders like IndyMac, Fannie Mae (NYSE:FNM), and Freddie Mac (NYSE:FRE). The strategy instead has been to modify loans to attempt to keep people in their homes.

Unfortunately, the track record of loan modifications suggests that strategy doesn't really work well. A recent study showed that around 53% of all modified loans again fell delinquent six months after modification, and 58% did so within eight months. To make matters worse, there are signs that some borrowers who can pay are intentionally skipping mortgage payments in order to get their loans renegotiated.

As predicted a year ago, banks are curtailing their lending in an environment where their contracts can be rewritten on a whim and they lose their main means to protect their investments. Without the ability to foreclose if someone fails to pay, banks have no incentive to make mortgage loans at low rates. Restore the credible threat of foreclosure and the lending market will have a real chance at recovering.

Step 4: Rein in the Federal Reserve
As the country's central bank and lender of last resort, the Federal Reserve should play a part in maintaining a functioning and healthy financial system. But when it hands out free money, it actively crowds out private capital.

For banks to ultimately recover they need to have the ability to attract deposits, not just coerced bailout cash and free Federal loans. But if a bank can get virtually unlimited supplies of essentially free money from the Feds, why would it keep offering rates above that to its depositors? As of December 16, the day the Federal Reserve shot its last bullet, this was all banks were offering to tie up your cash for a full year:





Capital One (NYSE:COF)


Allstate (NYSE:ALL)


Discover (NYSE:DFS)


Source: Bankrate.com.

Since the Federal Reserve plans to aggressively buy government debt to lower rates, you can expect those savings rates to drop even further. If banks aren't offering much in the way of interest, what exactly is the incentive for people to deposit money? Without deposits, where can banks go to get money to lend?

The rational principles for a lender of last resort dictate that the Fed should be lending at penalty, not cheap interest rates. For the banking system to fully recover, those principles need to be restored.

Let the economy recover!
It's not rocket science -- just common sense and the restoration of the bedrock principles that have served our country and market for generations. Given how poorly the government's current strategy has fared, isn't it worth a shot?

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.