We can beat this crisis

A few of F.D.R.'s advisors thought capitalism had failed and wanted him to nationalize the banking industry permanently. The President instead adopted a plan drawn up during the Hoover administration: The strongest banks began reopening, with government endorsement, as soon as the bank holiday ended, while the weakest were shut permanently. Those in between (about 45% of the country's remaining banks) were put in the charge of government-appointed conservators and recapitalized with government and private money.

Later came the creation of the FDIC, which insured bank deposits, and a revamp of the Federal Reserve System that pulled power away from the squabbling regional Federal Reserve banks and centralized it in Washington. It was a pragmatic approach to fixing the financial system, not the product of any well-articulated economic worldview. But it worked, mainly by restoring confidence.

That's part of the lesson of 1933 - that sometimes just doing something, as long as you do it decisively enough - can end a crisis. But a pair of economic breakthroughs that emerged after the crisis ended have also played a huge role in how officials respond to crisis today. One came from Irving Fisher of Yale, the other from John Maynard Keynes of Cambridge.

Fisher believed the economy had become stuck in a cycle of debt and deflation: Households and companies borrowed too much and then were forced by some economic shock to start scrimping and selling assets to pay their creditors. This thrift and panic selling drove prices down, in turn making it harder for debtors to avoid default, bringing on more selling, more price declines, and so on in a terrible downward spiral.

The best way to stop it, Fisher argued, was for the Federal Reserve to forget about just being a lender of last resort and print money - lots of money. (By "printing money" we mean buying Treasury bills and thus driving down interest rates.) And then keep printing it until, to get all jargony, inflationary forces counteracted the deflationary ones.

Keynes didn't disagree with Fisher's account - he just didn't think such monetary action alone was powerful enough to lift an economy out of the Depression. Instead, he argued, government needed to counteract the ever-more-miserly tendencies of businesses and consumers in a downturn by spending with abandon. It needed to become the spender of last resort.

You've probably heard of Keynesianism - it was behind the $167 billion in tax rebate checks sent out earlier this year and the gigantic deficits the country is sure to run for the next couple of years, no matter who is elected President. Fisher remains in ill repute for his September 1929 claim that stock prices were on a "permanently high plateau," so nobody talks about Fisherism. But some of his ideas were revived by Milton Friedman in the 1960s - and are now at the core of how central bankers like Bernanke, a student of the Depression, view the world.

It is today's bipartisan (if usually unacknowledged) acceptance of the arguments of Keynes and Fisher that explains why economists generally don't think we're headed for a repeat of the 1930s. Everything else might go haywire, but the Fed can keep the overall price levels from falling and the government can keep spending going.

That isn't the whole story, though. In the heavily regulated environment of the mid-1930s through the early 1970s, financial panics were unheard of in the U.S., and inflation and stagnation were the biggest dangers. But globalization and deregulation began to change that. Several big banks failed in the 1970s, and old-time financial crisis returned to the scene with the 1987 stock market crash - which quick Fed action kept from turning into anything worse.

Then came the 1990s, a decade replete with panics and crashes around the world. Most occurred in emerging markets, but some rich countries got hit too. In the wake of a stock market and real estate crash, Japan was slow to ease monetary policy and unwilling to shut down insolvent banks, but fended off a depression with years of deficit spending.

Meanwhile, several Scandinavian countries bounced back quickly (if painfully) from severe banking crises in the early 1990s by taking a page out of F.D.R.'s book. The Swedish government, for example, guaranteed all bank deposits and other debts, then put taxpayer money into troubled banks in exchange for big equity stakes, which it sold when markets recovered.

That brings us to August 2007, when the gathering collapse of the U.S. housing market first made itself felt in financial markets in general. The Fed responded both by making sure banks had the cash they needed and by pumping up the overall money supply. These measures worked, in that they kept the economy going, albeit fitfully. But they didn't fix the underlying problem.

"The tools have been the right tools," contends Frederic Mishkin, a Columbia University economist who spent two years on the Federal Reserve Board. "The rot that was exposed here was much worse than anybody anticipated."

What does Mishkin mean by rot? "This shock has revealed a tremendous problem in the way financial contracting is done and in the way securitization is done," he says, the core of which was that "nobody cared whether the ultimate holders of the securities got paid back." That is, mortgage brokers, securitizers, derivatives makers, and credit raters all got paid for making transactions happen, not for making good loans. And so a lot of very bad loans were made.

When loans go bad, we have long-established procedures in our society for apportioning the losses. For most companies there's bankruptcy, and for banks since 1933 there's been the FDIC, which makes sure insured depositors get out whole and then hands out anything that's left to uninsured depositors and other creditors. In special cases, where it deems the failure of a bank to pose a threat to the overall financial system, the FDIC is allowed to improvise by guaranteeing all creditors, arranging a sale, etc.

When the problem occurs on a mass scale, though, the case-by-case approach doesn't work so well. The Fed, Treasury, and FDIC have rescued some ailing financial institutions and let others die - Lehman Brothers being the most famous. European countries facing similar issues have also failed to stick to any clear rulebook. As a result, the providers of the credit that financial institutions need to keep going have turned ever more skittish. That's why banks are now so loath to lend to each other and increasingly loath to lend to anybody else.

There are solutions to this. Like F.D.R. in 1933 or the Swedes in 1993, the Treasury Department and the FDIC could quickly sort out which financial institutions are going to live and which have to die, and pour capital into the borderline cases that they want to survive.

The $700 billion bailout law passed by Congress allows for the money to be used this way, and Treasury Secretary Paulson was moving toward such action when this magazine went to press. He was also floating the idea of guaranteeing all bank debt and insuring all deposits. If done decisively enough, these measures could bring trust and confidence back to the financial system as banks stop trying to guess who might go under next. If coordinated with the efforts of other countries, they could be even more effective.

That said, more will surely remain to be done. The one big political decision made during the horrible, almost leaderless months of early 1933 was the ratification of the 20th Amendment, which moved Inauguration Day up from March to January. But markets now move at a speed that makes even a week seem like an eternity. Epochal decisions may have to be made during the 21/2 months between Election Day and swearing in. In the end, our fate may be determined as much by politics as economics. 

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