The vote on Monday, September 29 in the House of Representatives to reject the
$700 billion Paulson troubled asset relief plan (TARP) was regrettable—not because the design of the TARP is flawless but rather because a failure of the US administration and the Congress to agree on an effective systemic approach to managing this increasingly worrisome financial crisis can only depress confidence further. The historic decline in US equity markets following that negative vote—the difficulties at Wachovia Bank notwithstanding—was hardly a coincidence.

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The following essay traces the origins of the current crisis, assesses the actions of recent weeks, and suggests ways to implement the Troubled Asset Rescue plan before Congress. The Troubled Asset Rescue plan, this piece says, “may be enough to settle markets” but that “it would be a mistake to assume that the worst is behind us.” Because of the risk of failure, the authors urge that a Plan B be prepared now. They outline possible elements, including establishment by the Treasury of a “preferred equity injection program” for major financial institutions.

In order to figure out how to combat the current economic crisis, it is important to understand what kind of crisis we are dealing with. The conventional wisdom is that we are dealing with a housing crisis (falling housing prices) magnified by excessive leverage. But this puts the emphasis in the wrong place, and fails to grasp the key dynamics of the crisis.

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The global credit crisis is entering its fifteenth month. This crisis is different in its origins, but its contours are familiar to anyone who was watched such crises over the past several decades or to anyone who has studied the history of earlier crises. Those regularities include the replacement of greed by fear and the slow adjustment by policy makers as they gradually recognize that rules have to be broken.

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Should the United States be concerned about ending up like Japan in the 1990s? There are signs that American policymakers are worried about just such a development. By this they and other economists mean the threat of an extended recessionary period of sub-par growth, and an inability to sustain a recovery, apparently because of bad assets weighing down the economy’s financial system. Last week’s lock-up in the US commercial paper and short-term lending markets for solid non-financial corporations, reminiscent of what preceded the real economy nose-diving in Japan in 1997-98, made the prospect all the more real.

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The continued danger levels on a leading indicator of bank stress suggest it is time to complete the Troubled Asset Relief deal rather than delaying for additional Monday morning quarterbacking.

The “Ted Spread” between the interest rate paid on short-term US Treasury paper and the London Inter-bank Offer Rate (LIBOR) is one barometer of financial sector stress. A flight to quality depresses the return on short-term government paper, while a reluctance of banks to lend to each other causes the LIBOR rate to rise.

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