The Problem The Solution
First, we must understand the problem, which is fractional banking. The problem with fractional banking is that cash ALWAYS has to be less valuable than other alternatives. Otherwise, there is an immediate desire to deleverage (to get into cash), and the whole interconnected banking system, with all its counterparty risk, comes crashing down. We are seeing this problem now.
Because raising interest rates makes cash more valuable, the system is inherently biased towards needing and encouraging lower and lower rates. Look at the trend in interest rates ever since Volcker left office: it's down, down, down, a touch up, down, down, a touch up, down, down, down.
The deleveraging problem could have happened in 1995 (the year Greenspan uttered the words "irrational exuberance"), 1998 (Long-Term Capital, the Russian debt crisis), 2000 (the dot-com bust), or many other times in recent history. That is why the Fed has been running scared for so long. For two decades, the Fed and government have fought deleveraging by encouraging more leverage (mostly by lower interest rates, but also by deregulation, the allowance of off-balance sheet vehicles and the overnight sweeping of checking account, etc.).
However, the leverage can't go on forever. At a certain point, the leverage becomes ludicrous. The excess credit drives asset prices up to a point where the earnings on these assets do not justify the risk of acquiring them (3% rental yield for an apartment whose value is supported by a clearly overleveraged banking sector???). You know something is wrong when the most respected banks are 32 times leveraged (does that even count all the off-balance sheet agreements, the derivates, and the effects from any mark-downs on the asset side???).
So basically, as I pointed out in August, the U.S. is the subprime lender of the world (along with Europe!). Our entire banking system was then and is now obviously bankrupt.
When an entire banking system is bankrupt there are two options:
Preserve the value of the currency and let the banking system crumble. Honor contracts and force bankruptcies. Purge the system of its excesses through a massive depression. DOWNSIDE: Massive unemployment and a serious contraction in the economy. UPSIDE: Faith in the currency is maintained, the banking system is cleansed, and many decades of healthy, long-term economic growth can be built upon a solid foundation. [NOTE: Your average economist erroneously believes that the Fed's inaction during the Depression was the problem. The real problem, as it always is, was the Fed's previous allowance in the 1920s of excessive credit growth. Because of this lack of understanding, your average economist is not inclined to ascribe any long-term benefit to the Fed's purging the system of its excesses.]
Change the rules of the game. Have an activist government try to prevent bankruptcies. There are many ways to change the rules of the game: The Fed can start to monetize and retire assets, such as mortgages, corporate debt, etc. Alternatively, the U.S. government can have the Fed monetize its debt, and use the new money for public works programs or simply send the money directly to citizens. Such a process of rules changing will be highly contentious because it will favor certain segments of society over others. It will be extremely political. [For example, if Congress sends checks directly to people, the banking system will cry: inflation. If the Fed recapitalizes banks with cash, the people will cry: bailout]. DOWNSIDE: A loss of faith in the currency, especially among foreigners, who hold the currency (and its implied liabilities) but do not get the benefits associated with monetization (the money is only given to U.S. citizens or U.S. entities). Given that 70% of the entire world's central bank reserves are in dollars, such a loss of faith could have dramatic consequences. All the benefits the U.S. received from decades of printing U.S. dollars and sending them abroad for goods could quickly reverse, and we could see trillions of U.S. dollars come home, quickly diluting their value and causing hyperinflation and a run by everyone (including U.S. citizens) into anything but U.S. dollars. UPSIDE: Although uncertain, this option is thought to be more likely to preserve economic growth and employment. It is considered to be less painful.
Given that our national psyche was so scarred by the Great Depression (Option 1), I fully expect our politicians to go for Option 2. It will be interesting to see if Option 2 works out any better. It certainly did not for Europe before World War II, which is why their central bank is taking such a divergent approach.
Unfortunately, there is no free lunch. Excessive credit and leveraged were not only allowed to occur, but were the explicit policy of our government. Now we must choose a way to deleverage: either by a recession or by inflation. The trick is to deleverage in such a way that neither foreigners nor citizens lose faith in the system. Can that be done? We shall soon find out! It's going to be a wild ride.
Given that we are on the inevitable path to changing the rules of the game (Optioin 2), my proposed solution is that it should be done in a clear, unified, upfront and immediate manner. We need to get people to understand the problem and solution quickly. If it is done in piecemeal fashion, markets will gyrate wildly as they have been doing ("We're headed for a major recession, sell everything" one day, followed by "The Fed will sink the dollar to prevent recession, go to commodities and stocks" the next day). Such wild gyrations are likely to cause a loss of faith in the system ("It is rigged," "It's impossible to make money without knowing the next move out of Washington.") Every time a minor solution is proposed, the market rallies sharply. But the market soon realizes the solution is not working and goes back downward, forcing politicians to come up with yet another solution. Given the enormity of the problem, the solution should be comprehensive from the start.
The real question to answer is: to whom does the new money the government will create go first? The banking sector or the people? A select group of people or all people? My take is that the only way to put together as comprehensive a deal as is needed is to be totally fair. Send each and every American, regardless of age, indebtedness, health, or any other measure, a check for $30,000. It's a one-time thing. Get the Fed to monetize the Federal government debt that will be created to issue the checks. The Federal debt should have an infinite term and 0% interest (meaning it will always be on the government books, but never needs to be repaid). Will such a plan hurt the dollar? Probably. But maybe not. Will it be inflationary? Yes, but a lot of the money will be used to pay off debt, which will help deleverage the banking system and decrease money supply. Basically, what you are talking about is a plan to repartition the assets of a bankrupt banking sector in as painless a way as possible. But you are doing it in a creative, comprehensive, and quick manner, without having to run everything through the bankruptcy process.
I doubt such a plan would get very far, especially as all the people of Wall Street and all the establishment economists would fight it (mainly because it would be an equitable distribution of the value held by the banks, and it would --- in relative terms --- disempower the rich and make those less fortunate less beholden). However, it might be the only option for the banking class, and the best way to avoid a total collapse of the system. Through this solution, the banking sector may emerge better off than other alternatives.
While my solution is highly imperfect, I do believe it is the least worst compared to others. And it certainly is the most just.