Crust, then filling

The reign of the monetarists seems to be over, at least for now. The instruments of monetary policy assume that in general, people want to borrow and lend to pursue certain opportunities. Lending increases the net money supply, and so the rate of economic activity can be somewhat regulated by controlling the supply of money using key interest rates. Unfortunately, this process assumes that most of the loans issued will be repaid. When loans default, there is a contraction in the money supply due to (1) the lost value of the loan itself and (2) the reduction in overall confidence that the system requires.

This is why things are so bad right now. Loans were issued to people who had no hope of actually paying them back. Borrows and lenders assumed that someone else would come along and issue another loan for enough money to buy the asset (e.g. property) at a high enough price to cover the original loan. This is not a functioning free market, but a giant Ponzi scheme. Thus, the Fed can set its interests rates at zero and the economy will still tank because the confidence required to "create money" does not exist. The economy will not recover until there is confidence that loans issued to banks and other parties will be repaid, just ask anyone from Japan.

In order to create confidence, there must be a clear way forward. All options are bad and involve a lot of people losing a lot of money. Many of those will be investment bankers who will lose ~90% of their net worth and still live better than 95% of US citizens. The taxpayers, including proportionally larger amounts for said bankers, will get hosed. But we must know how that will happen. Ad hoc responses and unclear plans from the US Treasury Department will only prolong, and probably exacerbate the pain.

Thus, Washington right now looks to be reading a page from the Japanese book: build up political capital with fiscal stimulus and then address the banks when the pain gets too bad. This is backwards, like trying to bake the filling when there is no crust. Fixing the banks will be painful, more so in the year the fixes happen than the status quo. But until it happens, no amount of fiscal stimulus will help.