How bad is our economy?

Today’s question: How bad is the current fiscal crisis, and why can’t we just let the markets correct themselves? All week, Robert Kuttner and J.D. Foster debate election-year economics and Washington’s response to the financial crisis.

Come back with a better bill
Point: Robert Kuttner

Now that Congress blocked the compromise bailout worked out by House Speaker Nancy Pelosi and Treasury Secretary Henry Paulson, it’s time for it to get things right. Taxpayers are right to be outraged over bailing out Wall Street investors, but the right-wing Republican “private market” alternative is a joke. If it takes government insurance and government tax credits to unload bad bonds, what we have is hardly a private market.

What should Congress do now?

First, rescue the money markets and the toxic securities by refinancing the underlying mortgages -- rather than bailing out the banks. In the Great Depression, Franklin Roosevelt’s Home Owners Loan Corp., a branch of the government, refinanced one out of every five mortgages. Roosevelt’s administration saved about 1 million Americans from foreclosure. No middlemen got rich.

If we can stop the wave of foreclosures, we brake the collapse in housing prices. The bondholders would get bought out at so many cents on the dollar, just as they would have in the Paulson plan. But with the Kuttner plan, homeowners are the primary beneficiaries. Under Paulson’s approach, the bondholders get bailed out but many homeowners still lose their home or keep paying Mafia mortgage rates. It’s just what you’d expect from a guy who still operates as if he were the chief executive of Goldman Sachs -- which Paulson once was.

Second difference: The government should take over failing banks directly and get rid of toxic executives as well as the toxic investments they made. That’s what the Federal Deposit Insurance Corp. does when it takes over a failed bank. It’s a much better and cleaner approach. Then, when the FDIC has cleaned up the place and replenished its capital, it sells off the bank to honest and competent managers in the private sector.

Paulson has implicitly extended that federal safety net to the entire financial sector -- when it’s better to do it explicitly. He should make the entire financial system FDIC insured and subject it to tough FDIC rules, such as limits on speculative investments, regular examinations of assets and direct takeover when the institution fails.

There is still a lot more bad stuff in the pipeline, including about $60 trillion (right, trillion) worth of insurance contracts written by companies like AIG against the risk of exotic derivative bonds going bad -- and there are a lot more exotic products still to go bad.

At best, the Paulson package would have bought a few weeks or months. Now, Congress needs to do this right: Roosevelt-style rather than Goldman-style. And the next president will have to be every bit as bold as Roosevelt, or this toxic legacy of George W. Bush and Heritage Foundation laissez-faire delusions will fall in on him.

American Prospect founder Robert Kuttner’s new book is “Obama’s Challenge: America’s Economic Crisis and the Power of a Transformative Presidency.”

The real financial meltdown is on its way
Counterpoint: J.D. Foster

The United States faces not only a financial crisis but a fiscal crisis. The financial crisis washing over the broader economy is unfolding now, of course; the fiscal one is on the horizon.

The financial crisis stems from extraordinarily bad decisions from Main Street to Wall Street involving residential housing. Every homeowner who borrowed excessively, speculated through flipping homes or lied on a mortgage application shares the blame, as do the lenders -- on up to the Wall Street suits who played fast and loose in defiance of simple prudence.

The federal government also deserves blame. Years ago, it created a program that fostered a culture of imprudent mortgage lending to individuals who posed a high likelihood of foreclosure. It created and nurtured financial behemoths in Fannie Mae and Freddie Mac, which have now become wards of the state. It maintained a regulatory system fit for an age of typewriters and slide rules. And regulators worldwide were caught flat-footed as the threats built up.

The Paulson plan was certainly no cure-all; it was intended to keep capital markets functioning so they can resolve their own problems. The plan’s core was to make up to $700 billion of taxpayer funds available to purchase low-quality assets. We need additional steps, such as expanding the reach of deposit insurance at commercial banks. The problem began with housing, but it has now spread far beyond. Another homeowner bailout bill just won’t make much difference.

We face two choices. We can vent on the Paulson plan, as House members who voted against it earlier today, have done. Or months from now we can vent at Congress for not passing the plan, as the ranks of the unemployed swell by a couple million or more. The issue is whether to act to reduce the depth and duration of the economic slowdown, not whether to prevent it.

The Paulson plan’s sticker price of $700 billion is shocking, but in context, the consequences for the federal debt and deficit are relatively minor. The real fiscal crisis, which is just around the corner, is more than 100 times greater. That crisis involves the promises made through Medicare and Social Security. Compared with the excess costs in these central federal entitlement programs, the Paulson plan’s size is just a warm-up.

J.D. Foster is the Norman B. Ture Senior Fellow in the Economics of Fiscal Policy at The Heritage Foundation (heritage.org).