A long history of public policy mistakes has contributed to the financial and economic crisis. Although there will surely be more missteps, only through further aggressive and consistent government action will the U.S. avoid the first true depression since the 1930s.
In some respects, this crisis has its genesis in the long-held policy objective of promoting homeownership. Since the 1930s, federal housing policy has been geared toward increasing homeownership by heavily subsidizing home purchases. Although homeownership is a worthy goal, fostering stable and successful communities, it was carried too far, producing a bubble when millions of people became homeowners who probably should not have. These people are now losing their homes in foreclosure, undermining the viability of the financial system and precipitating the recession.
Perhaps even more important has been the lack of effective regulatory oversight. The deregulation that began during the Reagan administration fostered financial innovation and increased the flow of credit to businesses and households. But deregulatory fervor went too far during the housing boom. Mortgage lenders established corporate structures to avoid oversight, while at the Federal Reserve, the nation's most important financial regulator, there was a general distrust of regulation.
Despite all this, the panic that has roiled financial markets might have been avoided had policymakers responded more aggressively to the crisis early. Officials misjudged the severity of the situation and allowed themselves to be hung up by concerns about moral hazard and fairness. Considering the widespread loss of wealth, it is now clear they waited much too long to act, and their response to the financial failures in early September was inconsistent and ad hoc. Nationalizing Fannie Mae and Freddie Mac but letting Lehman Brothers fail confused and scared global investors. The shocking initial failure of Congress to pass the TARP legislation caused credit markets to freeze and sent stock and commodity prices crashing.
Now, a new policy consensus has been forged out of collapse. It is widely held that policymakers must take aggressive and consistent action to quell the panic and mitigate the economic fallout. An unfettered Federal Reserve will pump an unprecedented amount of liquidity into the financial system to unlock money and credit markets. The TARP fund will be deployed more broadly to shore up the still-fragile financial system, and another much larger and comprehensive foreclosure mitigation program is needed to forestall some of the millions of mortgage defaults that will occur otherwise. Finally, another very sizable economic stimulus plan is vitally needed. While there will be much more discussion about the size and mix of government spending increases and tax cuts to include, the House Democratic plan is a very good starting point. This is important, for while such debate is necessary it must be resolved quickly. Unless a stimulus plan is implemented beginning this spring, its effectiveness in lifting the economy will be significantly