What Obama Must Do

Compare the situation right now with the one back in the 1980s, when Volcker turned the economy around. All the Fed had to do back then was print a bunch of dollars (OK, it actually credited the money to the accounts of private banks, but it amounts to the same thing) and then use those dollars to buy up U.S. government debt. This drove interest rates down: When Volcker decided that the economy needed a pick-me-up, he was quickly able to drive the interest rate on Treasury bills from 13 percent down to eight percent. Lower interest rates on government debt, in turn, quickly drove down rates on mortgages and business borrowing. People started spending again, and within a few months the economy had gone from slump to boom. Economists call this process — from the Fed's decision to print more money to the resulting pickup in spending, jobs and incomes — the "monetary transmission mechanism." And in the 1980s that mechanism worked just fine.

This time, however, the transmission mechanism is broken.

First of all, while the Fed can still print money, it can't drive interest rates down. Why? Because those interest rates are already about as low as they can go. As I write this letter, the interest rate on Treasury bills is 0.005 percent — that is, zero. And you can't push rates lower than that. Now, you might think that zero interest rates would lead to an orgy of borrowing. But while the U.S. government can borrow money for free, the rest of us can't. Fear rules the financial markets, so over the past year and a half, as the interest rates on government debt have plunged, the interest rates that Main Street has to pay have mostly gone up. In particular, many businesses are paying much higher interest rates now than they were a year and a half ago, before the Fed started cutting. And they're lucky compared to the many businesses that can't get credit at all.

Besides, even if more people could borrow, would they really want to spend? There's a glut of unsold homes on the market, so there's very little incentive to build more houses, no matter how low mortgage rates go. The same goes for business investment: With office buildings standing empty, shopping malls begging for tenants and factories sitting idle, who wants to spend on new capacity? And with workers everywhere worried about job security, people trying to save a few dollars may stampede into stores that offer deep discounts, but not many people want to buy the big-ticket items, like cars, that normally fuel an economic recovery.

So as I said, the Fed has lost its mojo. Ben Bernanke and his colleagues are trying everything they can think of to unfreeze the credit markets — the alphabet soup of new "lending facilities," with acronyms nobody can remember, is growing by the hour. Any day now, the joke goes, everyone will have a Visa card bearing the Fed logo. But at best, all this activity only serves to limit the damage. There's no realistic prospect that the Fed can pull the economy out of its nose dive.

So it's up to you.

Rescuing The Economy

The last president to face a similar mess was Franklin Delano Roosevelt, and you can learn a lot from his example. That doesn't mean, however, that you should do everything FDR did. On the contrary, you have to take care to emulate his successes, but avoid repeating his mistakes.

About those successes: The way FDR dealt with his own era's financial mess offers a very good model. Then, as now, the government had to deploy taxpayer money in order to rescue the financial system. In particular, the Reconstruction Finance Corporation initially played a role similar to that of the Bush administration's Troubled Assets Relief Program (the $700 billion program everyone knows about). Like the TARP, the RFC bulked up the cash position of troubled banks by using public funds to buy up stock in those banks.

There was, however, a big difference between FDR's approach to taxpayer-subsidized financial rescue and that of the Bush administration: Namely, FDR wasn't shy about demanding that the public's money be used to serve the public good. By 1935 the U.S. government owned about a third of the banking system, and the Roosevelt administration used that ownership stake to insist that banks actually help the economy, pressuring them to lend out the money they were getting from Washington. Beyond that, the New Deal went out and lent a lot of money directly to businesses, to home buyers and to people who already owned homes, helping them restructure their mortgages so they could stay in their houses.

Can you do anything like that today? Yes, you can. The Bush administration may have refused to attach any strings to the aid it has provided to financial firms, but you can change all that. If banks need federal funds to survive, provide them — but demand that the banks do their part by lending those funds out to the rest of the economy. Provide more help to homeowners. Use Fannie Mae and Freddie Mac, the home-lending agencies, to pass the government's low borrowing costs on to qualified home buyers. (Fannie and Freddie were seized by federal regulators in September, but the Bush administration, bizarrely, has kept their borrowing costs high by refusing to declare that their bonds are backed by the full faith and credit of the taxpayer.)

Conservatives will accuse you of nationalizing the financial system, and some will call you a Marxist. (It happens to me all the time.) And the truth is that you will, in a way, be engaging in temporary nationalization. But that's OK: In the long run we don't want the government running financial institutions, but for now we need to do whatever it takes to get credit flowing again.

All of this will help — but not enough. By all means you should try to fix the problems of banks and other financial institutions. But to pull the economy out of its slide, you need to go beyond funneling money to banks and other financial institutions. You need to give the real economy of work and wages a boost. In other words, you have to get job creation right — which FDR never did.

This may sound like a strange thing to say. After all, what we remember from the 1930s is the Works Progress Administration, which at its peak employed millions of Americans building roads, schools and dams. But the New Deal's job-creation programs, while they certainly helped, were neither big enough nor sustained enough to end the Great Depression. When the economy is deeply depressed, you have to put normal concerns about budget deficits aside; FDR never managed to do that. As a result, he was too cautious: The boost he gave the economy between 1933 and 1936 was enough to get unemployment down, but not back to pre-Depression levels. And in 1937 he let the deficit worriers get to him: Even though the economy was still weak, he let himself be talked into slashing spending while raising taxes. This led to a severe recession that undid much of the progress the economy had made to that point. It took the giant public works project known as World War II — a project that finally silenced the penny pinchers — to bring the Depression to an end.

The lesson from FDR's limited success on the employment front, then, is that you have to be really bold in your job-creation plans. Basically, businesses and consumers are cutting way back on spending, leaving the economy with a huge shortfall in demand, which will lead to a huge fall in employment — unless you stop it. To stop it, however, you have to spend enough to fill the hole left by the private sector's retrenchment.

How much spending are we talking about? You might want to be seated before you read this. OK, here goes: "Full employment" means a jobless rate of five percent at most, and probably less. Meanwhile, we're currently on a trajectory that will push the unemployment rate to nine percent or more. Even the most optimistic estimates suggest that it takes at least $200 billion a year in government spending to cut the unemployment rate by one percentage point. Do the math: You probably have to spend $800 billion a year to achieve a full economic recovery. Anything less than $500 billion a year will be much too little to produce an economic turnaround.