Fifty days into the new US Administration, and one bear market later in the equity market, one has to ask whether President Obama is now not leading the economy into a deflationary trap. For his Administration seems to be doing too little too late in resolving the country's banking crisis. And more disturbing still, his Administration is coming up with even less by way of concrete policies that have any prospect of breaking the dangerous downward spiral in which the US economy now finds itself.

At the root of the recent deterioration in the US economic outlook would seem to be an egregious disconnect between the new Administration's diagnosis of the country's immediate economic predicament and the policy proposals that it has on offer. For the Administration stubbornly seems to resist seriously addressing the very real weaknesses now besetting the economy that it seemingly has little difficulty in correctly identifying.

At a conceptual level, Larry Summers, President Obama's chief economic advisor, has correctly pinpointed the fact that the present US recession is not of the garden variety kind that has been experienced ten times in the post-war period. Rather, it bears a closer resemblance to those of the Great Depression of the 1930s and of the Japanese crisis of the early 1990s. For driving the economy's downward spiral is the lethal combination of a virulent credit crunch and a decline in equity and home prices that has now destroyed the equivalent of 100 percent of GDP in household wealth.

Larry Summers has correctly advised President Obama that halting the economy's present downward slide requires bold and simultaneous policy intervention on three fronts. First, together with Federal Reserve Chairman Bernanke, he has cautioned about the urgent need to get credit flowing again through America's clogged and loss-ridden financial institutions. Second, he has argued that there is the need for an immediate and appropriately-sized fiscal policy stimulus that might cushion the major part of the spending pullback by an over-indebted American consumer. And third he has pointed to the importance of coming up with policies that might stabilize the US housing market.

As the actual details of President Obama's economic strategy have now finally emerged, one has to be struck at the gaping gulf between the Administration's diagnosis of what ails the economy and its policy prescription to promote a recovery. Particularly striking is the fact that instead of addressing the bank insolvency issue head on, the Administration is choosing to continue the charade that the banks' problems are largely those of liquidity rather than those of solvency.

As Tim Geithner's most recent presentation of his bank rescue plan reveals, the Administration is choosing to pursue its own version of the failed TARP policies of Hank Paulson. For rather than following a "good bank/ bad bank" model that might actually get bank lending flowing again, Geithner is restricting himself to engineering the purchase at fair value of around US$1 trillion of the banks' toxic assets. He is doing so seemingly oblivious to the unfortunate Japanese experience in the early 1990s of supporting zombie banks that led that country down the road to deflation.

Most perplexing perhaps is the highly disappointing nature of the US$800 billion fiscal stimulus package. Far from being front-loaded as the immediate downward economic spiral would seem to dictate, it defers its major impact to 2010 and 2011. And far from focusing on measures that would get the most "bang for the buck", it relies too heavily on tax cuts of the sort that singularly failed to boost the economy in 2008 and on infrastructure spending that by its very nature are slow acting.

The equity market's decidedly negative reception of President Obama's economic policies to date, coupled with the swoon in consumer confidence to record lows and the renewed problems in the banking sector, all but assure a further deepening and prolongation of the current economic recession. It also all but assures that unemployment will rise to at least 9 ½  percent by year end, or to levels not experienced in over 25 years, that will usher in a prolonged period of falling consumer prices.

Japan's painful experience with deflation during the 1990s would counsel that the Obama Administration would do well to stop dithering about addressing the financial sector's insolvency problem by adopting a good bank/ bad bank approach to the issue. By the same token, the Administration would do well to revisit its fiscal stimulus package with a view to making it more front-loaded and effective.

Japan's deflationary experience also holds cautionary lessons for Federal Reserve Chairman Ben Bernanke. In particular, it would suggest that he might build on his recently announced program of buying mortgage-backed securities and US$300 billion in long-dated government bonds to dispel any notion that the Fed will allow deflation to take hold. He might do so by announcing a formal inflation target as well as by buying TIPS, the government-linked inflation bonds which presently imply a market expectation that inflation, excluding food and energy, will be a negative 1 percent a year over the next five years.

Desmond Lachman is a resident fellow at AEI.