Resident Fellow  Desmond Lachman

History will judge American policymakers harshly for their misdiagnosis of the current crisis, which has become the worst in 80 years and may lead to the most severe recession since World War II. More than a year after the beginning of this crisis, both the U.S. Treasury and the Federal Reserve do not fully recognize how much falling home prices and rising foreclosure rates complicate the problems in the financial sector. Worse still, as the markets have been quick to realize, Secretary Paulson's bailout plan only partially addresses the liquidity problems of the financial sector, and does not address its solvency. Inadequately capitalized banks will remain mired in the process of selling assets and will restrict lending to repair their damaged balance sheets. Prices of assets will be driven lower as banks sell, compounding the problem.

The United States is already in a serious recession, and the most recent credit freeze and equity price plunge all but ensure that it will last through 2009, with unemployment rising above 7.5 percent. How long the recession lasts will be determined by the economic policy of the current administration over the next few weeks. The economy will not have a meaningful recovery until the housing market is stabilized and the banking system is adequately recapitalized, two goals that ought to be the first order of business of the next president. He should also consider another stimulus package, and the Federal Reserve should consider more interest-rate cuts.

The rest of the world will not be spared. Europe and Japan are already in recession. Their economies will also continue to be buffeted by falling equity prices, tight global credit, and severe housing busts in Spain and the United Kingdom; and the growth of the emerging-market economies will slow as their overseas markets shrink.

Desmond Lachman is a resident fellow at AEI.

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Visiting Scholar Allan H. Meltzer

The principal problem with the $700 Billion Paulson plan was that there was never a plan. Proponents were unable to explain how the plan would work or why it would work. Instead of developing a plan, they spread fear and anxiety to gain public support, talking up Depression, job losses, and employers unable to pay wages. A falling stock market heightened public concern for pensions.

Alas, the stock market continued to fall after Congress approved the program, not least because the bailout was never supported by an explanation of how buying mortgages would help firms to borrow for payrolls and inventories. Then the Federal Reserve found it necessary to support the commercial paper market, where firms in fact borrow money to finance payrolls, employment, production and inventories. Passing the bailout did not solve that problem.

Democratic governments should never use fear to frighten the public into accepting a program that most knew for what it was--a bailout of the lenders who mismanaged their business. The problem isn't the mortgage market. The mortgage market reflects the problem in housing.

No one can confidently say how far housing prices will fall, and the value of mortgages depends on those prices. The steeper the fall in housing prices, the more homeowners will default. That's the risk that buyers of mortgage bundles have to accept.

Contrary to much public comment, sales of mortgage bundles are still occurring. The low price paid reflects the large risk the buyer accepts. Usually, mortgages sell for less than 50 cents on the dollar of original value. Merrill Lynch sold a big stake for 22 cents on the dollar. Most financial firms that have large holdings would wipe out their capital if they sold at prevailing prices. They expect, or hope, to get a better price from the Treasury.

Promises of future profits for taxpayers are the stuff of dreams. The much simpler bailout of the savings and loans cost the taxpayers $150 billion. That will look small before we finish the mortgage bailout.

Allan H. Meltzer is a visiting scholar at AEI.