Or, what if the Fed gave out all this money to the banks and none of them are lending it out?
Econbrowser Plan A didn't work. Plan B didn't work. I suggest the Fed get going on Plan C. ... So here's my suggested Plan C. The goal of monetary policy should be to achieve a core inflation rate of 3.0% (at an annual rate) over the next 6 months. That's something that can be accomplished without rate cuts or lending facilities, and here's how.
Step 1 is for the FOMC to form a clear determination that a 3% core inflation rate is indeed their immediate goal. If you hope to get somewhere, it's a good idea to start with a plan of where you're trying to go.
Step 2 is to communicate the goal to the public. Bernanke and Kohn should state clearly that they're worried by the October fall in the CPI, that they see a danger of too much slack in the economy developing, and that they will now be adopting quantitative easing with the goal of preventing further declines in the overall price level.
Step 3 is to start creating money and use it to buy up assets until the goal set out in Step 1 is achieved. What sort of assets? My answer here would be the exact opposite in philosophy of the kind of purchases and loans that the Fed has been implementing over the last year. The Fed has been trying to sop up the illiquid assets that nobody else wants. But I think what the Fed should be doing is instead acquiring assets of a type that would allow it to quickly reverse its position if a sudden shift in perceptions causes inflation to come in above the intended 3% target. The Fed can't afford to dump the illiquid securities it's been taking on recently, and that leaves it with substantially less flexibility to ease out of an expansionary policy once it starts to be successful.
My goal would therefore be to buy assets for the Fed that won't lose their value with a reversal of expectations and whose sell-off by the Fed wouldn't be itself an additional destabilizing force.
What specifically would such assets be? I'd start with those clearly undervalued TIPS. Next I'd buy short-term securities in the currencies relative to which the dollar has been appreciating. Here again if the Fed has to sell these off in a sudden change in perceptions, the Fed will have both made a profit and, by selling, be a stabilizing force. If we're still seeing no improvement, the Fed can start to buy longer-term Treasuries.
What if the policy is unsuccessful, and we still get severe deflation despite the 3% inflation target? In some ways, that's the best outcome of all, since, as I explained previously, in that scenario the Fed has solved the nasty problem of all that debt owed by the Treasury.
Over at Economist's View Mark Thoma says:
John Hempton disagrees with me and others that the problem in financial markets is fundamentally one of solvency, i.e. lack of adequate bank capital. He says it is a matter of trust, trust that was destroyed by lies and deceptive practices among other things. If he is right, bank recapitalization alone will not bring back the trust that is needed - well capitalized banks can still lie - and because of that he believes some sort of "full guarantee of all sorts of bank debt" is needed to get bank credit flowing again from financial wholesalers to financial intermediaries. His preferred solution to provide the necessary trust is bank nationalization - the government won't default on its obligations to provide payment - and this allows taxpayers to fully participate in the upside in return for assuming the risk inherent in guaranteeing debt payments ... We agree that fear is the problem, people will not be willing to provide financing if they are worried about getting their money back, the question is what is driving that fear, insolvency, something else, or both. If it is insolvency alone, then recapitalization ought to work, but if it is a lack of trust that a solvent bank balance sheet means what it says it means, then the problem is harder to fix unless you are willing to inject massive amounts of capital - enough to remove all doubt - or remove uncertainties from the books through a massive toxic asset purchase program (a public relations nightmare).
My thoughts are nationalization. It removes all uncertainty and gives taxpayers the upside. Perhaps what is needed is a financial version of the Powell Doctrine:
Overwhelming financial resources should be brought to bear on a crisis. The objective is to minimize uncertainty and bring stability and calm to the financial markets in the shortest time possible. The following list has to be answered in affirmitive:
1. Is a vital economic interest at stake?
2. Do we have a clear obtainable measureable objective i.e. volatility in stock market, etc.?
3. Have risks and costs been analyzed with best available information?
4. Will risks and uncertainty increase if we try all other possible smaller options?
5. Is there an exit strategy to recoup costs of bailout?
6. Have consequences of all actions been considered?
7. Will the action be supported?
8. Do we have international support?
I believe the answer to all of the above is Yes for nationalization of the financial industry/sector as far back as early October.
Update: Fama explains the reasoning behind nationalization (note: he does not support nationalization) as a debt overhang problem.
Update: Nationalisation Linkfest