Since Jim laid out some of the proposals for addressing the mortgage problem, I thought I’d put in my two cents worth.
Now, let me say that I don’t have an answer. But it seems to me one of the most illuminating posts on the subject was Yves Smith’s typology of perspectives (without necessarily agreeing with the policy prescriptions). For conciseness’ sake, I’ll appropriate the WSJ Real Time Economics Blog summary:
1. Do Whatever It Takes. Smith says James Cramer is the “most extreme and vocal advocate” of this position, that central banks should do whatever it takes to keep the market afloat. Cramer has boasted of his much-YouTubed rant demanding that the Fed cut rates. Smith says others in this group include author and entrepreneur Don Luskin and economist Thomas Palley.
2. Cold Water Yankees. This group believes “any liquidity infusion is a bad idea,” and includes Nouriel Roubini, Andy Xie, Michael Panzner, Markham Lee and Marc Faber, Smith says.
3. The Realists. “They don’t disagree that too much cheap credit for too long has caused this mess, but they think a cold turkey approach creates too much collateral damage,” Smith writes. That is, “central bankers can’t sit around and let markets seize up.” In this camp are the Financial Times’s Martin Wolf and Martin de Grauwe, as well as European economists Walter Buiter and Anne Siber.
4. Reframers. Smith says this group wants to reframe the problem, and believes the solution “isn’t simply a matter of interest rate policy but of the larger regulatory framework” that manages the risk of asset bubbles. In this group, Smith places Australia’s former Reserve Bank Governor Ian MacFarlane, economist Henry Kaufman and Morgan Stanley’s Stephen Roach.
Personally, I have the view that when one is looking into the abyss (or perhaps just a very deep ditch), one has to take the actions of the past as given, and think of what can be done in order to mitigate the financial system turmoil that might result in an economic downturn. In other words, like Bernanke, I believe the banking — and more general financial system — performs a vital function in screening projects and providing capital, and failure to provide liquidity at critical junctures led to the Great Depression.
At the same time, one has to consider the moral hazard issue in a dynamic context. To the extent that a looser monetary policy might bail out some firms that undertook ill-advised investments, looser monetary policy might act like an insurance policy (what was perjoratively termed the “Greenspan put” in an earlier context). Perceived insurance would then lead to even greater risk-taking, setting up the system for another bout of turmoil in the future.
Where one fits into the typology depends upon (i) how close one thinks the system is to siezing up, (ii) how strong the moral hazard effect is, (iii) and whether lowering the Fed Funds rate (as opposed to the discount rate) would actually address the problem (is it illiquidity or insolvency).
While I haven’t drawn a particular conclusion regarding the right direction to move, one insight prompted by current commentary is that — if the Fed were to opt for looser monetary policy — greater regulation of the financial sector would make a lot of sense. While this seems like a no-brainer, several commentators have observed that greater regulation at this juncture would not help out the indebted households now, nor help the threatened firms, and indeed might be counterproductive insofar as it would exacerbate the credit crunch (e.g., see , ,  and ).
The lesson I take is that it’s not an either-or proposition. Policymakers might need to lower interest rates, either to offset systemic illiquidity, or to stabilize output. But if these actions are necessary, then one needs to consider how to implement effective regulation, rather than dismissing regulation on ideological grounds (see this post on the Administration’s view of financial regulation, which has in part led to the current state of affairs).
See also Mark Thoma at Economist’s View, who has once again beat me to the punch with a similar perspective.