The real solution to the financial crisis: recession

The much-maligned bailout appears set to become law. Members of Congress suggest they'll hold their noses but vote for it anyway. Their reasoning? Something must be done.

The premise is that doing nothing will hasten recession. And recession is unacceptable.

But that kind of thinking is a big reason we're now on the verge of a financial meltdown. By taking a zero-tolerance policy toward recession, Washington has dangerously juiced the economy with monetary steroids for more than a decade.

The painful truth is that recession may be precisely what's needed to restore economic health. Yet the bailout attempts to avoid this crucial reckoning – which may make things worse.

It may seem odd that avoiding slowdowns could have side effects. Recessions, after all, cause real damage: job losses, higher levels of business failures, and falling tax receipts.

However, just as seemingly healthy measures, such as taking vitamins, can cause damage if done to excess, so did the Greenspan-era Federal Reserve take recession avoidance too far. It helped feed the excessive borrowing that is the root of our current crisis.

In the wake of the dot-com crash, the Fed went way beyond past fixes and lowered the funds rate to 1.25 percent for nearly eight months, then an extraordinary 1 percent for a full year.

At such low levels, consumers who save lose; they are better off spending or borrowing. And they did both. Private debt as a ratio to Gross Domestic Product skyrocketed some 50 percent in five years. Similarly, the savings rate plummeted to zero.

But the Fed was overly permissive even earlier. By 2001, the "Greenspan put," the idea that the Fed would be quick to cut rates to prevent a stock market decline, was part of the vernacular and investor conditioning.

This was a radical departure, since the Fed had never seen the stock market as part of its job description.

In the 1990s, the central bank recognized the benign effect of cheap imports on inflation but failed to adjust interest rates accordingly, leaving them too low. In fact, the increase in the private debt to GDP ratio steepened starting in 1996, and the savings rate has been falling since 1992. Greenspan was famously obsessed with data, so his ignorance of the implications of these trends is incomprehensible. It is tantamount to keeping an athlete on steroids even when he is showing clear signs of distress.

To be sure, this easy money policy isn't the only culprit in today's crisis. Lax regulation failed to keep tabs on Wall Street's excessive risk-taking and byzantine financial products.

But even as they work fervently to beef up regulations, policymakers today are repeating the Greenspan error of trying to avoid recession no matter what. The ugly fact is that there is no painless way out of our financial mess.

John McCain and Barack Obama weren't willing to admit this in Friday night's debate. Mervyn King, the head of the Bank of England, has been more forthright, telling the British that their standard of living will fall. No US policymaker has been so candid. And Washington appears determined to minimize the immediate damage of Wall Street settling its debt, no matter the long-term cost.

The bailout bill is a classic example of expediency over effectiveness. It will purchase dud assets at above-market prices. It does serve to recapitalize banks, but it rewards the worst offenders and does nothing to restore trust. Even though Japan is the poster child of how not to manage a banking system crisis, this is a page straight out of its playbook.

By contrast, the most successful approach is to let asset prices fall to discover the extent of the damage, take over failed banks, recapitalize them, and later sell them back to investors. That's according to a new International Monetary Fund report that examined 124 banking crises in the past 27 years.

This approach is harder on the economy in the short term, usually leading to a two- to-three-year deep recession, but with a strong growth rebound after that. Too bad the US doesn't do recessions; the idea of a painful purge is deemed to be beyond the pale. And getting religion later doesn't work: the Japanese later recanted, forced banks to write down bad loans, and injected public funds, but today, 18 years after the country's asset bubble started popping, they remain stuck in a deflationary trap.

American attachment to instant gratification is strong. So is the pressure to pass the bailout. But left unchecked by self-restraint and honest reckoning, both forces may lead America to repeat, on a grander scale, the same sort of error that got us in this financial mess in the first place.

• Yves Smith has worked in the financial services industry since 1980. She blogs at nakedcapitalism.com.