Despite the broad historical and political background and multifaceted circumstances that contributed to and defined the massive crisis we currently face, the linchpin to a resolution is understanding—and ultimately modifying—how the wholesale application of the theories of Modern Finance influenced our entire financial system.
Modern Finance—a rarely discussed phenomenon— supercharged ongoing leveraging, and its mathematical approach to risk dissociated our financial businesses from the real risks in our markets. It enabled harmful institutional transformations in our financial industry while operating with deeply flawed risk management tools for decades.
What got us here goes much deeper than mere lack of capital or regulation. Just as the large banks strayed from their core business—relationship banking— financial markets strayed from their core function—the efficient allocation of risk and capital.
The faster we realize that much of the past two decades’ prosperity was not real but created by the multiplication of money, the better. And the more fully we can understand the pervasive influence of Modern Finance within the financial industry and its effects on individual, institutional, and systemic levels, the more effectively we can launch informed government policies to restructure our banking and financial systems and get them back on track.

No-one disputes the enormous political hurdles to a sensible policy shift. But it is a situation where the usual “pragmatic” solution spells disaster and it is in all our interest to develop the political will to understand the issues and act decisively.

1.    Separate all banks (unable to survive on their own) along business lines and secure commercial banking assets, nationalize these assets and assure functioning of the basic financial services under management with new contracts .

Commercial banks, the foundation and backbone of our financial system, are unsuited to a number of financial services, in particular the management of securitized or longer-term, non-collateralized risk. Because it was so profitable and largely unregulated, this business was ramped up and today weighs up to 10 times more than the core business in our large cornerstone banks, essentially crushing their commercial banking business and with it the system—the economy.  These commercial banking assets must be carved out and saved by the government.
In the U.S., total commercial banking assets amount to approximately $6 trillion. Should government have to bail out half of those assets, and assuming a 20% default, the ultimate damage to the taxpayer would amount to no more than $600 billion, a manageable price to pay for assuring the stability of our system. Commercial banking assets should however be the only assets bailed out by government.
These are the businesses that  provide the basic financial services to our economies. The business model, the organizational structure, and the institutional mindset to create that basic financial service is a long mile from managing the different kinds of risks these banks have taken on over the past decades and they are entirely unsuited for. But, by power of their commercial banking clout, banks became large hedge funds, and came to dominate all areas of finance.
Attached to their ill-suited business model was a defunct risk management tool. Convenient but dangerously flawed.
Further, it has to be noted, that commercial banks rely on government guarantees and backstops as a key factor of their leveraged business model. As such, they clearly have a fiduciary duty to the taxpayer, which they have fallen shamefully short in fulfilling.
Despite widespread and still pervasive opposition to “nationalizations,” for the re-establishment of proper regulative structures and incentive schedules within the industry, it will be helpful for government to own—even if for a limited time—systemically important banks.

2.    “Investment banking” assets must face the dynamics of the marketplace; many will deflate in value, which will cause widespread asset and wealth deflation.

We have to face the fact that a debt of 3.5 times GDP is in itself unsustainable, despite suggestions to the contrary by prominent professionals. Today, the U.S. taxpayer does not have the funding ability to underwrite any assets beyond those most precious to the common good.
Strong resistance from within the financial world and beyond is anticipated and understandable. We often hear today the argument that there is no legal platform that would allow government to step in and implement such policies. Had it not been for the funds and accounting changes provided for by government, all banks would be legally bankrupt today. I strongly disagree with the doomsday scenario that is being painted by the banks if this were to happen.
Almost everyone’s personal wealth and pension is closely tied to all these assets, which have been inflated to unprecedented heights by the leveraged boom. A sense of entitlement is natural. The inclination of usually wealthy politicians is to go along with policies that keep asset prices afloat, even if based on an elaborate pyramid scheme. Everyone is an asset owner, and it is hard to face the reality that much of it was an illusion. But everyone is also a taxpayer and likely the parent of children. It is time to take off that asset-owner hat and put on our taxpayer-and-parent hat. The faster we come to terms with the fact that a large part of the past two decades was not real but created by the multiplication of credit, the better off we will be in the long run. As painful as the immediate effect may be, we need to reinstate the price-discovery process in the economy. There is no getting away from this.
The only question is … who will pay for it? My guiding principle would be that it is the asset holders who need to pay. This will hit those who invested so carelessly and ignorantly and not their victims, who under current policies continue to pay the price. We have got the funds to safe the core of our financial system, we have go the funds for fiscal investment stimulus and to support those in need.
But, we simply don’t have the funds to bail out the asset owners.

3.    Incorporate “Distressed Assets Management” vehicles (DAMS).

Companies outside basic commercial banking should not be bailed out. Equally, bankruptcy should not have to run through the arduous legal process currently in place. DAMS can be equipped with the necessary powers to implement asset restructuring and liquidations, if necessary, to assist in dissolving all existing contracts and support orderly procedures.
Pension assets will have to be analyzed individually and, if necessary, restructured. The astronomical social security and pension liabilities ($50 to $70 trillion) built into past expectations will need to be corrected sooner or later.

4.    Reorganize the Fed.

The Fed is the ultimate center of the storm. It manages the U.S. monetary system and supervises the banking system.  Ever since the formation of the Bretton Woods system 60 years ago, the United States has managed the global currency of exchange and reserve, the U.S. dollar and has in effect determined global monetary policy. This places the Fed smack in the center of our global financial system, which in turn is the core mechanism that propels and steers our global economy. And over the past 20 years the policies of the Fed have been observed with more than a little skepticism, particularly from the European mainland and Asia.

One immediate step the Fed should take to get things back on track is to raise interest rates to around 2%. At zero, interest rates lose their signaling property to the market (one of the key issues in Japan during the past decade). At best, the signal is that times are tough and won’t look up for a while, increasing risk aversion and savings. In any case, the monetary transmission mechanism has been broken since mid 2007, leaving interest rates a useless tool in steering the credit creation process. The velocity of money has broken down, the river has dried up. The aim to offer the banks as steep a yield curve as possible is understood but misguided.  It is unlikely that they will be able to shovel themselves out of their mess in the current economic environment, no matter how steep the yield curve. Zero interest rates should go. Beyond that, the central bank must focus on the provision of liquidity and the proper functioning of the credit markets.
Among the additional steps to be taken, then, the Fed should …
a)    be mandated and organized as an institution independent from government.
b)    be overseen by a Congressionally elected committee.
c)    be held to clearly defined transparency and reporting schedules.
d)    narrow its mandate to the maintenance of price stability, which is the cornerstone of economic stability.
e)    provide transparency and clarity on tools and targets and define price stability as stability in the creation of money and credit.
Further, this might well be the time to discuss an agreement to elect at least 50% of the Fed board members on the basis of their demonstration of at least a good measure of independence from Wall Street and professional (as opposed to purely academic) experience.
Another important discussion revolves around the inclusion of international as well as asset markets and the dynamics of Modern Finance into monetary policy making.

5.    Create a fiscal investment plan.

The realities of a deleveraging process do not offer many options for counteraction. Some might argue, as does the Austrian School of economics and others, that no interference at all would be best. But logically, especially in the current circumstances, doing nothing would hardly be politically acceptable. Yet if we commission our government, we cannot ignore that its broken political process was largely responsible for this crisis to begin with. To now trust that same process to produce a solution would be daring and risky, even under new management.
Ultimately, as has been mentioned, we don’t have a choice, short of dissolving government altogether. After all, even if government were not involved financially, we would still need it to shape future regulations and business environment. Furthermore, certain services will always need to be organized (if not provided) by government, such as security or the provision of basic infrastructure, that often exhibits public good character that the markets have difficulties providing.
Despite evidence to the contrary, many still believe they’re in a normal business cycle that got just a bit out of hand due to a disgusting subprime market. Yet a sober analysis of the roots of the crisis reveals shocking distortions and likely mal-investments in ungainly proportions. While the entire economy—and mainly those deepest in debt, the U.S. taxpayer and the financial system—is obligated to cut back a great deal, the government would be well advised to preserve its financial firepower for its top priority: a sustainable future for the country.
And government is the American people. It is the American people who must inform themselves and demand policy action that is in their best interest. Washington doesnt like to make tough decisions. The political will to take the road less travelled is rarely born in Washington. The political will for the drastic measures necessary will only come from the grass-roots, the people who have underwritten our system, the people who stand to lose most.
Following are some recommendations as to how this could be done.
a)    Government Finance
Opinions about governments’ financial safety margins vary greatly, and indeed the question of how much debt a government should carry is influenced by many factors. To a certain extent, we are enjoined to build a future for our children, who should be that much more productive and wealthy than we are. It is therefore justified to have the next generation share at least some of the burden of the investments we make.
How much? Considering the present situation, there is some urgency to push the limit more than we would in normal times. That ultimate limit, in my view, is a debt spiral defined as the dynamic that ensues when debt service payments self-accelerate and debt starts to expand self-dynamically. Unfortunately, that point is in itself not exactly determinable, but it can be said that under normalized circumstances and interest rates, the area of interest is reached in the U.S. when debt reaches approximately 150% and debt service payments surpass 10% of GDP.  That is likely not much different for Japan, which has arrived at close to 200% debt ratio and is avoiding default merely due to exceptionally low interest rates.
This means that according to my estimations, in a base-case scenario, the U.S. government should have a margin of a maximum of $15 trillion in budget shortfalls, i.e. debt increases for the next 6 years, broken down as follows:
•    $5 trillion for likely tax and other revenue shortfalls
•    $5 to 6 trillion for debt service purposes
•    $3 (max $5 trillion) for fiscal investment spending
This should, if managed well, keep government debt service payments below the point of self-acceleration and below 10% of GDP. It would likely prevent a large dollar devaluation, an acceleration of inflation, and interest rate spikes. But unlike in earlier crises, we cannot rely on interest rates remaining as low as they are today.
The total write-off from the $50 trillion debt mountain may reach far beyond $10 trillion. Even a final bill, footed by government, of only $5 trillion in excess of the above figures, would increase the debt burden of government to above 200% of GDP within five years, and an almost certain debt spiral with a total debt of more than $30 trillion by 2014 and possibly a further $10 trillion in the following five years, all on the back of self-accelerating debt service payments.
b)    Infrastructure
U.S. Infrastructure is in a state of dilapidation and backwardness compared with the modern economies of East Asia, the Middle East, and even Continental Europe. Infrastructure and energy investment have always been quasi-public goods and therefore marred by market failures, which is one of the important reasons we pay taxes: for government to provide us with what we want but the market doesn’t want to give.
Not only will the restitution of basic infrastructure and energy create millions of jobs, it will also create the necessary business environment improvements that offer opportunities to our children, as well as buy some time to sort out the regulative mess in the financial industry.
c)    Unemployment Help and Education Support
While social security in some European countries has arguably created a government hammock for many, it is frightening to see how little support in education, healthcare, and housing the poorest and often hardest-working Americans enjoy. These people, who were on the sidelines of the boom, are now caught in the middle of the destruction.
d)    Taxes
Don’t change them, either up or down. Here’s why: If you want economic traction, investment, or consumption, don’t bet on taxes. While tax reductions certainly help (mostly to increase savings), they are most unlikely to generate any consumption or investment whatsoever.
Government is battling a $50 trillion giant with a budget of at most $5 trillion, and it will likely be a long fight (five to 10 years).  It had better preserve its firepower. Reducing taxes for lower-income people may provide relevant relief at modest cost, but tax breaks for corporate and high-income classes are generally a waste of time and money, shoring up already stable groups. Tax increases would hardly make any sense today.

6.    Regulate financial markets.

The widely abused theoretical concepts of Modern Finance have been a major factor in this crisis. The resurrection of the spirit of Glass-Steagall will go a long way in curbing the worst of the abuses, but more still needs to be done:
a)    Redefine the regulatory framework to limit the sphere of Modern Finance.
b)    Instill transparency in derivative contracts by listing them and adjusting accounting rules.
c)    Redefine capital requirements in finance according to “real” concepts of risk; design Basle 3.0.
d)    Create institutional guidelines that address and optimize risk management,  with the financial industry onboard to discuss and implement.
e)    Appoint independent oversight on industry best practices, incentive schemes, and the occurrence of moral hazard.

7.    Enlist international cooperation.

Economic leaders need to coordinate their monetary and economic policies with particular emphasis on the dynamics of the monetary system we are running.

a)    Monetary policy coordination, in particular within an economy with a common currency
Most prospering emerging markets have tied themselves to the U.S. dollar in an export-driven model, mostly at undervalued exchange rates, similar to the one successfully pursued by Europe and Japan after WWII. The U.S. Reserve currency-driven monetary system installed at Bretton Woods in 1944 is well understood, and we should finally act accordingly. Financial markets are a global phenomenon and have to be treated as such. It is high time that in our globalized, interdependent world domestic monetary policy is managed with a more credible global overlay.
Overall limits on inflation, i.e. credit creation/leverage, should be established globally and locally, short of returning to a gold standard. The theory that increasing leverage creates stability and wealth has been thoroughly discredited, and a currency devaluation race to the bottom ultimately has no winners.
b)    Banking regulation, globally coordinated and overseen
The Bank for International Settlements (BIS), which has been at the forefront of warning voices, would be a good place to start. Basel Standard 3.0 will have to be designed in light of the lessons learned from our adventure with Modern Finance. Glass-Steagall has to be global. The solutions to proper risk management and overall stability of the system are to be found in institutional setup, not in mathematical models.
c)    Risk management
The widely applied concepts for risk, with which the financial industry created and degenerated the leveraged boom of the past decades, must be thoroughly questioned and publicly discussed. And again, for a host of activities, mostly those in biggest trouble, mathematical models will need to cede to institutional solutions.
d)    Economic policy
In periphery countries, economic policy has to be normalized away from the export-driven one-way train and geared toward restoring a natural economic balance. Today, the goods produced in the periphery create revenues and dollar flows. These liquidity flows ordinarily need to be sterilized to avoid domestic inflation. Accumulated dollar assets, invested back into the center of the system, are driving up the prices of dollar assets. This is relevant for monetary policy at the center of the system (USA). All credit creation is inflation, not just a favored manifestation of it (i.e., core CPI).
Periphery countries should also step away from their hard tie to the U.S. dollar, which should allow them more monetary freedom. A popular first step is trade-weighted floating, where the local currency is managed to a basket of currencies as a function of trade.
These two steps will reduce export-led economies’ interdependence, overexposure to U.S. monetary policy, and export demand. It will create more stable and sustainable domestic-consumption demand and will also reduce the system’s propensity for the creation of asset bubbles. Needless to say, real growth rates will slow.
In the U.S., policy will have to account for the system’s tendency to encourage consumption and discourage savings. Being the reserve currency prompts a credit and consumption culture as the forces of excessive leverage are exported and do not impose immediate pressures to balance, as excessive consumption goes largely unpunished and saving is not encouraged.
The global monetary wheel is created and controlled by the U.S., by the Fed. With that power comes great responsibility. The level of globally acceptable money inflation is an important discussion to have.
e)    Trade
It must be a common goal to refrain from any protectionist tendencies. Our economies are in deleveraging mode. Trade will slow automatically, but slowing it down further will only accelerate and deepen the depression. Once we understand the dynamics of the deleveraging process, we will no longer fight unemployment with protectionism.
Conclusion
Ultimately, the U.S. needs to follow a strategy that convinces the holders of its debt that its economy is strong enough and its taxpayers productive enough to back all outstanding U.S. dollar debts globally. At 3.5 times GDP, this ability is drawn into question with the possible consequence of a currency implosion, triggering inflation and putting U.S. assets into foreign hands. The current policy stance of reflation at all costs must be abandoned. Once markets lose confidence, the fall of the dollar could be quick and hard.
Understanding the extent of the issues as well as the underlying dynamics that brought us here is crucial in order to correctly frame policy action and instill a sense of urgency. Given the gravity of the situation and the strong resistance that must be expected for decisive action, it is up to the people to inform and pressure their representatives into representing their interest. It would be naïve to assume that Washington will generate the political will necessary without substantial and informed grassroots pressure.
The key to any plan of significance is an active and informed population. Decisive and bold action based on a clear understanding of the situation is what we need and what we expect from the great American spirit, which has always emerged stronger from any challenge posed by history.