The world's governments are shocked and dismayed by their inability to stop the increasingly grave financial crisis. Nothing they have attempted has gotten lending flowing normally. Profitable companies are cut off from borrowing. Confidence is shot. Through Oct. 7 the U.S. stock market had its worst five-day performance since 1932 on fears of a severe economic downturn. Says Stephen Jen, currency economist at Morgan Stanley (MS) in London: "The choices for the real economy are between a recession and a depression."
Can anything be done to halt this panic? As a matter of fact, yes. It won't be quick or easy. But the prerequisite for a new approach is unlearning doctrines that were developed in the aftermath of the Great Depression, the last time financial conditions were worse than this. The world has changed in the intervening seven decades, and what worked to quell the financial crisis then may not work now—as anyone trying to borrow money can see.
So far, crisis managers in the U.S. and abroad have relied mostly on using "helicopter money"—that is, dropping dollars across the financial landscape in hopes of reviving lending and spending. Generations of mainstream economists around the world learned this approach at the feet of the late Nobel laureate economist Milton Friedman, who coined the helicopter metaphor. Federal Reserve Chairman Ben Bernanke, while parting from Friedman in some particulars, shares his general approach—and in fact earned the moniker "Helicopter Ben" after citing Friedman's coinage in a 2002 speech.
Following this logic, the Federal Reserve is aggressively lending money to all comers. The synchronized international rate cuts on Oct. 8—which lowered the U.S. federal funds rate to just 1.5%—is another example of helicopter money. Central banks figure that by flooding the banking system with reserves, they can get banks to relend the money to the rest of the economy. But while lowering interest rates and providing liquidity is essential, it's no longer enough, says Paul J.J. Welfens, president of the European Institute for International Economic Relations in Wuppertal, Germany. Says Welfens: "It's very dangerous if you don't have a strategy. The situation is worsening because no one is doing a [basic] program to restore confidence."
An alternate approach that's gaining favor in many quarters is to place money strategically where it can do the most good, even if that means picking winners and losers and allowing some channels of credit to dry up for the time being. One tactic: direct government investments in selected banks on a large scale. The theory behind this approach is that the banks are so wounded that simply lending them more money won't solve anything. To restore their positive net worth so they can lend freely, banks need fresh equity, and government is the only party that's capable of providing it in these extreme conditions. Sweden used this strategy to end a banking crisis in the early 1990s. And on Oct. 8, Britain took a giant step in the same direction, announcing an offer to buy up to $88 billion worth of preferred shares in Britain's biggest banks. The government also said it would guarantee up to $437 billion of the banks' debt. "This is beginning a process of [undoing] a big problem where banks won't lend to each other for long periods," Chancellor Alistair Darling told Sky News.