Ian Welsh has a very sensible mortgage bail out proposal. Essentially it is a cram down of the mortgages that are troubled. However, it is still the beginning of the problem, the problem is a contraction of the money supply leading into a recession. The key numbers are the no longer published M3, which represents the broadest claim on future resources, and the broadest range of liquidity, and MZM, or Money to Zero Maturity, which is the immediately available currency at par value, basically M2 with CDs and money market funds removed. These numbers tell a very simple story. MZM says that we have just passed through a recession, because MZM tends to spike up during or near recessions. It has flattened out now. M3 shows a rapid run up, and then a rapid fall. This is the source of the rapid intensification of the crisis.

What happened was this: the Fed did a first round of bail outs early, and then stood pat. This was a bad idea, everyone who was paying attention knew that more bail out was needed, but the massive hit of liquidity without restriction poured into resources, the poster child of which was oil, and the federal undirected stimulus bill, made sure that the economy revved up for one last round of inflationary growth. This is why the economy improved a bit during July, because of an almost Carteresque willingness to ignore inflation.

The key question is this: the American tax payers just bought the banking system. We are going to pay, with interest, upwards of three trillion dollars for it. A relative bargain actually. The question is what we are going to do with it now that we own it. Paul Krugman's crush, Ben Bernanke, stood stone faced next to Bush and Paulson as more good money was poured down after bad. Why is it that even liberals have been behind the curve through this crisis?

Ian has started things off by giving us a sensible foreclosure in place plan. Now it is time to follow things up with a plan for a better country. Liberals have pined for a new deal moment, well, it has arrived.

Most of the time politics and economics are about decisions made on the margins. That is small choices where most things are kept the same. Occasionally the basic equilibrium itself is adjusted, and even more occasionally, there are dire threats to the stability of the system. The impulse of policy makers, elected officials, and yes, academic economists, is to praise the actions needed to keep equilibrium in place. In fact liberals are even more prone to do so, because liberalism has a greater awareness of just how many threats to the basic equilibrium there are, and how there is no internal tendency for the economy to right itself at the highest possible level of economic activity. Or, liberals praise preventing things from going to hell in a bucket, because they are aware of the fact that hell is a good deal closer than than it appears.

However occasionally there is no road back to equilibrium, because more promises have been made than can be kept. One solution to such situations is a war, which is like bankruptcy for a nation.

This happens because wealth is not a property of physics, it requires economic activity to maintain wealth. Houses, slaves, gold, money, equipment - none hold value without other activities. The upkeep of wealth, in itself, is a drain on the economy. However, without wealth, there is no economic activity at all. Thus all economies exist at a knife edge, because having acquired wealth, those who have it desire nothing more than it's continuance. Having its continuance, they begin to believe that others should pay the upkeep for their wealth. Thus the obsession with aristocracies is to be tax exempt, and to create an ideology that does two things: rationalizes why wealth is an inherent property, and therefore the duty of society to maintain at common expense, and why they are superior to others, and hence deserve the wealth they have.

In our own time this twin role was filled by libertarianism. Libertarianism was a pseudo-ideology. It wasn't in fact a coherent theory of the world, nor was it ever intended to be. Instead it was a way of creating an excuse for social liberals to vote against their own economic interests, and a cover for social conservatives to vote against everyone else's economic interests. Libertarianism simultaneously offered an explanation as to why the people who were successful deserved their wealth, and why they should not have to contribute to society at all for its continuance.

This is hardly the first time a pseudo-ideology has been used to convince people on the very peripheries of privilege to support a system.

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One of the crucial moments of the New Deal was one which occurred before FDR was in office. He was offered, by Hoover, a chance to wield the powers of the Presidency early, if, and only if, he renounced the "so-called New Deal." For those who forget how radical even the outlines of the idea were, it has to be reminded that FDR had only two hard promises, other than the repeal of prohibition. The first was relentless experimentation, the second was some form of social insurance. Everything else, was on the table. FDR replied that he was still a private citizen, and would assume the duties of office at the constitutionally appointed time.

That is to say, FDR invited Herbert Hoover to engage in political auto-fornication. Now this is one of the most hard minded decisions that could have been made. It is absolutely true that some people who lost everything in the intervening months would have been temporarily spared had FDR accepted the agreement. It is also clear that millions more would have suffered far worse. FDR, as much as he would be the architect, or at least General Contractor, for the liberal state in America, was also willing to break eggs to make an omelet.

It is precisely this willingness to take short term losses, to not be held hostage by a mad man, that made FDR able to see through the project to its conclusion.

Similarly, Lincoln, thought more moderate on slavery than other Republicans, stiffened his back at the "Crittenden Compromise" which would have made slavery permanent through amendments to the US Constitution which could not be repealed. Again, the willingness to defend a line in the sand on principle helped precipitate the crisis, but gave hope to it's better resolution. By the time he expressed a willingness to have the Corwin Amendment passed, and transmitted the text of the amendment to the states, including those that had voted to secede, the die was already cast.

These were both moments were the previous equilibrium could not be maintained. More promises had been made than could be kept.

We are now at a similar moment in history.

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It is customary in these neo-monarchist times for private citizens hoping to wield some influence with a political figure to engage in the obsequiousness which sovereigns demand from subjects. It is a custom that I set aside, simply because every political leader is surrounded by a gaggle of people who coo nothing but unmeasured praise into the ears of the source of their gravy train. To be blunt: Barack Obama has been, here to fore, the weakest of candidates, pretending repeatedly that he would come to office with freedom of action to be a reborn Ronald Reagan. It is clear, to anyone who can count, that with trillions spent - adding this one trillion to the FDIC being nearly broke, the Fed filled with garbage debt on its balance sheet, the government farther in debt than official figures cite, and a huge off budget military commitment required regardless of policy - that the nonsense floating in the campaign bore no relation to reality - and further, it was a dangerous unreality.

What has been stripped bare is the delusions that the last 8 years did not happen. What has been stripped bare is the deceit of what has been called "big government conservatism" by one of it's supporters. A nation cannot have an unregulated free market, and yet run massive deficits to pay for distorting economic activity. Libertarianism is, and always has been, a wholly owned subsidiary of the far Hooverite wing of the Republican Party.

It is the sort of moment where executives are made or unmade. It is also the moment where their own underlying theory of government is made manifest. In the case of FDR's refusal of Hoover, it was a belief that simultaneously in both formalism and freedom. In Lincoln's case, it was a bend but do not break morality. Each future executive showed a care in defending the core of his freedom of action. Each executive drew the line at restrictions on how the future should be allocated.

To understand this moment, it is important to understand that it is not, mostly, a financial, physical, or theoretical crisis. It is a political crisis. It took no new economic formalism to foresee the use of revenue reductions to bail out the dot com bubble, devaluation to pay for those reductions and a war, a flaw in inflation accounting used to create a secondary bubble in real estate. Ordinary macroëconomic theory was quite capable of showing how each of these pieces fit together. Ordinary macroëconomic theory was quite capable of predicting the outcome. One could, in fact, build an almost bullet proof case against George W. Bush's economic plans, just by quoting Bernanke, Greenspan, and Mankiw.

While some improvements in mesöeconomic theory would allow people to see how monetary policy's supposed superiority to fiscal policy is illusory, since monetary policy comes attached, as is now abundantly clear, to fiscal and regulatory policy which means that it is never seen in the wild in the form predicted by open currency macroëconomics, this would not have been necessary to prevent what happened. It was well understood that Bush's fiscal and monetary policy regime was a catastrophe in the making, and only a unison fear of stating the obvious prevented people from saying it. Nothing is harder than telling people rolling in fake money, that it only gets dirtier the more they do it.

The problem is political. Having a sensible fiscal regime half the time, and the other half a criminal plundering of the treasury under corrupt cronyism, is not sustainable. The political problem is a vicious circle. With each failure to hold those in power accountable, they grow wealthier, and thus harder to ignore in the body politic. The malefactors of great wealth are not only too big to fail, they are too rich to prosecute. And with each failure to prosecute, they grow richer. Name one high official of this administration that will see the inside of a prison cell. Are the CEOs of the failed banks going to spend the rest of their days lighting cheap gas stoves with matches begged from the corner store? I think not.

While a better economic theory is needed, and would point the obvious way out of this crisis, no economic theory will suffice if the underlying political infirmity is not addressed.

What then is the source of this crisis? It is relatively simple. The United States has an economy which uses the development of land as the basis for money. At the time this system was created, America had unexploited oil reserves, unexploited land, and untouched reserves of labor and capital. The trick was to convert raw oil and land, into demand that would turn the factories. This, in turn, meant creating an incentive for those who ran the factories, and the ability to direct the national effort.

In the 1970's we reached the limits of domestic oil production. The liberal movement was unable to create a different direction, and America entered a neo-conservative era, whose mandate was to keep the land casino churning, regardless of how. This led to the creation of the paper for oil economy. The trick being to constantly create new ways of inflating paper, to buy oil. This process could have continued for sometime longer had America and Americans been more prudent. They were not. Instead all was staked on a single throw, to get the oil back.

The pressure of the paper for oil economy was to make it so that strategic acquisition of key assets was just beyond the reach of the oil states, and later, the mercantile states. Only Japan and Saudi Arabia ever were serious threats to do this. The Bush era used mortgage backed paper, and federal debt. The meltdown of mortgage backed paper, however, is not beyond the ability of the world's dollar reserves to buffer. The Chinese, Russians, Saudis and others have plenty of dollars. It is that if they do so, they will, and should get, voting control of the key financial infrastructure of the US and Europe.

The crisis is then how to force the American public to pay for continuing to keep control of the banks, without giving them actual say in running them. Government of the people, but not by the people or for the people. It should be noted that Rep. Barney Frank has recently called on the Fed to be democratized. It is something that has been obviously needed for some time. The answer to this crisis then comes from a political realization, an economic realization, and a social realization.

The economic realization is that the assertion that government doesn't matter is wholly without merit. The various pseudo-arguments, such as the size of government relative to the economy, are errant nonsense, concocted on cocktail napkins as a way of selling pork to the American public. The word fraud is correct here, regardless of how many right wing hacks have places in the academy. This economic realization, builds into a different synthesis of micro- and macro- economics through the lens of strategy and turbulence, that is to say, meso- scale economics.

The political realization is the obvious consequence of this. If government matters, then the American public must both participate in that government, and it is not free to simply choose between which ever two alternatives arrive on their doorstep after labor day.

This means that there is a social realization. The United States cannot, if it wishes to remain a global power, spend trillions in pandering to the neurosis of at the fringe of sanity. Darwin denying genocidal thugs who drive pick up trucks, however much money Fox News makes selling them lies and lubricants, cannot, any longer be regarded as an immutable social wall. I know that politicians must be more diplomatic in saying this, but we really do need to understand that one cannot compromise with crazy.

In fact, directly, Ben Bernanke was hired to make it so that crazy would never be out of money. Crazy, you see, has to capitulate to sanity when crazy has blown all of its money. Bernanke came equipped with an academic pedigree that said that there was always a way out. Bush liked that. Made him Fed Chairman.

Crazy, if it never ran out of money, could then avoid ever having to accept social equality and the liberal society, even though it would have the power of the liberal state. Conservatives could act like communists and spend like monarchists, knowing that should they run out of money, they could simply steal more from the Treasury without consequence. The Democratic Party has been an eager and willing participant in this process, and history will record them as the most willing to participate in lawless evil since the days of the Corwin Amendment. Perhaps, as a gesture to State's Rights and the Southern Hegemony, they could have states ratify this amendment, and thus abolish the 13th, 14th and 15th amendment at a stroke. They've already abolished the repeal of poll taxes.

If this essay seems acid, it is that eight years ago we were told by those who live high and fine, that Bush would govern as a "moderate" from the "center." We were told that Iraq would work out. We were told that the tax cuts would pay for themselves. We were told that housing values would not fall. We have been told over and over again by those whose job it is to capitulate to power to trust power. In each case, from which ever party, power has behaved in the interests of a narrow range of courtiers who existed to suck the money from the figure at the center of their faction.

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The answer to this crisis then is to restore equilibrium. To restore equilibrium means that the future flow of control and activity must balance. There must be enough action to sustain the direction that people have deferred consumption for. This means the problem with the global economy is extremely simple: there is too much fake money bidding up control, and that fake money is now entangled with real activity. The rich have grown so rich that they are able to trivially consume far more than everyone else. The rich did not used to be a significant burden. They largely flew on the same planes as everyone else, and while they could cut to the front of the line for resources, they could not drag down the whole of society. These two factors, that there is not enough activity to pay for the control which has been promised, and the global elite are consuming, in no small part because of the cost of their propaganda machines, more than can be sustained, lead to a very simple description of the problem:

Lack of investment supply. Investment demand is money looking for returns. Investment supply is the stream of businesses that can improve the total sum of happiness at a rate that can pay for the capital that they use. There is plenty of investment demand. While demand creates those who seek to fill it, it does not create supply. Just because you pay for it, does not mean you are going to get it.

This can be seen by the spiraling cost of a risk adjusted dollar of earnings. It can also be seen in the capsizing of the remaining areas of profitability.

It is this, and not the much maligned free trade of the reactionary protectionist that is the core problem. On the contrary, we have had the most protectionist policies imaginable in the last 8 years, with all of the effort and growth in the American economy coming from non-tradeable activity. Housing. Health care. homeland Security. War. Indeed the tax breaks given to mortgages and housing made it far more attractive to invest in non-tradables. People fled competitive trade, and entered safer non-trade. Since non-trade burn more oil, but created no new export to pay for it, there was debt. Regardless of what fiscal or economic regime, the means themselves, whether CDOs, derivs or something else, would have been secondary. What was important was loaning the revenue stream from non-tradeables.

However, this mean that with each iteration, fiscal and monetary stimulus become less effective, and more inflationary. It was precisely the same problem that led to the 1970's only with wages. Each rise in wages led to more oil demand, which led to more inflation. Each rise in debt met with a rise in oil prices as a response. Oil was the one tax people had to pay.

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So there it is, the solution is to restore equilibrium by creating a flow of investment. However, the brute force ways that people want to do this are not going to work. Consider for example "energy independence." Now if it were profitable to do this, then 140 dollar a barrel oil would have had investors lining up to do it. No such investors lined up, because energy independence means spew more carbon into the air, and the people doing this know they are going to do it any way. While energy independence can be used to extort a few drilling rights and build a few nuclear reactors, it does not generate a single bit of human happiness that would not have otherwise have happened.

Consider another, protectionism. Which will be met with protectionism in turn, and hence less exports, and even more pressure. At a certain point those outside will be tired of not being able to buy anything, and they will dump dollars. The result will be chronic high inflation here.

The answer in the very short term is to expand deposit insurance to cover all brokerage accounts and financial instruments, where ever the brokerage is based, as the price for access to the financial system. People already pay high mutual fund fees, the objective is to take a share of these fees that are currently going to put brass on door knobs, and make them into revenue. Step one is to globalize the function of the FDIC, which can be done through the IMF.

The second step is to impose a Pigou-Tobin tax on currency exchanges. Basically, any time someone changes currency X into currency Y, he has to pay the difference in their relative carbon foot prints. Go from high carbon to low carbon, pay less, go from low carbon to high carbon, pay more. It will mean that Japan will look better relative to the rest of the world, except their exports will count heavily against them, exports to high carbon being carbon. The design of this can be back figured from the sums needed.

Put all of the debt from Bush into a fund that will be paid by this revenue stream. Take on liquidation of high carbon activities in the US. For example Samuelson's renewal of the calls to buy junkers and take them off the road for scrap.

They key is to avoid being saddled with the debt, and leaving the same bums in charge. It's really that simple. That's why the Village is all fuzzy for the RTC all of a sudden: the consumer takes the shaft, and the people who crashed the sports car walk away scott free.

This is Obama's Presidential moment. If like FDR and Lincoln he torpedoes an unacceptable deal imposed on him by an outgoing order that wants to get everything in return for not knocking over the apple cart, then he has a chance at greatness. Otherwise he's just another janitor in the elephant parade, who will be, perhaps, well remembered by the people who do solve the problem, simply because they will need to well remember a few people as part of what they do.

His campaign option is simple: this bail out, if passed is toxic to the American public. People who have not seen a raise in 8 years, who are upside down in their homes, who are going to get laid off from some of the few good jobs streams left, who are in industries not being bailed out, are all going to be united in seeing this as what it is: odious frat boy socialism. If Obama wants to right flank the Republicans, then here is also his chance. He can present himself as a Main Street Republican at heart, as FDR often did, saying that the people who got to play, must now pay, and that personal responsibility attaches to great wealth.

So here it is Obama people, your guy wanted a defining moment. Today and tomorrow are it. The rest of us won't know how it went until much later, except we will see pretty quickly whether the bailout saddles us with the toxic waste, and gives us nothing in return. If this is the case, Obama will be a failed President before he even takes office, and we have to do this all over again, starting from 1992 and running through at least 2004, when the American public had a chance to get off this train wreck before it happened. Thus while there are lots of plans like National Health Care that will save a great deal of money, the reality is the progressive movement needs to answer two questions, really.

1. What promises are the people outside the US going to take in return for not foreclosing on is, because they can by just dumping dollars and raising the price of oil.

2. What mandate are we going to have that will allow us to tax those same people in order to make it so that the control of the world economy doesn't move to Dubai.

Everything else is merely an elaboration of your answer to these two questions.

Today's task is to raise a hue and cry to prevent a Republican Toxic Corporation from being formed. The "bad bank" idea is a bad idea. The public has to scream, and scream today, that they will not be stuck with this pig, while the people who have been slathering lipstick on it flee. That's really simple. No bailouts for the bums. Bad banks are bad ideas. Who ever heard of a bank that started out broke?

The rest, there is a great deal of work to do. The test for any plan must be that it will again allow M3 to rise, but sustainably without creating oil inflation. Higher M3 without resource inflation, simple policy test. To do this we must restore the linkage between MZM and M3, again without inflation. That means creating a new stream of value, and that stream of value must have a scalable growth path.