Opinion

FORMULA FOR FISCAL FITNESS

THE instant he takes office, President Obama’s imme diate priority must be to fix the economy, which is spiraling downward rapidly in the worst financial crisis since the 1930s. The clear answer is a combination of government spending (the “stimulus package”) and financial restructuring – and the latter is the more important.

The stimulus package is neither a bad idea nor the complete solution. Government spending could very well help to offset the free fall in private consumption and investment. And a sign of strong leadership might raise business and consumer confidence.

But don’t expect too much. It’s extremely hard to spend large amounts of money in a way that creates good value for society. Most of the spending should go for public infrastructure, with demonstrable long-term social benefits.

And how much GDP will the new government spending create? The administration estimates that each added dollar will boost GDP by $1.57. Even with this best-case estimate, $800 billion over two years is barely enough to reverse the GDP drop we’ll see from the mid-2008 to mid-’09.

The most important issue is the financial system. You don’t install new lighting until you’ve fixed the wiring, and the economy’s wiring is the financial system.

Japan’s no-growth decade is the classic example. After equity and house prices collapsed in 1989, the Japanese government spent trillions on infrastructure but failed to fix the effectively bankrupt banking system. The result: no growth for 10 years.

There’s some merit to arguments against giving more money to the people who created this mess, and the bailouts to date should’ve had terms less friendly to banks. But it’s critical that we focus on the future and create a well-capitalized financial system that supports the growth our economy is capable of generating.

Painful as it is, we must continue to recapitalize the banking system. Right now, several of our largest institutions are effectively bankrupt or close. Billions more are needed – but this time, we must do it in a way that isolates the banks’ accumulated bad assets from their ongoing operations. And high-risk borrowers must pay higher rates than others.

We also need to address borrowers’ concerns. Who was the source of the problem is less important now than guaranteeing an orderly process to resolve massive foreclosures on residential mortgages. The best policy will give incentives for mortgage servicers to restructure loans, probably via some combination of reduced face value and shared appreciation. Whatever the details, it’s essential that the process be quick and transparent.

Finally, we must reform the financial system. Reform will be complex but should:

* Address risk-taking incentives at financial institutions, e.g., changing the ways bankers and traders are compensated.

* Charge realistic prices for government guarantees like deposit insurance and bailouts.

* Increase the transparency of both individual contracts and financial institutions.

* Focus on the systemic, rather than individual, risk of too-big-to-fail financial institutions. We need to do what we can to reduce the chances of another crisis.

What should the new president do next week?

Pump more money into the financial system – in a way that strengthens viable banks and quickly disposes of those already bankrupt. Reinstate the original idea of the Treasury’s TARP program – namely, to use government money to buy distressed assets. Restructure troubled mortgages. Enact a government-stimulus program.

We wish President Obama and his team the best of luck. All of us have a stake in the outcome.

David Backus, Matthew Richardson and Nouriel Roubini are professors involved in the NYU Stern School project “Restoring Financial Stability: How to Repair a Failed System,” John Wiley & Sons, 2009.