There are, as far as I can tell, a lot of people out there who are for the stimulus, but don't want any nasty bankers bailed out with government money; a smaller number who favor the reverse; and then sizeable groups that favor both, or neither.  Which of them is right?

One argument is that we can't fix the economy without fixing the banking system, for reasons that Matthew Yglesias outlines:

But as Jared Bernstein was explaining on a call with progressive bloggers earlier today, stimulus and financial system recovery go hand in hand. Bernstein described the relationship in terms of a "chain." The technical term involves something I've mentioned previously, the "velocity of money" -- the speed through which economic activity moves through the system. The idea of a stimulus plan is that the government isn't just engaging in economic activity directly, but that the beneficiaries of that activity will spur additional activity. In other words, you get money via a tax cut or a job on an infrastructure program and you use some of that money to buy groceries, creating jobs for farmers and checkout people who spend their money, etc., etc.

You want the money to circulate smoothly and efficiently from those who have it to those who need it. That doesn't mean everyone needs to spend the money instantly. But it means that when people want to park their money, those funds should come available to other people who have good business opportunities that could be exploited with the assistance of a little credit. That's where a healthy financial system comes in.

You may have heard tales from Japan's "lost decade" in which stimulus measures failed to actually get the economy moving. Part of the problem was somewhat ill-conceived and ill-executed stimulus. But perhaps a bigger issue is that the didn't actually clean up their banking system. Instead, they put it on life support. And then they used fiscal stimulus to put employment on life support. But we don't want life support, we want stimulus that actually brings us back to life. And that requires a financial rescue package. Of course it also requires a financial rescue package that works and the jury's still out as to whether that's what the administration's come up with.

This is essentially the argument made by Hoshi and Kashyap in several papers on Japan, and now us.  As long as the banking system is broken, stimulus has limited effect, because the money you inject hits the banking system and just sort of stops moving. 

We're now making many of the mistakes that Japan did.  I know, I know--I supported TARP I.  But I did so because at the time, there seemed to be a reasonable possibility that the funds could stop a liquidity crisis from turning into a solvency crisis.  But if liquidity crises go on long enough, they become solvency crises, so whatever we had then, we now have a badly crippled banking system.  More of the same isn't going to help.

We need a plan that is going to force the banks to recognize and write down their bad loans, restructure dysfunctional borrowers, shut down the banks that are too far gone, and inject substantial capital into the banks that are strong enough to pull through.  But that kind of radical action is scary.  And whether they decide to do it by nationalizing bad banks, or by injecting capital into good ones, the political cost is going to be very high.  So we get baby steps and vague promises of major leaps forward down the road.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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