In the end, the financial rescue legislation was deeply flawed—but Congress was right to pass it. Many commentators referred to it as a “bailout” of Wall Street. In fact, the bill was even worse than that: the federal government allocated $700 billion of public resources to ensure that Wall Street would not self-destruct and take Main Street down with it.

As a country, we have a relatively low savings rate. We rely on debt to fund our excesses. That makes us heavily dependent on money lenders. Those intermediaries use our best obligations, the mortgages on our homes, as collateral for complicated securities sold to entities with opaque balance sheets. As house prices have declined, some of our fellow citizens have walked away from their obligations, reducing the worth of mortgage-backed securities. Investors have recoiled in the face of elevated uncertainty, pushing the value of those securities well below the economic loss associated with elevated defaults.

The government has to provide funds to shore up the financial firms at the center of the global trading system.

Until now, the responses of government officials have been inconsistent and improvisational. Their first impulse was to extend the federal safety net to investment banks. Thus, in March, the Federal Reserve rescued Bear Stearns, breaking a 60-year-old precedent by lending to a non-depository. That set in motion an uneven process of failure and intervention. The private sector lost its incentive to pump capital into troubled firms and gained an incentive to pick among the winners and losers of the government intervention lottery. Lehman Brothers or AIG? Washington Mutual or Wachovia? Rather than forecasting underlying values, financial markets were predicting government intentions.

We should not be here. But we are.

Having discouraged private sector capital infusions that would have solved the problem, the federal government must now fill the holes on financial balance sheets. This is a solvency problem, not a liquidity problem. The government has to provide funds to shore up the financial firms at the center of the global trading system. If it does not, then those firms will continue to shrink their balance sheets and refrain from creating credit.

If the government asked an economist for a solution, his or her advice would be simple: either inject capital directly into the firms that are systemically important or offer them some type of insurance. But this easy answer fails to recognize two inherent limitations of government.

First, the government is terrible at delimiting its programs. Any financial firm in the United States could plausibly argue that its balance sheet was impaired by the mortgage bust. Should they all be helped? That is not a question we should ever pose to our elected officials, who would expand the safety net well beyond available resources.

Second, the private sector knows far more about its own assets than the government does, which could allow financial firms to overstate their relief needs. Therefore, government support should be indirect. The government can purchase dodgy assets and improve the balance sheets of all firms. Questions of fairness and incidence seem secondary when purchases are across all markets. A rising tide can lift all boats.

Treasury Secretary Henry Paulson has been granted broad authority. He should use it. Now is the time for Paulson to show he understands that financial markets are stressed and undervalued. Now is the time for him to buy, buy, buy.

Vincent R. Reinhart, the former director of monetary affairs at the Federal Reserve Board, is a resident scholar at the American Enterprise Institute. 

Image by Shutterstock/The Bergman Group/Darren Wamboldt.