U.S. Treasury Secretary Henry Paulson is faced with difficult policy options in the wake of recent financial market disasters and the ongoing economic crisis. What are the implications of these policy options?

Resident Fellow Desmond Lachman

Adding to Paulson's unenviable task is the fact that the source of the problems with which he has to contend is not of his own making. Rather it is the consequence of Alan Greenspan creating the largest housing bubble in U.S. history by keeping interest rates too low for too long and being asleep at the wheel in his regulatory role.

What makes Paulson's present task all the more tragic is that his role in life now seems to bear a striking resemblance to that of the mythical Sisyphus, who kept finding the rock rolling back down the hill no sooner had he got it up the hill. For no sooner has Paulson plugged one leak in the U.S. financial system than he finds another leak springing up.

As an illustration of Paulson's exercise in futility, one only has to think of his massive bailout one weekend early in September of Fannie Mae and Freddie Mac, the two giant government-sponsored mortgage enterprises, which was followed by having to limit the fallout from the bankruptcy of Lehman Brothers the very next weekend. And literally a day after his efforts with Lehman Brothers, he finds himself having to grapple with the imminent collapse of AIG, the large insurance company that has a balance sheet many times the size of that of Lehman Brothers'.

At the heart of Paulson's present predicament is the fact that the banks' past lending excesses between 2000 and 2006 spawned the biggest U.S. housing and credit market bubble in the postwar period. Now that the bubble has burst, the banks in both the United States and abroad have had to recognize unprecedented loan losses on their past lending excesses. To date, at a global level, the banks have already recognized in excess of $500 billion in loan losses. And there is every indication that these losses will continue to mount in the months ahead as housing prices continue to decline and as the U.S. economy slips further into recession.

As those losses have mounted, the banks have been unable to raise sufficient capital to allow them to repair their troubled balance sheets. This has forced the banks to curtail their lending and to sell assets in the market. However, when all the banks try to deleverage at the same time, they only compound their own loan losses by driving asset prices lower in the market.

As the deleveraging process has gathered momentum, Paulson is faced with truly terrible policy choices. Either he could effectively bail out the banks with taxpayer money, as he did in the case of Bear Stearns in March and of Fannie Mae and Freddie Mac in early September. By going down that route, he might have minimized the risk of a systemic meltdown of the financial system--but at the cost of encouraging future bad bank lending behavior.

Alternatively, Paulson could go down the route of letting a large financial institution fail, as he did last weekend when he allowed Lehman Brothers, the fourth-largest U.S. investment bank, to fail. While that course of action certainly minimizes moral hazard in the system, it does so at the cost of risking a large meltdown in the overall financial system, as underlined so forcefully by AIG's present travails.

When all is said and done, U.S. policymakers will have to recognize that the financial market problems with which they are grappling are those more of solvency than liquidity, which threaten to plunge the U.S. economy into a prolonged recession.

If Main Street is to be spared the painful economic consequences of a financial market meltdown on Wall Street, policymakers have little alternative but to resort to unorthodox interventionist policies to put a floor under the housing market and to prop up the banks with taxpayers' money.

Hopefully when policymakers are eventually forced to go down that route, they will condition any assistance on the summary removal of management and the total wiping out of the banks' equity holders. By so doing, they will at least minimize the price of creating further moral hazard in the system.

Desmond Lachman is a resident fellow at AEI.