Corporations can't ride out the financial crisis on their own. The state has to intervene - By Nikolaus Piper

"The state should keep out of the market," is the familiar mantra of business leaders and economists. In the current financial crisis, that is no longer valid. With the world financial system worryingly close to meltdown, the public sector must take exceptional steps.

In the days preceding the Easter holidays, the global financial crisis took on a whole new dimension. It's no longer a matter of staving off a recession in the United States or calming global share markets. There is much more at stake. The world financial system seems worryingly close to meltdown. The narrowly averted collapse of Bear Stearns, the fifth-largest investment bank in the U.S., made that abundantly clear.

Meanwhile, the U.S. Federal Reserve has crossed a red line. In saving Bear Stearns, it took on a risk of $30 billion (around ?19 billion), accepting shares of dubious quality as collateral. In Germany, the head of Deutsche Bank, Josef Ackermann of all people, said he no longer believed in the ability of the financial markets to heal on their own and demanded joint action by the banks and state authorities.

But the really stunning news came from the International Monetary Fund. In a dramatic appeal, the IMF called on the governments of its member nations to put together huge spending programs if necessary to prevent the world economy from collapsing. True, IMF official Joseph Lipsky didn't say the economy is "collapsing," preferring the term "deceleration."

It quickly became clear, however, how serious the situation is. The politicians, said Lipsky, have to "think the unthinkable" and prepare for it. For the IMF, for which consolidation is key, this signifies a change of tack that couldn't be more radical. Until just a short time ago, IMF doctrine demanded budgetary discipline even in times of recession.

The situation has become dangerously uncertain and the share markets are trying to work out which way to go. There is almost no doubt anymore that the United States is already in recession. At times, the dollar seemed to be in free fall and gold shot over $1,000 an ounce - after the Federal Reserve had already pumped fresh funds into the financial markets.

Economists and politicians in the U.S. are discussing increasingly radical measures to end the crisis. One would have the state buy up bad mortgages on a massive scale, helping both debtors and banks out of their hole. Not long ago that would have been unthinkable.

Alan Blinder of Princeton, a long-time boardmember of the Federal Reserve, called for the Home Owners' Loan Corporation (HOLC) to be resurrected. The HOLC was founded in 1933 by President Franklin D. Roosevelt, to assist homeowners by giving them fresh capital. Martin Feldstein, former advisor to Ronald Reagan, proposed a voluntary loan-substitution program. It would perhaps be a little less bureaucratic than Roosevelt and Blinder's HOLC, but in economic terms, the differences are minimal. Both models involve bailing out homeowners who have got into trouble.

And somewhere in the background of these debates lurks the specter of the "unthinkable," the memory of the global economic crisis in the past century. Experts consider the current crisis to be the worst in 60 years. True, nobody, not even the biggest pessimists among economists, is predicting the collapse of the global economy and global trade, the impoverishment of large parts of the population and mass unemployment on the scale seen back then. Economists and politicians have learned the lessons of the 1930s. Even so, there are clear parallels between then and now.

These parallels are best demonstrated with a wonderful expression that has been all but forgotten in recent years: "liquidity trap." The economist John Maynard Keynes used this term to describe the situation in the 1930s, in which investors sit on their money because they're worried about the future. According to orthodox economic theory, in a recession, interest rates fall so far that investing becomes worthwhile again. Sometimes though, says Keynes, interest rates can't fall far enough because the concerns are so great. Investors are motivated by "animal instincts," in good and bad times. Once they have been spooked, they won't come out again on their own. In this situation, the state has to intervene and save the market from itself.

The extreme risk aversion that is dominating the financial markets at the moment is strikingly similar to this liquidity trap. Because nobody knows what risks other people have on their books, the big banks are suspicious of each other, leading to sharp falls in the price of even top quality securities.

In this kind of situation, monetary policy has clear limitations. The Federal Reserve has cut interest rates more aggressively than in most of its history and yet, it still couldn't take the fear out of the market. The last dramatic step came on Tuesday before Easter, when the Fed slashed its key lending rate by three-quarters of a percent. Share markets had expected it to lop off as much as a full percentage point.

At the same time, inflation, spurred by rising prices for raw materials and foodstuffs, is worryingly high. In the United States, the situation may have eased in February but with an annual inflation rate of 4 percent, interest rates would be going up under normal circumstances. In a statement on March 18, the Fed's Open Market Committee warned explicitly about rising inflationary expectations. Some people are invoking the "stagflation" of the 1970s, low growth twinned with high inflation.

At the moment, there is no single, correct solution to end the crisis. It seems clear, however, that without the state, or to be more precise, the American state, there will be no solution. The core of the problem, the mountain of bad debt overshadowing the U.S. economy, has to be dealt with.

An important first step is the President's Working Group led by Treasury Secretary Hank Paulson. It's preparing a complete overhaul of the rules governing the U.S. financial sector. The banks need to return to proven, conservative practices. One of those, for example, is the implicit understanding that a creditor takes on some of the responsibility for a debtor who can no longer pay up - even in the era of securitization, in which debt is parcelled off and traded on financial markets around the world.

New rules create trust, but they are also about the future. The administration in Washington will probably be forced to come to the aid of struggling homeowners (and their creditors) using tax payers' money - forced by public pressure but also by the panic attacks on financial markets.

The pressure has increased since the Fed stepped in to help Bear Stearns. Why shouldn't ordinary American homeowners get the kind of support given to the big names on Wall Street?

Such a move is always dubious because it ultimately rewards irresponsible lenders, bankers and investors. The homeowners whose lives were ruined by lax mortgage lending weren't just poor families, often they were speculators betting that property prices would continue to rise. Unless that bad debt is removed at some point, it will hinder any economic rebound. Japan went through the same thing in the 1990s.

In Europe, politicians have already given in to the pressure. The British government has gone so far as to effectively nationalize one bank, Northern Rock. In Germany, in a very dubious move, tax payers were called upon to save the IKB bank. Only time will tell which step was correct and which was premature.

Still, in a liquidity trap, governments sometimes have to do bad things to prevent even worse things from happening.

- Nikolaus Piper is the economics correspondent of the Süddeutsche Zeitung in New York.