The only way to clean [Financial Crisis] up on a tractable time frame is to take insolvent banks into receivership, explicitly pay off enough outstanding bank obligations to get things in decent shape, break up and reprivatize new healthy institutions, and manage “legacy assets” for the long-run.But basically nobody wants to do this. Obama and congressional liberals want to focus on their core agenda—health care, energy, labor law, education. Republicans don’t want to appropriate money. And bank managers want to continue to take advantage of implicit government guarantees and recapitalize themselves out of operating profits while paying themselves multi-million dollar strategies. Given enough time, that should work. But it could easily take years and give us a prolonged period of sluggish growth.
The political economy here is really messed up. Because the government cannot spend enough money or muster the political capital to really deal with the banking crisis, the problem continues to fester. But because the government has some influence, it tries desperately to prevent institutions from failing, and so throws money around, preventing the banks from bothering to solve the problem themselves. Continued political meddling from Congress makes any private actor very reluctant to trust government policies.
I suspect that had the government taken a clear stance early on not to bail out financial institutions, we would be in a much better place. In the end, how bad was Lehman's failure? We've already endured all of the problems that would supposedly happen if banks failed. Without implicit government guarantees, and government meddling, people on their own would have much bigger stake to solve the problems themselves.
But if you are going to bring the government into it, you might as well do so in a way that manages to fix the problems, while not risking taxpayer money. That's not happening.
The Republicans/populists now stand in the way of the kind of spending and policies necessary to fix the banks. But the Democrats too are unfocused on the problem, preferring to capitalize on the crisis to pass sweeping reforms on the domestic front rather than solve the crisis. As the economy fails to recover, because we will still have a financial crisis, these debts will pile up. And they will be inflated away at massive cost to ordinary Americans.