In the weeks ahead, Congress may finally provide American families with a seat at the financial regulatory table in Washington, D.C. If Congress passes the Consumer Financial Protection Agency (CFPA) Act of 2009, on which the House Financial Services recently reported favorably, it will establish, for the first time, a federal agency whose sole mandate is to evaluate financial products through the lens of consumer fairness. By putting the tools to evaluate loans in the hands of borrowers, it would also give families the chance, as well as the responsibility, to protect themselves.

For years, the consumer credit market has been broken. Healthy markets depend on full information between parties to contracts, but lenders have systematically hidden the costs and risks of consumer credit products while burying a wide assortment of tricks and traps in the fine print. The result is that consumers can’t compare the costs of different products or distinguish safe lenders from risky lenders. Because the costs and risks are so well-hidden, the broken market undermines real consumer choice, inhibits consumer-oriented innovation, and leads many borrowers to over-consume credit, putting themselves--and our whole economy--at risk.

This broken credit market results largely from the fact that consumers lack the same sorts of basic safety protections that they enjoy in markets for virtually every product we touch, taste, or smell. While several federal agencies exist to regulate banks, the regulators themselves are competing for the banks’ business. Today, financial institutions can “shop” for the regulator that regulates least, picking their regulatory agency by changing their charter. When a financial institution changes its charter and leaves a regulator, it takes substantial fees with it--paying them instead to the new regulator. Not surprisingly, the regulators understand the competitive environment they face. They have been quick to race to the bottom, offering the lightest touch in order to maximize fees and budgets. Even if they ignored these pressures, the regulators have other missions that take a higher priority. Banking examiners tend to focus on things like balance sheets and capital adequacy requirements, while the Chairman of the Federal Reserve focuses on monetary policy. For both, consumer protection is far down the list of priorities.

For proof, just look at the record of the agencies over the past generation. The Federal Reserve had the power to outlaw the most egregious subprime practices, but it chose repeatedly not to enact stronger rules and not to enforce existing consumer protection laws. The Office of the Comptroller of the Currency (OCC) has been more vigorous in its enforcement--but on the side of the banks instead of consumers. The agency worked hard to ensure that certain banks under its protective umbrella were shielded from state laws that might have averted some of the worst financial pain.

The current crisis offers a case study for the need for change.

In the years leading up to it, a huge industry thrived on a model of selling unsustainable loans to persons barely qualified, if at all, to pay the loan for a short term--typically two or three years. The business logic of the model relied on the high fees produced by serial refinancing, before the ARM “exploded” or the “Pay Option” Loan “recast.” Over the long run, serial refinancing was a losing game for the borrowers; it was staggeringly expensive, and it required perpetual increases in property value to provide the equity necessary to fund the next refinance. If the market flattened, and refinancing was impossible, the homeowners could lose everything they had invested.

As the signs of the coming crisis became clearer, federal agencies turned a blind eye to these practices. Despite calls from state attorneys general, housing experts, and academics, regulatory agencies took little interest in the ways the risks underlying these loans were repackaged and resold through mortgage-backed securities, derivatives tied to those securities, and credit default swaps of the type that ultimately swamped AIG.

At no point did regulatory agencies consider whether the harm to borrowers of highly leveraged, unsustainable loan products outweighed the benefit of short-term home ownership, nor did they ask whether refinancing was used to move people out of affordable mortgages and, eventually, out of their homes. At no point did any federal regulatory agency consider the predictable harm to our communities and their tax bases if unsustainable loans began to fail en masse, as lenders knew they would if home values leveled off. And at no point, as tricks and traps pricing became a prominent part of large banks’ revenue plans, did any regulatory agency consider how fee-gouging exacerbated the ongoing consumer debt crisis.

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The result of industry recklessness and regulatory failure was massive systemic risk that, once materialized, required equally massive government intervention that has cost at least a trillion dollars. While small businesses and families are left to fail when they take on unsafe risk or make bad decisions--1.5 million families and entrepreneurs will declare bankruptcy this year alone--we have been told we have no choice but to bailout the largest players in the financial sector.

One of the most important lessons from the financial crisis is that we need a regulator who will create safety baselines in the consumer credit market and bring clarity to a market loaded with tricks and traps. Clearer financial products will come from clearer rules in Washington.

The CFPA is designed to scissor through the existing consumer protection regulations, which are scattered among seven federal agencies and are as incoherent and ineffective as they are costly and cumbersome. The CFPA reported out by the U.S. House Financial Services Committee would create smart rules that would promote comprehensible, transparent products and, in turn, empower consumer choice and increase competition. This will be a welcome relief for many lenders--particularly community banks--that have been caught between the desire to offer clean products and the need to compete with the charlatans who promise lower prices, then boost their profits with consumer traps.

Of course, a market that allows for real competition drives price closer to the marginal cost of production and won’t be so profitable for some lenders. They want to hang on to their current business model. So, lobbyists have vowed to kill the agency and to make sure it never gets out of Congress. Others are furiously working to get exemptions and to dilute the agency’s overall effectiveness. According to Common Cause, banks, financial houses, and credit card companies pumped approximately $42 million into their lobbying efforts over the first six months of 2009 so that they can continue business as usual.

While the CFPA bill that emerged from the U.S. House Financial Services Committee is strong and has the potential to put an end to the Wild West era of consumer lending, the industry has already won some key concessions. A recent amendment weakened the ability of states to create rules that would go beyond the federal standards to protect their local citizens. This amendment grants discretion to the OCC to preempt state standards on a case-by-case basis when it determines that a state law prevents or significantly interferes with the business of a national bank. While this marks an improvement over current law, it is not as strong as the original CFPA proposal. Yes, compromise is the hallmark of the legislative process; however, states need plenty of room to maneuver to protect their own citizens.

States are important leaders in combating unfair and deceptive practices. Massachusetts, Illinois, New York, and North Carolina took the initiative to protect consumers and to go after predatory lenders well before the federal government intervened. Allowing states to participate meaningfully in rule-writing and enforcement efforts can lead to early detection of fraudulent practices, swift action to stop violators of the law, and the promotion of honest competition.The states can be a resource and a partner in protecting consumers, which is why the large financial institutions want them leashed.

Lobbyists have also succeeded at winning an ill-conceived exemption for auto dealers that originate consumer auto loans. The amendment would protect the ability of auto dealers to collect a fee for selling high-priced loans to customers--a practice that can cost families thousands of dollars. For moderate and lower income buyers, the high cost of these loans combined with limited other loan options makes these types of transactions ripe for predatory lending. (The abuses have been common and well-documented.) The exemption not only shields unscrupulous auto dealers from joint federal and state oversight, but it also gives those auto dealers a competitive advantage over community banks and other lenders.

We have already paid the price for lax regulation and unbridled free market decision-making: hundreds of billions of dollars in government bailouts, millions of consumers tricked into deceptive financial contracts, blighted cities and towns, and a financial crisis worse than any in our lifetimes. This price is too high. The CFPA would help make sure that we don’t repeat these mistakes in the future or ever again incur these enormous costs.

Martha Coakley is the Attorney General of the Commonwealth of Massachusetts. Elizabeth Warren is the Leo Gottlieb Professor of Law at Harvard University and is currently chair of the Congressional Oversight Panel.

It's safe to say there are not too many investment banking chieftains whose idea of a compliment was to tell you after a meeting that "you showed a certain amount of fingerspitzengefuhl in there." To which the appropriate response was, "Only a certain amount?" Followed by the inevitable rejoinder: "But were you effective?" Bruce Wasserstein, who died this week at 61, loved complexity and was a genuinely complex man himself. Like many of his former colleagues, clients, and competitors, I'll be trying to figure him out for years. And I'm looking over my shoulder, expecting his editorial comments any minute now.

For 15 of the last 20 years, off and on, I had a chance to work with Bruce (no one referred to him by his last name) and, well, negotiate with him. Not just about every aspect of professional life, but about such mundane issues as where to eat and when to leave for a meeting and whether to meet at the elevator or downstairs and whether to call to say you might be running late. This could be quite exhausting. He had a remarkable ability to get his way, even among the headstrong and rather self-important bankers and lawyers who make up the mergers and acquisitions community. After a while, you just began to cave. But then he wouldn't allow you to capitulate, so the negotiation cycle would begin anew.

Bruce had a love of media from his days on the University of Michigan student paper to his recent proprietorship of The American Lawyer, The Deal, and New York magazine, which helps explain why his son Ben was such a talented online editor here at TNR. Bruce's dalliances with self-promotion--his desire to create and control his personal narrative--sometimes got him into trouble because our celebrity-driven culture of journalism revels in cutting down those whom it has built up. Even he could not flawlessly negotiate his image management with the entire global press. But beneath the spin and the occasional controversy lay a substantive personal history of innovation in mergers and acquisitions, which makes his contribution an important piece of the economic history of the past quarter century. In a people business, Bruce (who was quite shy personally despite his aggressive persona) took a cerebral, intellectual approach to advising companies.

What was this innovation and why did it matter? Together with his longtime partner Joe Perella, Bruce understood that the combination of steady deregulation, globalization, and generous capital markets conditions had radical Darwinian implications for publicly traded corporations. Whereas the merger boom of the 1970s was driven by the notion that diversification and use of equity on the part of conglomerates created value, the disintermediation of traditional banking and the growth of bond markets turned that on its head. Public corporations needed to focus their business lines and restructure their portfolios. The problem was that this could not be done easily overnight and not every management team was ready for the accelerating pace of change. For every General Electric there was a General Motors. So M&A became a necessary strategic tool both to advance corporate objectives and facilitate the movement of assets to their highest valued user (to use the neoclassical lingo of the Chicago school). And the corollary was that the effective use of M&A techniques could differentiate certain companies from others in an age where shareholder value maximization ruled. Bruce broke new ground--and broke some glass--by bringing creative but unfamiliar tactics into the boardrooms of corporate America. This in turn added to the stock market's rocket fuel and reinforced the apparently benign Age of Equities. Eventually corporations, like most of Bruce's counterparties, capitulated. M&A is now an integral part of the business landscape, for better or worse.

My years at Wasserstein Perella and Lazard (or Wasserstein Not Perella, as some dubbed it) have given me a fair bit of material for what Disraeli would call my anecdotage. Bruce had a good sense of humor. After one particularly unsuccessful marketing session with a Silicon Valley CEO, the two of us, along with my partner Paul Haigney, started to recall our worst business meetings ever. There were lots of candidates. But Bruce's favorite was the time he was running late and his assistant told him he needed to get to his conference room right away to meet the finance minister of Slovakia.

Arriving well behind schedule, Bruce proceeded to launch into a distinctive, long-winded Wassersteinian monologue about all of the different issues facing Slovakia's privatization program, corporate sector, and politics generally given its recent separation from the Czech Republic. And why, of course, Slovakia needed a banker like Bruce to steer it forward. The guests and his colleagues tried unsuccessfully to interrupt several times. Finally, the finance minister said, "Excuse me, Mr. Wasserstein. We are not from Slovakia. We are from Slovenia." The way Bruce told it, the room went silent, with ashen faces around the table. After a brief pause, Bruce--always a bit faster and more confident than most of us--answered: "And that's precisely your strategic dilemma." What was the poor Slovenian finance minister to do, other than cave?

Laurence Grafstein, Chairman of The New Republic Advisory Board, is managing director and head of M & A at Rothschild in New York.

For the handful of people in charge of saving the U.S. economy, it’s been a grueling season. The last eight months have featured endless back-and-forths, tense stalemates, and spirited confrontations. Larry Summers, the president’s chief economic adviser, has drawn blood with his lacerating quips. Treasury Secretary Timothy Geithner has dropped expletives to signal his frustration. Even their aides have gotten in on the action.

And, in those rare instances when the wonks get a break, they step outside their conference rooms, loosen their ties, and do the same thing all over again. On a tennis court. For years, Summers, Geithner, and a variety of deputies have stared each other down from opposite sides of a three-foot-high net. These tennis relationships have played out on courts from Jackson Hole, Wyoming, to Davos, Switzerland, and on pretty much every flat surface in Washington, D.C. It turns out that tennis is the unofficial sport of the Obama financial team. And, if you want to understand the way its members go at it behind closed doors, it’s worth watching them go at it with tightly strung rackets.

Start with Summers, the famously blunt former president of Harvard. It’s not hard to deduce the on-court approach of a man who, as a young professor, favored such expressions as, "Here’s why what you’re thinking is wrong," and who believes the way to respond to a financial crisis is with overwhelming force. "Basically, he hits the crap out of the ball," says Jon Gruber, an MIT economics professor who began playing with Summers in the late 1980s.

A quick look at Summers suggests diving for drop shots isn’t really his game, though opponents say he’s deceptively agile. The typical Summers point will start with a cannon-like serve. If the return is weak, the bulky six-footer will cut the ball off and swing for a difficult angle. Each additional shot is more likely than the last to either be out or un-returnable--the shorter the rally the better. As a player, "Larry is very tenacious … like his personality," says Summers’s sometime coach, Nick Bollettieri. "I don’t think Larry ever smiles." (Adds Bollettieri: "I told Larry if he has enough money, I can still get him to another level.")

It may come as a surprise that the normally understated Geithner--his trademark verbal tic: "I don’t know anything about this, but …"--would play a similarly incautious game. But, decked out in tennis shorts, Geithner is wont to let it rip. "He’s a little different on the court than Tim Geithner the central banker," says one colleague. "When he isn’t playing well, it’s because he’s going for it and missing, not because he’s being too careful." Though nearing 50, Geithner is a natural athlete with a runner’s physique. He can materialize at net so quickly it feels like he served from mid-court, and the sight of his five-foot-eight-inch frame almost dares an opponent to lob him. This is generally not advisable, as Geithner has more impressive ups than you expect to find at a G-20 summit. One hallmark of a game with the Treasury secretary is an unusual number of overhead smashes. Geithner was, after all, a Summers protégé.

Since the inauguration, Geithner, Summers, and several other senior economic officials--including Deputy Treasury Secretary Neal Wolin and Assistant Secretary Alan Krueger--have played roughly half-a-dozen doubles matches. (Various members of the group rotate in or out on any given day.) The star of these outings is Gene Sperling, a top Geithner aide who, early in the administration, became known as the "undersecretary of everything" for dispatching the many thankless tasks circumstances had thrown his way. As a teenager, Sperling’s scrappy baseline play won him a tennis scholarship to the University of Minnesota, where he broke the will of more powerful opponents by chasing down every shot. So far this year, the team with Sperling on it has taken all but a single set.

This is not for any lack of effort. In February, Geithner and Sperling teamed up against Summers and Krueger for a match at Washington’s Rock Creek Park Tennis Center. Geithner and Sperling took the first set 6-3 on the strength of their aggressive net play, forcing Summers and Krueger to scramble defensively. There was talk of switching teams once the set ended, but the idea was promptly nixed. "We thought we’d come back," says Krueger. He and Summers proceeded to lose 6-3 all over again.

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Most of these tennis ties date back to the 1990s, when the men filled out the upper ranks of the Clinton economic team. But it took the Bush administration to usher in the golden age of Clintonite tennis. Not long after leaving office in 2001, Summers and a Treasury colleague named Lee Sachs spent a long weekend refining their strokes at Bollettieri’s world-famous tennis academy in Florida. (Among the illustrious alumni: Andre Agassi, Boris Becker, and Anna Kournikova.) "He and I were making the adjustments to post-government life," Summers recalls. "His father lived down there, and we decided to try it for several days."

The trip soon became an annual ritual, with Geithner, Sperling, and several other former colleagues joining in. Each March, the wonks-in-exile would present themselves to the Bollettieri instructors for two days of extensive drilling. In one particularly taxing exercise, the campers would hit a forehand approach, then charge the net to take two volleys before sprinting back to the baseline--one after the other in a whir of circular motion. Imagine the Waltz of the Flowers from The Nutcracker; then imagine that the dancers are middle-aged men of roughly average dexterity, and you have the idea.

Well, most of the idea. "Those guys are very, very competitive. Put that in there. Holy shit," says Bollettieri. "There’s no friendship on the friggin’ court. They want to beat the shit out of everybody." And how do they stack up? "Sperling is better than any of us," Summers says. "I was probably second-best at hitting the ball, but I don’t move as well--I’m not as fast. So I would say Geithner or I were probably second-best."

As it happens, ranking the members of Obama’s economic team has been a Washington pastime from the get-go--albeit according to influence rather than their ground strokes. Geithner is widely believed to have beaten out his former mentor for his current job, and the press has seized on any sign of discord. "Mutual acquaintances say that the longtime friendship between Mr. Summers and the 47-year-old Mr. Geithner has been strained," The New York Times wrote this summer in an exhaustively reported account. The piece was replete with verbs like "forcefully debated," "clashed," and "collided"; a major subplot was a sharp-elbowed struggle over access to the president.

There’s something to be said for this storyline. So far this year, Summers has grilled Geithner over his reluctance to nationalize banks. He’s prodded Treasury officials to make sure the stress tests were tough enough. (An Easter Sunday meeting on the subject ran five or six hours.) For his part, Geithner reportedly lobbied the president to reappoint Federal Reserve Chairman Ben Bernanke--with whom he’d worked closely during the financial crisis--even though Summers’s desire for the job was well-known.

But these tales of intrigue can miss a more subtle dynamic: The members of the economic team are close confidants. They spend evenings at tennis camp discussing children and career moves. They decorate their offices with pictures of each other in tennis garb. It’s only every now and then, when they reach a point in a match that will separate winner from loser, that their competitive pride kicks in. Conventional wisdom aside, the men aren’t enemies or frenemies or even rivals. They’re more like … frivals.

Late this summer, at a tennis court in Washington, Geithner teamed up with Sperling to take on Krueger and another colleague. Krueger’s team notched a commanding 6-1 win in the first set, then Geithner and Sperling stormed back to a 4-1 lead in the second. That’s when the trouble started. "I hurt my hand too bad to keep playing, and Tim really hurt his back," recalls Sperling. But neither wanted to throw in the towel. "We stayed on the court for another thirty minutes negotiating who was going to look weak and use their injury as the excuse to end the match." Finally, they agreed to call it quits so that neither would be crippled. Every frivalry has its limits.

 Noam Scheiber is a senior editor at The New Republic.

The shock of the financial meltdown has had congressional committees scrambling for their gavels for the better part of a year. Politicians have been discussing how to make sure that such a near-cataclysm never happens again, and, for the most part, they've focused on the need for new regulation. What's called for, President Obama said in March, is "a financial regulatory mechanism that prevents the kind of systemic risks that have done so much damage over the last several months."

But all the talk of regulation misses a key point: If we don't know which institutions are doing what--if we don't actually monitor what we've regulated--then that regulation won't work.

Indeed, signs of regulators' ignorance about what really goes on in the financial markets have been building up for years. Regulators got a warning in 1998, when a little-known hedge fund called Long-Term Capital Management (LTCM) suddenly faced collapse over a series of bad bets on emerging economies' debt. It wouldn't have made news, except that the little fund from Connecticut turned out to be holding 5 percent of the market where financial institutions traded risk with each other. In Washington, the heads of the major financial regulators were frantic.

"When LTCM came close to collapsing in the fall of 1998, that came as a great surprise to the Federal Reserve Bank of New York and to the Board of Governors, even though the counterparties to the contracts of LTCM were the big banks and the big investment banks," says a highly placed member of the Clinton administration.

Yet the authorities didn't learn. Two years later, the Commodity Futures Modernization Act, whose formulation was guided by a report signed by Alan Greenspan and Larry Summers, removed whole categories of so-called "over-the-counter" derivatives from oversight, allowing financial institutions to trade these securities in secret. It didn't take long to see what could happen: In 2001, the Enron debacle showed how a single company could use over-the-counter derivatives to accumulate billions of dollars in debt--unbeknownst to rating agencies and its own shareholders.

And still the laissez-faire attitude of regulators continued, even through the signal event of this crisis, the collapse of Lehman Brothers, when it became clear that the government simply hadn't understood the extent to which letting Lehman fail would tear the tightly knit fabric of the markets. The current crisis "probably was the result of inadequate information with too much financial innovation," says Malcolm Knight, a vice-chairman of Deutsche Bank who led the Bank for International Settlements, the bank of the world's central banks, from 2003 to 2008.

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Nonetheless, it's possible that policymakers will still continue to miss the point. The solutions that lawmakers and some financial experts are now suggesting--like putting derivatives on markets rather than letting banks and other businesses trade them secretly--do not reveal all of the markets' internal workings, which is why some researchers believe the only way to handle the new economy is with stunningly new ways of collecting data about the global financial firmament, using all-seeing, all-knowing monitoring systems right out of Philip K. Dick's "The Minority Report."

The trouble, however, is that, even as these researchers race to finish their designs, skepticism is growing among the very industries that would be monitored by these systems, and by the regulators who might use them. A couple of years ago, this opposition might not have been surprising. Now that we know what's at risk, however, it is probably improvident, and possibly dangerous.

The new tools that researchers now envision are meant to foresee crises in financial systems that have become impossibly complicated. "You want to see the build-up to a crash," Markus Brunnermeier, a professor of economics at Princeton, told me in a recent interview. "You want to see it coming on." Brunnermeier has met with Treasury Secretary Timothy Geithner on several occasions and has collaborated with researchers at the Federal Reserve Bank of New York, the chief implementer of American monetary policy.

Brunnermeier's method for seeing it coming would begin with the data that the Fed already collects. Every quarter, 26 big bank holding companies report a number to the Fed called "value-at-risk," which is an estimate of the maximum money they might lose in the near future with a given probability. But, while banks can calculate their own value-at-risk, they can only guess how stable other banks are--which makes them vulnerable to the ill fortunes of those with whom they share thousands of financial ties.

This is where Brunnermeier had his insight: What if I knew the relationship between one bank's value-at-risk and the value-at-risk of the entire industry? Then I could see how one institution's problem spills over to other institutions, and I could focus on the institutions that seem to be at the source of these problems. The data, collected not only from banks but also from hedge funds and insurance companies, would have immediate implications for the firms' activities. If the data pointed toward a risk pocket during a crisis, the firms would have to stop taking on new risks and stockpile more cash. If groups of firms started to show similar vulnerabilities, computers and human supervisors would see these patterns, ideally before they got out of hand.

But, while Brunnermeier's solution would require collecting new data from thousands of firms, many of which currently report nothing to the Fed, some of his colleagues say his solution--looking at a few key numbers for each institution--does not go far enough. Andrew Lo, a professor and director of the Laboratory for Financial Engineering at the Massachusetts Institute of Technology, sees the global financial system as the universe, where each financial center is a galaxy: a collection of stars, planets and other celestial objects held close to each other by their own gravity--in this case, the trades and contracts that tie them together. If you could chart the entire universe and measure all the forces connecting every object inside it, you would have what economists and other scientists call a network map. To Lo, fully understanding what's going on in the markets requires the entire map--not just one value-at-risk number, but every major transaction that connects one entity to another, reported daily.

Another pair of researchers is working along similar lines at Sandia National Laboratories, a government research installation in Albuquerque, New Mexico, concerned primarily with nuclear safety and national security. Until 2001, Robert Glass had been studying highly mathematical topics like how fluid flows through porous materials and the patterns that form in air turbulence. In 2004, he and Walter Beyeler, an expert on the disposal of nuclear waste, turned their modeling skills to two crucial pieces of American infrastructure: the power grid and the payments system that is the backbone of our financial architecture.

Beyeler and Glass started creating network maps of the payments system, and, not by coincidence, they looked a lot like the maps Lo described. "The basic idea is that a small number of the nodes in the network have a very large number of connections, and there's a very large number of nodes in the system that have one or two connections," Beyeler says. In such a map, Lehman would have shown up as a node connected in myriad ways to scores of other nodes, including virtually all of the other big financial institutions. In other words, it would have been a critical hub whose disappearance would cause ripples throughout the system.

Mapping proposalshave received at least moral support from Democrats. "I think there is a lot of potential here--in fact, Andrew Lo has been talking to my staff," says Congressman Barney Frank, whose Financial Services Committee is slated to hear testimony on systemic risks in the next couple of weeks. "But we're not going to prescribe that; we're going to empower that. These are specifics that should be decided by the regulator, and not by Congress."

But even the regulators themselves are skeptical. "We're not the National Security Agency [with] total information awareness," says a senior official from the Federal Reserve Bank of New York who insisted on anonymity. "When you start to get to the type of information that would be required for the network maps, I think there would be a real reticence on the parts of the sovereigns and the institutions to provide that information."

So far, the financial industry's reaction has been to discount the feasibility and usefulness of network maps. Its trade group, the Institute of International Finance (IIF), decided to set up its own market monitoring group to "connect the dots" and "build a systemic picture" of the markets, yet it stopped short of recommending a network map.

"The practical and the concrete tools to have people do this are still being developed," says Hung Q. Tran, the IIF's senior director of capital markets and emerging market policy. "It's difficult in many instances to see how relevant information can be collected and made available to people at the right time."

The mappers' plans need to be more specific, too, said the Fed official. "There would be lots of different types of network maps," the official says. "There would be funding maps. There would be hedging maps for different types of market risk. Some of that we've been able to get further on, but I don't think we'd ever be able to get the full view of the market."

Yet, even if the United States balks, other countries may go ahead with network mapping. In February, Otmar Issing and Jan Krahnen, members of a commission advising the German government, wrote in the Financial Times that a global network map was "a vital element" for preventing future crises. And the main consultative document prepared for the European Union also recommended a map of global risks. But, without cooperation from the United States, any supposedly global map will be woefully incomplete. In the end, the question may be whether Washington is finally willing to stand up to the industry ... for its own sake.

Daniel Altman is president of North Yard Economics, a nonprofit consulting firm serving developing countries. He is writing a book on the future of the global economy.

Until last September, when the banking industry came crashing down and depression loomed for the first time in my lifetime, I had never thought to read The General Theory of Employment, Interest, and Money, despite my interest in economics. I knew that John Maynard Keynes was widely considered the greatest economist of the twentieth century, and I knew of his book's extraordinary reputation. But it was a work of macroeconomics--the study of economy-wide phenomena such as inflation, the business cycle, and economic growth. Law, and hence the economics of law--my academic field--did not figure largely in the regulation of those phenomena. And I had heard that it was a very difficult book, which I assumed meant it was heavily mathematical; and that Keynes was an old-fashioned liberal, who believed in controlling business ups and downs through heavy-handed fiscal policy (taxing, borrowing, spending); and that the book had been refuted by Milton Friedman, though he admired Keynes's earlier work on monetarism. I would not have been surprised by, or inclined to challenge, the claim made in 1992 by Gregory Mankiw, a prominent macroeconomist at Harvard, that "after fifty years of additional progress in economic science, The General Theory is an outdated book. . . . We are in a much better position than Keynes was to figure out how the economy works."

We have learned since September that the present generation of economists has not figured out how the economy works. The vast majority of them were blindsided by the housing bubble and the ensuing banking crisis; and misjudged the gravity of the economic downturn that resulted; and were perplexed by the inability of orthodox monetary policy administered by the Federal Reserve to prevent such a steep downturn; and could not agree on what, if anything, the government should do to halt it and put the economy on the road to recovery. By now a majority of economists are in general agreement with the Obama administration's exceedingly Keynesian strategy for digging the economy out of its deep hole. Some say the government is not doing enough and is too cozy with the bankers, and others say that it is doing too much, heedless of long-term consequences. There is no professional consensus on the details of what should be done to arrest the downturn, speed recovery, and prevent (so far as possible) a recurrence. Not having believed that what has happened could happen, the profession had not thought carefully about what should be done if it did happen.

Baffled by the profession's disarray, I decided I had better read The General Theory. Having done so, I have concluded that, despite its antiquity, it is the best guide we have to the crisis. And I am not alone in this judgment. Robert Skidelsky, the author of a superb three-volume biography of Keynes, is coming out with a book titled Keynes: The Return of the Master, in which he explains how Keynes differed from his predecessors, the "classical economists," and his successors, the "new classical economists" and the "new Keynesians"--and points out that the new Keynesians jettisoned the most important parts of Keynes's theory because they do not lend themselves to the mathematization beloved of modern economists. Skidelsky's summary of what is distinctive in Keynes's theory is excellent.

Skidelsky's book is flawed by its insistence on asking what Keynes would say if he were alive today (to which the only sensible answer is that no one knows), and more seriously by its insistence that "deep down," Keynes "was not an economist at all"--that he "put on the mask of an economist to gain authority, just as he put on dark suits and homburgs for life in the City" (London's Wall Street). Keynes was the greatest economist of the twentieth century. To expel him from the profession is to confirm the worst prejudices of present-day economists by embracing their bobtailed conception of their field.

The General Theory is a hard slog, though not because it is mathematical. There is some math, but it is simple and, with the exception of the formula for the "multiplier" (of which more shortly), it is incidental to Keynes's arguments. A work of elegant prose, the book sparkles with aphorisms ("It is better that a man should tyrannize over his bank balance than over his fellow-citizens") and rhetorical flights (most famously that "madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back"). But it also bristles with unfamiliar terms, such as "unit-good" (an hour's employment of ordinary labor), and references to unfamiliar economic institutions, such as a "sinking fund" (a fund in which money is accumulated to pay off a debt). And it brims with digressions, afterthoughts, and stray observations, such as: "the two most delightful occupations open to those who do not have to earn their living [are] authorship and experimental farming." Two important chapters, dealing with the "trade cycle" (that is, the business cycle--booms and busts) and with mercantilism, usury, and thrift, are deferred to the last part of the book, which is misleadingly titled "Short Notes Suggested by the General Theory."

It is an especially difficult read for present-day academic economists, because it is based on a conception of economics remote from theirs. This is what made the book seem "outdated" to Mankiw--and has made it, indeed, a largely unread classic. (Another very distinguished macroeconomist, Robert Lucas, writing a few years after Mankiw, dismissed The General Theory as "an ideological event.") The dominant conception of economics today, and one that has guided my own academic work in the economics of law, is that economics is the study of rational choice. People are assumed to make rational decisions across the entire range of human choice, including but not limited to market transactions, by employing a form (usually truncated and informal) of cost-benefit analysis. The older view was that economics is the study of the economy, employing whatever assumptions seem realistic and whatever analytical methods come to hand. Keynes wanted to be realistic about decision-making rather than explore how far an economist could get by assuming that people really do base decisions on some approximation to cost-benefit analysis.

The General Theory is full of interesting psychological observations--the word "psychological" is ubiquitous--as when Keynes notes that "during a boom the popular estimation of [risk] is apt to become unusually and imprudently low," while during a bust the "animal spirits" of entrepreneurs droop. He uses such insights without trying to fit them into a model of rational decision-making.

An eclectic approach to economic behavior came naturally to Keynes, because he was not an academic economist in the modern sense. He had no degree in economics, and wrote extensively in other fields (such as probability theory--on which he wrote a treatise that does not mention economics). He combined a fellowship at Cambridge with extensive government service as an adviser and high-level civil servant, and was an active speculator, polemicist, and journalist. He lived in the company of writers and was an ardent balletomane. 

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Keynes's theory, and its application to our current economic plight, is best understood if one bears in mind one historical fact and three claims that he made in the book. The historical fact is that England, between 1919 and 1939, experienced persistent high unemployment--never less than 10 percent, and 15 percent in 1935, when Keynes was completing his book. Explaining the persistence of unemployment was the major task that Keynes set himself. Though he famously declared that "in the long run, we are dead," he tried to solve a problem that, already when he wrote, had had a pretty long run.

The three claims are, first, that consumption is the "sole end and object of all economic activity," because all productive activity is designed to satisfy consumer demand either in the present or in the future. "Consumption" is not in the title of the book, however, because the only thing that interested Keynes about it was how much of their income people allocated to it--the more the better, as we will see. The second claim is the importance (and the deleterious effect) of hoarding. People do not save just to be able to make a specific future expenditure; they may also be hedging against uncertainty. And the third claim, related to the second, is that uncertainty--in the sense of a risk that, unlike the risk of losing at roulette, cannot be calculated--is a pervasive feature of the economic environment, particularly with respect to projects intended to satisfy future consumption.

A nation's annual output, which is also the national income, is the market value of all the goods (and services, but to simplify the discussion I will ignore them here) produced in a year. These goods are either consumption goods, such as the food people buy, or investment goods, such as machine tools. What people do not spend on consumption goods they save: income minus consumption equals savings. Since income minus consumption also equals investment, savings must, Keynes insists, equal investment. But equating savings with investment is confusing. If you stuff money under your mattress, you are saving, but in what sense are you investing? If you buy common stocks, you are investing, but the contribution of your investment to the productive capital employed in building a factory is attenuated.

At the very least, we should (and Keynes implicitly does) distinguish between enabling productive investments and actually making them; or, equivalently, between passive investment and active investment. If you deposit some of your savings in a bank, the bank--not you--will decide whether to lend the money to a businessman to invest in his business (or to an individual to invest in buying a capital asset, such as a house). Still, the money is invested. Even the money you stuff under your mattress can be considered a form of investment, for in all likelihood it will be spent eventually (though perhaps not for generations), and thus, like all investment, it is an aid to future consumption. But as in this example, passive investment may take a long time to stimulate active investment.

The lag can retard economic growth. Income spent on consumption, in contrast to income that is saved, becomes income to the seller of the consumption good. When I buy a bottle of wine, the cost to me is income to the seller, and what he spends out of that income will be income to someone else, and so on. So the active investment that produced the income with which I bought the wine will have had a chain-reaction--what Keynes calls a "multiplier"--effect.

And here is the tricky part: the increase in income brought about by an investment is greater the higher the percentage of income that is spent rather than saved. Spending increases the incomes of the people who are on the receiving end of the spending. This derived or secondary effect of consumption is greater the higher the percentage of a person's income that he spends, and so it magnifies the income-generating effect of the original investment. If everyone spends 90 cents of an additional dollar that he receives, then a $1 increase in a person's income generates $9 of additional consumption ($.90 + $.81 [.9 x $.90] + $.729 [.9 x $.81], etc. = $9), all of which is income to the suppliers of consumer goods. If only 70 cents of an additional $1 in income is spent, so that the first recipient of the expenditure spends only 49 cents of the 70 cents that he received, the second 34.4 cents, and so on, the total increase in consumption as a result of the successive waves of spending is only $1.54, and so the investment that got the cycle going will have been much less productive. In the first example, the investment multiplier--the effect of investment on income--was 10. In the second example it is only 2.5. The difference is caused by the difference in the propensity to consume income rather than save it. (No one today, by the way, thinks that investment multipliers are that high.)

For Keynes, in other words, it is consumption, rather than thrift, that promotes economic growth. And here the second key claim of Keynes kicks in: that people often save with no particular aim of future spending--they hoard. Keynes mentions a host of reasons why people save that may not promote active investment (he also discusses the analogous motives of businesses), at least in the short run. Savers may want to "bequeath a fortune," "satisfy pure miserliness," "build up a reserve against unforeseen contingencies," "enjoy a sense of independence and the power to do things, though without a clear idea or definite intention of specific action," or, implicitly, obtain a reputation for being thrifty. (This latter motive is reminiscent of the "Protestant ethic" of which Max Weber wrote.) Since Keynes was centrally concerned with unemployment, he was suspicious of saving because, as we just saw, the greater the percentage of income that is consumed rather than saved, the greater the demand for goods, and therefore the greater output, and so the lower the unemployment rate.

But it is here that Keynes's equating saving with investing becomes particularly confusing. Isn't investing a good thing? It is what drives income. And if investment is a good thing, mustn't saving, being synonymous with investing (as Keynes has told us), be a good thing, too? Keynes's answer, though it is not stated as clearly as one would wish, is that investing increases output, and therefore employment, only when it finances the creation of productive capital. When it takes the form of hoarding, the link between saving and promoting economic activity is broken, or at least frayed.

The third claim that I am calling foundational for Keynes's theory--that the business environment is marked by uncertainty in the sense of risk that cannot be calculated--now enters the picture. Savers do not direct how their savings will be used by entrepreneurs; entrepreneurs do, guided by the hope of making profits. But when an investment project will take years to complete before it begins to generate a profit, its prospects for success will be shadowed by all sorts of unpredictable contingencies, having to do with costs, consumer preferences, actions by competitors, government policy, and economic conditions generally. Skidelsky puts this well in his new book: "An unmanaged capitalist economy is inherently unstable. Neither profit expectations nor the rate of interest are solidly anchored in the underlying forces of productivity and thrift. They are driven by uncertain and fluctuating expectations about the future." Only what Keynes called "animal spirits," or the "urge to action," will persuade businessmen to embark on such a sea of uncertainty. "If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation."

But however high-spirited a businessman may be, often the uncertainty of the business environment will make him reluctant to invest. His reluctance will be all the greater if savers are hesitant to part with their money because of their own uncertainties about future interest rates, default risks, and possible emergency needs for cash to pay off debts or to meet unexpected expenses. The greater the propensity to hoard, the higher the interest rate that a businessman will have to pay for the capital that he requires for investment. And since interest expense is greater the longer a loan is outstanding, a high interest rate will have an especially dampening effect on projects that, being intended to meet consumption needs beyond the immediate future, take a long time to complete.

The "sinking funds" I mentioned illustrate institutional hoarding: money is accumulated to pay off a debt in the future rather than being spent, and its unavailability for investment causes interest rates to rise. High interest rates discourage active investment while making passive investment attractive, and thus deliver a one-two punch to consumption. True, high interest rates discourage the hoarding of cash by increasing the opportunity cost of such hoarding, but they also encourage forms of passive investment, such as purchasing government bonds, that may have only a remote effect in encouraging active investment.

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Keynes's analysis provides an explanation--though there is debate among economists whether it is the correct one--for England's persistent high unemployment in the interwar period, or more precisely for the component that represented involuntary unemployment, the plight of unemployed workers who would have preferred to work at a wage below the prevailing rate than to be on the dole. One might think that wages would have fallen to a level at which anyone who wanted a job could have found one. But Keynes pointed out that since workers are a high proportion of all consumers, a fall in the wage level will reduce incomes, and therefore reduce consumption and investment, unless prices fall proportionately. They would be likely to fall somewhat, because producers' labor costs will be lower.

But a general fall in the price level--deflation--imperils economic stability, and actually cutting workers' wages to make room for the unemployed is a surefire formula for industrial strife.

And workers are not fungible. A factory that employs 100 highly skilled workers may have a lower average cost of production than one that employs 120 less-skilled workers at a lower wage. Only if demand for goods is high may the market have room for a firm that, because it employs those less skilled workers, has higher costs of production than the existing firm.

Thus a high level of involuntary unemployment could be, as Keynes showed, an equilibrium, rather than a temporary result of the business cycle. His analysis casts a particularly bright light on the cyclical downturns that we call recessions, or in extreme cases depressions. For when the demand for goods and services falls, as in the present downturn, the economic environment becomes unsettled and even the near future becomes unpredictable. This dampens businessmen's animal spirits and causes consumers to hoard--and businessmen as well. For when the urge to action deserts them, they build up their cash balances, in lieu of active investment, in order to hedge against uncertainty. Owing to uncertainty, businessmen even in the best of times lack "strong roots of conviction" in their estimate of what the future holds, and so a sudden change in economic conditions can paralyze them. If so, a downward spiral will develop, as falling demand and falling investment reinforce each other, causing layoffs that reduce incomes and therefore consumption and production, and so induce more layoffs.

But the government may be able to arrest the decline--another of Keynes's central ideas, and one strongly resisted by the conservative economists of his time, as of today. It can reduce interest rates (by buying government bonds or other debt for cash, which increases the amount of money that banks are permitted to lend) in an effort to reduce the costs of active investment and thus encourage employment. Keynes urged this approach. But he also pointed out that it might not work well--as we have learned in the current downturn. The banks may lack confidence in "those who seek to borrow from them," so that "while the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition." In fact, banks in America today are hoarding, rather than lending, most of the cash that they have received from the government's bailouts. The hoard may make the banks a little freer with lending, but the effect on economic activity, at least in the short run, may be tepid.

Fortunately, there is more that government can do to arrest a downward economic spiral besides pushing down interest rates. It can offset the decline in private consumption and investment in a recession or a depression by increasing public investment. When we say that the government builds highways, we mean it buys highways from private contractors. And the more it buys, the more that investment--and because of the multiplier effect, the more that income, output, and employment--are stimulated. And because private decisions to invest and to consume are influenced by confidence in the future, or the lack thereof, the government must do everything it can to convince businessmen and consumers that it is resolute and competent in working for economic recovery. An ambitious public-works program can be a confidence builder. It shows that government means (to help) business. "The return of confidence," Keynes explains, "is the aspect of the slump which bankers and businessmen have been right in emphasizing, and which the economists who have put their faith in a ‘purely monetary' remedy have underestimated." In a possible gesture toward Roosevelt's first inaugural ("we have nothing to fear but fear itself"), Keynes remarks upon "the uncontrollable and disobedient psychology of the business world."

But for a confidence-building public-works program to be effective in arresting an economic collapse, the government must be able to finance its increased spending by means that do not reduce private spending commensurately. If it finances the program by taxation, it will be draining cash from the economy at the same time that it is injecting cash into it. But if it borrows to finance the program (deficit spending), or finances it with new money created by the Federal Reserve, the costs may be deferred until the economy is well on the way to recovery and can afford to pay them without endangering economic stability. When investors passively save rather than actively invest, government can borrow their savings (as by selling them government bonds) and use the money for active investment. That is the essential Keynesian prescription for fighting depressions.

Keynes's emphasis on consumption as the driver of active investment and hence of economic growth may seem to give his theory a hedonistic flavor. He was indeed hostile to thrift, which is another name for hoarding. We have seen the damaging effects of thrift in the current downturn, in which rich people's forswearing luxury purchases in the name of thrift has reduced employment in the retail sector, thus deepening the downturn. This is an example of the "paradox of thrift." "Prodigality is a vice that is prejudicial to the Man, but not to trade," in the words of the seventeenth-century economist Nicholas Barbon, quoted by Keynes. (The full paradox of thrift is that, if incomes fall far enough because people are saving rather than consuming, savings will actually decline.)

Keynes commends FDR for having destroyed agricultural stocks during the Great Depression, since sales from existing inventories do not stimulate active investment, but are actually a form of disinvestment. He even discusses sympathetically, though ultimately he rejects, the curious proposal of "stamped money," whereby people would be required to have their currency stamped periodically at a government office in order to remain legal tender, because the bother of having to get one's money stamped would have the effect of a tax on hoarding.

All this may seem like an incitement to profligacy, consistent with Keynes's rather bohemian private life as a charter member of the Cambridge Apostles and the Bloomsbury group. But nothing in his theory limits consumption to the purchase of frivolous private goods, or indeed to private goods of any kind. I gave the example of a public highway; other examples are the purchase of military equipment for national defense and the public subvention of education and art. And while he famously (or notoriously) argued the value of unproductive projects--or so they would seem to us--such as the building of the Egyptian pyramids, on the ground that they provided employment, which increased consumption (the workers, even if they were slaves, had to be fed and clothed and housed), he preferred that governments undertake productive projects.

Correctly anticipating the rapid growth of living standards, moreover, Keynes predicted that within a century people's material wants would be satiated, and so per capita consumption would stop growing. People would work less, but only because their need for income, and more important their desire for it, was less. And then the challenge to society would be the management of unprecedented voluntary leisure. This was a popular 1930s theme--think of Huxley's Brave New World--but it underestimated the ability of business to create new wants, and new goods and services to fulfill them.

That was merely a mistake, an oddity in Keynes's belief in the possibility of perpetual boom. He has wise words, which Alan Greenspan and Ben Bernanke could with profit have heeded earlier in this decade, about the need to raise interest rates to prick an asset-price bubble before it gets too large. Yet just a few pages earlier he remarked that "the remedy for a boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last." (That may have been what Greenspan thought!) The statements can be reconciled by observing that as long as there is involuntary unemployment, low interest rates, by stimulating active investment and therefore production without raising labor costs, should not produce inflation. But we have just seen, in the United States of the 2000s, how even if labor costs are steady, low interest rates can produce an asset-price inflation (the housing and credit bubbles) that can precipitate an economic collapse. Keynes had earlier in his career written prophetically about the potentially disastrous effects of inflation. There is almost no mention of inflation in The General Theory, but he does say what many of his successors forgot--that when an economy no longer has any involuntary unemployment, further efforts to stimulate demand will merely cause inflation.

Perpetual-boom thinking illustrates the left-leaning utopian strain in The General Theory. This was what made Keynes a bête noire for conservatives, but it charms Skidelsky, who devotes the last chapters of his book to celebrating Keynes as a "green," a philosopher of limits to growth, of "the good life" lived simply, even of the end of economics. Recall Keynes's erroneous prediction that within a century people's material wants would be satiated. When that happened, the demand for capital (to finance consumption) would plummet and rentiers (people who live on income from passive investments, such as stocks or bonds, and thus are hoarders) would be wiped out--a prospect that delighted Keynes, who looked forward to "the euthanasia of the rentier," though fortunately he did not mean this literally. He questioned free trade--that holy of holies of conventional economists--by pointing out that a country whose people had a low propensity to consume could stimulate investment by depreciating its currency so that its exports were attractive, because that would encourage its industries to invest in producing for foreign consumption and therefore to employ more workers. The country would accumulate foreign currency that it could use to invest abroad--the policy that China has been following lately, with pretty good results. He even had kind words for usury laws, arguing that they had reduced interest rates and thus discouraged hoarding. He favored a heavy estate tax, reasoning that it would increase consumption by reducing accumulation for bequests. (The standard economic argument against the estate tax is identical--it encourages "wasteful" consumption!)

Although there are other heresies in The General Theory, along with puzzles, opacities, loose ends, confusions, errors, exaggerations, and anachronisms galore, they do not detract from the book's relevance to our present troubles. Economists may have forgotten The General Theory and moved on, but economics has not outgrown it, or the informal mode of argument that it exemplifies, which can illuminate nooks and crannies that are closed to mathematics. Keynes's masterpiece is many things, but "outdated" it is not. So I will let a contrite Gregory Mankiw, writing in November 2008 in The New York Times, amid a collapsing economy, have the last word: "If you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront. . . . Keynes wrote, ‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave of some defunct economist.' In 2008, no defunct economist is more prominent than Keynes himself."

Richard A. Posner is a judge on the U.S. Court of Appeals for the Seventh Circuit and a senior lecturer at the University of Chicago Law School.

Few issues since the collapse of venerable Lehman Brothers one year ago have caused as much consternation as performance bonuses for bailed-out bankers. Yet, even among sophisticated observers, there is confusion about what really happened. So, with the benefit of a year's perspective, how should we think about banker compensation in the context of bank bailouts?

Here's a hint: The bonus outrage has distracted attention from the more important way that taxpayers underwrote the wealth of profligate bankers, which was to preserve the extensive equity holdings that senior personnel at these institutions had accumulated prior to the debacle of 2008. And this diversion, in turn, has delayed effective action that might inject a bit of moral culture into the money culture of Wall Street.

Long before Martin Wolf became the chief economics columnist for the Financial Times, he wrote the newspaper letters--lots and lots of letters. It was the early 1980s, the height of the Thatcher era, and Wolf was running research at a think tank in London that was sympathetic to the government's pro-trade agenda. The FT's letters section became the ideal place to take to task all those who would stand in the way of the first waves of globalization.

The national ideological tilt has shifted fast, away from libertarianism and toward broad support for interventions like the new federal "pay czar," who will oversee banker compensation for bailout recipients. Such a sudden and dramatic reversal suggests that ideology has not been moored to steady principles. Instead, we have grasped too quickly at ephemeral data points and permitted our worldview to be shaped by panic. In this haze of hyperbole, we have an obligation to discern the more modulated truth. Indeed, if we now quickly move from lax regulatory enforcement to heavy-handed bureaucratization of our economy, we will be just as lost a decade from now as we are today.

The annals of Sino-American relations have seen more than a few celebrity-diplomats: Henry Kissinger, a young Richard Holbrooke, and, of course, the current secretary of state. But, unless the record has been lost to history, none has ascended to this rarefied plane of geopolitics while running the Office of Management and Budget.

And yet, there was budget director Peter Orszag rushing to a lunch with Chinese bureaucrats on a Monday in late July. To his surprise, when Orszag arrived at the site of the annual U.S.-China Strategic and Economic Dialogue (S&ED), the Chinese didn't dwell on the Wall Street meltdown or the global recession. The bureaucrats at his table mostly wanted to know about health care reform, which Orszag has helped shepherd. "They were intrigued by the most recent legislative developments," Orszag says. "It was like, 'You're fresh from the field, what can you tell us?' "

To many observers, the Federal Reserve has never looked more heroic than it does right now. This past winter, America’s financial system faced the prospect of utter ruin. And, while the economy has suffered plenty in 2009, the worst did not come to pass. The banking system that lends to our employers, thereby allowing our economy to function, never did collapse. Now, many of the accolades for averting catastrophe are going to the Fed. President Obama himself ratified this analysis last week when he renominated Fed chairman Ben Bernanke for a second term. Bernanke, the president told reporters, had marshaled “his background, his temperament, his courage, and his creativity” to help prevent a second Great Depression.

What these words of presidential praise obscured was that the Fed may well have mitigated our current crisis by sowing the seeds for the next one. All modern economies need a financial system that can connect people who want to save with those who have good investment projects. This is essentially what banks do. But, unfortunately, this process often goes wrong. And that is precisely what is happening now. Our banks have gotten into the habit of needing to be rescued through repeated bailouts. During this crisis, Bernanke--while saving the financial system in the short term--has done nothing to break this long-term pattern; worse, he exacerbated it. As a result, unless real reform happens soon, we face the prospect of another bubble-bust-bailout cycle that will be even more dangerous than the one we’ve just been through.

If you’ve studied U.S. economic history, none of this will come as a surprise. We have seen this spectacle--the Fed saving us from one crisis only to instigate another--many times before. And, over the past few decades, the problem has become significantly more dire. The fault, to be sure, doesn’t lie entirely with the Fed. Bernanke is a prisoner of a financial system with serious built-in flaws. The decisions he made during the recent crisis weren’t necessarily the wrong decisions; indeed, they were, in many respects, the decisions he had to make. But these decisions, however necessary in the moment, are almost guaranteed to hurt our economy in the long run--which, in turn, means that more necessary but harmful measures will be needed in the future. It is a debilitating, vicious cycle. And at the center of this cycle is the Fed.

Banking was once a dangerous profession. In Britain, for instance, bankers faced “unlimited liability”--that is, if you ran a bank, and the bank couldn’t repay depositors or other creditors, those people had the right to confiscate all your personal assets and income until you repaid. It wasn’t until the second half of the nineteenth century that Britain established limited liability for bank owners. From that point on, British bankers no longer assumed much financial risk themselves.

In the United States, there was great experimentation with banking during the 1800s, but those involved in the enterprise typically made a substantial commitment of their own capital. For example, there was a well-established tradition of “double liability,” in which stockholders were responsible for twice the original value of their shares in a bank. This encouraged stockholders to carefully monitor bank executives and employees. And, in turn, it placed a lot of pressure on those who managed banks. If they fared poorly, they typically faced personal and professional ruin. The idea that a bank executive would retain wealth and social status in the event of a self-induced calamity would have struck everyone--including bank executives themselves--as ludicrous.

Enter, in the early part of the twentieth century, the Federal Reserve. The Fed was founded in 1913, but discussion about whether to create a central bank had swirled for years. “No one can carefully study the experience of the other great commercial nations,” argued Republican Senator Nelson Aldrich in an influential 1909 speech, “without being convinced that disastrous results of recurring financial crises have been successfully prevented by a proper organization of capital and by the adoption of wise methods of banking and of currency”--in other words, a central bank. In November 1910, Aldrich and a small group of top financiers met on an isolated island off the coast of Georgia. There, they hammered out a draft plan to create a strong central bank that would be owned by banks themselves. What these bankers essentially wanted was a bailout mechanism for the aftermath of speculative crashes--something more durable than J.P. Morgan, who saved the day in the Panic of 1907 but couldn’t be counted on to live forever. While they sought informal government backing and substantial government financial support for their new venture, the bankers also wanted it to remain free of government interference, oversight, or control.

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The initial idea was politically controversial: It looked like a trick to get taxpayers to effectively finance banks and their various speculations. The eventual compromise, brokered by Woodrow Wilson, diluted the Fed’s proposed powers and gave the government a stronger hand. But, while those who hatched the Fed didn’t get everything they wanted, they did get the most important thing: an institution that could help cushion the blow when banking crises occurred.

In the years to come, the Fed would repeatedly provide lifelines to banks in need of help. This support has taken two broad forms: liquidity loans, whereby the Fed gives a bank a short-term loan that can be rolled over many times; and lower interest rates, which increase banks’ profits by reducing the cost of most of their funding. These efforts would often help to mitigate individual disasters. But, by insulating banks from the terrible consequences of their own blunders, these measures would also encourage them to keep taking unwise risks, and thereby lay the groundwork for future crises.

In 2002, Ben Bernankeissued an apology on behalf of the Fed--but not for anything he had done. Bernanke was apologizing for the Fed’s role in causing the Great Depression. He was referring to the fact that the Fed’s monetary policy had been too tight from 1929 to 1933, allowing too many banks to fail. But this is only half the story. During the heady days of summer 1927, the Fed had done something else that would contribute to the Great Depression: It lowered interest rates. Markets responded to the rate cuts with a strong rally in the second half of 1927, and the Fed then decided to raise rates from 3.5 percent to 5 percent in 1928. But it stopped there. A higher rate would have choked off farmers who needed capital and were facing falling commodity prices throughout the decade. Moreover, it would have ended the bonanza of stock price gains that was benefiting the financial sector. To reduce risk, the Fed could have used its powers to convince banks to stop providing loans for stock purchases and to increase their capital, but this too would have ended the bonanza. It was a classic Fed dilemma: Should it raise rates and take other actions to curtail financial speculation involving excessive risk-taking, but possibly slow down the rest of the (real, not financial) economy in the process--and bear the resulting political damage? The Fed decided to stand aside. And so, history’s most damaging economic bubble was created.

After 1929, the government considerably tightened the rules controlling banks, securities transactions, and risk-taking more generally. For a while, the system worked reasonably well. But, eventually, banks would learn how to play the new game. They would spend serious money lobbying to keep regulations lax, hiring lawyers and accountants to find methods to minimize or avoid regulations, and incentivizing employees to hide risk from regulators. While the banking sector became more risky, creditors to banks (such as depositors and lenders) knew they could count on the Fed to engineer bailouts via lower interest rates and access to credit if times got tough--so banks had no trouble raising funding from creditors, and our financial system grew rapidly.

The Fed did not create this atmosphere of elevated risk, but it ended up playing a central role in perpetuating it. Since the 1970s, successive financial crises have required ever more dramatic reactions from the Fed. Every time there is a potential financial meltdown, the Federal Open Market Committee quickly cuts short-term interest rates. These cuts have become larger and larger over time, now essentially taking interest rates to zero. Each round of interest-rate cuts has made sense when a given crisis breaks. But these cuts--which effectively function as bailouts for banks that have gotten into trouble--often helped bring about the next financial crisis. And the crises are getting larger, not smaller, over time.

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Every crisis of the past few decades has had its distinctive features, of course, but the broad pattern is the same. Paul Volcker cut interest rates after the Latin American debt crisis broke in the early 1980s; this lowered the cost of funding speculative real-estate deals and--combined with regulatory breakdown--helped pave the way for the S&L crisis. Ironically, Volcker--seen as the very model of a traditional anti-inflation central banker--presided over the first major modern instance of using interest policy to help banks get back on their feet. Next, Alan Greenspan cut interest rates following the stock-market crash of 1987 and the development of commercial real-estate problems in the late 1980s and early ‘90s. The resulting credit boom helped push (unregulated) financial exuberance into emerging markets. One by one, there would be crises in those emerging markets: Mexico, Thailand, Indonesia, Malaysia, Korea, Russia, and Brazil all experienced economic calamity between 1995 and 1998.

In September 1998, we saw the failure of a single lightly regulated U.S. hedge fund, Long-Term Capital Management. This threatened our financial system, and the Fed cut rates preemptively--making popular the term “Greenspan put.” (A put is a contract that gives the owner the right to sell assets at a fixed price, and it is often used to lock in profits or limit losses. So, if your assets fell in value, Greenspan would effectively buy them or--literally--put a floor under their value. Stocks, for example, are underpinned by future expected company earnings; the value today of those future flows goes up when interest rates are lower--so any cut by the Fed is welcomed by stock-market investors.) In a bright shining moment, markets realized that the Fed was prepared, through interest rate cuts and loose credit, to do whatever it took to bail out financiers facing large losses. Risk-taking without fear for the consequences became the name of the game, at least for our largest financial players: They get the upside if things go well, and the Fed will limit their downside when the speculative frenzy of the day finally runs out of steam.

This environment helped feed the technology bubble--and bust. And this led to further rate cuts--championed by Bernanke, then working under Greenspan. Those 2001 rate cuts--and subsequent decisions to hold interest rates low--encouraged our housing bubble. The phrase “Bernanke put” is now catching hold, meaning an explosive burst of bailouts, liquidity provision, and supportive fiscal stimulus far larger than anything implemented under Greenspan. But Bernanke’s mega-put is just one further step along a path that was established long ago, back in 1913 when the Federal Reserve was founded.

Over the past century, we have moved away from a system where bank shareholders and senior executives paid dearly for bad management--and toward a system where fired bank bosses make off with fortunes or launch brilliant political careers. No one is on the financial hook, other than the taxpayer. Consider the case of Citigroup, a seriously troubled bank. Chuck Prince, the CEO who fell flat on his face, walked away with close to $100 million. Win Bischoff, former chairman and interim CEO of Citigroup during the debacle, has just been appointed chairman of Lloyds Banking Group in the United Kingdom--reflecting the high esteem in which he is apparently still held. And Robert Rubin, Treasury secretary under Clinton, made over $100 million as board member and chair of Citigroup. In an interview late in 2008, he brushed off any responsibility for the mismanagement of anything. And so, our recurring financial crises are not isolated random events; they emerge from a pattern of private and public sector behavior. Enabled by the Fed, our system’s tolerance for risk is out of control. This is an increasingly dangerous system. It is only a matter of time until it collapses again.

What will that collapse look like? The bubbles this time will likely appear abroad. Parts of Asia and Latin America, a tiny fraction of the size of the U.S. economy, are experiencing large capital inflows, low interest rates, and the beginnings of a major boom. Countries with intact banking systems and access to global capital markets will lead the next speculative wave. The United States will be pulled in--probably soon enough that we will all be surprised by a supposedly robust recovery, fed by continued low interest rates and loose credit. We all know these episodes end in tears, but they can be spectacular while they last.

Just like in the late 1920s, most central banks--the Fed among them--will undoubtedly wait a long time to raise interest rates. Inflation remains low, and bankers will surely argue that financial-sector fragility means we should be cautious. It would take a tremendous political battle to stop the next bubble; who wants to take away the punch bowl in the midst of a perceived boom? By the time the Fed and other central banks get around to tightening monetary policy, it will already be too late.

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Based on what we have seen over the past two decades, the cost of the next collapse will invariably be steep. Since the early 1980s, the Fed has gone back to its origins as the bailout machine for the financial sector. The only difference is that this sector has become much larger since 1907 or 1913. Back then, it accounted for around one percent of GDP. Now it is closer to 8 percent. The cost of bailouts--the current one and those to come--has skyrocketed as a result.

In June 2009, Treasury Secretary Timothy Geithner unveiled the administration’s plans for reforming our financial sector and preventing a major crisis from happening again. The cornerstone of the proposal is to (slightly) reduce the number of agencies carrying out regulation, and to give new powers to the Fed.

Unfortunately, these changes are unlikely to work. They do not alter the enormous incentive our banks have to take excessive risks. They don’t address the fact that strong financial groups can lobby our lawmakers and beat down regulators until they are largely ineffective. And they don’t affect our propagation mechanism: The printing presses at the Fed remain open and available for when the next crash comes, and that makes creditors confident that they can lend without risk to our heavily leveraged financial sector. As long as this combination remains in place, today’s financial executives fully understand that the party goes on.

Consider the lessons learned in the past twelve months by our major banks. If they again get into serious financial trouble, the Fed can be counted on to lend them essentially unlimited amounts at effectively zero interest rates. What would you do with free money? You’d pay off all your old debts, then you’d find something to invest in that would yield a decent return. But then you’d reckon--why not take more risk? After all, if things go badly, you’ll get more free money.

We don’t need to repeat history and make bank owners subject to “unlimited liability”--but we do need to make their financial outcomes more closely linked to the risks they take. First, we should sharply raise capital requirements at banks so that the shareholders have more at stake. Shareholders need to feel that when a bank takes gambles, their money is truly at risk. Under our current regulations, a bank like Goldman Sachs puts up only $1 billion of equity for every $13 billion of assets. Who is taking this risk? It is us--as taxpayers.

How much capital is enough? This is a hard question, with no definite answer. One answer, offered by Nobel Prize winner Robert Merton in 1995, is: not much. Merton reasoned that modern risk management and the availability of sophisticated hedging strategies meant that more and more of what banks do is essentially riskless and, therefore, does not need capital. Of course, Merton was deeply involved in the failure of Long-Term Capital Management in 1998, as well as the broader ideological development that underpinned the highly leveraged strategies built around housing during the early 2000s. His view remains theoretically elegant but completely ignores the reality that our financial system--because we bail it out every time things go wrong--provides strong incentives to take bad gambles.

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The idea that banks should carry an “equity cushion” (to absorb losses before anyone has to turn to the government) worth around only 6 or 8 percent of their assets is a quite modern idea. (As recently as the mid-nineteenth century, banks financed significantly more of their assets with equity.) Perhaps a low equity cushion made sense when banks were tightly regulated and limited in the risks they could take, say from 1935 to around 1980. But leading students of central banking today, such as Charles Goodhart, argue strongly that, with the collapse of effective regulation over the past two decades, thin equity layers at many leading banks (in combination with limited liability of shareholders) are completely inappropriate for maintaining a stable financial system.

Second, the managers and boards of directors of financial institutions should be personally liable up to a reasonable sum when their companies fail. They should lose a portion of past salaries and bonuses, while also seeing their bank-provided pensions reduced substantially. Richard Parsons, the chair of Citigroup since February 2009, is estimated to be worth more than $100 million. Yet he reports that he owns only around $750,000 of Citi stock. Such negligible personal downside risk for the board of directors is the norm in high finance today. We should let bank executives be paid well when they are successful--but they should truly lose if they take risks that lead to taxpayer bailouts. It can take up to a decade before the success or failure of past business decisions really becomes evident in banking, so reductions in pensions, and clawback of bonuses, should take this into account.

Third, we need to set rules so that our regulators and public servants, who have the role of protecting taxpayers, are not financially conflicted. Today, the revolving door from government leads directly into the lobbies of our major banks. We need a rule that all employees of the Fed, the U.S. Treasury, and other regulatory bodies are not permitted to work in finance for at least five years after they leave office. If government employees have joined a regulatory authority from the financial sector, they should have a “cooling off” period within which they are prohibited from any official role in the design or implementation of regulation or bailouts.

Finally, we need more assertive leadership at the Fed regarding broader system issues. The Fed, of course, will protest, “This is not our job.” It will say that Treasury is responsible for the administration’s approach and that authority ultimately rests with Congress.

This is true, strictly speaking. The Fed did not create our current atmosphere of deregulated risk-taking. But neither is the Fed blameless. The Fed is partly a prisoner of the current system--but it is also partly a jailer. In the moments when the Fed is presented with a rescue-the-banks-or-the-economy-will-collapse scenario, it is a prisoner. But the Fed, and especially the chairman of the Fed’s board, has plenty of power to shape the environment that produces this choice. And it has taken on the challenge of shaping the financial climate before.

During the 1930s, Fed chair Marriner Eccles was an advocate for change across the financial system. Now, Bernanke needs to play the same role. He needs to advocate for rules and regulations that ensure financial leaders will bear serious costs when there is a future failure due to excessive risk-taking. Otherwise, the Fed will continue to be a handmaiden to repeated bailouts. And, with each bailout laying the groundwork for the next one, the peril facing our financial system will only grow worse.

Peter Boone is chairman of Effective Intervention, a Britain-based charity, and a research associate at the London School of Economics’s Centre for Economic Performance. Simon Johnson is a professor at MIT’s Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. They write for The Baseline Scenario, a blog on economics.

On March 15, Treasury Secretary Tim Geithner and a top lieutenant named Lee Sachs were summoned to the Roosevelt Room for a three o'clock meeting with the president and his chief advisers. For Team Obama, early March had been the psychological low point of the financial crisis. The Dow had sagged to a post-crisis nadir of 6440, with the stock prices of banks like Citigroup and Bank of America stuck in remainder-bin territory. Nobel Prize-winning critics like Paul Krugman and Joseph Stiglitz had accused the administration of tinkering at the margins with its plan to purchase toxic assets from banks--or, worse, of catering to Wall Street. "[T]he administration would shower benefits on everyone who made the mistake of buying the stuff," Krugman thundered in his New York Times column.

The Roosevelt Room meeting was a drawn-out affair--the president stayed until five o'clock, then returned at seven for almost three hours. The motion on the floor was whether or not to abandon the Treasury plan. Though no adviser was eager to seize a major bank, some, like National Economic Council director Larry Summers, wondered if Treasury was underestimating the need for a more aggressive approach.

But Sachs and Geithner gradually defused these concerns. It was Geithner's habit to insist, "You could not want to do something that bold more than I do," before explaining why the boldest course was not, in fact, desirable. Sachs was, if anything, even more leery of nationalization. A trim, balding man in his mid-40s, Sachs had spent more than a decade at the investment bank Bear Stearns. He had the banker's penchant for funereal-looking suits, which sometimes clashed with his boyish expression and youthful voice. Around Treasury, Sachs was fond of comparing the decision to seize a large bank with the decision to invade Iraq. "There are hundreds of billions of dollars of value in these institutions," he'd say. "If you're going to go and destroy that ... you'd better know there are WMD there."

When liberals complained about a Wall Street conspiracy, Sachs was precisely the person they might have had in mind--had they even known he existed. Bearing the modest title of "counselor," he had no formal place in the Treasury hierarchy--meaning no confirmation hearings, no regular reports to Congress, no public profile. But he wielded enormous influence behind the scenes. Indeed, by the time the session broke up that evening, the White House had all but decided to stay the course. "In many ways, [the meeting] was a bit of a triumph for Tim, " says one administration official. "Lee was very much his wing man on that."

It is, of course, hardly surprising that the administration would turn to people like Lee Sachs to help navigate the crisis. There's simply no way to revive catatonic markets without first knowing something about them. But the flip side of this is to base trillion-dollar decisions on the advice of wealthy financiers deeply socialized in the mores of Wall Street. Conspiracy or not, how queasy should this make us?

Sachs was one of the first economic officials in the door at Obama transition headquarters. The financial crisis team in those days was "shockingly skeletal," one colleague recalls, and so, it fell to Sachs to survey the wreckage by shuttling between the Fed, the Bush Treasury, and a handful of agencies overseeing the banks. "I've got recollections of his feeling grim," recalls Summers, who had yet to arrive himself. "The more he learned, the worse it looked."

When Obama chose Geithner to be his Treasury secretary in late November, the nominee quickly put Sachs in charge of the crisis response. The two men had become friends in the Clinton Treasury Department and had remained close ever since. During the Bush years, they'd sometimes joined fellow Treasury alumni on an annual pilgrimage to the Nick Bollettieri Tennis Academy in Florida. Sachs and Geithner even competed together in a triathlon.

It was Sachs's job to hammer out the toxic-asset plan prior to the early February deadline Geithner had set. But, with less than two weeks to go, Sachs and his team decided it would be all but impossible for the government to buy the assets. There was simply no satisfying way to arrive at a price. "If you overpay for the assets, you'll get shit politically. If you underpay, no one is going to sell them to you," says one aide. The solution, the group concluded, was to piggyback on the pricing power of self-interested investors. If the investors put up money alongside the government, they'd have an incentive to price the assets fairly.

Though, by this point, there wasn't time to fill in the details, Geithner and Sachs insisted on sticking to their schedule. Every day brought more anxiety in the markets, and delaying seemed riskier than unveiling an incomplete plan. Still, no one had illusions that the process would be painless. Going into the rollout, says one colleague, Geithner told his staff that, in a crisis, "we had to be one government" and that different agencies "had to sign in blood, with no tribal conflict."

When Geithner announced the vague outlines of the plan on February 10, the reaction was brutal. Investors bid down the Dow almost 400 points, and pundits questioned his basic competence. Over the next several weeks, Treasury actually began wheeling out the more effective pieces of the financial fix--such as programs that expanded credit to consumers and small businesses. But, outside Treasury, Geithner couldn't shake the perception that he was ineffectual and overwhelmed. More than a few critics insinuated he was a pawn of Wall Street.

What these critics missed was that Treasury was prepared to take over the banks if necessary. But Geithner and Sachs had practical reasons for their lighter touch. "Lee's great strength is that he's exceptionally careful about thinking through implications of any particular choice," Geithner told me. "He's got a very good feel for markets and a sense of what practical considerations apply." The two men worried that nationalization would trigger an exodus of bank personnel. If that happened, it would leave the government with all the risks a bank was shouldering and all of its losses, but with no way to generate revenue--or, for that matter, to sell it back into private hands. These were the kinds of concerns that resonated at the March 15 meeting with Obama. "That was the moment it really hit a lot of people that, rather than Tim and Lee looking cautious, maybe they were thinking through the risks at a deeper level than other people were," says one administration official. (Sachs declined to comment for this piece.)

Though no one at Treasury is prepared to claim victory, the subsequent course of events seems to vindicate these impulses. On May 7, the Fed announced that the country's 19 largest banks were collectively short $75 billion in capital. Within a month, they'd raised more than $65 billion from investors. In early June, ten banks won permission to return $68 billion in bailout money.

One Friday night in February, Sachs was doling out assignments for yet another weekend of work when a member of his team piped up with bad news: Treasury's server would be down for eleven hours during the installation of a backup generator. There would be no e-mail, no access to key documents and data--none of the tools you take for granted when triaging a modern financial system. "It was like, 'Oh shit,'" recalls one of the officials. "The absolute last thing we needed."

Suddenly Sachs, who is about as mild-mannered a person as you'll meet in a yoga studio, began to mutter excitedly. "This is not going to happen, it's not going to happen," he repeated as he left the room. Fifteen minutes later, he reappeared with a twinkle in his eye: "It's fixed," he said. End times might be imminent; until then, Sachs's charges would have inboxes. "It was enormously funny," says the staffer. "This combination of assertive and self-effacing. ... The world was out of control, but he was asserting control over one little corner."

Sachs's inability to play the hard-ass without subtly mocking himself can make you wonder how he ascended the upper ranks of Bear Stearns, once among the more aggressive houses on Wall Street. By his late twenties, he was running Bear's corporate-debt underwriting division and mixing with such world-class vulgarians as Jimmy Cayne, the firm's former CEO. "The way in which the firm has been characterized is exaggerated," says one former colleague. "But, even if you accept that, he was still among the most soft-spoken people within the firm." In fact, Sachs's studious bearing was an asset. It created no enemies and made him "effective at representing the firm" with clients, recalls another colleague.

In 1997, Sachs decided he'd like to give Washington a shot. As an undergrad at Denison University in Ohio, he'd studied economics and political science and gotten himself elected student body president. He spent his first few years at Bear assuming he'd eventually leave for law school. But Bear kept making it worth his while to stay. Finally, he reached out to Mike Berman, a family friend and longtime Democratic power broker, who introduced him to the chief of staff of then-Secretary Robert Rubin. Sachs joined Treasury the following year as a deputy assistant secretary.

While it may be tempting to assume Sachs's caution with the banks reflects a sympathy for Wall Street, his intuition has often cut against moneyed interests. "He is a progressive guy," says one Obama official. "His instincts are with the little guy." That's certainly true of the initiative that took up much of Sachs's time during his first tour at Treasury, an effort to clarify the legal status of derivatives. (Administration lawyers worried that recent regulatory moves had cast doubt on the legality of contracts worth billions of dollars.) Today, many on the left regard the largely deregulatory measure, called the Commodity Futures Modernization Act (CMFA), as a symbol of Clinton administration cravenness. But Sachs earned a reputation as something of a CFMA hawk.

A derivative is basically a bet between two "counterparties" over the price movement of an asset, like a stock or commodity. The problem is that these bets link financial institutions in a complicated web: If one fails, it can bring down not just that company's counterparties, but all of their counterparties, too. To sever these links, Sachs wanted to mandate "centralized clearing," meaning the institutions would bet with a clearinghouse rather than directly with one another. "Lee pressed very hard--I give him credit--to make sure that we tried to bring these over-the-counter derivatives into clearing," recalls one Treasury colleague. But Alan Greenspan's Fed and the GOP-controlled Congress reflexively opposed the idea. If the administration wanted Congress to act (and some critics question the need), there was simply no way to get it done without caving on mandatory clearing.

Thanks to his resume and his relationship with Geithner, most Treasury watchers initially assumed Sachs would end up as under secretary for domestic finance, a top-ranking position. But, in March, The Wall Street Journal reported that Sachs would remain a counselor. It's not clear what precipitated the decision, but a Treasury spokesman says there were no vetting issues and that Sachs opted against taking it for unspecified personal reasons.

Whatever his formal title, it's hard to think of Sachs as anything other than Geithner's senior financial official--a position he'll retain for the foreseeable future. He is buying a house in Washington, and his family will move down from Westchester later this summer. Sachs is also staffing up--he now oversees a staff of a half-dozen aides, most of them plucked from Wall Street. (The team was deeply involved in the mid-July decision to withhold additional aid from CIT, the bank holding company then on the verge of collapse.)

The heavy reliance on informal counselors like Sachs does raise basic questions of accountability. For example, Treasury recently announced the nine money managers with whom it will partner to purchase toxic assets. The arrangement could prove highly lucrative, and competition for the slots was intense--Treasury received more than 100 applications. Given the potential for conflicts of interest, and the fact that we won't always have someone as widely respected as Sachs designing such a program, it might be nice if the person in his position had to undergo a full Senate scrubbing. (In fairness, Treasury's career staff vetted the applications and made the actual decisions.)

On the other hand, there's a reason Geithner has leaned so heavily on his counselors: His department simply lacks a reserve of financial-market expertise, even when fully staffed. Compared with the finance ministries of other countries, Treasury's regulatory role has traditionally been weak. That's made it a less than desirable destination for sharp Wall Street minds looking for public sector work. "Think about what the Treasury Department's here for," says one official. "To pay the bills, issue debt, collect taxes, that sort of thing. Institutionally, were we prepared to design a convertible-preferred security?"

Until recently, Treasury's lack of Wall Street heft wasn't necessarily a problem: Postwar recessions occurred when the Fed raised interest rates to prevent the economy from overheating, not when a bubble burst. But, as both Summers and Krugman have pointed out, recent recessions have followed progressively more serious financial turmoil--the S&L crisis of the late 1980s, the dot-com bust in 2000, and the current real-estate collapse. These recessions render the old playbook of lower interest rates and fiscal stimulus less effective and require a far more intricate government response.

Inevitably, it's Treasury that must lead in this terrifying new order. Which is why its limitations have become so glaring. "The Pentagon is geared up to fight two wars at once, that's the mission. The White House is a crisis management operation, it runs twenty-four hours a day," says one Treasury official. "We want that capability." And so, once the dust settles, Geithner is determined to put Treasury on a Pentagon-style footing. "One of things I hope to be able to do is leave a stronger institutional architecture in domestic finance with more depth in the career staff, more weight, more full-scale expertise in markets, regulatory policy, economics, the legal financial area," he told me. When that day comes, you probably still won't see much of Lee Sachs. But you can bet he'll be manning the situation room.

Noam Scheiber is a senior editor at The New Republic.

Should we care about economic inequality? That question is the subtext for most debates in American politics. It just remains below the surface because the party that thinks we shouldn't care about inequality--I'll give you one guess--has an endless string of obfuscations ("death tax," "small business," "tollgate to the middle class") to avoid admitting that it doesn't care about inequality.

There are, however, some real reasons not to care about income inequality, and right-wingers who don't have to run for public office are happy to admit it. A new paper by the Cato Institute's Will Wilkinson, which compiles all the reasons why we shouldn't worry our pretty little heads about inequality, has drawn a lot of attention. It's a usefully honest and relatively persuasive iteration of the belief system that undergirds right-wing thought.

Alas, it still isn't very persuasive. Wilkinson begins by pointing out that, while the gap between how much the rich and the non-rich earn has exploded, the gap between how much the rich and the non-rich consume has remained fairly stable. And that's true. But Wilkinson misunderstands the implications of this fact. "Suppose you made a million dollars last year and put all but $50,000 of it in a shoebox," he writes. (He must have enormous feet.) "Now imagine you lose the box. What good did the $950,000 do you?"

Wilkinson's point--money only has value if you eventually spend it--may be true. Yet most rich people don't put their money in shoeboxes. They invest it so they, their children, or young trophy wives can one day spend even more of it. And, indeed, the gap in wealth (how much money you have) has grown even faster than the gap in income. Meanwhile, the middle class has tried to keep pace with the rich by spending beyond its means, sending average household debt skyrocketing. Tell me why this should make us feel better about inequality?

Wilkinson's most interesting argument holds that material inequality between the rich and the non-rich lags behind the wealth and income gaps. For one thing, he argues that the luxury goods rich people own offer only marginal improvement over the cheap stuff that poor people own. For instance, he compares the luxurious Sub-Zero PRO 48 refrigerator to a standard IKEA fridge. Despite the vast difference in cost ($11,000 vs. $350), he writes, "The lived difference ... is rather smaller than that between having fresh meat and milk and having none." He also notes that rich people have used some of their increased income merely bidding up the price of positional goods, like fancy real estate or elite college tuition, forcing them to buy the same stuff at higher prices. Wilkinson thinks this goes to show that there's "an often narrowing range of experience" between being rich and being poor, so inequality isn't that big a deal.

In fact, Wilkinson is inadvertently bolstering the strongest liberal argument against inequality: it's inefficient. In case you're unfamiliar with this argument--as Wilkinson seems to be; he doesn't rebut or even mention it anywhere in his paper--it runs like this: Taking money from the rich and giving it to the poor helps the latter more than it hurts the former (at least until you create serious work-incentive effects, a point which most liberals think we're not close to). Wilkinson is saying the rich are getting little (in the case of luxury goods like refrigerators) or zero (in the case of real estate and higher tuition) actual benefit from their rising incomes. So why not take some of that income away and use it to buy extremely useful but currently unaffordable things for the non-rich, like, oh, basic medical care?

Watch Chait and Wilkinson face off over the inefficiency of inequality (and check out the rest of the debate here)