A scramble to unlock bank lending

It also happened during the takeover of the Continental Illinois Bank, then America's seventh largest, which failed in 1984 after making bad loans, says Doug Roberts of Channel Capital Research in Shrewsbury, N.J. The US government ultimately sold that investment to Bank of America and made money on it.

But not all analysts would agree that the time has come for the Treasury to burst the last boundary of market-based economics and pump taxpayer funds directly into private banks.

At the least, the move may be premature, given that the Treasury's $700 billion Troubled Asset Recovery Program is still in the planning stage, says J.D. Foster, a senior fellow in the economics of fiscal policy at the Heritage Foundation in Washington.

"I'm not convinced at this point. It seems to me that the tools they already have ... are adequate to get the markets functioning more normally," says Mr. Foster.

He fears that the pressure on Washington to begin making direct management decisions might become irresistible.

There's a phrase for that, and it isn't "free-market economics." It's "social democracy," the sort of government involvement with corporate economic policy that characterized much of Western Europe in the post-World War II period.

"We could out-France France with this," says Foster.

Some economists suggest there may be other ways to get credit to needy businesses.

Mr. Gramley, the former Federal Reserve governor, says the Fed could expand its program that makes loans directly to businesses. On Tuesday, the Fed announced it would buy commercial paper directly from large companies, the first time it has done that since the Great Depression.

"That's fine for businesses that can finance their needs in the commercial paper market," he says. But he says the Fed can set up a program to lend to smaller firms that need money, and it can use local commercial banks to funnel that money to the businesses. "If they are good loans normally, they would be good loans now, and it would break the logjam business is experiencing," he says.

Bethune of Global Insight suggests that banks no longer base their lending rates on the London Interbank Offer Rate (LIBOR), a global measure of lending rates. Banks formerly had based their lending on the prime interest rate – the rate they loaned to their best customers.

"The prime rate has been coming down, and [shifting away from LIBOR] removes us from the European banks and their problems," says Bethune.

Strangely, the data do not show loan growth slowing. As of Sept. 27, commercial and industrial loans and consumer loans were still growing, says Gramley.

But anecdotal reports since then indicate a serious problem, he adds.

"If we don't do something, the economy will go down the tubes," he warns. "In prior recessions, if the Fed hit the gas pedal hard, we would get out of recession. But that was when the credit markets were normal."

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