Honestly, I am deeply honored to have such a highly inquisitive and creative readership. Putting it another way, your median IQ is well above the mean. You quickly figured out the main purpose of this "contest": to elicit ideas and engage in productive discussion, i.e. Hell knows Hell's answer, but there are more answers that are "more better". Hats off to all of you.
Therefore, I encourage all to take a look at yesterday's comment section for lots of interesting ideas. Who's the winner? That's a trick question - and always was. ALL OF YOU, OF COURSE!
Now, what's my answer? Many of you got it: gold standard then vs. fiat money now.
The implication is that today's crisis cannot evolve into a deep banking crisis that affects retail depositors - there are no bank runs in our future, unless the authorities really screw things up. And they haven't so far, we must give them that. I strongly believe that what turned the 1929 Crash and the recession that followed into a deep Great Depression was the inability of banks (and thus the entire economy) to operate under the tight constrictions of the gold standard. No wonder that Keynes called it a "barbarous relic" (as early as 1924).
Today the Fed is telling everybody willing to listen that it won't allow any (major) financial institutions to fail - and is doing so at the top of its lungs. A hundred billion? Done. Two hundred? No problem. A...trillion? Whatever it takes. You don't have to like this policy - just understand it
This should not be mistaken as setting the stage for hyperinflation, however. Instead, the Fed is acting as the financial system's Fire Department. It MUST prevent the fire from spreading and it MUST put it out as quickly as possible, using "all means at its disposal". At the same time, it MUST take care that all "flammable" material are properly looked after so that new fires don't break out elsewhere. In the FFD (Fed Fire Dept.) flood damage is considered a secondary danger, at least right now.
Which brings me to CDSs. In my opinion they are a major - very major - factor in this financial conflagration and the principal reason why the Fed and Treasury have had to act the way they did. Credit default swaps didn't cause the crisis (loose lending and asset bubbles did), but they are certainly making it much more difficult to deal with it (the mess at AIG being just one example). CDSs are acting as the virus of a highly contagious disease, cross-infecting parts of the finance community that thought they were dealing in vaccines, instead. Thus, we must quarantine and exterminate them. How?
This is where the Fed and Treasury come in - and the fiat nature of money. The stated policy of the authorities (or un-stated, but clearly understood) should simply be this: we shall operate so as to make 90+% of all CDS contracts (by market value) expire worthless. We shall force all participants to net down to the customer level (thus vastly reducing nominal amounts outstanding), we shall demand that both sides of the CDS (buyer and seller) post collateral based not only on the face amount but also on the market value of the contract, we shall force the rapid migration of the business - future AND existing - to properly regulated exchanges.
Of course, tweaking the technical aspects of the CDS market won't do the trick alone. It will take something much more powerful to send CDS buyers (i.e. those betting on the continuation and deepening of the credit crisis) into reverse mode. Let's use the bully pulpit - more appropriately, the bailout pulpit - but do it in a smart way. Don't use bailout money to pay the CDS buyers (as happened in the AIG case), but to convince them to sell their CDS as quickly as possible, thus setting off a rally in the credit market.
What should be the target? To get credit spreads down to reasonable levels ASAP. Actually, things are going in that direction, anyway, because the really smart money is already figuring out that Ben's Helicopter Brigade is not fooling around and really means business. Spreads for commercial paper are down from "nosebleed" to being merely "high" (see chart below, click to enlarge).
This does not mean that debtors and lenders should walk away scot-free, bailed out willy-nilly by the government. Far from it; corporate borrowers that cannot meet obligations should give up equity and lenders should accept painful haircuts. As for those involved in their CDSs they should be "gently" encouraged to settle amongst themselves. A skillful negotiator, armed with the Fed's and government's big sticks, should be able to quickly put the fear of God into all concerned.
We are living in very interesting times. Let's hope there are smart people out there who can appreciate the benefits of "boring", finance-wise.