The U.S. economy is facing its most severe challenge since the Great Depression. Home prices and equity prices have experienced their worst single-year decline in 77 years. Credit markets remain virtually frozen, despite massive interventions by the Treasury Department and the Federal Reserve. And the real economy shows every sign of having fallen off a cliff.

This raises the real danger that the United States could become mired in a vicious downward spiral of asset price deflation and credit market deleveraging of the sort that plagued the Japanese economy during the 1990s. Both consumers and corporations seem paralyzed by fear. The crisis demands a robust policy response that can be explained to the public. Though Barack Obama does not take office until January 20, he and his economic team—especially his designated Treasury secretary, Tim Geithner—must outline their stimulus strategy as soon as possible.

To be effective, the Obama strategy must include three components. First, there must be a large fiscal stimulus package, worth at least $500 billion, designed to boost consumer spending and aggregate demand in the short run. Such a stimulus package must be presented in the context of a responsible medium-term budget plan which assures the markets that America’s public finances will remain in good shape over the long term.

Second, the strategy must include clear prescriptions for unclogging the credit markets and rejuvenating bank lending. This will entail a wholesale rethinking of the Treasury Department’s Troubled Assets Relief Program (TARP), which has failed to deliver its intended results.

The strategy must include clear prescriptions for unclogging the credit markets and rejuvenating bank lending.

Third, the strategy must include a plan to curb the sharp decline in U.S. home prices that continues to erode consumer confidence and compound bank losses.

It is essential that the money in Obama’s stimulus package be spent quickly rather than saved. (Many earlier stimulus plans have failed because the stimulus money was saved rather than spent.) To that end, the stimulus package should include measures that extend the duration of unemployment benefits and provide aid to state and local government. It should not rely too heavily on infrastructure spending, which generally takes a long time to be executed.

The benefits of any fiscal stimulus package will be short lived if the financial system remains hopelessly clogged. For this reason, Obama and Geithner should revisit TARP and consider overhauling it. If TARP is not reformed, the United States risks repeating Japan’s mistake during its “lost decade,” which was to prop up insolvent financial institutions that were in no position to resume lending. Obama and Geithner should also examine the successful financial rescue strategy used by Sweden in the early 1990s. The Swedish program rapidly restructured insolvent banks into “good banks” that were then re-privatized and “bad banks” that remained in public hands.

As for stabilizing the housing market, many have argued that the government should buy up and restructure bad mortgages or that it should mandate changes in the negotiated terms of mortgages. We should not minimize the long-term drawbacks of such proposals, which could upset the proper functioning of the housing market. But policy inaction is not a viable option. If the government does nothing to quell the housing crisis, we can expect a continued downward spiral in home prices and a further rise in foreclosures.

The task facing Obama, Geithner, and the rest of the incoming economic team is daunting. But Lawrence Summers (Obama’s pick to direct the National Economic Council) and Paul Volcker (Obama’s pick to chair the Economic Advisory Recovery Board) seem more than capable of coming up with innovative solutions to today’s problems. Now is the time for a bold new economic strategy. Let’s hope that Team Obama delivers one.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

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