We need to examine banks in detail, with fair valuation procedures. After this bank should be immediately recapitalized with enough government capital to keep going, with the government taking an appropriate equity share. The whole procedure should be accomplished as fast as possible. Market mechanisms will not work; revaluation without recapitalization brings disaster; recapitalization without revaluation brings trillions in losses for the taxpayer. Here's why:
In general the markets are very good at allocating capital. But sometimes the markets can go very awry, and it's possible for a central planner to surpass them. As I've expressed in my Naked Capitalism upgraded comment, I think *Paulson* will be substantially worse than even a deranged market, but that might not be true for a wiser Treasury secretary.
Markets inherently cannot correct for a major malinvestment of financial capital. Financial capital represents in the real world actions and resources allocated for coordination - obviously a very important thing. If those resources or lost via malinvestment they must be replaced, which requires high relative interest rates for financial investments. However, the losses mean that current financial investments are overvalued, which requires low relative interest rates to correct. So the market can't correct the problem.
The solution, then, must be imposed by non-market cooperative activities, which on this scale means government. The correct action is to force immediate write-downs of the bad assets and then to force recapitalization by having the government provide the capital, implicitly backed by its taxing authority and ultimately its legitimacy and guns.
The write-down could be accomplished by a Defazio-type plan (bank examiners) or approximated by a devaluation. Recapitalization could be done by a bazillion plans although I think in the context of American politics preferred stock purchase (as suggested by Stiglitz, Krugman, and many others) is the way to go. Note that you have to take *both* actions - one alone leaves part of the problem unfixed.
To be fair, if you do one, then the market *can* do the other. So if you do a DeFazio plan, real interest rates can soar to draw in capital. If you do only Stiglitz/Krugman, they can collapse to erase the post-recapitalization value of financial investments. From the viewpoint of the taxpayer, Stiglitz/Krugman without DeFazio is thus a bum deal, although it will repair the economy.
I think the reason there's near-unanimity in the blogosphere on the idea of "write-down and recapitalize", across a very wide political spectrum is simply that, on basic principles, it's the right action.