While the current financial crisis demands a new financial architecture, there are things that government needs to do in the short and medium term to reboot the financial system. And our new financial architecture should be based on five principals.

In the short-term it needs to find a way to eliminate the lack of trust that is causing banks to borrow money from the Fed and hoard it instead of lending it out in the short-term debt market to other banks and companies as banks do when the system is functioning normally. This might be accomplished by offering a government guarantee to repay defaulted CP -- somewhat akin to the guarantees government recently provided for money market funds that break the buck.

In the medium-term, the government must help FIs recapitalize. As I posted, I think the best way to do this is to pick the survivors and inject them with sufficient capital to give them a fortress balance sheet -- with a ratio of asset to capital of 10 or lower. This capital could come from private equity firms -- as long as they maintain a minority stake. And it might make sense for taxpayers to provide the additional capital these survivors require -- with an equity stake that could be sold back to the public to recover taxpayer's investment. Lagging banks would either find a merger partner or close down. Finally, we need to consider what a new financial architecture would look like.