Volcker: Retreat? Yes. Surrender? No!

Look. We’re fighting the wrong war — against debt liquidation and price deflation.

It’s the wrong war because we’re losing. And it’s the wrong war because debt liquidation and price deflation are the economy’s natural mechanisms for cleansing itself — a process we need to manage proactively.

Treasury Secretary: Please explain.

Volcker: What were — and still are — the great, insurmountable, intractable problems of our economy? They were (a) excess debt and (b) high prices, making homes unaffordable, hampering education, making it impossible for our workers to compete internationally. Now, with this crisis, all that is naturally being flushed out and reversed. Debts are being liquidated. Prices are falling. American workers are suddenly willing — even anxious — to work more for less.

Granted, this cleansing process is progressing far too quickly and too traumatically. We must cool down its feverish pace. But that’s all part of managing the crisis.

Treasury Secretary: OK. Suppose we retreat. What then is the new battle line?

Volcker: The war we can win, and do so inexpensively.

Treasury Secretary: Against foreign competition?

Volcker: That too, but that’s not our first priority. Our first priority is right here at a home — to ready ourselves for the battle that is now being fought on a secondary plane, sometimes neglected entirely.

Treasury Secretary: Which is …

Volcker: Think ahead. Connect the dots. Three hundred million people. Banking system in shambles. No jobs. No money.

Citigroup: We’re all a bit perplexed here. What are you getting at?

Volcker: It’s staring us in the face. It’s the hidden underbelly of this crisis. We’ve been so intensely focused on saving the big institutions, we’ve failed to anticipate the magnitude of the human tragedy ahead — let alone make the needed preparations.

Citigroup: I believe he’s talking about unemployment.

Volcker: No one can predict exact numbers. But imagine temporary periods of on-again-off-again industrial shutdowns — periods when fewer people are on the job than out of work. Not necessarily on a national basis, but certainly in blighted industrial regions like Michigan. Imagine 20% or 30% unemployment nationwide; bread lines and soup kitchens for the hungry; tent cities for the homeless. And that’s assuming we do take the urgently needed steps to prepare ahead of time. If we do not prepare, consider the real possibility of mass migrations of the middle class, starvation of the poor, pandemics of diseases that are eminently curable.

Chief of Staff: I mean no disrespect. But is this your idea of a made-for-TV documentary? On the History Channel or the Sci-Fi station?

Volcker: Neither. It’s the real thing, and I have the stats to prove it. It’s Katrina-like conditions in all major metropolitan areas, including large segments of the middle class. Except it’s caused by financial storms — the kind that can make natural storms and civil wars seem small by comparison. I am not predicting this. I just want to open everyone’s eyes to the ultimate consequences of complacency in the wake of a massive economic disaster.

Treasury Secretary: Don’t we already have depression-era institutions to handle all that?

Volcker: In name only. They’re grossly outdated, underfunded and understaffed. But even the most ambitious relief efforts are going to be far less expensive than the least ambitious financial bailouts. We have the surpluses. We have the technology and the know-how. That’s the battle we can easily win. But if neglected, it’s also the battle we could easily lose, like Katrina.

Treasury Secretary: So you win the battle against hunger and sickness. You create a super welfare state. And at the same time, you lose the battle for the private economy. This sounds like a socialistic dead end to me.

Volcker: No more so than protecting New Orleans from a second Katrina! No more so than protecting the homeland from foreign attacks! And I never said we’d give up the battle for the economy. What I said was that we would manage the economic crisis more rationally. Once a substantial portion of the bad debts are liquidated, once the deflationary forces are mostly exhausted, then we can pour more money into stimulating a recovery.

Never forget: The U.S. government is the largest single investor in the entire economy. So you must think like a big investor, like a Warren Buffett or a George Soros. Do you buy near the top, when your buying power is overwhelmed by selling, when your capital is chewed up to pieces? Or do you apply your buying power nearer to the bottom, when your capital is far more effective?

Right now, we are already powerless to stop the decline anyhow. We have already cut rates to practically zero. But that didn’t do the trick. We rushed out the biggest bailout packages of any government at any time in history. But that didn’t do the trick either. And now look! Citi and Morgan. Technically insolvent.

My recommendation: Wait for the right time. Then buy.

Treasury Secretary: Buy what?

Volcker: The surviving companies that have the best solutions for our society. Give them the access to innovative technology and talent. Give them the low interest loans, if needed. Give them the capital infusions if you must. Not the white elephants of a bygone era!

Treasury Secretary: I cannot accept this defeatism. I will never accept it. We must do whatever it takes to keep the credit flowing. I don’t care what you call them — bankrupt or not bankrupt, solvent or insolvent. We must do whatever it takes to keep them fully capitalized. That’s the case we must make before Congress again and again … until we lick this.

Volcker: I beg to disagree.

Treasury Secretary: Then what do you propose?

Volcker: Before I build up to a proposal, I want to lay down the foundation with a basic principle. Ultimately, the fork in the road ahead is between (a) deflation and depression or (b) hyperinflation and destruction of our currency. But there can be no debate whatsoever as to which is the lesser of the evils.

The deflation road is extremely arduous, but ultimately leads to recovery. The hyperinflation road can provide a temporary palliative, but it ultimately leads to the destruction of our society and culture.

Treasury Secretary: Was it not the deflation of the 1930s that led to World War II?

Volcker: No. The true roots of World War II lie in the hyperinflation of Germany in the 1920s. But let’s not debate history. Let’s look at our choices here and now …

Choice number one: A strong currency — the nation’s social and political anchor. It gives workers a reason to work and be team players; families a reason to save and come together; entrepreneurs a motive for innovating.

Choice number two: A failed currency — a nation’s albatross. It gives speculators, market manipulators, scam artists and the worst criminal elements the upper hand — not just on the sidelines of power, but in the upper echelons of government and enterprise.

Treasury Secretary: Please give us your proposal.

Volcker: Step number one: Tell it like it is, the bad news we discussed earlier.

Step number two: Make a solemn vow to the public that the government will set the standards, enforce the law, help ensure fairness, and provide emergency aid to the sick, hungry or homeless.

Step number three: Tell the American people that the government can no longer be the lender, spender and investor of last resort. Leave no doubt that, going forward, the U.S. government is exiting the bailout business.

Step number four: Make it absolutely clear that it is now time for all citizens to step up and make the needed collective sacrifices to save our country.

Step number five: Take immediate action to stop the cancer that is now threatening to tear down our country.

Treasury Secretary: I thought you said we should exit the bailout business.

Volcker: This is the last bailout, the primary topic of the other emergency meeting which some of us must now join. But if we have just 10 more minutes, I can give you a thumbnail sketch of what the emergency involves. It involves the fact that the major government security dealers are having serious difficulties placing U.S. government bonds for sale.

The truly dangerous cancer that’s spreading in the world today is the cancer of mistrust. First, it was mistrust in subprime mortgages. Then, mistrust in higher quality mortgages. Next, mistrust in Fannie Mae and Freddie Mac. Then, mistrust in almost every private financial institution in the world.

Let me fast-forward now to the final, fatal stage of this cancer, the stage we are coming to soon. It is mistrust in the U.S. government itself, the phase when investors all over the world no longer trust the debt of the United States Treasury Department.

Gentlemen, I know this monster well. I looked it squarely in the eyes decades ago. In those days, we did not have collapsing financial institutions or trillion-dollar bailouts.

Chief of Staff: I was not around then. Please help me understand it better.

Volcker: It was 1980. We were meeting at Camp David. Present were President Carter, myself, the Treasury Secretary, plus others. In some ways, this meeting today reminds me of that meeting then — the same sense of siege, similar philosophical disagreements. But there was one aspect we all agreed upon: The reality of the spreading investor mistrust in U.S. government bonds.

That mistrust was so intense and so widespread, we could not sell long-term government bonds. No one wanted them and the entire market for them was as close to a total shutdown as it’s ever been in the history of our country.

Fed Chairman: But that was because of inflation. Now we have deflation.

Volcker: Relevant in theory, but not in practice. In practice, although the reasons for selling were different, the consequences were the same. Then it was fear of inflation. Now it will be fear of exploding deficits, fear that we will go wild with more bailouts. In both cases, the end result is crashing bond markets.

Chief of Staff: What is the nexus of the crisis?

Volcker: The dealer network for U.S. government securities. The U.S. government is like General Motors. It issues bonds like GM makes cars. And like GM, it rarely sells those bonds directly to the public; it distributes them through a dealer network. The dealers buy the bonds wholesale. They hold them in inventory. They mark them up. And they sell them retail to customers.

Now, imagine what would happen if GM’s dealer network were to shut down! How would GM be able to sell its cars? That’s the same kind of situation the U.S. government was facing for its bonds in those dark days of early 1980 — and the same kind of crisis that seems to be brewing now.

Back in 1980, nearly all the government security dealers were shutting down their government bond operations. They had no other choice. They could not afford to hold bond inventories sinking dramatically in value. By February 1980, they had lost so much money from falling bond prices, they refused to buy them at auction and hold them in inventory.

Salomon and Merrill were the only ones still trading. Salomon would call Merrill to sell what’s considered a small lot of, say, $100 million in 30-year Treasury bonds. At the same time, someone else at Merrill would call Salomon to place a similar trade. It was like two kids on the street corner trying to trade each other the same marbles. There were no buyers. Virtually all the other dealers had packed up and gone home.

Three-month Treasury bills? No problem. Investors trusted us for three months. But 20- or 30-year Treasury bonds? No! The market for Treasury bonds had dried up. And without it, the U.S. government simply could not continue to fund its own operations, couldn’t meet payroll. Hard to believe, but true: We faced a shutdown of the U.S. government.

Our only answer was to kill the source of the mistrust, which, at that time, was inflation. But to do that, we had to jack up interest rates. We had to cut off credit to millions of Americans. And in the process, we knew, or we should have known, we were going to squash the economy.

Carter was up for re-election. So you can imagine his initial resistance to the Draconian steps we were proposing. But he had no choice. He could either (a) risk the possibility of losing the election in November or (b) face the certainty of a government shutdown in March.

Treasury Secretary: Can we bring this back to the present?

Volcker: Absolutely. Let’s bring this back to the present by asking this question: Is this the direction you want to take the country? If anyone in this room is willing to take that risk, say so now or forever hold your peace.

Because that’s the fork in the road we are now approaching — the end of the fast lane we’ve been on. I’m referring to the fast lane of open-ended government bailouts. The fast lane of “consistent messaging” to cover up the true cause — and the true consequences — of these bailouts.

Mr. Secretary, never forget: Millions of investors, mostly overseas, have put their faith in U.S. government securities. They’ve loaned you their money because they trusted you, the U.S. Treasury Department. If you continue to pour their money into these bailouts, what do you think their reaction will be?

What makes you believe that they’ll respond any differently than they did in 1980, when they disappeared from the U.S. government security market or, worse, dumped their bonds in fear? What makes you believe you can stop the cancer of mistrust from spreading to 1500 Pennsylvania Avenue — to the U.S. Treasury Department itself?

Now that day is approaching. Now we must make absolutely sure that U.S. Treasury does not, itself, become the next victim of the greater subprime crisis. Fortunately, it is not too late. We can still save our country’s credit if we act today, right now, while we still have a country, while we still have the resources as a nation to make the needed sacrifices.

This is the last government rescue, and it must be to save the government itself.