WASHINGTON — Remember the Rule of Holes: When you find yourself in one, the first thing to do is to stop digging.

Right now, we're in one of the deepest economic holes anyone has ever seen. And what we need to do is to stop making things worse by continuing to over-rely on financial markets and financial institutions that have proven to be incapable of performing their core missions: getting capital to where it needs to go and pricing that capital in a way that reflects the risks and underlying economic values. We have to stop digging. Another week like this one, and there won't be much left to rescue.

To begin, the markets could use a timeout just about now, something that lasts longer than a weekend and gives policymakers around the world the chance to get a good nice sleep and evaluate their options without feeling like they have to respond to every movement flashing across their Bloomberg screens. It would allow some time for passions to cool and for real investors to regain control of markets now dominated by the computerized short-term trading strategies of hedge funds and hot-shot money managers desperate to recoup some of their losses. It would give banks and major corporations a chance to regain the trust of the markets by issuing unscheduled updates on their financial condition. And it would be a powerful reminder to everyone that markets need to serve the interests of the economy and society, not the other way around.

As we should have learned long ago, markets are not self-correcting. They require collective action to put them back into working order.

The top priority ought to be on setting up a new clearinghouse for those credit default swaps that everyone's heard about but few understand. The swaps are essentially insurance policies — in this case, insuring against the possibility that a particular loan or bond or tranche of an asset-backed security will default. But unlike real insurance companies, the hedge funds and investment banks that wrote these policies were largely unregulated and were not required to set aside any reserves in case they were required to pay up. The big fear now is that when those defaults start to roll in, as they almost surely will, the "insurer" will be broke.

The Federal Reserve is already working on launching a clearinghouse. It would offer the advantage of finally bringing credit-default swaps out from the shadows and into a regulated marketplace where they can be standardized, traded and priced in a way that everyone can see. More importantly, to gain access to this marketplace, buyers and sellers could be required to pay into a re-insurance fund that could be tapped in the event that one of the "insurers" can't make good on its policies. And until the market has been around long enough for that re-insurance fund to build up a sufficient reserve, the Fed might have to finance it with a sizable loan.

The logic is simple: Better to have the government bail out the CDS market, and finally bring it under government regulation, than be put in the position of having to bail out a dozen more AIGs out of a fear that their failure would also take down the CDS market.

It was a little disappointing Friday that the major industrial countries stopped short of doing the one thing that is desperately needed, which is to free up interbank lending by guaranteeing the short-term loans made between the biggest money-center banks and bank-like institutions. Because these banks operate globally, some sort of collaborative action is necessary. The International Monetary Fund, which has been looking for something useful to do, could be authorized to finance and administer the guarantee program, using the IMF's existing funding formula, with countries recouping their contributions through a fee imposed on participating institutions.

More encouraging is that the Treasury is moving quickly to tap the new $700 billion rescue fund to provide additional risk-capital to banks that want and need it, in exchange for preferred stock that will give taxpayers an ownership interest and a handsome quarterly dividend whenever there are profits to distribute. Britain has already announced such a program. That is also the policy preferred by most economists, who believe it's just the thing to get banks lending again, to each other and to customers.

I'm a bit skeptical that additional capital is the best treatment for a financial market in the midst of the panic. What we're seeing is that even banks that are well-capitalized are not protected from the market's hurricane-force winds. This hardly seems like the time to be sprinkling a little capital around to any bank of any size that wants it, even if the banks promise to use it to step up their lending.

Rather, at this moment what's most needed is to direct the capital toward the biggest institutions that present the biggest risk to the stability of the rest of the financial system, whether they are banks, investment houses, insurance companies or nonbank lenders like General Electric. And instead of waiting until these institutions are on the brink of bankruptcy, sizable investments — a mix of preferred stock, loans and loan guarantees — ought to be made now, on terms that are favorable but not punitive and that stop short of putting the government in day-to-day control of the company.

Wouldn't that be picking winners and losers? In a way, yes. But remember that the reason we are in this fix is because markets, at least for the moment, are broken and can't be relied on to allocate capital more wisely than Hank Paulson. A little bit of well-timed, well-crafted socialism is just the thing to save capitalism from itself.