Fixing the credit crunch is going to take more than just monetary actions. But even government intervention won’t be enough to prevent a recession, suggests Merrill Lynch & Co. Inc. in a new research note.

“The Federal Reserve’s liquidity provisions are not a substitute for capital, and do not remove the financial institution’s balance sheet constraints, which are at the epicenter of the financial credit crunch,” Merrill says. “Fiscal action may be needed to loosen the tight credit market conditions. And the deeper and more prolonged the crisis, the bolder the initiatives likely become, in our opinion.”

“To alleviate credit market paralysis, the outright purchase of illiquid mortgage-backed securities is probably required, and could employ government-backed fiscal action,” it says. “So far, government-backed plans have relied on just voluntary actions by loan-servicers to modify existing mortgage loans, resulting in low participation.”

The Federal Reserve could buy some of these securities, Merrill says, but it suggests that the Fed likely cannot unclog the congestion in the credit markets by itself.

“The U.S. Treasury, under the auspices of the White House, has rejected plans calling for government intervention. However, a combination of the quick demise of Bear Stearns and the domino effect this could have had on our financial system, plus home prices still in free fall has increased calls for government involvement,” it notes. “Eventually the Bush Administration may have to change its attitude.”

“However, more aggressive monetary or fiscal policy responses will not end the economic recession, stop home prices from falling, or reverse the dramatic deleveraging in the financial system. Bolder Washington initiatives can, at best, only soften the negative impact on the economy and possibly provide for somewhat of an orderly unwind of credit conditions,” Merrill concludes.