Friday, September 19, 2008

What makes a bailout good? 

Let's begin with agreeing that a bailout is on, and that it is massive. �There are many critics. �Are they right?

A year ago I posted a quote of Walther Bagehot, from his famous�Lombard Street.

But that object is not attained if the amount of that reserve when so published is not enough to tranquillise people. A panic is sure to be caused if that reserve is, from whatever cause, exceedingly low. At every moment there is a certain minimum which I will call the 'apprehension minimum,' below which the reserve cannot fall without great risk of diffused fear; and by this I do not mean absolute panic, but only a vague fright and timorousness which spreads itself instantly, and as if by magic, over the public mind. Such seasons of incipient alarm are exceedingly dangerous, because they beget the calamities they dread. What is most feared at such moments of susceptibility is the destruction of credit; and if any grave failure or bad event happens at such moments, the public fancy seizes on it, there is a general run, and credit is suspended.

In order for a bailout to work it has to be large enough to convince EVERYONE WANTING TO WITHDRAW DEPOSITS that it's available and backed by good paper. �Some of the people you bail out have made bad decisions, some of them even criminal. �But there's a sequencing of actions in a financial panic that stop it, and hanging the bankers from the lampposts is hardly a wise first step. �

I also will remind from a conversation also had here last August:

Yves Smith has an outstanding review of four views of how the central bankers have gotten this right or wrong. These are, to summarize: a group that thinks the Fed has not done enough now and must rescue the financial system (and is uncritical of its role leading up to the crisis); "cold water Yankees" who think the financial markets need to bear the pain and should thus go cold turkey; the realists of the financial markets who have been quoting Bagehot at length -- "yeah, mistakes have been made but their sunk costs and lending freely must be done now"; and a group that believes this crisis stems from both a lack of a mandate for dealing with asset bubbles like subprimes, and thereby calling for both more regulation and changing central bank charters.

Who here is a realist now, fourteen months later? Clearly a number of conservative commentators have become cold water Yankees. If you could accurately tell us how much pain there would be and who would bear it, that might be wise advice. The government has made a decision that it knew where the pain of Lehman would fall; in that case, it threw cold water on it even though it meant a bankruptcy like none we've ever seen. But in many other cases it is not possible to know, such as the connection between AIG and the credit default swap market. So it turns back to the realist camp.

I'll say this until everyone agrees with me :) �You aren't promised a certain price, you're only promised the market will be open so that you can find a price. �The financial markets have worked. �And to do that the Fed must lend freely, and it has. �Meanwhile we will get either a new RTC from the Bush Administration, a MFI Trust from a possible McCain Administration, or something so far undefined by the Obama Administration. �The question for Team Obama: �Realist, Yankee, Rescuer or the end of the Fed? �Do they know yet? �This flowchart is unhelpful. �Hint: �Don't bother asking Raines and Johnson.

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