| | An economics professor I know makes the following argument for bailing out large financial institutions: Many of the so-called bailouts refer to emergency loans funded by the money-creating powers of the Federal Reserve. The loans are very likely to repaid, and many have already been repaid. These were made in light of the systemic risk of a massive liquidity crisis posed by the impending collapse of large financial institutions; the payments system would possibly have broken down. (If some large institutions default, some otherwise healthy institutions would then not receive payments necessary for themselves to avoid default, etc. The ripple effect would be enormous. A panic could ultimately be touched off as it is realized that the insurance fund of the FDIC could not possibly cover all the bank accounts involved.) The troubled institutions may be quite viable on a long-term basis, but private lenders cannot be counted on to lend to them right now (as explained below).
Smaller institutions do not create systemic risk. You can call it to "favoritism" toward large entities; others would call it a difference in their character that justifies a difference in treatment.
It may be the case that, absent the Federal Reserve, Fannie Mae, the Community Reinvestment Act, etc. we would not be in this situation, but we are in it.
The ordinary banking system has suffered from a massive prisoner's dilemma in the last few weeks; if major banks would lend more freely, others would as well, but an individual bank fears that if it lends more freely while others do not, the economy will be terrible and many loans might not be repaid.
Classical principles do not apply well in this crisis. For example, I have criticized Keynesians for viewing saving as a "leakage," but it IS a leakage if people put funds in the bank, and the bank just sits on them -- and we may be seeing a significant rise in the private sector's saving rate as people cut back on spending to try to pay down debt -- and also because of a lack of confidence about the future. I expect the velocity of money to show a pronounced fall.
What say you?
- Bill
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