In a nearby thread, I argue that the quest for a pain-free correction to the current economic crisis, through government intervention, is likely to lead to more pain rather than less. Unfortunately, this is of largely academic interest, because we have already granted the Federal Reserve such sweeping power over our economy that massive government intervention is a certainty. Bloomberg reports that the Fed intervened to put another $630 billion into the system yesterday.
To put it another way, we do not have before us the choice between a “bailout” solution and a “free market” solution. Our choice is between an explicit bailout, such as the one that failed yesterday in the House, or a back-door bailout. As I understand it, the back-door bailout works like this: The Fed lends cash to struggling banks so they can meet customer demand. In return for this cash infusion, the Fed takes collateral from the banks — it is, after all, supposed to be a loan. But as the demand for cash increases, the banks find they need to give the Fed poorer and poorer collateral. When a bank fails, that bad collateral ends up on the federal balance sheet anyway, despite the Congress’s failure to pass an explicit bailout.
The difference between the explicit bailout and the back-door bailout is not that one of them puts taxpayers on the hook while the other does not; it is that one of them accomplishes the transaction in one step, via direct purchase by the Treasury, and the other accomplishes the transaction in two steps, via a Fed loan and then a bank failure. Thus, in creepy imitation of the “lesser of two evils” philosophy at work in most national elections, some readers have argued to me that I should support the explicit bailout because it is preferable to the back-door bailout in at least two respects: (1) it engenders greater confidence in the system because it avoids widespread bank failures; (2) it arouses greater anger among the electorate (most of whom will never realize the back-door bailout took place), and this makes them (us) more likely to demand systemic change after the election.
This is a plausible argument, and I would feel better if I heard supporters of the explicit bailout articulating their position this way — and making anticipatory declarations of support for the long-term reform we need. As long as the dominant theme is the avoidance of short-term pain, I’m not persuaded — I think the pain is both inevitable and necessary as a wake-up call. But I thought I’d put the theory out there and see what reasonable minds think about it.