The Bailout Bailout UPDATED

After all those shenanigans around the Bailout Rescue Plan, the market has spoken: down 20%+, huge spread between LIBOR and the 90 day T-bill, frozen interbank lending, frozen commercial paper market.  Government at its best!  Lots of noise, no solution.  Why?  The bailout is too slow acting: it requires the Government to bid and buy toxic debt at a discount, and the banks are reluctant to sell.  Although this bailout hasn't really gotten started, we had a similar bailout over the summer - the now forgotten $300B homeowner rescue plan, which had a similar buy-out-at-a-discount focus.  Well, the mortgage holders aren't selling at a loss.  So that plan has barely gotten off the ground. 

UPDATE 10/18:  A trenchant analysis by the co-author of the late Milton Friedman of their definitive study of the Great Depression, says that the Fed is fighting the last war: trying to provide liquidity, which was the problem in 1931, since the runs on banks took deposits out.  Instead, the problem today is solvency, since the toxic debt lowers the value of the banks loans.  In other words, the problem is on the asset side of the balance sheet (loans), not the liabilities side (deposits).  

Time for Plan B: recapitalize the banks. Save the sound ones, let the reckless ones fail.

The banks' problem is that mark-to-market of their bad assets, or worse actually selling them to the government at a loss, puts their balance sheet at risk of being technically insolvent, and puts the whole bank at risk of bank runs and regulatory takedowns .  The solution is to provide more capital.  After all, in our reserve banking system, each $1 on the balance sheet can support $9 of loans.  (Or more, since in one of the egregious and little noticed actions of the Fed under Greenspan, he gave room for money center banks to go beyond the 10:1 reserve requirements by allowing them to sweep accounts and offer money market funds.) 

The likely way this will emerge is for the Treasury to sell more bonds to the Fed, who can then use them to provide capital to banks.  In a fiat money system, why not issue more debt!  But this may not solve the problem, just begin to call into question whether the US Government can really afford to shore up the whole global banking system. 

An alternative is for the Fed to issue gold-back bonds, and provide them to banks who raise new capital, perhaps on a 2:1 or 3:1 basis (for every $3 from, say, Warren Buffet, the bank can pull in $1 of gold-backed securities).  We have a lot of gold sitting in the NY Fed and in Fort Knox.  Why not use it, and keep the taxpayers off the hook?

I suppose a lot of mainstream economists would be loathe to go back to gold, even in this narrow way.  But then again, a lot of them were Keynesians until the '70s showed the failure of Keynesian Economics.  And a lot became Monetarists; but I daresay that this fiasco has disproven the core idea of Milton Friedman that floating exchange rates can act as good as gold.  Monetarists will soon be as scarce as Supply Siders. 

Fiat money has the obvious flaw that governments induce their central banks to cheat via inflation, and the currency cheapens.  The Dollar is now worth about what 2c bought in 1913. 

In a banking crisis as now, it has an even worse flaw that both sides of the balance sheet are based on confidence, not reality.  The Fed has already cheapened its reserve by swapping Treasuries for Toxic Debt, and if it continues to try to offer layers of debt to shore up banks balance sheets, at some point the monetary system will cry out "The Fed has no clothes"!" The Fed's reserves can be liquidated down to - nothing.  In contrast, its new gold=backed bonds would be

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