Paul Krugman Gets, I Think, too Close to His Inner Hayek
The Liqudity Trap, and Open Market Operations on the Risk Premium on a Pan-Galactic Scale

Jim Hamilton on the Paulson Bailout

Over at Nouriel Roubini's place. Very good:

RGE - Paulson bailout: Let me begin with the point on which I am in complete agreement with Treasury Secretary Henry Paulson and Federal Reserve Chair Ben Bernanke--it is hard to overstate just how scary this week's developments in financial markets could be.

Prior to the establishment of the Federal Reserve in 1913, the United States would periodically experience events that are often referred to as "financial panics."... [T]he difference between the interest rate on 3-month certificates of deposit and 3-month treasury bills. The alarming behavior of this spread began in August 2007, when it spiked up to 243 basis points, higher than anything seen in the previous 20 years.... Following the bankruptcy of Lehman Brothers, the spread reached 527 basis points on Thursday. Financial intermediaries, who earn their profit by lending at a modest markup over their borrowing cost, simply cannot be expected to function in this kind of an environment. Lending institutions that had been solvent before this week would not remain so for long if this situation were to persist....

By my count, the Federal Reserve has already extended something on the order of $455 billion in loans collateralized by some of these same troubled assets, namely $125 billion in repos, $150 billion in the term auction facility, $50 billion in "other loans", $30 billion from the Bear Stearns deal, and $100 billion in "other Federal Reserve assets". That $455 billion total does not include this week's $85 billion loan to AIG, nor the $180 billion in reciprocal currency swap lines.

[T]he $700 billion is construed to be in addition to the comparable sum that's already been committed by the Federal Reserve. And it seems to be in addition to the $1.7 trillion in debts from Fannie and Freddie that the U.S. Treasury has now apparently assumed, and is in addition to the guarantees on $3.1 trillion in agency MBS for which the Treasury has again apparently assumed responsibility. And do you think that this week's $700 billion is going to be the last such request? Granted, these numbers I've been adding up represent loans or guarantees, which are something very different from outright expenditures. Actual losses should only amount to a small fraction of this sum. But even a small fraction of $6 trillion is still a huge number.

Before we can solve these problems, we need to agree on what caused them. In a narrow mechanical sense, that seems straightforward to answer. Reckless underwriting standards and excessively low interest rates contributed to bidding up house prices to unsustainable levels. Real estate price declines have now engendered current and prospective future default rates that translate into large capital losses for institutions holding assets based on those loans. This erosion of capital makes creditors wary of extending any new funds to these institutions.

But there is also a deeper question here that is harder to answer. How did the financial system come to be susceptible to such a profound degree of miscalculation and inappropriate leveraging of risk in the first place?...

How you get from our current situation to one where financial institutions are adequately capitalized is of course one of the key challenges of the moment.... Transparency strikes me as something that ought to be easier to achieve. I would start with a centralized clearing house for reporting all derivative contracts and collateral pledged for them.... the taxpayers are asked to commit such sums, we are owed a coherent and compelling explanation of why this kind of problem is never going to occur again...

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