Can’t the media find any economists who don’t think that handing hundreds of billions of taxpayer dollars to the big banks and the incredibly rich people who own and manage them is a good idea? Apparently not, given the coverage so far to the Fed’s proposal to lend $200 billion to the banks using mortgage backed securities as collateral.
The workings of the Fed and the financial markets can appear complicated, so let’s simplify matters a bit to make it more clear what is going on here. Suppose that it was suddenly discovered that much of the wealth held by the country’s leading financial institutions was in fact counterfeit. Instead of having hundreds of billions of dollars of real currency in their vaults, institutions like Citigroup, Merrill Lynch, and Bears Stearns actually had hundreds of billions of dollars of counterfeit currency. Suppose further that the public did not know exactly who held what in terms of counterfeit currency, only that all of them had a lot of it. (The point here is that these banks hold mortgage backed securities, many of which are only worth a fraction of their face value, and therefore can be viewed as the equivalent of counterfeit currency.)
In such circumstances, investors would be very reluctant to accept the credit of any of the major financial institutions. They couldn’t know whether most of their assets were in fact counterfeit, and they were dealing with a bankrupt institution, or whether the counterfeit currency was only a limited share of the wealth, which would not jeopardize the institution’s ability to meet its obligations.
This is in fact the credit squeeze that we’ve have recently witnessed. The spread between the interest rates on a wide variety of assets and the interest rate on safe assets (U.S. government debt) has soared. As a result, the Fed’s effort to stimulate the economy, by lowering the federal funds rate, has been largely unsuccessful because other interest rates have remained high.
In response to this situation the Fed today announced that it would lend $200 billion to banks and other financial firms, accepting mortgage backed securities as collateral. This is effectively the same as saying that the Fed is going to lend money to banks and accept the counterfeit currency as collateral, treating it just as though it were real money...
Obviously Mr. Baker hasn't been listening to Karl Rove, who says that if we just stopped talking about them, all the economic problems would just go away.
[a tip of the tinfoil to Avedon for the link]