http://www.huffingtonpost.com/dean-baker/why-bail-the-banks-have-a_b_130124.html

Dean Baker
Posted September 29, 2008
Why Bail? The Banks Have a Gun Pointed at Their Head and Are
Threatening to Pull the Trigger

If you have a real story, you don't have to make up phony stories.
That's pretty straightforward.

I've heard lots of phony stories. Much of the country's political and
economic leadership has been running around raising the prospect of
the Great Depression and a breakdown in the banking system (I actually
had taken the latter seriously). These stories are absolutely not
true.

There is no plausible scenario under which the no bailout scenario
gives us a Great Depression. There is a more plausible scenario (but
highly unlikely) that the bailout will give us a Great Depression.
There is no way that the failure to do a bailout will lead to more
than a very brief failure of the financial system. We will not lose
our modern system of payments.

At this point I cannot identify a single good reason to do the
bailout.

The basic argument for the bailout is that the banks are filled with
so much bad debt that the banks can't trust each other to repay loans.
This creates a situation in which the system of payments breaks down.
That would mean that we cannot use our ATMs or credit cards or cash
checks.

That is a very frightening scenario, but this is not where things end.
The Federal Reserve Board would surely step in and take over the major
money center banks so that the system of payments would begin
functioning again. The Fed was prepared to take over the major banks
back in the 80s when bad debt to developing countries threatened to
make them insolvent. It is inconceivable that it has not made similar
preparations in the current crisis.

In other words, the worst case scenario is that we have an extremely
scary day in which the markets freeze for a few hours. Then the Fed
steps in and takes over the major banks. The system of payments
continues to operate exactly as before, but the bank executives are
out of their jobs and the bank shareholders have likely lost most of
their money. In other words, the banks have a gun pointed to their
heads and are threatening to pull the trigger unless we hand them $700
billion.

If we are not worried about this worst case scenario (to be clear, I
wouldn't want to see it), then why should we do the bailout?

There has been a mountain of scare stories and misinformation
circulated to push the bailout. Yes, banks have tightened credit. Yes,
we are in a recession. But the problem is not a freeze up of the
banking system. The problem is the collapse of an $8 trillion housing
bubble. (It was remarkable how many so-called experts somehow could
not see the housing bubble as it grew to ever more dangerous levels.
It is even more remarkable that many of these experts still don't
recognize the bubble even as its collapse sinks the economy and the
financial system.) The decline in housing prices to date has already
cost the economy $4 trillion to $5 trillion in housing equity. This
would be expected to lead to a decline in annual consumption on the
order of $160 billion to $300 billion.

Given the loss of housing equity, I have actually been surprised that
the downturn has not been sharper. Homeowners had been consuming based
on their home equity. Much of that equity has now disappeared with the
collapse of the bubble. We would expect that their consumption would
fall. We also would expect that banks would be reluctant to lend to
people who no longer have any collateral.

This is the story of the downturn and of course the bailout does
almost nothing to counter this drop in demand. At best, it will make
capital available to some marginal lenders who would not otherwise
receive loans. We should demand more for $700 billion.

For the record, the restrictions on executive pay and the commitment
to give the taxpayers equity in banks in exchange for buying bad
assets are jokes. These provisions are sops to provide cover. There
are now written in ways to be binding. (And Congress knows how to
write binding rules.)

Finally, the bailout absolutely can make things worse. We are going to
be in a serious recession because of the collapse of the housing
bubble. We will need effective stimulus measures to boost the economy
and keep the recession from getting worse.

However, the $700 billion outlay on the bailout is likely to be used
as an argument against effective stimulus. We have already seen voices
like the Washington Post and the Wall Street funded Peterson
Foundation arguing that the government will have to make serious
cutbacks because of the bailout.

While their argument is wrong, these are powerful voices in national
debates. If the bailout proves to be an obstacle to effective stimulus
in future months and years, then the bailout could lead to exactly the
sort of prolonged economic downturn that its proponents claim it is
intended to prevent.

In short, the bailout rewards some of the richest people in the
country for their incompetence. It provides little obvious economic
benefit and could lead to long-term harm. That looks like a pretty bad
deal.