I am of two minds about the proposed bailout. Not about the specifics of any particular proposal, those can be dealt with later, I am of two minds about the idea of a bailout itself. The arguments in its favor are relatively sound, but, on the other hand, they are plagues by very short term thinking and a tendency to ignore the fact that there are long term repercussions. And, worse still, they completely ignore the fact that the bailout does not solve the problem, only defers the time when we eventually have to face the consequences.

An analogy was found during the Carter years. To be fair to Carter, when he took office the economy was already rocky, being troubled by Nixon's removal of the dollar's final ties to gold and the subsequent price controls. However, in an effort to avoid facing the consequences of those decisions, the Carter administration began massive inflation of the money supply in an effort to stimulate the economy. It was about the worst decision anyone could have made. It did give a tiny boost when started, but almost immediately the economy adjusted tot he anticipation of regular devaluation of the dollar, and we entered the well know "stagflation" of the Carter years. Rather than solve the problems Nixon created, Carter simply substituted inflationary problems. The eventual crash, which was inevitable, finally took place in the Reagan years.

Likewise, the Clinton years saw some similar economic shenanigans. Clinton largely avoided explicitly monetary inflation. Instead, he used federal influence over private lenders, causing credit expansion (such as the increase in mortgages), which effectively increased the money supply*, though by many measures the money supply remained largely unchanged. It created a short term boom during the Clinton years, but one that eventually led to a crash. Or rather, two. First, the slump that  inaugurated the Bush administration. And second, the eventual collapse of the housing bubble that we are seeing now**.

But enough history, let us consider the arguments for and against a bailout.

I will ignore now the arguments about the propriety of the government involving itself in this matter. My beliefs ar eclear elsewhere on this blog, so I won't go into them here. In an ideal world, the government would stay out of business, but this is not an ideal world. the government is so intimately involved in the credit market that it is senseless to argue the government should stay out now. Likewise, for now I will ignore the perverse incentives of such a bailout. As it is unlikely another such bailout will occur in the enxt decade, I doubt anyone will act based on the expectation of another bailout. Even if they did, I think the bigger economic questions are far more significant than any incentives such a bailout may provide.

So, looking at it purely from an economy-wide perspective, why would we want a bailout?

The simple argument, and one that many seem to reluctantly embrace, is that allowing the bundled subprime mortgage instruments to become worthless would be, in effect, a sudden, massive deflationary influence. Such influence have, in the past, been associated with recessions and depressions. And it is certain that were all the bundled Fannie Mae mortgages to become worthless, it is certain that several of the holders would either go bankrupt or, at the very least, experience substantial losses. As the holders are many of the larger institutional investors, this would also likely destroy a large part of the capital market, which will be quite harmful for the markets in general and would obviously slow any future growth for some time.

The counter argument, and one which troubles me, is that any bailout won't truly solve the problem, but will simply displace it and push the time we have to face it into the future.

We are not going to pay for this bailout by increasing taxes or reducing spending. We are going to bail out these companies by increasing our debt. That means one of two things, either in some future time we will have to raise taxes or decrease spending, which is not going to happen, or we will end up printing money. We may not do it right away, but at some future time, the money supply will be expanded to deal with this. 

Now, not all money supply growth is harmful. A slow, gradual increase in the money supply, when coupled with economic growth, may be relatively harmless***. However,  this debt is large enough that I doubt that will be the case. This expansion will be, to some degree, a harmful inflationary pressure. And, as with all excessive inflation, it will eventually help fuel a crash and subsequent deflation. In other words, today's bailout will just postpone the inevitable, the eventual deflation necessitated by the credit expansion these mortgages represent.

For a long time the money managers in Washington have believed they can avoid paying the piper if they delay long enough. They have thought that they can inflate, and, when the crash is about to strike, inflate again and put off the deflation. They seem to believe that if they postpone it long enough, economic growth will have caught up with them, and they will never have to face the deflation. that has been the delusion of our money managers since the Fed was created, and the experiences of 1929, the 1930's and the 1970's should have disabused them of this notion, but it hasn't.

Managed money is just a bad idea, but it can be made relatively stable if the managers can avoid the pressure to inflate for political reasons, to "spur growth" or "ease credit". However, they never can. Instead they over inflate, then try to postpone the deflation that follows. And they might be able to do that, were they to not inflate while they waited for the economy to catch up with the money supply. The problem is, they got into this problem because they could not resist pressure brought on them to inflate, so how likely is it they won't inflate for months or years while waiting for the economy to settle down? Instead they pile on new inflation, and just increase the size of the eventual crash which awaits them in the future.

And how likely is it this bailout, which amounts to postponing a needed contraction, will inspire the Fed to stop increasing the money supply? Or the EHOC or HUD to stop pressuring lenders to overextend credit to bad risks? All of which means we are only postponing the inevitable.

So, I am left with a difficult question. Is the economy in such a state that it is better to put off the crash, even if it is made worse as a consequence? Or is it better to face the music now? Should we simply take our lumps, suffer through the contraction, and start fresh without this threat hanging over our head? We will have to face the contraction eventually, so is it better to do it now, or face it alter?

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* When a credit expansion is only partly backed by reserves, as much lending by financial institutions is, it is in effect an expansion of the money supply, as it creates new assets which did not previously exist.

** The housing bubble was not just the result of excessive subprime lending. It was a major influence, but there were also several other factors, such as smart growth and building caps in many markets, a real increase in income with consequent increased demand for housing, and finally, the high demand for investment properties as the continual boom market fueled itself. However, without the pressures to provide mortgages to unqualified buyers, the boom would probably have been much smaller, much more mild, and lacked the crash we are now seeing.

*** I am not saying that inflation is harmless. The expansion of the money supply still results in economic dislocations, and the anticipation of future inflation can cause additional harm. However, so long as money supply expansion is less than the expansion of the economy, the harm done is relatively small. It does mean there is an erosion of purchasing power relative to what it would be without inflation, but as there is economic growth, that is hidden and purchasing power appears to remain unchanged. So in the eyes of consumers, the money supply growth does not harm, and there is no tendency to build in inflation premiums into interest rates. However, hsitorically, there has never been a government which resisted the temptation to over inflate for political reasons.