The credit markets have come to a standstill as evidenced by the skyrocketing TED spread. This is the difference in rates between three-month LIBOR and three-month T-bills and is a gauge of how fearful banks are to lend to one another.
The reason LIBOR has exploded is that the value of the assets on the balance sheets of banks have been declining leading to widespread worry that they could could be worth less than the value of the liabilities resulting in failure. No bank will lend out funds when it has doubts of being repaid.
This is a very serious problem in our credit dependent economy because it can cause economic activity to come to a virtual standstill. For example, naked capitalism examines how letters of credit are not being honored by banks causing global trade to seize up.
Up to this point government responses have not directly addressed this solvency issue, but have tried to cure the symptoms by lending boatloads of money to provide liquidity. This has been ineffective because banks have been taking these funds and using them to shore up reserves rather than lending them out because they question the survivability of other firms as well as themselves. Thus, the credit markets remain arrested.
The Paulson plan recognized that the capital levels of banks needed to be increased and planned to address this by buying up distressed CDOs and subprime loans for a small fraction of par value. The hope was that this would make the balance sheets of banks more attractive for private sources of capital to invest in. Meanwhile, the government, with its low borrowing costs, would hold the assets to maturity for a profit. But the plan is faulty because it requires a lot of time to implement and the $700 billion allocated to it is insufficient. And there is no guarantee that banks will receive sufficient capital from the private sector.
In the meantime the financial system is melting down which has finally made officials realize that the best way to tackle the problem is to directly inject capital into troubled firms. In addition, they plan to guarantee all interbank lending and provide a blanket guarantee on all bank deposits. This should restore confidence in the banks and credit should start flowing again to where it is needed.
In the long-run these policy decisions could lead to big losses for taxpayers and prevent the economy from correcting its many years of malinvestment in the financial sector. I am opposed to any government interference in markets and would much rather see the entire financial system collapse followed by a return to a true gold standard with no fractional reserve banking. After an initial depression, the economy will grow at its full potential. But no one wants to suffer any near term pain. The result is that the government bailout of banks will lead to a less severe downturn in the economy, but no strong recovery for many years, i.e. we get a softer, but longer depression.
But for the time being the credit markets will begin to function more normally. Businesses and individuals who are low risk borrowers will soon be able to get the funds they need and a complete meltdown in the financial system will be averted. However, we will still have to deal with the fact that banks will restrict loans to only the most creditworthy borrowers and demand for loans will drop off as individuals reduce their debts. Consumer spending is going to disappoint for several years and business investment will be sluggish.
But the panic caused by the turmoil in the credit markets will soon subside and the TED spread should moderate.