Why The Bailout Is Failing

The equity markets have passed judgment: The Bailout is Failing.

The current list of Bailout Failure symptoms is large: Declining markets, historically large spreads, and etc. The underlying cause of all of these symptoms is that confidence in the financial system has been shattered.

Sadly, several Fed actions have exacerbated the situation. For instance the Fed has proposed numerous facilities to jumpstart credit. Naturally, every time a new facility is introduced, a portion of the credit sector shuts down, since no sane business would ever continue issueing credit in competition with the Fed. As parts of the credit food chain are subsumed by the Fed, businesses shut down their operations in the next part of the credit food chain, which the Fed has just made nonviable. Consequently, the Fed needs to create another facility for that newly shut down operation. And so on.

Underlying all of these issues is the fact that there are many insolvent institutions. Ben Bernanke, who is a student of the depression, knows well that runs on financial institutions occurred due lack of confidence in the 1930s. Once the system was reflated in 1933-4, reconstruction could begin.

However, it seems lost on him that a major aspect of the reflation is that the insolvent institutions had already been removed from the system by 1934. At the moment, there seems to be not even a whisper of shutting down the large banks that were so incompetent that they drove their businesses into bankruptcy. We are even rewarding those institutions by augmenting their shareholders with government capital. (Let's face it: It's not likely that these banks are going to suddenly grow new neurons and become smart and sensible operations.)

We should not expect any real change until we remove the rot from the system; it is the underlying cause.