By all appearances, Ben Bernanke has a four-second tape in his head that says "We let the banks fail during the Depression, and look what happened." Then the tape repeats. There is no subtlety that says, "yes, but we let the banks fail in the most disruptive and disorganized way possible, forcing them into piecemeal liquidation as Lehman had to do. Today, the FDIC is fully capable of preserving and transferring the operating entity while properly cutting away the failing bondholder and stockholder liabilities so that depositors and customers are not affected." This understanding would prove useful in the event we observe further credit strains.
Basic ethical principle dictates that policy makers should not burden ordinary Americans to pay the losses that well-informed bondholders voluntarily took when they lent money to failing institutions. From my perspective, it is urgent to recognize that Fannie Mae and Freddie Mac obligations are not legally obligations of the U.S. government, that its backing was always at best implicit, and that even the Treasury's distressingly generous 3-year promise to bail out Fannie and Freddie only takes those obligations through 2012. Longer-term GSE securities held by the Fed and by investors represent debt obligations of insolvent institutions, yet are still treated by investors as if they are default free. Congress should quickly clarify that FHA debt is sovereign debt and GSE debt is not. Congress should limit the Fed to purchasing sovereign debt, or it should bless GSE debt explicitly so Americans understand that the U.S. dollar will ultimately become the Reichsmark.
A few additional notes. We are likely to observe a substantial increase in U.S. government debt in the next couple of years, not only because of stimulus spending and possible further bailouts, but also due to tax shortfalls and aid to states and municipalities. The key question to ask is the extent to which the increase in debt is matched by an increase in productive capital or urgently needed social benefit. Remember also that the crucial consideration is how the money is first spent - how productively the money is used. Once the funds are spent, there will be government liabilities as evidence of that spending, but it is important to recognize that those liabilities are simply IOUs.
Interestingly, some observers lament that corporations and some individuals are h olding their assets in "cash" rather than spending and investing those balances, apparently believing that this money is being "held back" from the economy. What is preposterous about this is that the "cash" that companies and individuals are observed to be holding is primarily in the form of government securities and base money created over the past couple of years, which somebody has to hold at every point in time until those liabilities are retired. This is not money that is waiting to be spent. It is a stack of IOUs representing resources that have already been squandered, and now somebody has to hold these pieces of paper until they are retired.
In short, instead of directing savings toward investments in real, productive assets that we would observe as physical output, fixed capital, and equipment (and claims on those assets in the form of corporate stocks and bonds), our economy has been forced to choke down a massive issuance of government liabilities in order to bail out bad debt. For every dollar of debt that should have defaulted, we now have two dollars of debt outstanding (the original debt, and a newly issued government security). What appears to be "sideline cash" is simply the evidence of past spending. Again, the crucial consideration is how the government spent the funds in the first place. Rapidly mounting evidence suggests that the answer is "not very well."
