What macroeconomic theory says that we run the risk of a Depression if we don’t have a bailout? Try to come up with an argument that is either already in a textbook or that you would put in a textbook. If macro is a genuine discipline, it has to consist of something more rigorous than “If Bernanke is worried, then so am I.”In layman’s terms, we are trying to answer the question of how Wall Street relates to Main Street. How do you explain why we need to help Wall Street to help Main Street?

The IS curve, for example, represents a feedback mechanism from Wall Street to Main Street. When credit markets tighten, interest rates rise, and investment declines.

The LM curve represents feedback from Main Street to Wall Street. As the pace of economic activity picks up, people have to use more cash. They remove assets from Wall Street, and interest rates increase.

But what theory describes the motivation for the bailout?

The textbook analysis says that when interest rates rise, the Fed can supply more money to bring them back down. Why can’t that work today? Any macro theorists want to answer? Bueller?

As far as I can tell, the theory that is implicitly being employed today is something like the following.

The Fed is constrained by a “bank capital trap.” As in a liquidity trap, the Fed may be unable to end a recession by injecting reserves into the banking system.

In the liquidity trap, the problem is that borrowers already are paying minimal rates, but because of deflation the real interest rate is high. Clearly we’re not in that situation. Borrowers’ real interest rates are not high because of deflation. They are high because nominal rates are high, due to hefty risk premiums.

Insttead, we are in a capital trap, because the binding constraint at banks is capital requirements, not reserve requirements. Adding more reserves has no effect. If the Paulson plan is turned down, then this theory says that the binding capital constraint will lead to higher interest rates for borrowers, a slowdown in economic activity, more loan defaults, more erosion of bank capital, and a downward spiral.

I have not seen the “capital trap” theory in any macro textbook. How can we be undertaking one of the most extreme policy measures in economic history based on a theory that no one has ever studied?