Dear Ben,
The Wall Street Journal reports,

“If it doesn’t pass, then heaven help us all,” responded Mr. Paulson

He is referring to legislation to authorize the next round of bailout activity by the Treasury, with rules, methods and accountability all to be determined. You should oppose this legislation. It is an attempt to avert a financial meltdown by means of a political and fiscal meltdown.

I fear you may be seeing this crisis through the lens of the Great Depression. Then, the wave of bank failures was an element in the severity of the downturn. However, keep in mind that there is still controversy over the relative weights of various causes of the Depression, and not everyone is convinced that bank failures per se were the main factor.

Today, it is clear that the U.S. financial sector needs to shrink. As another one of your former classmates, Ken Rogoff, has pointed out, the financial sector has accounted for an unusually large share of corporate profits in recent years. It is time for this country to shift talent and capital elsewhere. In order for that to happen, some firms in the industry need to tighten their belts, some weaker firms need to merge with stronger firms, and the weakest firms need to fail. As tempting as it is to intervene in this process to try to make it more orderly, dislocation is inevitable, and intervention may only make it worse.

We have excesses. Too many housing units. Too many “homeowners” who don’t have equity in their homes and never did. Too many banks and financial institutions. The excesses need to be worked out by the markets.

Henry Paulson is not the first strong Treasury Secretary to appear in a crisis. John Connally held that job in the Nixon Administration, In response to a run on the dollar, he abandoned the Bretton Woods agreement and introduced wage and price controls. In the short term, this was well received, and it allowed the economy to rebound in time for Nixon’s re-election. In the long run, it was a disaster, ultimately unleashing virulent inflation and, as oil prices rose, leading to the painful disorder of rationing and lines at gasoline stations.

Connally’s cure was worse than the disease. I strongly suspect that Paulson’s cure will prove similarly harmful.

My suggestion to you is that you get out of your financial industry cocoon for a while. Talk to people who are concerned about the direction that policy is taking, including former colleagues of yours in academia. A Central Banker should stand up to fear-mongering. Even when it comes from a Treasury Secretary.