Two Quick Takes
Will the commercial paper market dry up?
The Fed had to deal with this in 1970, when the Penn Central Railroad went bankrupt. In this narrative, “the Fed’s index finger started to bleed” from dialing up every bank and telling them to make loans to corporations that were having trouble. That would work today, but–you knew I was going to say this–they would have to relax capital requirements.
2. In a comment on my Where are the Macro Theorists? post, G. Martinez says that he teaches the current crisis as a surge in money demand, with Treasuries playing the role of money. Everyone else’s borrowing rate goes up, and the rest happens according to a textbook.
That’s a good analytical approach.
UPDATE: I’m going to put my original continuation below the fold. I’ve thought more since.
OK, so now we have a story that we can put into a textbook macro framework (I’ll play that game for now). We’ve had an increase in liquidity preference. Why, if we don’t act this weekend, will we get the Great Depression? I don’t think that what has happened so far is going to do it. Do we really think that the lagged response of spending to the increase in liquidity preference that has already taken place will be that large? I don’t.
Instead, you have to tell a story that says that we could find ourselves with liquidity preference increasing even more in coming weeks, that only the bailout can prevent it, and that if it is not prevented it cannot be treated. That’s a hypothesis, but I’d much rather test it (by not passing the bailout) than proceed as if it were nonfalsifiable.
Another hypothesis is that Paulson is too closely wedded to the financial industry, and Bernanke is too closely wedded to Paulson.[original continuation] The right policy response to a surge in demand for this “money” would seem to be to exchange “money” for bonds, which in this case means issuing Treasuries and buying private securities. If that’s the right policy, then I would have the government invest in bond mutual funds rather than mortgage securities. First, that would give you diversification, instead of putting all your chips on house prices. Second, it would allow you to undo the trade easily if market psychology changes in favor of corporate bonds. Third, there would be nothing magic about $700 billion. Maybe it takes a lot less to nudge corporate bond rates down.
UPDATE: Some similar thoughts from Andrew Feldstein via Joe Nocera, pointed out to me by reader Mike Gibson.