fdr.thumbnail.jpgWhat was causing the panicked "must pass bill now" gasps from Senators and the Treasury was not the various bank failures. They have been pretty orderly and no one who failed wasn’t expected to fail. Instead the problem was that banks aren’t lending to each other. This isn’t because they fear that other banks won’t repay if they fail, in every case when a bank has failed, the Fed has made sure that banks with outstanding interbank loans got their money back. So this isn’t a question of systemic risk causing fear.

Instead the fact of the matter is that banks can make more money lending elsewhere and, more importantly, by causing the system to seize up they were making it likely that they’d get a huge, oh 700 billion to 1.5 trillion dollar bailout. Whatever you can get for lending overnight to other banks kind of pales in comparison.

Now that this bill has failed, the real risk is that banks will pile on the pressure. Since just not lending to each other has not been sufficient, the next step is to severely tighten credit to consumers and businesses. They will claim that this is because they just can’t afford to lend.

We need to make sure this doesn’t happen. Here’s how we do it:

1) If a bank stops making regular loans we take that as evidence that they must be insolvent. After all, if a bank’s business is to make loans, and they’ve stopped doing business, then it must be because they can’t do business. In this case the FDIC steps in and takes over the bank, since they clearly need to be taken over. Give the FDIC a hundred billion to tide it over to January with this additional mission. We can be assured that banks that can lend, will lend, otherwise they won’t be in business any more.

2) Get the Fed to start making the necessary interbank loans itself. To do so, have the Treasury sell some bonds to expand the Feds balance sheet (which is filled with trash due to their fruitless efforts to do what Paulson wanted more money to do). 150 billion should do it.

This gets you to January without the banks being able to collapse the economy to blackmail the public into bailing themselves up.

In the meantime, the election issue is now what sort of bill occurs in January so that the new President has a mandate to get it done and to fix the economy and the finance sector long term by doing it right. I’ll point readers who want to know what a good economic reform bill would look like to this outline.