Why we need a bailout, even if not this bailout

Having (hopefully) scared you appropriately with the previous post, I now point out that the money markets were only one part of the picture.  Let's not forget that we still have the mortgage market and the insurance markets freezing up quite apart from the money market disasters.  Every crisis gets compared to the Great Depression.  This very nearly was.

There are strains on the left and the right that are kind of okay with this idea. 

The right wing version says "Let them fail! Fractional reserve banking is inherently unstable, and we've been living on borrowed money.  We need to cut back to our natural, credit-free level of output and consumption."

The left wing version says "Let them fail!  Capitalism is inherently unstable; greed is no way to run an economy.  We need to force banks to stop doing all of these dangerous things and regulate them so heavily they can't make a mistake.  Also, as a general rule, rich people should suffer for their mistakes, and ordinary people shouldn't.  This is a great opportunity to repeat FDR's awesome victories!"

These are two ways of being dangerously silly.  Whatever your ideal looks like, there are two rules of financial system change:

1)  Very rapid change is very bad
2)  See above.

The Great Depression took place in an economy much less dependent on liquid credit markets than today's system.  In three years, from 1929 to 1932, GNP fell by about 30%.  Unemployment hit almost 25%, and stayed within spitting distance of 10-15% for most of the rest of the decade.  This was not selective, picking out only the bad people who had bought radios on time, invested in Florida real estate, or taken a flyer on an investment trust.  People lost their jobs not because they were bad, but because their company could not sell enough stuff to cover expenses.

In an earlier thread, someone said, roughly, "I don't buy on credit and my company invests on retained earnings.  I can sit this out for a couple of months."  The problem is, the effects of really rapid contractions don't last a couple of months.  They last years.  Can your company withstand the bankruptcy of some major clients with large outstanding accounts?  How many people will it have to fire if its order book drops 40%?  Can it cover its fixed expenses even on half staff?

Liberals hoping that this will bring on a second new deal, however, should think again.  What FDR did was a one-trick pony.  For one thing, he was operating in an environment with vastly more scope for action than the current government has.  Since then, the Federal government has hemmed itself in with a combination of laws, regulations, and legal decisions that make federal projects of any scale take decades.  There will be no second WPA or TVA.

More importantly, FDR was working with a financial blank slate.  In 1928, income tax receipts were about $1 billion on GNP of roughly $100 billion.  State and local taxes were also low.  Now the effective federal tax rate for Arnold Schwarzenegger is more than a quarter of his income.  The Federal government's share of national income peaked at roughly 50% (IIRC) in World War II, and has averaged about 20% since then.  We can't add another 20% so easily.  When federal, state, and local governments are taking more than half peoples' incomes, they get awful feisty.  Plus, if we take more money, what are you going to do when the bills for Social Security and Medicare come due?

There is no benefit from a "tough love" strategy for anyone that even begins to approach the catastrophic consequences, for everyone, of a massive and rapid contraction.