Bernanke suggests that “prompt passage of the financial rescue legislation” will allow financial firms to fulfill “their critical function of providing new credit”, but even there he misreads the problem. Banks don’t so much lack money to lend as they don’t trust the balance sheets of other banks. The latter in mind, the alleged financial rescue plan will only serve to make the health of banks and the securities on their balance sheets even more opaque due to the insertion of money not from market-disciplined investors, but from the federal government itself.
This part of the piece really hit the nail on the head in my mind. Tyler Cowen posted a while back over at Marginal Revolution on the same idea. His example was something along the lines of this:
Suppose there are 10 banks in an economy, 3 of which are insolvent. The public doesn't know which ones are insolvent, but the insolvent banks know who they are. If the Fed steps in and starts giving all 10 of them money then we end up prolonging the process of discovering which banks are the bad apples and should be allowed to fail.
It makes sense when you think about it. Masking the problem doesn't fix it. But I guess some would argue that giving the bad banks money may actually resolve their problem of insolvency...changing the bad apples into solvent institutions. But this would only happen if the insolvent banks received enough cash. The biggest banks in America are only receiving a proposed $125 billion. If you're a bank in serious trouble then a relatively small injection from the government will only delay your failure. The banks that are in good shape know that there have to be some minimum number of insolvent banks out there that will go under in time. The smart thing would be to shorten the amount of time it takes for the discovery to take place. Injecting capital into financial institutions is only increasing the amount of time needed; we should be doing exactly the opposite to hasten this crisis of trust.