In a post yesterday, I wondered why we needed a $700 billion bailout when investors are obviously willing to invest in sound financial institutions. I have also said that this crisis is a result of government meddling in the market. The current phase of the crisis is also a result of government intervention. There has been a lot of talk about TED spreads and LIBOR blowouts and it looks like the credit system is blowing up. But is it really? Ken Rogoff, who previously worked for the IMF and Federal Reserve and is now an economics professor at Harvard, had this to say yesterday (via Credit Slips):

At a Harvard panel discussion yesterday, economist professor Ken Rogoff made an interesting point: The liquidity crisis isn’t real.  Or, to restate it: Any liquidity crisis is caused by the promise of a government bailout. Ken said that his many friends in investment banking said that there is plenty of money to invest in financial services, but right now it is “sitting on the sidelines.”  Why?  Because the financial services industry does not want to pay the terms required to get that money back in circulation (e.g., give up equity).  As he put it, why do business with Warren Buffett who will negotiate a tough deal, if you believe that the government will ride in soon with cheaper cash? 

Ken also talked about the need to shrink the financial services sector. He thinks it is good that the investment banking houses are failing and many people on Wall Street are losing their jobs because, in his view, we have an oversupply in that sector and our economy just can’t support it.   

Ken’s background with the IMF and on the Board of the Federal Reserve add a certain credibility to his assessment of conditions on Wall Street.  If he is right, the $700 bailout is saving some investment bankers’ jobs in the short term, but overall it is just making the financial system worse. 

For a financial institution that is having a tough time, why take Warren Buffet’s terms when the government will take all that bad paper off your hands? Buffet got a 10% dividend and warrants from Goldman Sachs for God’s sake. What would he want from a National City or Wachovia? Obviously, it is better to wait and see if Paulson will get down on bended knee and offer to buy your paper above the market value than sit down and get Tony Soprano terms from a savvy investor.

As for the TED spread and LIBOR, well, when the central bank is flooding the zone with cash, why borrow from another bank when you can get a lower rate from the Fed or ECB? Bankers would actually be criminally stupid to borrow from anyone but the Fed right now. I think a big part of the problem is that the stigma of borrowing from the Fed has been lifted. The whole purpose of the TAF and TSLF was to allow banks and brokers to borrow from the Fed without anyone knowing. That has to end or there will be no interbank lending. The only way to accomplish that is to bring back the stigma and raise the discount rate. There is a reason why it is said that the central bank should lend freely in a crisis, but at a penalty rate.

This crisis has been manufactured by the government’s intervention. There is no reason that a housing bubble in a few states should bring down the entire US financial system. If the Fed had allowed this to run its course, we would far along to recovery right now instead of wondering if Washington will bail us out.

If the bailout goes ahead, and it appears that it will, the US financial system will take longer to heal. This is what Japan did back in the 90s. They propped up failing banks rather than let them fail and those zombie institutions continued to clog up the system. It would be much better to allow the banks that made bad loans to face the consequences of their actions and let the stronger banks pick up the pieces. We are supposedly a capitalist country and that is what happens in a captialist system. Why don’t our “leaders” trust the market to function as it should?