Brad DeLong is always correct...

Or phrased differently, Brad DeLong quoting Bagehot to refute Geithner


The Money Quote

Back when Martin Wolf was taunting Larry Summers about how useless economist was, Summers said: "There is a lot that is useful about the financial crisis in Bagehot." Walter Bagehot (1873), Lombard Street, is the nineteenth century's manual for dealing with a financial crisis. It says that in a financial crisis the central bank should:

• lend freely
• at a penalty rate

Lend freely: The first-order problem is that the market has seen a sudden rise in the share of their portfolios that investors wish to hold in cash--for safe, liquid, savings vehicles--just as events and then the fallout from the crisis itself diminishes the supply of cashThe central bank by lending freely to debtors can turn their liabilities that are no longer cash--no longer regarded as safe, and hence no longer liquid, and dubious as savings vehicles--back into cash. Moreover, confidence that the crisis will not spiral out of control will reduce the demand for cash. And so the economy and the financial crisis will right itself.

At a penalty rate: The second-order problem is that the failures of risk management and of foresight that caused the crash and crisis need to be punished and not rewarded. If the financiers whose over leverage set the stage for the disaster emerge wealthier than ever and even more confident that the government will bail them out, you have created an economic, political, and moral disaster. The disaster is economic in that you have just given incentives to create bigger episodes of moral hazard and bigger financial crises in the future. The disaster is political because voters will conclude that you are wholly-owned tools of Wall Street. The disaster is moral because there is no way an outcome that leaves over leveraged financiers still in the game and as wealthy and ever can be just and fair.