The workings of the Fed and the financial markets can appear complicated, so let's simplify matters a bit to make it more clear what is going on here. Suppose that it was suddenly discovered that much of the wealth held by the country's leading financial institutions was in fact counterfeit. Instead of having hundreds of billions of dollars of real currency in their vaults, institutions like Citigroup, Merrill Lynch, and Bears Stearns actually had hundreds of billions of dollars of counterfeit currency. Suppose further that the public did not know exactly who held what in terms of counterfeit currency, only that all of them had a lot of it. (The point here is that these banks hold mortgage backed securities, many of which are only worth a fraction of their face value, and therefore can be viewed as the equivalent of counterfeit currency.)
In such circumstances, investors would be very reluctant to accept the credit of any of the major financial institutions. They couldn't know whether most of their assets were in fact counterfeit, and they were dealing with a bankrupt institution, or whether the counterfeit currency was only a limited share of the wealth, which would not jeopardize the institution's ability to meet its obligations.
This is in fact the credit squeeze that we've have recently witnessed. The spread between the interest rates on a wide variety of assets and the interest rate on safe assets (U.S. government debt) has soared. As a result, the Fed's effort to stimulate the economy, by lowering the federal funds rate, has been largely unsuccessful because other interest rates have remained high.
In response to this situation the Fed today announced that it would lend $200 billion to banks and other financial firms, accepting mortgage backed securities as collateral. This is effectively the same as saying that the Fed is going to lend money to banks and accept the counterfeit currency as collateral, treating it just as though it were real money.
The intended effect of this policy is to convince other investors that the counterfeit currency is in fact real currency, or at the very least that there is a really huge sucker out there (the Fed) which is prepared to treat the counterfeit currency as real currency.
So how does this story play out? Well, insofar as the Fed is successful, the counterfeit currency retains its value for a while longer. This allows Citigroup, Merrill Lynch, Bears Stearns and the rest of the big boys more time to dump their counterfeit currency on suckers who haven't figured out how the game is played.
It is possible that they won't be able to find enough suckers, in which case these banks will end up defaulting on their loans and the Fed (i.e. the government ) has lost tens or hundreds of billions dollars paying good money for counterfeit currency. Alternatively, perhaps the big boys are successful and can offload enough of their counterfeit money to restore themselves to solvency before the music stops. Then the Fed is repaid, but the counterfeit money now sits in the hands of other, less informed, or less inside, investors.
Either way, this is a policy of dubious merit. Why wouldn't we want the banks to be forced to come clean and eat their losses? This is always the policy that the economists advocate when the parties in question are not the big New York banks. Does anyone remember the East Asian financial crisis when the media was full of condemnations of crony capitalism and the IMF insisted imposed stringent conditions on South Korea, Thailand, and Indonesia as a condition of getting bailed out? At that time, everyone insisted on transparency. Aren't there any economists who still have this perspective? If so, why aren't their views appearing anywhere in the news?
