Arnold Kling, picking up on a paper by Jeffery Rogers Hummel suggests that Bailout are inconsistent with an Aggregate Demand story.

My main takeaway from this paper is that from an aggregate demand perspective you should never need a targeted bailout. This is obvious if you think about it. Every aggregate demand shock is either a money supply shock or a velocity shock. Any negative velocity shock can be offset by a money supply increase. Thus, if an institutional failure is going to cause a negative velocity shock, you can absorb the failure while increasing the money supply.

I think that the case for targeted bailouts has to rest on a supply-side story. That is, you think that losing Citicorp will affect the supply side of the economy in some horrible way.

I think that is somewhat right. A collapse of a major financial institutions could induce a recalculation or structural readjustment. The banking system provides liquidity through unique channels. If those channels are destroyed the economy must recalculate to a new equilibrium. This is part of the reason bank failures are so deadly.

We should note also that unless we think that the creation of the banking system itself was somehow second-best, then this recalculation cannot be optimal.

For people lost in the terminology, think about it like this. Suppose I have a big micro-lending program going on that supports women in Bangeldesh. Then suppose one day the micro-lending org goes under because the CEO embezzled a lot of money.

Then all of the villages that once received funding are going to experience a major supply shock.  Because it takes time to develop these relationships, another micro-lender can’t just swoop in. Moreover, trust in the whole micro-lending process has been eroded. This could lead to a structural increase in poverty in those villages. This will also be second-best and is why micro-lending bailouts as a public policy make sense.

However, there is also a massive liquidity loss from the micro-collapse as well. Credit tightens, spending will drop and cash hoarding will rise. This will induce an Aggregate Demand shock and a cyclical collapse in the villages as well. This collapse can theoretically be undone through monetary injections, though without a bank to provide those injections you will probably have to resort to direct payments.

For the case of the United States, I think TARP largely prevented the former scenario. The only place there was a massive structural collapse was in the mortgage market. It was possible for some people to purchase homes in 2005 who simply cannot purchases homes now and a person in their circa 2005 circumstances may never be able to purchase a home again. This is a supply-side collapse.

However, that process was underway long before Lehman fell apart. The Lehman fall could have produced a secondary structural collapse but various interventions including TARP largely prevented that from happening.

There still was, however, a liquidity collapse. We can debate over whether we want to call it a fall in the money supply broadly-defined or an increase in money demand narrowly-defined but the underlying dynamics are the same. Liquidity became scarce and as such people started hoarding cash.

So in short I don’t think these stories exist in opposition, nor do I think the necessity of TARP implies that our problems are mostly structural. It is because of TARP and other programs that we avoided full scale structural collapse. We still, however, have not dealt fully with the Aggregate Demand collapse.