Market Failures and the Banks

Economists agree that markets work, except when they don't. The philosophical debate starts when markets don't work and people wonder what should be done about it. One side says the government can intervene constructively, and the other says that the government will probably only make things worse. But the debate at this point is not over whether markets have worked well in the financial sector, it's about what to do about it now that they have not. Larry Summers was on the News Hour (audio: HERE, and video: HERE), and explains it much better (his interview starts at 4min, 55sec):
 

GWEN IFILL: At the heart of this plan that Secretary Geithner introduced today is the idea that somehow these assets, which some people call "toxic assets," but which I notice you all call "legacy assets," that they're somehow worth saving. How do you value that? How do you know that it's worth a government investment?

LARRY SUMMERS: Well, our approach is premised on the recognition of a market failure that we have right now. Traditionally and usually these assets trade all the time between people who borrow money in order to finance their purchase.

That market, where they're able to borrow money, what people call "get leverage," has broken down. And as a consequence, the assets have lost a significant part of their value, just as if, all of a sudden there was no mortgage value, houses would lose a substantial part of their value.

And so, by providing the financing that enables that market to work, we enable more realistic valuations of these assets. We enable these assets to trade again. That means that people are in a position to originate loans and sell them into the market, and that gets the flow of credit going.

The point, though, is to create enough liquidity (and, by putting well-trained econ geeks like Summers and Romer out there, confidence) so that scared banks can both retain the higher levels of excess reserves they feel they need, and still keep credit flowing to private businesses. The alternative would be nationalization of the banking sector, which, in a more fundamental way than simple income redistribution or even public health care, would truly be a step in the direction of "socialization" of the private sector. Nobody, (even this administration, contrary to what some folks believe) wants that.