Several people I know have argued with my "do nothing" approach to the current mortgage and liquidity mess. Their argument is that the current crisis has frozen the short term money market, with banks refusing to lend to each other, and only doing so via central banks. The problem, they claim, is that this could lead to an extended drying up of business to business credit. For example, two people both used the fuel retailing example, arguing that inventory purchases are made on credit, and paid off as the inventory is sold. The logic, I assume, is that businesses have all reduced their working capital, and so a drying up of short term business credit will cause the economy to lock up, with producers and retailers unable to buy components and inventory. One such argument here.
I guess the questions are 1) for how long and 2) how best to fix it. To the first question, this is by no means the first time in my lifetime that short-term credit has dried up. Liquidity eventually returns, mainly because lenders need to lend as much as borrowers need to borrow. As to the second question, central banks are currently handling this by increasing the amount of money they will lend short term. Rather than lend to each other directly, bank A deposits with the Fed and then the Fed lends to bank B. The cycle ends NOT when every bank is healthy but when banks and other institutions are confident they know which banks are healthy. All the bailout is doing is delaying this reckoning. I don't think it matters that banks and certain financial institutions survive, I think it matters that the ones who are not going to survive are identified quickly so the rest can start lending again to each other.
Given these concerns, I reiterate my position that if the government is going to inject liquidity and create new financial asset insurance programs, it makes more sense to me to do it at the point of concern, i.e. in the credit market to main street businesses, rather than dumping the money into the toxic sludge of credit default swaps.