The theory was beautiful (well in the abstract)…

Give troubled banks more credit and they will lend it out and the economy will stop its free-fall.  Now, that sounds like utopia to me.  Create credit and we will all be saved for unemployement, slowing production, decreased consumer spending, and rising interest rates.

HOLD ON… let’s put a toe back on the plane of reality…

Banks aren’t lending much more than before eventhough they are being handed gobs of cash.  Why wouldn’t banks lend out free money?

What if…

1. there aren’t any borrowers worthy of getting loans? — Let’s say during a recession!  Oh right the economy slows WAY… DOWN.
2. there are more troubled banks and unknowns on banks balance sheets.
3. banks are holding the cash knowing full well that there is another storm on the horizon

I didn’t pull this out of thin air like the Fed does with money.  An article in the NY Times starts with

The banks aren’t lending. And despite what you have heard, they probably won’t start just yet.

Sorry Paulson your plan isn’t working.

“Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital,” Mr. Paulson said in a statement Monday. “And we expect them to do so, as increased confidence will lead to increased lending. This increased lending will benefit the U.S. economy and the American people.

Of course, with a $250 billion injection into America’s biggest banks — not all of which were troubled — Mr. Paulson has a political sales job to do. And no requirements to lend were attached to the money. (Some banks may use the money to buy others.)

But Mr. Paulson is making a big assumption about confidence, because until the real economy recovers — which could take more than a year — lending to Main Street is unlikely to return rapidly to normal levels.

“It doesn’t matter how much Hank Paulson gives us,” said an influential senior official at a big bank that received money from the government, “no one is going to lend a nickel until the economy turns.” The official added: “Who are we going to lend money to?” before repeating an old saw about banking: “Only people who don’t need it.”

Again banks don’t want to lend into a very uncertain future.  They want confidence in the economy — there isn’t any and the opposite is occurring.  People are spending less as they become more concerned about the safety of their jobs.  Most Americans have no savings cushion to fall back on.

Roger Bootle and Jonathan Loynes of Capital Economics in London wrote a sobering note on Monday about the cash infusions into European banks that may apply here as well. “We expect rising loan defaults and further asset write-offs over the next couple of years to practically wipe out the governments’ capital injections, leaving banks back at square one,” they said. “Given that banks will need to increase their capital in order to expand their lending book, these measures on their own are unlikely to prevent bank lending from stagnating.”

Wait a minute… all that money being put into the system to restore confidence and spur lending may just vanish?  So at the end of the day more banks fail, the economy continues to contract, available credit continues to contract, unemployment rises, and interest rates eventually rise.  This isn’t what Paulson sold to us with his bailout plan.  Were we duped?

Nah, the individuals responsible for the government’s actions are always in need of votes and making a horrible situation look not so bad or at least feasible to fix.  At the end of the day our failed bailouts will have a disastrous effect.  The consequences are a HUGE debt burden, a larger interest payment on that debt, the world losing confidence in the value of the dollar, and a prolonged recession probably followed by major inflation.  I’ve been singing this song for a while and it will take time to play out, but as you can see this is a VERY rocky road.