re: We're made to believe these bailouts can prevent that suffering, but that is not true

Why Financial Collapses Are Unavoidable And Government Actions May Be Backfiring

Excerpt:

Government bailouts could endanger government credit and credibility.

The credit market contagion has spread in phases:

* In the mortgage sector, it was initially confined to subprime mortgages. Then it reached the mid-level Alt-A mortgages. And now it has affected prime mortgages.

* In short-term credit markets, it was first restricted to commercial paper issued by weak financial institutions. Next, it spread to the short-term paper of stronger financial institutions. And now it has hurt nonfinancial paper as well.

* In bonds, it began with the most speculative junk bonds, then reached middle-tier bonds, and now has impacted most corporate bonds of all stripes.

Each time, frightened investors sought the safety of government paper. And each time, this fear factor drove up government bond prices while driving down their interest rates.

This may be giving U.S. Treasury officials the false impression that they enjoy strong investor demand for government securities and easy access to funds for more handouts to near-bankrupt corporations. But this influx of money may also be obscuring a frightening prospect:

Governments could be the next victims.

To the degree that the authorities pursue the purchase of bad bank assets, or to the extent that they go forward with the injection of government capital into a collapsing banking system, they may become subject to the same contagion of mistrust.

If the governments’ heretofore stellar credit is sucked into this crisis, it could

* make it much more expensive for governments to roll over their maturing debts;

* make it difficult to raise the cash needed to maintain government operations; and

* ironically, deprive authorities of the last weapon they have to help bring about a subsequent recovery: The credit and credibility of the world’s leading governments.

Government actions could aggravate, or even cause, the systemic meltdown they are seeking to prevent.

Reason should dictate that governments should do everything possible to liquidate insolvent institutions, quarantine the weakest institutions, fortify the strongest, and insulate the government’s own credit from the scourge. Instead, it seems that U.S. and European authorities are doing precisely the opposite. They are engineering

* shotgun mergers that sweep bad assets under the carpet of otherwise stronger institutions;

* bailouts that create zombie banks and corporations, weakening the system as a whole; and

* new, bigger and unaffordable FDIC-type guarantees of bank deposits that further obscure the difference between worthy and unworthy banks.

The long-term, fundamental affect of these actions is widely known: They are corrosive. They cause far more losses and pain in the end.

What’s not so widely recognized is that the short-term consequences could be equally catastrophic: By

* combining bad assets with good assets,

* merging weak banks with strong banks, and

* confusing risk with safety,

the authorities are merely making it more difficult for millions of savers and investors to discriminate between each of the above.

The result: Instead of shifting from riskier banks to safer banks, many people are exiting the banking system entirely.

Inadvertently, the authorities could be transforming what should have been a shift within the system to a run on the system.

Instead of a harsh, but ultimately manageable, collapse of the weakest institutions, they could be leading us toward the systemic meltdown you warned about this weekend.

http://www.moneyandmarkets.com/why-financial-collapses-are-unavoidable-and-government-actions-may-be-backfiring-27466

MARTIN FELDSTEIN, Harvard University: I don't think that the program that we've heard is going to provide enough confidence to generate substantial interbank lending or lending from the banks to the wider economy...simply injecting equity by itself isn't going -- there isn't going to be enough equity injected to make other financial institutions and other investors in the commercial market willing to provide lots of additional funds to the major banks that are holding impaired securities...the fundamental thing in my mind about the situation in the United States that makes us very different from Europe is that our bad mortgage paper, our bad assets in these financial institutions, is being driven by the foreclosures and defaults in the residential real estate market...we have to get at the fundamental cause of all this, which is the rapid decline in house prices, which is causing individuals to default on their mortgages, leading to foreclosures and a further downward spiral in house prices.

JOSEPH STIGLITZ, Columbia University (Nobel Prize winner): ...I want to echo what Marty said. The fundamental problem is the problem of foreclosures, the problem of mortgages. What we are doing is analogous to a massive blood transfusion to a patient that is hemorrhaging very badly, and we're doing nothing or very little to address the fundamental problem. And if we don't, the problem is going to get larger again. That is, there are going to be more foreclosures. The holes in bank's balance sheets are going to get larger. People aren't going to be repaying the loans...Buying bad assets improves liquidity, but doesn't solve the problem of the gap in their balance sheet.

http://www.pbs.org/newshour/bb/business/july-dec08/globaleconomy_10-13.html

In short, these guys are saying exactly what Walter Map and I have been saying: The problem isn't fixed, because it is not even being addressed.