Paul Krugman is writing about The Face-Slap Theory.

"The scariest thing I’ve read recently is a speech given last week by Tim Geithner, the president of the Federal Reserve Bank of New York. Mr. Geithner came as close as a Fed official can to saying that we’re in the midst of a financial meltdown.

The Fed’s latest plan to break this vicious circle is -- as the financial Web site Interfluidity cruelly but accurately describes it -- to turn itself into Wall Street’s pawnbroker. Banks that might have raised cash by selling assets will be encouraged, instead, to borrow money from the Fed, using the assets as collateral. In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities.

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Drop In The Bucket

Several people have asked me recently if I have been changing my tune on a Fed bailout. The answer is no. I long ago predicted the Fed would try all sorts of things to stop a deflation threat. But I also have also said these measures would not work, and indeed they haven't. What is happening is the Zombification of Banks, that is exactly what happened to Japan as well.

See The Fed Feigns Control and the Fed's New Role as Pawnbroker for more on the Zombification of Banks and the Fed turning the TAF (Term Auction Facility) into the PAF (Permanent Auction Facility).

From Krugman: "$200 billion may sound like a lot of money, but when you compare it with the size of the markets that are melting down -- there are $11 trillion in U.S. mortgages outstanding -- it’s a drop in the bucket."


The Red Queen Race

On two prior occasions I have likened the liquidity efforts of Bernanke to The Red Queen Race. Here it is again.

In Lewis Carroll's Through the Looking-Glass there is an incident involving the Red Queen and Alice constantly running but remaining in the same spot. The scene is often referred to as The Red Queen's Race.

"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!" (Click here for the whole story)

Bernanke, like the Red Queen and Alice, simply cannot run fast enough when it comes to bailing out this financial mess.


Why Measures Fail

Face Slapping, the TAF, the PAF, lowering interest rates etc. are measures that can only work if the problem is lack of liquidity. The problem is not one of liquidity. The problem is solvency. Massive amounts of credit was created out of thin air because fractional reserve lending allows it. Speculation in assets went through the roof when the Fed held interest rates too low too long.

Now with falling asset prices, margin calls are running rampant. Margin calls beget margin calls in an ever escalating chain reaction. Carlyle Capital, a once $32 billion fund, was Hit With Margin Calls And Default Notices. It may have to liquidate. If it does, most of that $32 billion will be wiped out because of the 32:1 leverage it was using.

For those who want a Seasonal Lenten Message here it is: Remember credit that thou art dust and to dust thou shall return.


Remarks by Timothy Geithner, President New York Fed

Let's now turn our attention to the speech that has Paul Krugman spooked: The Current Financial Challenges: Policy and Regulatory Implications. It's a long speech in which Geithner attempts to spread the blame around.

"The origins of this crisis lie in complex interaction of number of forces. Some were the product of market forces. Some were the product of market failures. Some were the result of incentives created by policy and regulation. Some of these were evident at the time, others are apparent only with the benefit of hindsight. Together they produced a substantial financial boom on a global scale. "

There were complex interactions for sure but blaming market forces is lame. The second sentence gets to the heart of the matter. I suggest these problems were entirely "the result of incentives created by policy and regulation".

Of course few see it that way. Many are blaming lack of regulation, specifically the unwinding of the Glass-Steagall Act for its role in this mess. Such blame is ill placed as discussed in Did Lack Of Regulation Cause This Mess?

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