This covers a lot of ground from the idea of money up to the credit market, why the seizure is bad, and a lot of other things. It's a primer for today's hot issue.

So let's talk money.

Money.

"There is nothing quite as wonderful as money.
There is nothing quite as beautiful as cash.
Some people say it's folly, but I'd rather have the lolly,
because with money you can make a splash!" - "The Money Song"

What is money? It's not the dollar bills in your wallet. Those are just representations of money. It's not the numbers in your bank account. That is just a measure of money. Money is the promise of work, it is potential energy, it is time, sweat, blood, and tears made transferable. When you pay for a car you aren't paying for the car itself, as the car has no inherent value. You are paying for the work that everyone up the supply chain put into that car. People accept your money in trade because of the promise that others will also accept that money in trade for their efforts. Without that promise, there is no money. Remember that when you spend a dollar or the taxman cometh, that money just doesn't disappear (generally), it gets used to inspire someone else to expend effort, and then another, and another, and so on. Money flows through the economy. More accurately, the flow of money is the economy. Makes those financial dominants seem a bit less hokey, doesn't it?

Credit.

"You load sixteen tons, and what do you get?
Another day older and deeper in debt" - "Sixteen Tons"

We all know what credit is. It's money today in exchange for the promise of (more) money later. Hmmm, there's that "promise" word again. That might be important. So credit is the promise of the promise of work. Isn't that essentially the same thing as "the promise of work"? It means that as long as both promises are good, credit is money. Now here's the stinker: over 90% of all monetary value exists as some form of credit. Some of it is direct credit like a bank loan. Most of it is indirect credit, like the equity in your home. It's indirect credit as the monetary value is still based on the premise that someone will pay that money for it. So it isn't a credit you owe to a particular entity, but a credit that economy as a whole owes you. So if one of those promises behind credit gets undermined, large sums of money stop existing.

Banks, Money Supply, and the Credit Market.

"Money, its a gas.
Grab that cash with both hands and make a stash.
New car, caviar, four star daydream,
Think Ill buy me a football team." - "Money"

The money you have stored in you bank account is a credit as well. It is money that the bank has promised to pay you when you ask for it. A savings account is not you storing money, it is you loaning money to the bank. So that money isn't sitting in a vault, the vast majority of it is on loan to someone else. Banks try to only keep enough to meet the reserve requirement for on demand withdrawals. Through this, banks act to multiply the money supply. Which is why businesses, start-ups, and individuals can get the loans they need and why our economy can be worth $10 trillion when there is only ~$800 billion in cash. The banks can do this because the vast majority of the time, you don't need your money. So if everyone tried to get their money at once, there wouldn't be enough money on hand to accommodate more than a small percentage of them. When this happens, it is called a run on the bank and will force the bank into default. Washington Mutual was brought down just this way, with a run on the bank to the tune of $40 billion. Banks only work because people have confidence in them, because people have confidence in their promises.

Another way to look at it is restaurant where the customers provide their own seats and store them there. Some people will bring a seat there (make a deposit) and others will sit down and eat (make a withdrawl/loan). Let's say you have brought a seat. Even if you eat there every day, you don't need the seat the vast majority of the time. A restaurant doesn't do so well when they have a bunch of habitually idle seats. So the restaurant sells the seat out to other patrons so they can use it while you aren't. The loaning of those seats allows the restaurant to feed many more people than it would otherwise. Now if everyone who owned a seat tried to come in to eat, there wouldn't be enough seats left as a lot of them would still be occupied by the patrons the restaurant had loaned them out to. Those without seats get to go hungry.

As banks try to keep as little money on hand as possible they are almost always in a state of having too much or too little money on hand. In order to rectify that situation, they go to the credit market and buy or sell money as needed. This market works because banks have confidence in each other's ability to pay their debts.

The Making of the Credit Crunch

"Money, its a hit.
Dont give me that do goody good bullshit.
Im in the high-fidelity first class traveling set
And I think I need a lear jet." - "Money"

This whole debacle was triggered by the housing market. The housing market isn't the only thing to blame, as there is plenty of blame to go around. This was just the first domino to topple. Post tech-bubble, a whole bunch of people got the asinine idea that the housing market was immune from going down. So, smarting from the tech-crash, they invested in real estate. This pushed prices up, which in turn lead more people to buy in, and so on and so on. Now banks are a major player in the real estate market as most purchases are financed through them. So these banks are now sitting on a crap load of mortgages and someone has the bright idea: "Let's package these mortgage payments and sell them! We can customize or cash flows that way. If we are short on cash, we sell the rights to some payments and if we are long, we buy some". So these payments were packaged and sold as "Mortgage Backed Securities" or MBSs. In their zeal, these MBSs and other credit instruments got more and more complicated to the point that few had any real idea what they were buying. This was all good until the housing bubble started to pop. Then the defaults started to roll in. Suddenly, banks were on the hook for mortgages and agreements that they had no real knowledge of and no way of knowing if they were going to get paid nor how much they would owe. The banks also knew that all the other banks had been doing the same thing. No one knew who was on the hook for what. So now everyone wanted money and no one wanted to lend it out of fear that A: they would need the money and wouldn't be able to get it, and B: that the person they were lending to wouldn't be able to pay them back. The banks lost confidence in each other, so the credit market seized and interest rates shot up.

Shrinking Money Supply.

"Money, so they say
Is the root of all evil today.
But if you ask for a raise its no surprise that they're
Giving none away." - "Money"

"My money deposit is guaranteed by the government up to $100K, why should I care about the credit market seizing and bank trouble? Let those rich Wall Street fuckers flounder and fail" Because when the banks stop loaning to each other, they restrict their loaning to everyone else as well. This means that the money supply shrinks, so money becomes more scarce for everyone, including the companies that pay your salary and the people that buy your products. Less money is now flowing, so the economy shrinks. Their pain quickly becomes your pain.

Depression Psychology.

"Prosperity is just around the corner." - Herbert Hoover

"Alright, so the money supply drops. Supply and demand dictates that goods should simply fall in price as money becomes more valuable. I don't see how this leads to economic trouble." In small cases, there would just be an adjustment period with an attached recession. The trigger point for something serious is when the psychology of scarcity sets. What happens when something gets scarce enough? People hoard it. The same goes for money. As each person hoards, it encourages the next person downstream to hoard as well, because now they are getting less money. The result of all that hoarding is large sums of money being pulled out of circulation. As the flow of money is the economy, well now, that flow just got a whole lot smaller. The only way to break the hoard mentality is for the flow to pick up again so people feel safer about spending the money that they do have. Without intervention, this can be a long process as everyone waits for their coffers to reach a certain point before allowing more money to flow down the line. The idea behind deficit spending as an anti-depression measure is that it helps flood the economy with money to break the perception of scarcity. This is what happened through the government spending in the great depression. It started in earnest with the alphabet soup and finished with the massive spending and deficits incurred with WWII.

The Problem With Deficits.

"Giving money and power to the government is like giving whiskey and car keys to teenage boys" - P.J. O'Rourke

As deficit spending became acceptable, the government had no control set against spending more and more money. To cut government spending is to piss someone off. To piss someone off is to hurt re-election chances. On the other hand, increasing government spending makes people happy (more often than not). Not to mention that no one wanted to be the one who let the economy slow down on their watch. What a death sentence that is. So what's a politician to do? The ones that manage to stay in office are the ones that continue to increase spending. Notice what happened when there was a surplus. The general response on the hill wasn't "We should cut taxes" or "We should pay down on our debt", instead it was "How should we spend it?". As the government was already spending more than it took in taxes, the push to spend ever more meant ever larger deficits. This poses a big threat to the government's ability to use deficit spending as a stimulus measure because the government can spend itself into a corner and lack the ability to pay for more borrowed funds. It's rather like living paycheck to paycheck. Say you get a pay cut, so you get a loan to cover the shortfall of funds. Then you get a pay raise, but instead of using that money to pay back the loan, you use it to convince the bank to give you a bigger loan and then you go back to living paycheck to paycheck. Thusly, if you hit economic problems again, you are in even worse financial shape than before. So why not just raise taxes to fund the increased spending?

Taxation

"Money, its a crime.
Share it fairly but dont take a slice of my pie." - "Money"

Everyone hates taxation. However, for a stable monetary economy, taxation is needed. Why? Because making a regular profit means that money is being concentrated. The higher the concentration of money, the less of it that is free flowing, so the higher likelihood that the perception of scarcity will set in and the less money there is available to inspire the efforts which keep the economy going. So for the good of the economy as a whole, not only do the rich have to get taxed, they have to get taxed at a higher rate than everyone else in order to break up the concentration of wealth. Now, this doesn't mean that there should be a communist standard of everyone being paid the same. This has it's own problems.

First problem is the issue of motivation. If everyone gets the same reward, there is no incentive to try harder, to be better. Taxation also discourages money from changing hands as we only tax money when that happens. So the higher the tax rate, the less people will care to try and the rarer profitable opportunities are.

The second problem is capital efficiency. The rich, the banks, the corporations, act as intermediaries between the supply of money and the demand. Because of this, they both act to provide more efficient capital movement (because you can go to a much smaller group of people to raise the funds that you want) and serve as a filter against poor capital allocation (in most cases, they got there because they have some idea what constitutes a wise allocation of funds and it is in there best interests not to loan money out to bad ideas, else they wouldn't stay rich). So having some rich people does carry an economic benefit.

Good taxation has to walk the line between ensuring that people are still motivated to improve and transact, and ensuring that the concentration of wealth doesn't get out of hand.

Bringing It All Together.

If you managed to read and understand this far, you now understand more about money than most people will learn in their entire lives. Yes, I have skipped and glossed over a lot, however I wanted to keep this short (hah!).

What does all this say about the "bailout"? That the bailout was probably better than doing nothing, but not terribly effective. What the re-capitalization did was address the banks need for money to cover for their shortfalls and worries about what they may be on the hook for. However, it only indirectly addressed the confidence issue which lead to the credit market locking up in the first place. The banks still don't know who is on the hook nor how safe their competitors are (just that some of them are safer then they were), so the credit market is still pretty stiff. The money doesn't really increase the money supply any as the banks will hoard it, expecting the worst. The other problem, is that once someone gets bailed out, they will expect to be bailed out again. This was a harmful precedent for the future of our financial industry.

What about the "bad bank" idea? This idea assumes that banks know which debt is going to be bad, that they are going to be able to get something like a decent price for their debt, and that the government can afford to buy enough of it up. The truth of the matter is that a lot of them don't know, they will probably only be able to sell it at fire sale prices, and the government may not be able to afford to buy enough of it. This means that there will still be quite a bit of pain as that credit disintegrates and the money implied disappears. Though it probably beats another bailout. However, such a bank would need to be of limited duration.

The promises that make the foundation of our economy have been given a good hard kick. The best solution must directly address the confidence issues. Both the confidence of the banks, and the confidence of the population as a whole.