The Paulson bailout failed in the House. If it isn't a death blow to the plan, it should be. This is not an economic plan: it is a heist.

It will go down as The Great Bank Robbery of 2008.

The economics behind it are nonsense, but we are naïve if we spend much time even considering the "arguments" for it. This is a money and power grab, pure and simple.

Just as magazine covers today feature scantily clad women that would have been scandalous a generation ago, in the same manner Paulson's proposal — made in broad daylight and on national TV! — is almost naked in its audacity.

Austrian economists tend to be libertarians in their political views, and they are often chided for not keeping these systems hermetically sealed and separated in their minds. Fortunately, this alleged vice is a virtue in our present situation. Because of all the mumbo jumbo thrown around to show why the plan is necessary, some very sharp academic economists are in a tizzy trying to treat this as an extra-credit question, rather than a crime scene. That is a waste of time.

In this article, we will of course cover why the Keynesian justifications — coming from a "free-market" administration — are nonsense. But in the grand scheme, that's not entirely relevant. People didn't seriously consider the testimony of the tobacco company CEOs about the nonexistent dangers of smoking, because everyone knew those executives stood to lose billions from the settlement. So by the same token, no one should pay much attention to the official statements made by Henry Paulson, since he stands to personally be put in charge of doling out hundreds of billions of dollars to some of the most powerful people on the planet.

The Keynesian Fallacy: The Paulson Plan Won't Create Wealth

In very simple terms, the Paulson Plan is a straight-up transfer of $700 billion — and counting! — from the taxpayers to a few big financial institutions. (Some smaller banks are complaining that they don't own the exotic mortgage-backed derivatives, but rather simple mortgages. They do not believe they will see a dime of the Paulson money.) It's easy to get all twisted around, but just remind yourself of this: the Paulson Plan has the federal government borrow $700 billion (through issuing Treasury debt) in order to buy assets from Wall Street banks. (We are neglecting the time delay in the program; the entire $700 billion wouldn't be spent all at once.)

Some analysts think that the price paid for these "toxic" assets is important. No it isn't. The government officials running this operation will dole out the favors on both ends, when the mortgage-backed securities are coming and when they are going. Neglecting this insight, some people want to say that if the government pays $700 billion for a portfolio of assets that is really only worth $400 billion, then the taxpayers really only lost $300 billion, not the full $700 billion.

Yet this thinking is naïve. The taxpayers are not going to be treated as equivalent to shareholders of a firm that just acquired $400 billion in assets. The taxpayers are not going to get a cut of the monthly mortgage payments (less the servicing costs on the $700 billion in new debt) tied to the government's massive portfolio. Instead, the government will simply bump up its annual spending by a few billion dollars. Maybe it will have to spend the money on homeownership programs, or homebuilder job retraining, but the net income from those government-owned assets certainly won't translate into a dollar-for-dollar tax cut.

And then at some point — during a future Republican administration, no doubt — there will be a push to "privatize" the secondary mortgage market, and the government's portfolio at that time will be auctioned off at very generous prices to politically connected institutions. For example, maybe the $400 billion portfolio is auctioned off for $250 billion. (Perhaps the big banks have to set up subsidiaries owned by minorities and women who get preferential treatment in the bidding process. But whatever the ruse, they will find a way to justify the low prices.) When all is said and done, the government will have played hot potato with the MBS , and the national debt — borne by taxpayers — would be $450 (=$700-$250) billion higher. The favored financial institutions would be "up" roughly the same amount, collectively. (Throughout, we are ignoring the timings of the payoffs and the effect on present discounted value.)

It is the crudest Keynesianism to view the Paulson Plan as an injection of capital or "liquidity." That money has to come from somewhere. If it is taxed or borrowed, then it is just a shell game; the liquidity is drained from elsewhere, to be injected into Wall Street.

Besides taxing or borrowing, the government has a trump card: it can have the Federal Reserve simply create the new money out of thin air, by engaging in some "Open Market Operations." Yet even in this case, real wealth still hasn't increased. Certain nominal figures, like "aggregate asset values" might go up. But that's not very relevant, because the economy isn't really richer. After all, there aren't more tractors or office buildings just because Bernanke allows the monetary base to grow more rapidly. So what happens in this case is that prices rise; people find it harder to buy milk, bread, and gasoline. But the Wall Street fat cats are fine with the general price hikes, because they got their hands on the newly injected funny money early in the game.

But Won't the Credit Markets Collapse?

Some observers would admit the legitimacy of my analysis above. "However," they might say, "the Paulson Plan, or something like it, is necessary to avert a total meltdown of the financial system. We're not trying to boost aggregate investment, so much as clearing out a clogged pipe."

This talk of a breakdown in the financial system is a bogeyman. Steve Landsburg does such a great job of exploding this myth that I will simply quote him:

So what's special about banks [that they deserve a bailout]? According to what I keep reading, it's that without banks, nobody can borrow, and the economy grinds to a halt. Well, let's think about that. Banks don't lend their own money; they lend other people's (their depositors' and their stockholders'). Just because the banks disappear doesn't mean the lenders will. Borrowers will still want to borrow and lenders will still want to lend. The only question is whether they'll be able to find each other. … [A]s any user of match.com can tell you, the technology for finding partners has improved since [the 1930s]. When a firm wants to raise capital, why can't it just sell bonds over the web? Or issue new stock? Or approach one of the hedge funds that seem to be swimming in cash? Or borrow abroad? … I'm not sure these big Wall Street banks are really necessary, and I'm not sure we'd miss them much if they were gone. Maybe there's something I'm missing, but if so, I think it should be incumbent on Messrs. Bernanke, Paulson and above all Bush to explain what it is.

Conclusion