In a recent article, Tyler Cowen claims that the Wall Street bailout by Bernanke, Paulson, and Geithner appears to have been a good idea--at least so far. While the additional government debt might cause future problems, the bailouts avoided, "many more failed banks, very strong deflationary pressures, a stronger seize-up in credit markets than what we had, and a climate of sheer political and economic panic, leading to greater pressures for bad state interventions."
Cowen goes on to cite Milton Friedman in support, claiming " some libertarians like to pretend that Milton Friedman blames the Fed for "contracting" the money supply by one-third in that period but in reality Friedman blames the Fed for having let the money supply fall by one-third and not having run a bank bailout."
What then, is a "bank bailout?" Milton Friedman certainly claimed that it was bank runs that directly caused the contraction in the money supply. Or more precisely, it was the increase in the demand for currency, the increase in the currency-deposit ratio, and the reduced money multiplier that caused the drop in the M2 measure of the quantity of money. According to Friedman, that drop in the M2 money supply was responsible for the drop in nominal expenditure, real output, employment, and prices. Friedman criticized the Fed for failing to expand the monetary base enough to offset the drop in the money multiplier.
He specifically criticized the Board of Governors for reversing the open market operations that had been undertaken by the New York Fed, arguing that instead that program should have been expanded enough to keep the M2 money supply on its pre-Depression growth path. Friedman's criticism of the Fed's view that low nominal interest rates showed that its monetary policy was "loose" is withering. And he did argue that if it weren't for the contraction of output and the deflation caused by the reduced money supply, few banks would have failed.
Having the Fed expand the monetary base to accommodate an increase the amount that the nonbanking public or banks want to hold is fundamentally different than covering losses that banks have made from bad loans. Because a monetary contraction and the resulting recession and deflation can cause bad loans, having the Fed avoid such a contraction does benefit banks indirectly. However, it is not the same thing as "bailing out" the banks for their errors.
Bernanke, Paulson, and Geithner, on the other hand, developed a policy aimed not only at bailing out key players on Wall Street, but have further targeted lending to "weak" sectors of the credit markets, which has amounted to trying to revive the business models of those key players. While these policies could have avoided the collapse in nominal expenditure in the fourth quarter of 2008 and the first quarter of 2009, they didn't.
The recent financial crisis and Great Recession involved only a slight increase in the demand for currency and the currency deposit ratio. There has been a very large increase in the reserve deposit ratio, and a dramatic drop in the money multiplier. Fortunately, the Fed has expanded base money enough to avoid contractions in the M2 quantity of money, so conditions are very different from those that concerned Friedman in the thirties. However, through a variety of avenues, the loss of confidence in the shadow banking system, has resulted in a large increase in the demand for the assets making up the traditional measures of the quantity of money. If confidence in the shadow banking system had been revived, and all of the increase in money demand avoided or quickly reversed as people returned to holding asset-backed commercial paper used to fund securitized loans, then perhaps there would have been no rapid drop off in nominal expenditure. That approach failed.
Distracted by its futile efforts to rebuild the shadow banking system, the Fed failed to expand the monetary base enough to keep nominal income on its previous growth path. If it had done so, this would have improved the financial condition of all banks. On the other hand, it would not amount to a "bank bailout." Banks that had made bad loans--in particular, lending into the peak of the housing bubble, may have failed.
With stable growth of nominal income, shifts in the allocation of credit, bottlenecks in the expansion of reorganized banks, and perhaps other factors, would have led to slower growth of real output and somewhat higher inflation. However, the way the market system disciplines entrepreneurial error, such lending funds to poorly-capitalized investors in over-valued assets is losses and bankruptcy. Bailing out such mistakes, and creating a system of privatized profits and socialized losses, invites future losses.