The good news

There is some.  First, it seems (knock on wood) the Fed and Treasury may make money off the AIG deal, at least over a time horizon of one to two years.  Felix Salmon explains some detail.  The company has assets and if it needs to borrow money it is paying the Fed at Libor plus 850 (!). 

Second, the size of a guarantee does not represent the cost of the bailout.  I have been getting many emails about "the cost of the bailouts" and in truth we still don't know what those costs will be.  But think in terms of balance sheets to start on the problem, not numbers in headlines. 

Third, if the Fed needs to "print money" to make good on various guarantees (NB: this has not been the case), this need not be as disastrous or as inflationary as it sounds.  If it came to this, the Fed is creating money to protect against potentially deflationary events so the inflationary impact of that money creation is blunted.  (That said, you don't usually want to trade in bank-created higher monetary aggregates for an increase in borrowed reserves.)

You might wonder if AIG is (possibly) a money-making deal, why no one else wanted in on the action.  Think of it as a prisoner's dilemma among the lenders.  No one of them wants to put up money at non-exorbitant rates and so the company -- which has partially illiquid assets and profit-maximizing, weakly capitalized shareholders determined to take advantage of lenders -- fails.  But with the guarantee the company can borrow cheaply and the lending continues.  The company can continue and oversee an orderly liquidation.  That's not a pretty picture and it does mean that, in the bad world-states, losses continue to stack up precisely because the guarantee was extended.  But the good world-states are there too and the expected value of the guarantee and purchase may well be positive.  To give an example, Argentina in its crisis days had net positive value but no one wanted to lend to them either.

Recent events remind me of the arguments against free capital movements for developing countries and whether those capital movements boost economic stability and growth.  Well, we have free capital movements for investment banks and insurance companies and of course the losers get hit by whipsaw effects.

Did you notice that short-term Treasuries have been trading at rates close to zero?  That's not good news. 

In presenting all this "good news," I don't mean to communicate a pollyannish attitude.  The bad news is indeed very bad but let's understand it in its proper context.

I'd like to stress again that I remain worried about the rule of law in all these events.  First, the referee is on the playing field.  Second, while Dodd and others are on board, basically we have the executive branch of our government -- the Treasury -- operating without formal checks and balances.  (Does that sound familiar?  Would this administration do that?)  That's why it is all being done through the Fed.  Fortunately the Fed is also a competent technocracy (as is the current Treasury) but the broader implications here are very worrying, both for governance and for the future of the Fed itself.

Maybe there is no better alternative, but these developments are a sign of just how dysfunctional American government has become.