Is a Potential Bailout Making Things Worse?

Ken Rogoff says yes.  Elizabeth Warren at Credit Slips summarizes Rogoff’s discussion at a Harvard Roundtable (video):

Any liquidity crisis is caused by the promise of a government
bailout. Ken said [Actually this was Greg Mankiw, AT] that his many friends in investment banking said that
there is plenty of money to invest in financial services, but right now
it is "sitting on the sidelines."  Why?  Because the financial services
industry does not want to pay the terms required to get that money back
in circulation (e.g., give up equity).  As he put it, why do business
with Warren Buffett who will negotiate a tough deal, if you believe
that the government will ride in soon with cheaper cash? 

Ken [this is correct, AT] also talked about the need to shrink the financial services
sector. He thinks it is good that the investment banking houses are
failing and many people on Wall Street are losing their jobs because,
in his view, we have an oversupply in that sector and our economy just
can’t support it.   

Ken’s background with the IMF and on the Board of the Federal
Reserve add a certain credibility to his assessment of conditions on
Wall Street.  If he is right, the $700 bailout is saving some
investment bankers’ jobs in the short term, but overall it is just
making the financial system worse.

In a related point Felix Salmon suggests that the Ted Spread may not be a valid measure of distress when the Fed is providing lots of liqudity.

…if you’re a bank, you really neither want nor need three-month
interbank funding right now. Global central banks, led by the Federal
Reserve, have flooded the system with so much overnight liquidity that
you can get as much cash as you need, at a much lower interest rate,
directly from your central bank, overnight. The choice between that and
locking in a high interest rate for three months is a no-brainer.