She offers a clear statement of the previous default point of view:
…this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he’s shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."
This is almost certainly true if the number of "problem banks" is sufficiently small. It works less well if the number of problem banks is very large. And why might you believe the number of problem banks is large?:
1. The very actions of Bernanke and Paulson — both smart and competent people and in the case of Bernanke with libertarian sympathies — are signaling that the number of problem banks is large.
2. The credit freeze signals that the number of problem banks is large.
3. We cannot afford to take the chance that the number of problem banks is large.
4. Direct knowledge that the number of problem banks is large.
#1-3 seemed increasingly persuasive to me as the crisis went on, but it would be nice to shore up #4, which to this day remains weak. Of course since #4 is not independent of what government is doing at any point in time, the signal extraction problem is significant. If we see banks doing poorly, it could simply be that markets do not like the chosen remedy. Furthermore share prices reflect what the market thinks banks are worth, but only conditional on what policies the market expects.