This one is even more modest than the last.
Let’s say you have ten banks and two of them are insolvent. But you don’t yet know which two. So the credit market is messed up for all ten because at some sufficiently high level of risk credit just shuts down. The goal then is to reveal which two of the ten banks are insolvent.
I’ve been thinking of all those old puzzles where a bunch of guys enter the room and only so many of them have smudges on their foreheads and you have to find the algorithm to reveal that information.
What can be done? Temporarily allow insider trading, with short selling of course? (Bryan Caplan’s idea) Make executives either resign or post personal bonds, where default of the bond follows if the bank ends up insolvent? Change laws and make banks exhibit their books to the public and let traders sort it out?
I don’t know. But maybe sorting out the bad banks is one alternative to finding and isolating the toxic assets. Because once all the remaining banks are good and known to be good, the problem of toxic assets no longer seems so paralyzing.
I’m still not sure that the Treasury buying bank assets is to best way to make this sorting, and that’s leaving aside the price tag. In fact maybe Treasury buying postpones this revelation of information.
Of course if eight of the ten banks are bad, maybe we don’t even have the luxury of asking these questions.