I'm glad to see while I was away on vacation that not only did economists come to an agreement on a proper bailout plan, but also that a plan did get signed into law. It's just too bad that the two weren't quite one and the same.

As Alex Tabarrok of Marginal Revolution wrote last Friday, the consensus among academic economists is that the government needs to help banks recapitalize. Why is this important? Undercapitalized banks are forced to reduce their asset base which means that they have to reduce lending.

For most of the past year, the much-talked about credit crunch had been felt most in the interbank lending markets, hence the terrifically high spreads between Libor and Overnight Index Swap rates. But by the time money market mutual funds started breaking the buck in September following Lehman's collapse, the credit crunch had officially filtered through to the rest of the economy. These mutual funds typically purchase short-term debt from companies, but after shares of the Reserve Fund fell below $1, managers of these funds began to hoard cash to defend against mass exodus. The result of that is ordinary day-to-day funding operations of some large companies, like the routine rolling over of debt, were threatened. In a situation like this economic growth will almost inevitably suffer.

In response to worries in the commercial paper market, the Fed turned back the clocks this morning and announced another "liquidity backstop," but this time it wasn't for investment banks (since there aren't any of import left). This backstop will involve the purchase of commercial paper by the Fed with the intention of encouraging "investors to once again engage in term lending in the commercial paper market."

Douglas W. Diamond of University of Chicago called the Fed move a smart one and described it as a "bridge loan" of sorts to get the financial system to move from one type of financing source another.

"As long as the Fed holds the commercial paper for a while until it matures and these companies can switch over to borrowing from the banks, it doesn't have to be anything so bad," Diamond said.

While this was a necessary move, it's very much a reactionary one, something that the Fed and the Treasury Department have been criticized for repeatedly during the crisis. Still, it may provide the insurance that's needed to get over the current panic and allow for a refocusing on the need to get the banking system functional again.

Writing in the WSJ last week, Nobel-winning economist Edmund Phelps supported bank recapitalization, but added that some entity -- either the government or markets -- will have to figure out who is worth saving:

it is clear that the main prong of any "rescue" plan must serve to advance the recapitalization of the banks. Cash transfusions in return for warrants are a good way to do it, as it lets taxpayers share in the upside. The rescue of Chrysler used warrants. This past Monday the FDIC got $12 billion in preferred stock and warrants in the deal that saw Citigroup buy Wachovia. The question is which banks are to be thrown a lifeline, which will have to sink or swim. This one-time dose of corporatism is unpleasant, though the banking industry is to blame for its necessity.

Under the bailout package signed into law this weekend, the first step in recapitalizing banks will be the purchase of toxic assets. A potential problem here is if TARP doesn't pay enough for the securities. Under that scenario, some institutions will be able to avoid going kaput in the short-term but will still be undercapitalized for the long haul. This has the affect of inefficiently lengthening the readjustment process in the financial sector. But the problem with paying too much is that it potentially sows the seeds for the next financial disaster.

As this process works itself out, it will hopefully become clearer which banks are more solvent than others. The Treasury may then decide that it still needs to inject additional capital into banks and will likely choose the more solvent ones. While it might seem counterintuitive for the government to help banks that may be able to weather the storm on their own, infusing them with funds will allow them to expand their balance sheets, buy up the assets of failing banks, and extend credit to support economic growth.

If the government chooses to move to this second-stage of the bailout process as faulty banks continue to fail -- a scenario many economists believe is likely -- regulators should make it clear that all short-term creditors will be protected.

"If you announce that you're going to make institutions bear losses, you don't want that to start a run," said Diamond.

And in this process, the next hurdle will be to see if the $700 billion approved by the bailout package will be enough to recapitalize the system.

This morning in its Global Financial Stability Report, the IMF estimated that in order to keep the crunch from adversely affecting private sector credit growth (the economy's main engine) the government would need to spend about $2 trillion.

Even if you add the the $300 billion in MBS purchases mandated earlier this year, the $1 trillion in public funds setup to buy private sector assets would still be one-half the IMF amount. If there were no public purchases of private sector assets, credit growth would fall 7.3 percent, the IMF estimates. The story is similar for Europe, and the end result will be "a profoundly negative impact on the real economy," the IMF wrote.

What's surprising about a lack of commitment to this type of recapitalization on the part of Bernanke is that during the Great Depression -- which is after all the Fed Chairman's forté -- an inability to attract capital may have led to unnecessary failures. A study released earlier this year by Fed economist Mark Carlson concluded that "many of the banks that failed during the panics appear to have been at least as financially sound as banks that were able to use alternative resolution strategies. This result supports the idea that the disruptions caused by the banking panics may have exacerbated the economic downturn."

One of the alternative resolution strategies Carlson talks about is recapitalization, something which the private sector is unwilling/incapable of doing right now. This would seem to suggest that a larger, but surely politically unfriendly, government-backed effort could prevent unnecessary economic harm.

Why were Paulson and Bernanke hesitant to put forth a more comprehensive recapitalization? One reason has to be the higher bill. But, according to his Congressional testimony, Bernanke was actually open to the idea, even on that would involve government equity stakes:

if it were possible to convince the markets that, in fact, the government was going to act like Warren Buffett and make investment banking deals based on, you know, negotiations and approval by the common shareholders and the board, et cetera, et cetera, I think that's something that's probably worth discussing with the -- with the White House to see if they see any -- any -- any benefit in that.

But Paulson saw something much more ominous in recapitalization:

we're trying to get markets working, because we don't want to have to deal with a failure. RTC is about failure. Putting capital in institutions [is] about failure. This is about success."

If what we're seeing right now can't be described as a banking system failure, I'd hate to see what would qualify as one for Paulson.