The pricing of the toxic assets of the banks is in line with the pricing of other risky assets. There is no evidence that prices of credit instruments are now reflecting fire sales or distress selling. The evidence, if anything, suggests that the prices are actually on the high side. This means that the liquidity rationale of the Keynesians has no basis in fact.
The findings are sure to be contested in the literature, as most research is. In the end, they will prove robust. They will hold up.
The debate on bank bailouts is broader than economics. It goes to a question of justice. Should one group, taxpayers, be forced to pay for the mistakes of another group, bankers? It goes to a question of freedom versus socialism and fascism. Should banks operate in a profit and loss system and bear the losses that they incur, or should they not, in which case the financial system becomes more socialist and fascist? Even before addressing these questions, if the Keynesian policy does not do what it is claimed, then in economic terms the Keynesian case falls.
The government and FED claim that the financial system lacks liquidity. They say that there is a market pricing defect or failure. This, they say, is why the bad loans (toxic assets) held by the banks are worth more than the prices that they are fetching in the market. These prices, they claim, are fire sale prices. The remedy, they call for and implement, is for the Treasury and FED to supply the banks with liquidity, i.e., bail them out. Thus, the government and the FED are directing trillions of taxpayer dollars to shore up weak banks by buying their bad loans rather than overseeing a judicial-like process of re-organizing the banks and cleaning out these loans in established bankruptcy-like procedures.
The Austrian position is that the financial system does not lack liquidity. The bad loans were overpriced to begin with, largely because the FED and government engineered a speculative bubble. The bubble burst. The loans were repriced in the market. The loans are now worth what they are bringing in the market. Thus, the government has no liquidity justification for bailing out the banks. The government’s economic rationale has no merit. Many banks are insolvent. On the economic merits, they should be allowed to fail, not bailed out.