Somebody please correct me where I go astray in my thinking:
So this is why it's so urgent to inject capital into the banks: it's not enough to just borrow dollars from people who have them, because that doesn't enlarge the money supply. Only the banks can create money. That is to say, you don't create money by borrowing, but by lending, specifically through the fractional reserve system. It doesn't create money to borrow money from cash lenders, so they have to inject it into the banks, which can multiply it. If they don't do it soon... what happens? Deflation? Shrinking money supply. Production decreases as capital dries up. Jobs are lost. Foreclosures on collateral ensue, but as the underlying value has been decimated, the money that was created by the bank is now a liability on the balance sheet, further reducing the ability to loan... downward spiral. Bankruptcies of the banks happen eventually, erasing the liabilities and resetting the system at the level where the money left is in some kind of equilibrium with the (greatly diminished) value of existing resources? And then it starts again, albeit from a slightly better place every time because some of the things that the capital bought (interstate highway system, the internet, medical advances, more efficient vehicles, etc) have intrinsic value and don't evaporate with the money they were measured by (day spas, inflated residential land, inefficient status vehicles, crappy miracle drinks). Although every time you do have more people who are less self-reliant than the previous generation - I'm thinking about the fact that during the last depression, we were still largely rural, and people had the ability to raise their own food, which offsets the effect of diminished income to some degree. This is no longer true for any meaningful percentage of the population.
Of course the Paulson plan could work. Asset values are reinflated by the simple fact that people have money in their pockets and can make their payments again. Productivity and resource consumption resume growing, enabling the creation of "value" to keep up with money supply so debts don't default.
So why is it inherently evil, as many here seem to believe? It seems like, as long as the debt continues to be serviced, actual value is created (in the form of things that increase peoples' standards of living). I get the part about it being unsustainable in terms of resource consumption, and that's something I worry about for non-economic reasons, but it seems that in terms of creating wealth, it's a pretty good system, albeit one that requires strict regulation so that things like simple greed and outright dishonesty don't produce asset bubbles which create disequilibrium and its attendant mayhem.
