Brad DeLong explains the evolution of the bailout plan:
From Plan A to Plan G, by Brad DeLong, CIF, The Guardian: ...An occupational disease of being an economic historian is to insist that the answers to all questions lie in the Great Depression... When the financial crisis hit in a sudden squall in August 2007, in the back of the Federal Reserve's mind was that it should not repeat any of the mistakes that led to the Depression. Hence Ben Bernanke and his Fed loaned extraordinarily freely to banks and near-banks and non-banks in order to avoid what Milton Friedman said was the key mistake that made the Depression Great:... a liquidity squeeze that made cash hard to get. Call this Plan A.
In a couple of months it became clear that Plan A was not working. The economy was weakening. And the Fed remembered the theory - put forward by, among others, Lawrence Summers and myself - that what made the Depression Great was that businesses began to expect deflation. The expectation of falling prices made every business postpone its investment spending - better to wait ... and build ... when prices were cheaper - and so private investment collapsed. So Bernanke and his Fed lowered interest rates to what they thought were levels that might trigger inflation, as a way of making sure that no business anywhere would even begin to suspect that a deflationary spiral was in the making. That was Plan B.
But the economy fell toward (if not into) recession, and interest rates had already been pushed down so low that the Fed's monetary policy had lost its virtue and vigour. So it was time for Plan C: mail out a bunch of extra tax-rebate cheques, hoping that ... consumer spending ... would recover with at worst a small recession.
Meanwhile, the investment bank Bear Stearns collapsed. The Federal Reserve and the Treasury concluded that they could not stand by and wait to see if Plan C was working. They had to move to Plan D: case-by-case forced mergers, liquidations and nationalisations of banks and other financial institutions in order to prevent the course of events that the third theory of the Depression said had made it Great.
This theory was Bernanke's: that the downfall of 1929-1933 was largely the result of bank failures that collapsed businesses' ability to borrow to expand or even fund ongoing operations. So we had the forced merger of Bear Stearns into JPMorgan Chase; a lull to see if Plan C would work (it didn't); the renationalisation or deprivatisation of the mortgage lenders Fannie Mae and Freddie Mac; ... the Fed bought the insurance company AIG; and the bankruptcy of Lehman Brothers...
The failure of Lehman Brothers triggered or uncovered or brought on financial catastrophe.... It was time for Plan E: the Paulson plan, a $700bn programme by which the Treasury would buy up troubled mortgages, mortgage-backed securities and derivatives...
The hope behind the Paulson plan was supply and demand. ... If the Treasury were to buy $700bn of risky financial assets and put them on the shelf, this would diminish the supply. When supply falls, prices rise. As the prices of financial assets rose, banks would profit immensely - and people would no longer fear that the bank ... might dry up and blow away in the next week.
The financial markets swallowed the passage of Plan E without a burp and continued on their downward spiral... It was time for Plan F..., governments could invest public money in the banks whether they liked it or not, thus making them so well-capitalised that their failure would be inconceivable...
Now we get to see whether Plan F will work, and whether this ... will stop the slide of the world economy, and keep us in mild recession rather than severe recession or even depression.
There is every reason to hope that it will. The liquidity-squeeze theory, the expected-deflation theory and the Bernanke banking-collapse theory were the only live theories of the Great Depression. The first two no longer seem viable. ... So if we can counteract the chain of causation of the third - the only one left standing - we should be in no danger of even a not-so-great depression. But the theory ... could be wrong.
If Plan F fails, we move to Plan G: we pull the Keynesian fire alarm and begin an enormous government infrastructure building programme in the whole North Atlantic to keep away depression.
But as of now there is every reason to hope that it will work - that this time, for sure, what our magicians pull out of the hat will be the desired rabbit.