In the liquidity trap, the problem is that borrowers already are paying minimal rates, but because of deflation the real interest rate is high. Clearly we’re not in that situation. Borrowers’ real interest rates are not high because of deflation. They are high because nominal rates are high, due to hefty risk premiums.

Insttead, we are in a capital trap, because the binding constraint at banks is capital requirements, not reserve requirements. Adding more reserves has no effect. If the Paulson plan is turned down, then this theory says that the binding capital constraint will lead to higher interest rates for borrowers, a slowdown in economic activity, more loan defaults, more erosion of bank capital, and a downward spiral.

I have not seen the “capital trap” theory in any macro textbook. How can we be undertaking one of the most extreme policy measures in economic history based on a theory that no one has ever studied? ~Arnold Kling

Kling’s main points against the bailout are here.  Kling elaborates in a radio interview here.

There seem to be two reasons for why Congress is pressing ahead with the bailout, the details of which they claim to have worked out tonight, and these are fear and deference to administration demands.  For that matter, making those demands requires instilling a tremendous amount of fear in members of Congress, and it appears that this fear and the desire to be seen “doing something” have overwhelmed everything else.  As I said before, the argument the administration has advanced is not persuasive.  It has failed to explain clearly why the bailout is necessary, except to say that it is necessary, no other alternative will suffice and doom awaits those who fail to submit. 

Kling has been discussing the option of reducing capital requirements as part of a solution.  As Kling says:

Lower capital requirements for bank lending to small business. The down side of lower capital requirements is that they raise the risk of bank failures, but we have a good system in place for monitoring banks and resolving failures.

The problem of tight credit and the problem of unmarketable mortgage securities can be separated. Focus on the problem of tight credit, and leave the mortgage securities alone. 

If the main fear is that lending will become impossible as credit becomes tighter, does this not alleviate a significant part of the problem?  Combined with Boockvar’s suggestion that major banks halt their dividend payments and use those funds instead for lending purposes, it seems as if there could be plausible alternatives that would not involve major government intervention.  These seem to be reasonable suggestions, and it sounds as if they would alleviate the main concern that credit would become unavailable. 

Update: Kling criticizes the bailout on bloggingheads.