Fiscal stimulus for Wall Street!

When a Central Bank pumps the monetary system with cash but banks hoard it, monetary policy is no longer effective and the economy starts to crash. This is called a "liquidity trap" and it normally occurs when real interest rates are at or close to 0% or in negative territory and/or when there is a crisis of confidence in the financial markets. Though newly minted money is injected into the banking system, banks refuse to recycle it through normal lending, and the money gets trapped in financial institutions that are paralyzed by fear. Japan fell into this trap in the late nineties and it took nearly a decade to emerge from the deflation and recession that followed.

Now, more or less the same scenario being enacted in the US and the alarm bells are ringing loud. The Fed monetary report shows that during the week ending Sept. 22, money supply (as measured by seasonally adjusted M2) increased by $165.5 billion to $7,900 billion, or an astonishing 108.94% growth on an annualized basis. The TED spreads have widened to a record high, as LIBOR keeps rising and yields on short term Tresury securities falls closer to zero.

The Fed has been aggressively pumping money into the system in the hope that radical monetary stimulus will restart lending. However, despite the high spreads, the perceived counter party risks and the possibility of runs on their deposits, have made banks are wary of lending and made them flee to safer and liquid Treasury Bills. The commercial paper, municipal bonds, and other hitherto safer markets are now feeling the credit squeeze. In other words, the financial markets are getting gridlocked into a "liquidity trap".

With monetary policy becoming ineffective, Mark Sunshine argues in NYT that only fiscal stimulus remains. He feels that the Paulson Plan is a fiscal stimulus that will be injected directly into the banking system to supplement almost nonexistent private-sector lending with government cash and determination. Unlike the traditional fiscal stimulus of tax cuts or government spending on infrastructure, this one will be targetted at financial institutions.

Update 1
The bid to cover ratio for the Fed's auction of Treasury Security Lending Facility (TSLF), a 28 day liquidity support mechannism where participants are provided Treasuries in exchange for eligible collateral securities (mostly MBS's nowadays), was a very high 1.96.

Update 2
William Buiter agrees.