Two things have to happen without fail. The financial system must keep going and it must do so without excessive moral hazard. The value of most everything we own depends on the whole economic system continuing to function. A car would rapidly lose all value if you couldn’t buy gas or drive it on roads. A car’s value depends on there being functioning gas stations and working pothole-fillers. Financial instruments are no different. Crash the system and things which would be valuable in use become valueless in a wrecked system. So a bailout in some form will be necessary.

To keep the financial system going, assets to which the market can presently assign no sufficient value need to be propped up so that credit can continue to be made available on the “value” of these assets. So that the assets themselves don’t lose value. There are several ways to do this. As I understand it, the Paulson plan calls for replacing these assets with money, via their purchase at some price. The moral hazard lies in determining what that price will be. If the market can’t value them, how can Treasury?

But as some have noted, the assets need not be purchased at all. They can be insured, which is what some House Republicans are suggesting, so they can be notionally treated as retaining valuable because they have contingent worth. This really means the commitment is to “buy” assets on a case-by-case basis when they are put to the proof. On the surface at least, the market plays more of a role and moral hazard is reduced.

I’m not going to plump for one or the other alternatives. But the issue always seems to come down to the question of how to keep the system liquid without handing unimaginable amounts of money to bad economic actors. Complicating the situation is the circumstance that the bad economic actors have an enormous incentive to corrupt the process. Therefore there will be a huge push to do the wrong thing simply because the opportunities for ripoffs are so great.