I should begin by saying that I like the idea of being a financial romantic. But the real reason Paul Krugman is wrong about this hugely important question is that he is confusing (uncharacteristically) issues of liquidity and solvency. He invokes Bagehot in support of a clear-eyed defense of bailing out the financial sector in its times of distress, but Bagehot was observing the need for a lender of last resort.
Lending and bailing are two entirely different animals.
We should expect the Fed to provide essentially unlimited liquidity if there is a run on the banking system—if the system is unable to cover the mismatch between its long-term assets and short-term liabilities. As long as financial institutions have positive net worth at realistic asset prices, this will be nearly costless for the taxpayer and priceless for the economy.
But bailouts are something altogether different. The financial system cries to be bailed out if it faces a solvency crisis, if the value of its assets are plunging and the last shreds of equity are at risk. Examples of this kind of rescue include the injection of vast sums to buy up dubious mortgage-backed securities at face rather than market prices, assuming the liabilities of failing speculators like AIG toward their speculator counterparties, and so on. The US government shouldn’t have done this the first time around, and they damned sure shouldn’t do it a second. I would not be upset to see our legislators sign a blood oath against all manner of bailing.
Yes, a solvency crisis nearly always triggers a liquidity crisis, but you can patch the second without trying to reverse the first.
Another objection arises: how can you let banks fail if they are too big to fail? Very generally, there are two alternatives: you can temporarily take ownership of them—wiping out the equity of their previous owners and sacking the management—while you use public money to resolve their net liabilities, or you simply let them fail while using public money to buy up their assets at liquidation prices to jumpstart a system of public banking. I’d go for the second, but either is feasible and way, way preferable to bailouts.