Bailout or no bailout, taxpayers will pay

President Bush makes another pitch for the Paulson plan, but is anyone listening. Meanwhile, the credit crunch gets worse

Published September 30, 2008 3:26PM (EDT)

Two hours after trading began on the U.S. stock market on Tuesday, the Dow was up 250 points, on "hopes for a new plan," according to the Wall Street Journal. Why investors would suddenly turn optimistic after Monday's rout is a puzzler. President Bush's early morning attempt to whip up support for the bailout didn't offer anything new, and his administration's inability to twist the arms of House Republicans is manifest.

(Although, we can give him credit for getting at least a handful of Texas representatives to vote for the plan. McCain, in contrast, couldn't get a single member of the Arizona delegation to Congress to get in line.)

Both presidential candidates pitched in this morning, with Obama making a detailed pitch for expanding FDIC insurance from $100,000 to $250,000 as way of stabilizing the banking system. But the most likely explanation for early morning optimism is well-capitalized bargain hunters swooping in looking for deals. And they can swoop out just as quickly.

Focusing on hourly or daily swings of the stock market, we are warned by scores of economy watchers, isn't the best way to understand the economy. A 777 point drop in the Dow, as numerous TV analysts intoned Monday night, was the biggest point drop in history, but in percentage terms, the 7 percent decline didn't come close to the 22 percent drop on October 19, 1987.

But this crisis isn't about the stock market. It is, as Felix Salmon reminds us for the umpteenth time this morning, a credit crisis. And credit is tighter than ever. Last night, the rate at which banks lend each other money over night spiked to its highest point ever, 6.88 percent, sparking a couple of observations in a Bloomberg article that are being cut-and-pasted across the econoblogosophere.

"This is unheard of, the money markets should be the engine driving the financial system but they have broken down," said Kornelius Purps, a fixed-income strategist in Munich for UniCredit Markets and Investment Banking, a unit of Italy's largest lender. "Any institution that hasn't completed its 2008 funding needs by now is going to be in very serious trouble. More banks are going to need to be bailed out."

"The money markets have completely broken down, with no trading taking place at all," said Christoph Rieger, a fixed- income strategist at Dresdner Kleinwort in Frankfurt. "There is no market any more. Central banks are the only providers of cash to the market, no-one else is lending."

The implication of those numbers is that more banks will fail. Or rather, more banks will be bailed out because they cannot be allowed to fail. And as banks collapse or are bailed out, wider ripple effects will spread. The proper way to look at this crisis is not as a snapshot of economic woes at any one point, but as a widening gyre. Looking all the way back to August 2007, the credit crisis has steadily deepened. The Fed injected another $300 billion into markets on Monday hoping to loosen things up, and appears to have failed completely.

In the absence of some form of government action that addresses the structural roots of the current crisis, the Fed and Treasury and FDIC will continue on their present path. The growing consensus that not bailing out Lehman Brothers only accelerated the crisis is just going to encourage regulators to jump in even more eagerly. Taking no action, as the House did on Monday, may end up costing us more than taking action, even on a flawed bailout. Time's Justin Fox, once again, cuts straight to the heart of the matter:

By voting down the proposed $700 billion financial bailout package -- and causing a spectacular stock market rout -- a majority of members in the House of Representatives made a clear statement that they didn't want to put taxpayers on the hook for the failures of financial institutions.

But there's a catch: taxpayers are already on the hook for the failures of financial institutions, and it's possible that the bill will actually be larger without bailout legislation than with it. That's because the regulators who mind the financial industry -- the Federal Reserve, Treasury and FDIC -- will keep doing what they've been doing: stepping in to prevent the chaotic failure of banks and other large financial institutions. This means continuing to put hundreds of billions of taxpayer dollars at risk, but in a way that adheres to no clear plan of action and doesn't require members of Congress to explicitly approve their actions.

Which brings me back to the proposal to raise FDIC insurance limits. What does that really accomplish? Those lucky enough to have more than $100,000 at any single financial institution may feel more comfortable, potentially preventing the kind of bank run that doomed Washington Mutual. But increasing the federal government's insurance liabilities means that the regulators will only be more determined to keep banks standing, by any means necessary. And as long as credit keeps getting tighter, banks are going to keep getting weaker.

Oh, and meanwhile: Home prices fell again, sharply.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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