Bet on passage of a bailout, but more pain is on the way

Jay Hancock

September 30, 2008

Congress will pass a bailout package. The stock and credit markets are making sure of that.

Sure, congressmen are loath to tell constituents right before the election that they spent taxpayer money rescuing prodigal fat cats. But they'll be even less eager to explain why they triggered what might be a titanic stock collapse, a lending Ice Age and the worst economic downturn since the Depression. If they need markets as political cover to placate voters who don't seem to get how much danger we're in, so be it. But bet on a package being passed later this week, a temporary recovery in stocks and then a long, painful recovery punctuated by more crises.

People in the Clinton administration used to complain about the "vigilante bond market" that punished policymakers with breathtaking plunges if it didn't get its way. But those troubles were a croquet match compared with what will happen if Washington doesn't move now.

Yesterday's 778-point tantrum by the Dow Jones Industrial Average was a mere preview. And stocks aren't where the main action is. If you want to be truly unnerved, talk to somebody who knows what's going on in the credit markets.

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They're iced up. Until Washington starts quarantining radioactive mortgage loans, nobody wants to lend to anybody because they don't know who'll go kablooey.

Like it or not, economies have been built on credit for centuries. Very little grows without someone else's money.

The global economic fire alarm these days is the TED spread - the difference in interest rates between short-term Treasury bills and what banks loan each other for day-to-day business.

Usually there is little daylight between them. The risk of lending to a bank isn't much different from lending to the U.S. government. But when fear is abroad and banks are suspect, the needle on the TED spread moves.

People freaked out when the spread hit 2 percentage points in March, during the meltdown of investment bank Bear Stearns. Last week, it surpassed 3 points and broke a record set during the 1987 stock market crash.

Yesterday, after the House rejected the Bush administration plan, it smashed that record. So little confidence did financiers have in their sister banking companies last night that they were demanding interest of 3.5 percentage points over the Treasury rate.

And if banks are in trouble, so is the economy.

The idea in Congress and among voters seems to be that Wall Street's problems won't hurt the rest of the economy. Let the tycoons and suits drown in a deluge of their own design while we watch from the top of the canyon.

There is reassuring evidence from history. The collapse of the dot-com bubble in the early 2000s didn't increase unemployment much. The 1987 stock market crash barely registered on the larger economy.

But this is different.

Even financially sound companies are having trouble renewing short-term borrowing privileges. When everybody suspects everybody else of being a bad credit risk, the economy as a whole can get thrown into reverse.

So far, Washington has allowed only one large financial institution to fail - Lehman Brothers. But in an interconnected economy, that one collapse threatened $3 trillion in money-market mutual funds, the world's biggest insurance company - American International Group - and dozens of other huge firms.

Abdication now by Congress would multiply that scenario tenfold.

The time for firm-by-firm rescues is over, because it is impossible to tell who is in danger. Without a sweeping bailout, companies of all kinds would cut back and downsize. Market flops would smother consumer spending. Unemployment would rise, and Congress would realize too late that finance is the essential economic lubricant.

Of course it's exasperating to aid the financiers who caused this. But revenge too sweet would backfire. Want to get mad? Focus on the policymakers who allowed it to happen. And starting in January, make sure the new Congress enacts rules to ensure it never happens again.