Analysis: Washington's Trillion Dollar Wall Street Bailout

Investors hope this costly rescue plan will begin to wind down the credit crisis.

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So after the Mother of All Bubbles comes the Mother of All Bailouts. Main Street saves Wall Street. It now looks like Uncle Sam will create a new entity to take hundreds of billions of bad debt off the books of America's major financial companies. (Look for this to get done before Election Day, if not early next month.) "This is a gigantic step forward, the only way to fix the crisis," writes Ian Shepherdson, economist at High Frequency Economics. "Economy still a mess, but systematic risk way down."

Details are still forthcoming, but one possibility would be an $800 billion fund to purchase toxic bank assets. But whatever forms it takes, Congress will provide something close to a blank check to solve the American banking crisis. Already the Treasury Department has come up with a one-year, $50 billion guarantee of money market funds. You have questions. Here are some answers.

Is a bailout necessary?

Look, the financial system probably couldn't take another week like the one we just went through. Stocks plunging, credit markets freezing. As economist Robert Brusca puts it, "The proposed US government rescue plan comes at the end of a week of almost unprecedented turmoil on world financial markets amid a crisis of confidence in banks." The government had to get ahead of the curve and quit reacting on a case-by-case basis. If you look at banking crises in Japan and Sweden, for instance, all roads eventually led to a government bailout with taxpayer money at risk. The rule in these cases seems to be the sooner, the better. If you want more evidence, markets around the world and here in the United States are soaring on this news. Strategist Richard Bernstein of Merrill Lynch, in a research note, says the bailout plan is "an opportunity for the government to solve the on-going problems through one system-wide solution."

No, I mean could we have avoided needing a bailout?

Perhaps the government could have offered this sort of plan a year ago and dispensed with the massive rate cuts and the new loan facilities from the Federal Reserve. Clearly neither Ben Bernanke or Hank Paulson thought the situation would escalate the way it has. Recall that Bernanke at one point called this a $100 billion problem. It now looks like he was off by a factor of ten or 20. No, I mean could we have avoided the Mother of All Bubbles leading to the Mother of All Bailouts?

As long as we have markets and humans there will be bubbles, whether in stocks, homes, Beanie Babies, tulips, or whatever. But as far as the housing/credit bubbles go, I think it could have been avoided. Alan Greenspan cut rates too low and left them there for too long, creating an extreme financial situation that Wall Street tried to profit from. Uncle Sam also fed into that market distortion by making greater homeownership a national goal, using both tax policy and the regulation like the Community Reinvestment Act to, essentially, push capital into homes. And were regulators as tough as they could have been? Obviously not. Can we really afford a $1 trillion to $2 trillion bailout?

Yes. Now we are definitely talking about a lot of money. In addition to this bailout, we also have $9 billion in losses from the collapse of IndyMac, $29 billion of guarantees from the Bear Stearns bailout, $85 billion of guarantees from the American International Group bailout, and up to $200 billion for the Fannie Mae/Freddie Mac rescue. (Plus, Detroit wants a $25 billion loan to help it go green.) Current U.S. public debt is 60 percent GDP vs. a bit more for Germany and France and nearly 200 percent for Japan. But consider that every year that we don't deal with long-term Social Security and Medicare liabilities adds $2-3 trillion to that total annually, currently $40 trillion or so. Yet markets don't even seem to notice. Nor does our $13 trillion economy. Or remember when Congress passed Medicare Part D? That was like adding another Social Security program to our long-term national debt. (Actually worse, Social Security has $6.8 trillion in long-term liabilities. The prescription drug benefit has created $8.6 trillion in long-term liabilities.) Again, the bond market didn't seem to notice. But the Wall Street bailout probably does make entitlement reform a front-burner issue for the next administration.

But aren't there other things we could do with the money?

Assuming you wanted to borrow $1-2 trillion, you bet. The Pickens Plan to supply 20 percent of U.S. energy from wind supposedly cost $1 trillion. Fixing America's infrastructure problem. That would also cost about $1 trillion. How about $10,000 "baby bonds" for every U.S. newborn? The list goes on and on. What should Washington do next?

The worse the economy does going forward, the more this bailout is going to cost as home prices fall further and more Wall Street debt goes bad. Dramatic cuts in corporate and capital gains taxes might be a good start. This might be the ultimate case for tax cuts paying for themselves. In addition, we need to reform entitlements and reduce that $40 trillion in long-term liabilities. Doing so would send a message to global markets that America is getting its financial and fiscal house in order.