September 27, 2008 -- A KEY reason the public hasn't bought the case for the $700 billion bailout plan is that the Bush administration hasn't explained why the financial sector is unique - unlike the auto industry or any economic actors who are hurting and asking for aid. Hence the opposition on the left, from those who want a broader bailout, and on the right, from those who want no bailout for anyone.
The basic problem is that the financial sector faces systemic risk in a way that no other industry does: By its nature, it is a house of cards that can collapse at a moment's notice.
Let me explain.
First, the vast bulk of the nation's money supply is in the form of bank deposits, not currency and coin. No bank on earth could pay even a fraction of its depositors if they all demanded all their funds in cash immediately. This is called a run on the bank (and is very familiar to anyone who has ever watched "It's a Wonderful Life").
During the Great Depression, such runs forced hundreds of banks to close. At the time, there was no system for protecting bank deposits - so a vast amount of money literally disappeared in the process. The nation's money supply contracted by about a third between 1929 and 1933.
As a general proposition, a one-third decline in the money supply would, in the aggregate, lead to about a one-third decline in the prices of all goods and services. If that could happen quickly and easily, changes in the money supply would have no effect on the real economy.
But that's not the case, of course. Businesses resist selling goods for less then they paid for them, workers resist cuts in their pay, and so on - leading to an economic depression. For this reason, most economists believe that a severe deflation should be avoided at all cost.
The second problem with the financial system - again, by its nature - is that banks borrow short and lend long. When you make a bank deposit, you're essentially lending your money to the bank, which relends it in mortgages, to businesses and for other purposes. It makes a profit on the spread between what it pays depositors and what it receives on commercial loans.
Thus, there's an inherent mismatch between a bank's assets and its liabilities - it can't cash in all its assets quickly, even though it is in theory obliged to pay most liabilities on demand.
So, even if depositors were willing to take checks instead of currency for their deposits, they couldn't all be paid if there were a bank run. It would take a considerable amount of time for any bank to call in its loans or sell them to raise the funds necessary to pay off every depositor.
If a bank finds itself in such a situation and has to sell a lot of its assets quickly, any potential buyer will certainly offer much less than the assets are worth: When you have someone over a barrel, you can pretty much name your own price.
That "fire sale" situation will drive down the value of those assets - increasing the risk of bankruptcy even when a bank has been managed responsibly.
A secondary problem can then develop - because other banks hold similar assets. When one bank starts unloading at fire-sale prices, this drives down the market price - imposing losses on everyone holding such assets.
Under mark-to-market accounting rules, banks must recognize these losses immediately - even when their intention is to hold a bond or mortgage to maturity and (likely) be paid the full face value of the asset.
What prevents this house of cards from falling is confidence: People don't feel compelled to hold all their money in cash under their mattress and the system functions smoothly.
But, should confidence be shaken, the risks are very great indeed.
There are, of course, policies in place today that didn't exist in 1929 that make another Great Depression unlikely. (The most important is federal deposit insurance for the vast bulk of deposits.) But there is still a great danger that, if the financial sector becomes overloaded with assets falling in value, it could lead to a long period of economic stagnation, such as that suffered by Japan in the 1990s.
One reason for this is that Federal Reserve policy becomes impotent when the financial system simply can't distribute changes in the money supply throughout the economy.
We're seeing evidence of this already, as interest rates on Treasury securities fall to very low levels. When this happens, we have what economists call a "liquidity trap" - and it means that the Fed is incapable of stopping a deflation once it gets started.
Bottom line: We're closer to the precipice than Congress or most of the public understands. Our entire economic system really is at stake - and those treating the bailout plan as just another government spending program are seriously wrong.
Failure of this plan risks another Great Depression. Really.
You can see the fear in Treasury Secretary Henry Paulson's eyes and in those of Federal Reserve Chairman Ben Bernanke. But they dare not say how critical the situation is - lest it shake confidence and make matters worse.
This is not to say that the administration's plan is the best we could do. But now is not the time to come up with something better. There is no time. The program can be revised later, when the emergency is past. For now, everyone should hold their noses and vote "yes" on the bailout.
Bruce Bartlett was a White House economist in the Reagan administration and a Treasury Department economist in the George H.W. Bush administration.
