Who is going to pay? You are going to pay.

As the credit crisis becomes more entrenched, an unholy alliance of unpopular politicians and desperate bankers are setting up the UK taxpayer for an unprecedented financial sector bailout. Today's Observer reports:

“Intense discussions involving the Treasury, the Bank of England and the UK banks are going on over how this blockage (i.e. the credit crunch) might be cleared. One possibility is that the authorities might either purchase or guarantee assets to put a floor under their prices, the theory being that it might encourage investors, who are staying out of the market because they fear prices might fall even further, to wade back in.”

Yes, it is as bad as it looks. The government, the Bank of England and the commercial banks are working towards a massive public sector intervention to secure banking sector profits. The taxpayer is about to be presented with a massive bill for all those long years of irresponsible monetary policy, lax lending standards, and failed financial sector supervision. The chickens are coming home. Balance sheets are deteriorating, and the banks want the public sector to come in and clean up the mess.

The very idea of a bailout based on the principle of purchasing degenerated bank assets or trying to put a floor under prices is so outrageous that it should leave all decent people speechless. For ten years, UK banks cooked up an unprecedented rise in asset prices, while the Bank of England and the FSA were willing accomplices. As credit flowed into the housing market, prices exploded, and although all the warning signs of a bubble were evident 5 years ago, nobody did anything to put a stop to this lunacy. Interest rates stayed low, the FSA allowed banks to run riot with minimal risk management, while the government happily took in huge amounts of housing-related tax revenues.

Now, the bubble is crashing faster than anyone ever thought. Everyone now sees a terrible danger just ahead of us. A chain of events is now underway that could lead to an unprecedented financial sector meltdown. The housing bubble has gone too far, and many borrowers now find it difficult to service their loans. The banks know that defaults are about to rise catastrophically, and they would prefer to hold whatever cash they have on their own balance sheets. Furthermore, no one wants to lend to another bank because of a genuine fear of another Northern Rock style failure. Mortgage volumes have collapsed, and demand for housing has been flushed away.

The situation is about to get really nasty. As demand collapses, house prices can only go one way. Since the market is top full of speculators, falling prices will lead to panic. As speculators dump their unwanted houses onto the market, the crash escalates further. The shock then hits the real economy. Tumbling prices will make home owners less wealthy, and when everyone realizes that they are not as asset rich as they previously thought, consumption will fall back. Economic growth will slow, unemployment will rise and eventually the default rate on all those mortgages will begin to rise. Then it will be time to say hello to a systemic banking crisis.

Since everyone sees what is coming, there is a natural desire to dodge the oncoming freight train that is about to hit the UK economy. However, when politicians are involved, we can always count on the short-term fix to dominate the long-term solution.

Brown, and Darling have surveyed the scene. Both understand that economic policy under New Labour was been built on three pillars; house price inflation, easy consumer credit, and public sector expenditure. Last August, two of the three pillars came crashing down; and if the UK slips into a recession, tax revenues will decline, taking the third pillar with it.

Understandably, Brown and Darling want the good times back. They have concluded that if only banks began to lend to each other, the crash could be avoided. For Brown and Darling, the solution lies with more credit to households. If only there were more mortgages, house prices will stabilize. No one will feel poorer, consumption will remain high and the recession will be avoided. This all points to the government buying up compromised bank assets.

Of course, this ignores the underlying source of our difficulties. People are overloaded with debt. A rising default rate is inevitable, and any foolish scheme that props up the housing market will only delay a housing crash. It will not prevent it.

So, if a guarantee on housing market assets is not the solution then what should the bank of England and government do right now. After all, the threat of a banking crisis is very real and something needs to be done.

The first thing we need to understand is that this crisis is a distributional question. There are huge losses out there, and it is simply a question of who will pay. Will the taxpayer end up with the bill or will it be the banks, their shareholders, and homeowners.

Naturally, the banks and their shareholders are looking to pass the cost onto taxpayer. The banks would also like to limit the losses for homeowners who previously enjoyed huge capital gains. It is not that they care about homeowners per se. Rather; banks regard the long-term welfare of homeowners as intimately linked to their own well being. Banks need solvent borrowers, and a housing crash will destroy the net worth of many homeowners. This huge loss of housing equity will reduce the value of the collateral holding up bank balance sheets. Besides, an army of upside-down homeowners gives the bank a powerful ally to pressure the government towards accepting a taxpayer-financed bailout.

There is another, fairer solution that would push the losses back onto the banks and and homeowning speculators. The government should pass emergency legislation that requires all banks to keep an absolute minimum of two percent capital. Any bank falling below that level will be automatically nationalized and all shareholder capital will be wiped out. This will give the banks a strong incentive to maintain capital levels and avoid pushing their losses onto the public sector. The two percent capital requirement will also give the government a buffer to limit public sector losses.

The legislation would also tighten up the requirements on who could manage a bank or take a position on a bank board. Any director connected with a failed bank would automatically banned from holding a similar position for 15 years. Again, the idea is to align incentives for managers to discourage excessive risk taking.

The government should also create a bank resolution agency that will manage any nationalized banks. The agency would break up all failed banks and sell off their assets. This new agency would rapidly clean up bank balance sheets and quickly stabilize the financial system.

Unfortunately, there is likely to be losses. Nevertheless, the magnitude of those losses will almost certainly be lower than any half-baked purchase and guarantee scheme that the banks are now pushing on a desperately unpopular government.