A mad rally to end a crazy week

Last Sunday, Paulson played tough. There would be no public money for Lehman. A week later, financial markets had humiliated him, forcing him to retreat and offer a blanket guarantee to buy up all toxic mortgage-backed securities. Finance had opened the door of the US Treasury and had taken control.

The failure of Lehman provided the key to the door. When Paulson denied public money to resolve Lehman's difficulties, financial markets around the world had a collective nervous breakdown. Equity prices collapsed. Financial markets simply could not believe that the US government would let an investment bank go to the wall.

By Thursday, pressure was beginning to build on Morgan Stanley and Goldman Sachs. Moreover, there was no buyer for Washington Mutual, and behind that bank, a queue of rapidly deteriorating regional banks was quickly forming. The tough stance on Lehman was looking decidedly rash, even downright stupid.

Meanwhile, liquidity around the world had dried up. Short term dollar interbank rates were up, and money markets around the world were seizing up. In response, central banks around the world starting to pump in unprecedented amounts of liquidity.

So Thursday night, Paulson backtracked. He announced that he would offer a comprehensive plan to resolve all the problems bedevilling US financial markets.

Today, with Paulson at his side, Bush presented the details of the plan. The US government will begin to buy all those mortgage backed securities that had created this crisis in the first place. The FDIC would extend deposit insurance to money market funds, while the SEC would ban short trading of financial stocks.

So, in the course of one week, Paulson kills off one bank in order to save a few billion dollars worth of government guarantees. He ended up offering a blanket guarantee to buy up every toxic overvalued piece of mortgage-backed trash in America.

The news of this foolishness sent equity markets into a frenzy of optimism. Markets around the world recorded unprecedented gains. Everything is back to normal; the Lehman thing was an aberration. The US government will, after all, come to the rescue of equity holders, bankers and housing speculators.

So could it be true? With the US government back in bed with finance, have all the problems have magically gone away? Of course not, you would have to be mad to think it. The problem has not gone away, it has simply moved from one balance sheet to another. The banks are off the hook; the US government and the taxpayer are now swinging in the wind. With this bailout, long term US fiscal sustainability has been fatally undermined.

But it is worse than that; US houses are still overvalued; foreclosures are still rising; and the economy is slowing. Inflation is close to 6 percent; while both the external and fiscal deficits are huge.

The temptation to inflate the government debt problem away will be too much for the Fed. In the circumstances, printing money looks very attractive. Today's bailout offers a clear direction of future policy. An explicit objective was to get the banks lending again.

The taxpayer now has to face the consequences of that ghastly US housing bubble. It is almost too obscene to contemplate, but all those fat financial sector salaries and commissions, pulled out from all those toxic mortgage backed securities, will now appear on the tax bills of US households.

Today, investors weren't thinking deeply about these long term problems. Instead, investors celebrated the fact that financial interests had taken control of the US government in order to rob the tax payer for years to come. Finance held a gun to the head of the US government and said "give me the bailout, or the economy crashes". Today, Bush, Paulson and Bernanke gave in to this blackmail. It is a decision that ordinary Americans will regret for years to come.