Jeremy Warner's Outlook: Paulson's $700bn bailout hangs in the balance. But even if it passes, will it save the system from meltdown?

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With Hank Paulson's $700bn plan to save the global banking system still in the balance, the fundamental question remains the same: will it work?

The plan was again in trouble last night, with Congressmen from both sides of the political divide queueing up to express their dissent. To Republicans it looks like socialism, while to Democrats it looks like the worst possible use of taxpayers' money - bailing out the fat cats of Wall Street. Yet despite the almost universal revulsion, you have to assume that such is now the extreme nature of the banking crisis, that it will eventually get approved, if only in compromise form. Lawmakers have little option. The money markets are almost completely frozen, and stock markets are again falling like a stone. Policymakers have warned of economic catastrophe if it doesn't pass, and even if that prophecy always looks a little suspect, it now becomes self fullfilling if the Administration fails to get its way.

These are uncharted waters, so you would expect policymakers to make mistakes as they attempt to navigate through the rocks. With hindsight, it was a misjudgement to allow Lehman Brothers to go to the wall. The effect has been to make the money markets freeze up almost entirely, with banks hoarding money and refusing to lend to each other except at very short maturities. If Lehman's can be allowed to fail, so can others. The prevailing mood has therefore become that it is better to keep your cash under the mattress, earning no interest at all, than lend it to a private sector bank.

As detailed in our analysis, an extreme flight to safety occurred in the wake of this collapse, with money seeking the lowest risk repositories available, from the Bank of England to US Treasuries, gilts, gold and anything else that provides shelter from the storm.

In the British retail market, the phenomenon has manifested itself in a perverse migration of money away from banks perceived as potentially "unsafe" and into Northern Rock, which after nationalisation is underwritten by the taxpayer. Like the original run on Northern Rock before depositors were guaranteed by the Government, this is a rational response to the crisis. The retail depositor will take no lectures from regulators on the "irresponsibility" of such action. The money men of the wholesale markets have already run for the hills and withdrawn their funding, leaving only the little guy, the Government and the Bank of England standing between some of these banks and oblivion.

Mr Paulson must have known it was a gamble when he refused to support Lehman's, and it is one he seems to have lost. In attempting to draw a line in the sand and say "no more bail-outs", he is now widely seen as having made a bad mistake, leading to the $700bn plan to bail out the system as a whole. Yet though the Lehman's decision brought matters to a head, it seems likely that the crisis would have ended in some such generalised bail-out in any case.

For months now, it has been obvious that a state-sponsored fund to take the bad debts off the banks' balance sheet must be part of the solution. It's been tried and tested in banking crises before, and generally it works. The alternative had become buying up the organisations at the heart of America's banking and insurance industries one by one as each in turn was driven to the brink. Once the markets had finished with one organisation, they merely moved on to another. Removing their bad debts instead should ultimately prove a cheaper and better solution.

But I don't want to apologise for Mr Paulson. The main criticism of his proposal remains as it was at the start – a breathtaking lack of detail. Small wonder after the way they were bulldozed into financing the Iraq war that congressmen were not going to sign a blank cheque. Mr Paulson, a former chairman of Goldman Sachs, was demanding carte blanche to spend the money as he wanted, and for legal immunity in so doing to boot.

Having somewhat naively agreed the plan last Friday in the heat of the moment, lawmakers returned to their constituencies for the weekend where they were rightly given a rocket, and returned filled with fire and fury. Ordinary Americans don't want to bail out bankers, they want to string 'em up. That's to come. Hundreds will go to jail for this in a purge that dwarfs Enron and other corporate scandals of the early Noughties.

Congressmen may win concessions on pay-offs, oversight, and recompense for taxpayers, but in the end they have little option but to agree, if only to the staged bailout fund, with separate tranches of money being voted on individually as they become necessary, being talked of as a possible compromise last night. If they don't, it is sayonara the American banking system, which though superficially a not unattractive proposition would disrupt the wheels of commerce to such an extreme degree that even the Great Depression look mild by comparison. Nobody likes the Paulson plan. Bailing out the miscreants is offensive and objectionable in almost every respect.

It is also possible that different policy decisions at an early stage may have made the crisis less severe. But given where events have got to, it's hard to see what the alternatives might be.

George Soros, the billionaire speculator whose constant lecturing on the crisis is a bit rich given that he's a founding father of the unbridled capital markets which gave us the credit crunch, thinks the solution lies in recapitalising the banks with taxpayers' money, rather than buying their bad debts. This strikes me as both impractical and unlikely to succeed. Never mind the absent detail on Mr Paulson's plan, it would take months and possibly years to decide on an equitable scheme for the showering of bankers with taxpayer funded equity that Mr Soros seems to propose. The crisis in markets involves problems of both liquidity and solvency, yet one of its lessons is that you can have as much regulatory capital as you like, but once confidence is shot, the funding that banks need to stay in business goes too. Providing more capital doesn't solve the bad debt problem.

Banks demand more handouts from Old Lady

As America's 51st state, back here in Britain we are unfortunately joined at the hip to the crisis. If the Paulson plan fails, then our banks are going to be in jeopardy too. Arguably, several of them already are. To save HBOS, the Government has had to suspend its competition rules and agree a massive consolidation of the banking market. There will be a lot more of that before the crisis is over. Bradford & Bingley's days as an independent company are plainly numbered. The only question is whether shareholders can salvage anything at all.

As the Paulson package wobbled, the UK banking system too seemed to grind to a halt. Interbank lending at maturities of any more than a week has virtually dried up, and whereas there is as yet little sign of the distress Mr Paulson refers to in the US economy, with even big, non-financial companies experiencing difficulties with their overnight funding, in the absence of a solution, it may be only a matter of time. UK banking has become highly dependent on overseas, wholesale money to fund its lending, and right now, there's not much of it about. Instead, the gap is again going to have to be filled by the Bank of England. In the next few days, the Bank will be forced to increase sharply the amount of "repo" money it lends at longer maturities of up to three months. Overnight money is no longer a problem, so much so that there is actually an excess which the Bank is being forced to drain from the system. In the flight to safety, banks are also putting some of this excess on deposit with the Old Lady of Threadneedle Street, even though they are being forced to accept 100 basis points below base rate for the privilege.

Longer-term money, on the other hand, is becoming ever harder to come by. The amount of one-week money the Bank of England had out on loan soared to an unprecedented £66bn last week. As at other critical stages in the credit crunch, the Bank may be forced to offer approaching the same in three-month money.

These facilities are being buttressed by the Special Liquidity Scheme, which, somewhat belatedly given the snowballing nature of the crisis, was recently extended for a further three months. Already, the SLS has lent more than £100bn of three-year money to the banking system. All these measures help to ease the pain, but as in the US, a permanent solution may have to be found.

At this stage, ministers believe there will be no need for a Paulson-type plan in the UK. On one level, they are right. UK banks have taken on a lot more of the US's toxic mortgage and other forms of securitised debt than they should, but as far as the UK economy is concerned, there is as yet no underlying bad debt problem, or at least none which the banks cannot absorb. As a consequence, there are no bad debts the Government could legitimately buy.

Yet there is a funding crisis, at present being addressed by lending the banking system money, and this is being accentuated by the fear that we may be only months behind the US in developing similar levels of default. It has already driven one bank – Northern Rock – into government ownership. If the Paulson plan fails, others may follow. Regrettably, the UK's public finances are already stretched enough, and are therefore even less capable of absorbing liabilities on such a scale than those of the US.