A necessary step forward, with caveats

After turning down the administration’s rescue bill last Monday, then watching the Senate pass its own version Wednesday, the House agreed Friday that the nation’s financial system needs a federal infusion.

The bill, which President Bush signed almost immediately, is as flawed as might be expected under the circumstances.

For example, one provision – added in an apparent bid to secure the bill’s passage – exempts excise taxes on certain wooden arrows manufactured by a company in the Oregon district of Democrat Peter DeFazio. Another, aimed at Don Young, R-Alaska, provides favorable tax treatment of income from litigation over the 1989 Exxon Valdez oil spill.

These are the lamentable – but expected – earmarks that accompany most legislation. Another provision, involving expansion of federal deposit insurance, is more worrisome.

On the whole, however, the law is a welcome and necessary step forward.

It preserves a key element of the original proposal: giving the government the authority and money to buy up Wall Street’s non-performing assets.

This will obviously restore confidence in the credit markets and lubricate the economy, permitting business to resume normal borrowing and spending. It also signals foreign markets and governments that the U.S. can take bold steps to avert crises.

Withholding judgment about whether its credit stimulation approach is the right one, the law addresses the challenge of restoring the smooth functinoing of the credit markets.

Without confidence in the ability of banks, other corporations and individuals to borrow and repay their debt, the economy will grind to a halt.

As it is, the economy is rapidly heading into a recession, if not already there.

Just before the House took action, the Department of Labor reported that the economy lost 159,000 jobs in September, its worst performance since March 2003. So far this year, the economy has shed 760,000 jobs.

The stock market’s reaction to the new law – a decline of more than 157 points on the Dow Jones Industrial Average on Friday and a loss of about 7% for the week – underscores the widespread unease. The public is uncertain and largely unwilling to assume new risks.

The rescue law’s increase in federal deposit insurance from $100,000 per account to $250,000 is intended to allay the public’s concern and restore confidence in the banking system. It probably will, at least in the short run.

As money market mutual funds endure their own crises of confidence, requiring massive capital infusions from parent fund companies in many case to keep share prices from “breaking the buck,” the safety of cash has become a major concern. After Treasury securities, whose returns have been driven to micron-thin levels as a result of the stampede to quality, its safest haven is bank deposits guaranteed by the Federal Deposit Insurance Corp. in Washington.

Raising FDIC account limits, therefore, probably will attract even more assets to banks. This also will help ease liquidity concerns in the banking system.

But the temporarily higher FDIC limits, which are supposed to end in 2009, are likely to be extended, as most popular government programs are, and that poses a problem.

Unless the government raises premiums for FDIC insurance – which it says it won’t – it is adding huge liabilities to an already weakened deposit insurance fund, which stood at just $45.5 billion at the end of the second quarter. That insurance backs about $4.5 trillion in deposits.

Emulating the financial giants it bailed out, the government in effect has issued the world’s largest credit default swap, yet isn’t even earning a premium for its risk.

Now that the $700 billion rescue program is in place, no one is in a position to consider another massive bailout. Let’s seriously hope we won’t have to.