After U.S. bailout party, beware the hangover

By Emily Kaiser - Analysis

WASHINGTON (Reuters) - The price of averting a U.S. financial sector meltdown goes well beyond the mind-boggling sums that the government is handing out and may be repaid with years of higher borrowing costs and slower economic growth.

President George W. Bush said on Tuesday that phase one of the $700 billion bailout, which involves the Treasury Department investing up to $250 billion in banks, would get money flowing to consumers and companies and kick-start the economy.

Economists said the move was a necessary evil, but questions remained about whether banks would now have sufficient capital and confidence to resume lending into a weakening economy, and how much longer the world would be willing to finance cheaply the ballooning U.S. debt.

"Even with banking being brought back from the brink, lending is likely to be very slow to recover," said David Owen, an economist at Dresdner Kleinwort.

Without a return to normal lending, economic growth will be subdued at best. Many Wall Street economists think that even with the government stepping in, unemployment may reach its highest level since 1983 and corporate profits will suffer.

Judging from Tuesday's stock market slump, investors seem to think that it is too late for government intervention to prevent a recession.

In essence, the U.S. Treasury Department is betting that the slump will be short and shallow enough that banks can muddle through without any more significant damage to their balance sheets, and private investors will feel confident enough to step in and take the taxpayer's place.

Under this scenario, the government would soon recoup its investment and the debt pile would shrink.

But if the downturn is more severe and defaults on mortgages, credit cards, auto loans and corporate debt stack up, banks may quickly find themselves in trouble again and the government burden would swell -- perhaps above $700 billion.

"The world is not going back to where it was before September," said Andrew Busch, a strategist with BMO Capital Markets. "The (credit) freeze has meant that the outlook for the economy has soured and we're still not sure by how much."

LEND, BABY, LEND

Including the $700 billion financial rescue, government pledges to stem the credit crisis are nearing $2 trillion. The spike in government spending has become a political issue as the November 4. presidential election nears and the candidates face tough questions about what campaign promises might fall by the wayside due to budget constraints.

So how much is enough to end the crisis? The Treasury's pockets are deep but not bottomless. The latest figures show the national debt stood at $10.2 trillion as of Thursday, well within the $11.315 trillion limit.

The risk is that the financial system has been so weakened that banks will keep the government's money and it won't reach its intended target: the households and businesses that need funding to keep the economy going. Treasury Secretary Henry Paulson acknowledged that concern on Tuesday.

"At a time when events naturally make even the most daring investors more risk-averse, the needs of our economy require that financial institutions not take this new capital to hoard it, but to deploy it," he said.