If the bailout comes, watch for a dollar dive: James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - If the United States bails out the financial system by buying mortgage debt directly, the price just might be surging inflation and a dollar crisis.

Calls are increasing for the government, either directly or via the Federal Reserve, to cut the knot of the credit crisis at a stroke by buying up mortgages that banks and investment banks are finding difficult to finance.

If the United States bought mortgage debt at or very near 100 cents on the dollar, despite the fact that much of it is trading well below that, it would allow banks to pay back loans used to finance these holdings.

If done in sufficient size, say $800 billion or $1 trillion, it would relieve the terrible pressure on bank balance sheets and allow other credit markets, like those for corporate loans, to return to something approaching equilibrium.

That in turn would make Fed monetary policy more effective in the sense that banks would be able to increase lending and pass on interest rate reductions.

Of course this is a radical step, and way beyond the Fed's already extraordinary policy of swapping mortgages held by banks and some investment banks for easy to finance Treasuries.

It is also hugely risky in terms of the Fed's obligation to maintain stable prices. Putting aside moral hazard -- many foolish borrowers and lenders would thus be given a free ride -- and depending on how such a bailout was done, it could stoke inflation to levels intolerable to foreign creditors, provoking a sharp fall in the dollar as they sought safety elsewhere.

Such a bailout would either have to be paid for by taxes, which seems unlikely, or would involve issuing more government debt or effectively expanding the money supply.

"There would be an inflationary impact because of the huge introduction of credit," said Philip Gisdakis, strategist at Unicredit in Munich.

"It's not $50 billion; we are talking about more like $1 trillion. This injection of capital you need will have consequences for the U.S. economy."

A bailout of that size is very likely to stoke inflation, which is already uncomfortably high, by effectively creating more dollars and putting them into circulation.

"If it's too big there will have to be an element of monetization, with the Fed financing it," said Tim Drayson, economist at ABN AMRO in London.

"Monetization is rising from what was a small likelihood to what is now an increasing risk."

To be sure, there is no political consensus for a major bailout, which is openly opposed by the Bush administration and would face serious difficulties gaining agreement in an election year. The U.S. Treasury said on Wednesday that proposals it had seen would do more harm then good.