Already paying for Paulson's plan

Treasury Secretary Henry Paulson fears a failure in the credit markets.

More from Fortune

Will Mmmhops be a hit? NBA confirms L.A. Clippers sale to ex-Microsoft CEO Steve Ballmer FBI and SEC probe into Carl Icahn and golfer Phil Mickelson

FORTUNE 500 Current Issue Subscribe to Fortune

NEW YORK (Fortune) -- Henry Paulson's latest lurch on the policymaking front is already hitting Americans in the wallet.

The Treasury secretary has proposed to use $700 billion in taxpayer funds to buy financial-sector assets in the latest government bid to shore up the struggling U.S. banking system. The proposal adds to a Federal Reserve-Treasury rescue tab that has already run into the hundreds of billions of dollars.

But what Paulson's proposal wouldn't do may be just as important in explaining Monday's unrest in the financial markets, where stocks slumped, the dollar posted its biggest single-day drop in four years and the price of crude oil surged 20%.

With the bailout proposal, Paulson seems to have abandoned hope of holding financial-sector players responsible for their mortgage-related missteps and is instead intent on distributing those losses to taxpayers.

Paulson "should have appeared for his 10 a.m. press conference in a Santa Claus suit," says Marc Heilweil, manager of the Marathon Value mutual fund in Atlanta. "But these gifts aren't going to underprivileged children."

Only a week ago executives and investors would have been held responsible for their multibillion-dollar misjudgments.

In other interventions of late, Paulson and other policymakers penalized troubled companies before committing any federal funds, on the principle that shareholders and CEOs should pay dearly for the privilege of using taxpayer dollars.

That stance was behind the ouster of top executives at mortgage guarantors Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRD) and insurer AIG (AIG, Fortune 500), and in the near wipeout of equity investors in those companies and at Bear Stearns, the investment bank that collapsed in March.

But Paulson's proposed Troubled Asset Relief Program, or TARP, makes no such demands - apparently in the name of persuading troubled financial companies to take part in the program, and thereby speed up the recovery of the troubled banking sector.

With financial companies struggling under the weight of bad loans, credit has become scarce, threatening economic growth. Reversing that trend, Paulson argues, is of paramount concern.

"We're trying to offer a program across the whole financial landscape to buy the assets that are clogging up the system so that the markets can work," Paulson said Sunday on ABC's This Week. "We don't want to make it punitive and make it difficult."

But despite Paulson's assurance that "the ultimate taxpayer protection will be the stability this... program provides," the early signs are that socializing financial sector's mistakes will add to the strain felt by many Americans.

On Monday, the Dow Jones industrial average was down 3%, and the dollar staged its biggest decline against the euro in four years. A weaker dollar pushes up import prices and fuels inflation. The price of crude oil, meanwhile, continued its recent rebound, rallying to $127 a barrel.

Financial markets seem to fear how an already heavily indebted nation will handle a new and possibly huge burden on the public purse.

The dollar selloff and oil rally are noteworthy, because they come after a two-month-long relief rally in the greenback and a steep decline in the price of fuel. A sustained reversal of those trends would add to the burden being felt by U.S. consumers, who already are struggling with stagnant wages and an economy that has posted eight consecutive monthly job losses.

What's more, Heilweil says the decision to prop up the finance sector at taxpayer expense will slow any recovery from the credit crunch that started weighing on growth in August 2007. "We're substituting chronic long-term pain for something that could have been acute and short-term," he says.

Paulson's plan, as proposed, comes with a huge helping of uncertainy - one thing the financial markets weren't looking for right now. It's not clear that taxpayers will even know what they're buying, or what prices the Treasury envisions paying for troubled assets.

So while the authorities stress that the potential losses to be funded by taxpayers will be substantially less than the amount earmarked for the mortgage rescue, there's no way of knowing just how much less. This too strikes some observers as a less than equitable approach.

"When you're proposing to use $700 billion of taxpayer funds," says Brad Setser, an economist at the Council on Foreign Relations, "the taxpayers should know what they're buying."

Congressional Democrats and Republican presidential nominee John McCain have called for more oversight of TARP than Paulson's plan envisioned, but as of Monday afternoon it's not clear what shape a final bill will take.

No matter that shape, thought, the rising bailout tab will only add to concerns about the willingness of foreigners to finance Americans' $2 billion-a-day current account deficit. U.S. creditors such as China, Russia and the Gulf oil states have substantial dollar holdings whose value has taken a big hit during the dollar's steady depreciation this decade.

Though China's central bank and other authorities have so far shown no signs that they'll exit the dollar en masse, Setser notes that "having a big losing position isn't much of a reason to keep adding to that position."