11/11/2008 05:12 am ET Updated May 25, 2011

Right Now, Propping Up the Banks Is the Only Thing

"G-7 Leaders Agree on Principles To Confront Crisis, but No Joint Plan," The Wall Street Journal, October 11, 2008

Right now restoration of financial confidence isn't everything. It's the only thing. So for the time being, we can forget about Troopergate, hecklers at McCain rallies and the latest opinion polls. Nobody cared about Gary Condit's love life on the morning of 9/11.

Time is of the essence. This week, hopefully before markets open in Asia on Sunday (New York time), our government must announce a plan similar to that being enacted in Britain, where, for a temporary period, all bank deposits will be insured by the government.

Banks don't just rely on federally insured deposits from people like you and me. Of the $7 trillion in U.S. domestic bank deposits, measured on June 30, 2008, about $2.5 trillion did not benefit from FDIC insurance. After the bump in the individual FDIC insurance limit to $250,000, close to $2 trillion in deposits remain uninsured. Most of that $2 trillion represents inter-bank loans used to make the system work.

Think about it. Corporations manage their cash through banks. When you pay your AT&T bill or your American Express bill, the money received by those corporations is collected by banks and wire transferred to other banks. For banks to be able to balance out their books at the end of each day, they need to rely on their relationships with other banks with which they often have corresponding balances. (When you leave a deposit with a bank, you're effectively lending that bank money.)

Right now, banks have all but stopped lending to one another because in this environment, they don't know which institution will face another liquidity crisis. This virtual shutdown in the inter-bank lending market can cause a panic that spirals out of control.

And the loss of confidence in banks quickly spreads to the rest to the economy. AT&T has trouble accessing the commercial paper market, which has shrunk by 20% in the past month. The corporate bond market has been virtually shut down for over a month. (The crisis began when Lehman was allowed to fail.)

I'll bet many people are offended by the idea extending further support to the banks. Why should we bail out the people and banks who got us in this mess? For the same reason that de-Baathification didn't work. Once you allow the whole system to become unraveled, then the damage is irreparable and it is far more difficult to create order out of chaos. There will be plenty of time to extract a pound of flesh from the responsible parties.