Resident Fellow David Frum

What should a free-market believer think about the plan for a government bailout of the U.S. mortgage market?

Try this analogy:

You have a white carpet in your upstairs hall. The normal rule is that nobody can wear shoes on the carpet. But the house is on fire--and the baby is upstairs. Will you tell the arriving fire department to wait and kick their boots off before dousing the flames?

The financial bailouts we've seen on Wall Street over the past month are very different from the bailouts we've seen in the past for firms such as Chrysler or Massey-Ferguson.

The object is not to rescue the shareholders and employees of any one single firm. In fact, U.S. authorities have made a point of emphasizing that shareholders and management of the rescued firms will get nothing. The "golden parachutes" of the CEOs of Fannie Mae and Freddie Mac have been cancelled. Shareholders in Bear Stearns received pennies on the dollar. Shareholders in AIG have lost 80% or more of their investment.

The object of this bailout is to prevent bad debts at one financial firm from destroying credit throughout the U.S. and global economy. The financial blogger Barry Ritholtz offers a vivid analogy to understand why the Fed has felt it had no choice but to rescue some firms--while leaving others to perish:

• Lehman Brothers was like the little kid pulling the tail of a dog. You know the kid is going to get hurt eventually, and so no one is surprised when the dog turns around and bites the kid. But the kid only hurts himself, so no one really cares that much.
• Bear Stearns is the little pyro--the kid who was always playing with matches. He could harm not only himself, but burns his own house down, and indeed, he could have burnt down the entire neighborhood. The Fed stepped in not to protect him, but the rest of the block.
• AIG is the kid who accidentally stumbled into a bio-tech warfare lab, finds all these unlabelled vials, and heads out to the playground with a handful of them jammed into his pockets.

Fed Chairman Ben Bernanke is one of America's leading academic experts on the Great Depression. At a dinner in honour of Milton Friedman's 90th birthday in 2002, Bernanke finished his tribute to the great monetarist with this acknowledgement of Friedman's (and his colleague Anna Schwarz's) thesis that the Great Depression was caused by central bank failure: "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

We can hope that this bailout may prove less costly to the taxpayer than the big scary numbers in the headlines suggest. As Americans discovered during the Savings and Loan bailout of 1990, the government acquires a lot of assets in these bailouts. The big scary headline numbers describe only one side of the ledger. The net cost may well be much smaller.

But even if the tax cost proves less than feared, the impact upon the overall economy will surely be painful.

The huge expansion in U.S. mortgage debt since 2002 did two things: It enabled (1) uncreditworthy buyers to buy homes they never should have bought via subprime loans; and (2) middle-class Americans to finance more consumption than they could afford via home-equity loans.

The great theme of the next half decade or so is going to be debt repayment, both for Americans as individuals and for the United States collectively.

Americans consumed too much in the Bush years. They will consume less in the years ahead. Individuals will have to repay debt by working more and buying less; the nation will have to repay debt by exporting more and importing less.

In other words, even if the United States is able to avoid a technical recession, the next little while will sure feel like a recession.

Even before today's crisis, it was reckless and irresponsible for Democrats to be proposing large new social-welfare schemes on the verge of the Baby Boomers' retirement. It's about to become nightmarishly difficult to pay for the social programs the United States has got already. The last thing anybody should be considering is adding more.

Republicans meanwhile will have to accept that there is now very little hope for the renewal of the Bush tax cuts. Big deficits and big debts go badly together. Party time is over. Clean-up time has come.

David Frum is a resident fellow at AEI.