Washington's bailout: the good, the bad and the confusing

A day after the U.S. Federal Reserve jumped intoWall Street's ongoing financial debacle, experts aredebatingfuriously whetherthe central bank's policy flip willwind up as an economic flop.

"In the current environment, success is going to be much harder to achieve because the panic is related to the unknown size of the risks facing the financial services sector," said Stephen Sapp, associate professor of finance at the Richard Ivey School of Business at London'sUniversity of Western Ontario.

Tuesday's change of heart

Late Tuesday, the U.S. Federal Reserve madeits second unexpected move in a day when it became an 80 per cent shareholder in terminal insurer American International Group Inc.

Earlier in theday, stock markets rallied after the U.S. Federal Reserveunexpectedly decided to leave interest rates unchanged at two per cent.

The central bank stayed on the sidelines despitea widespread view among financial experts that the U.S. Fedwould chop borrowing costs to helpthe ailingfinancial sector.

Financial services firms had been reeling after Monday's announcement that brokerage house Lehman Brothers had slid into bankruptcy and Bank of America had bought out troubled Merrill Lynch & Co.

Many expertsinterpreted the AIG takeover as Washington's unwillingness to stand on the sidelines while one of the world's largest insurance companies went under the auctioneer's gavel.

Tuesday's contradictorymoves by the Federal Reserve, however, confused investors as to whether or not Washington wouldjump in again with the next financial failure.

"This could work out, but that remains to be seen," saidKenneth Kim, Stone, an economist withStone & McCarthy Research Associates. "The Fed is trying to restore confidence, but sentiment can turn on a dime."

On the one hand

The debate about the Federal Reserve's decision to intervene in the financial markets is long-standing and contentious.

One side of the argumentmaintains thatthe economy is better off whenailing companies fail and the market starts growing again.

Government policies that prop up these corporate dogs, goes this line of thinking, only serve to slow, but cannot stop, the slide.

"U.S. history and the international experience teach a hard lesson: delaying the resolution of [a] financial crisis only makes it more costly," said Vincent Reinhart, former director of monetary affairs at the Federal Reserve and resident scholar at the American Enterprise Institute.

On the other hand

Opposing the free market crowdare economists who believe that big companies, especially financial ones, influencethe economy sufficiently that their failure would lead inevitably to a widespread and lengthy slowdown.

"The problem is that there are so many huge other impacts when these financial giants come tumbling down," said Jim Stanford, economist with the Canadian Auto Workers union and a long-time economy watcher.

Firstly, the shareholders and employees of AIG and the other trouble spots lose through disappearing valuations and jobs.

In addition,healthier firmssuffer because they have invested money in these problematic corporations.

For example, Sun Life Financial Inc. admitted on Wednesday that it held $315 million worth of AIG bonds. Earlier in the week, the fiscally healthyCanadian insurer said it also held $33 million of Lehman financial assets.

Finally, in the case of Wall Street's current woes, the affected companies held billions in now close-to-worthless asset-backed commercial paper, a financial vehicle linked to the falling U.S. housing market.

Other companies in different industries also hold these types of assets.In this country,UTS Energy wrote off $1 million in the Canadian equivalent of the asset-backed bonds.

Without new government policies, these firms would have little hope of recovering any cash in this damaged market.

Governments help and hurt

Ivey's Sapp said government interventioncanhelp but only in situations where the issues are clear.

In the late 1990s, for instance, the Hong Kong governmentjumped into foreign currency markets to shore up that country'sdollar, which was under pressure from speculatorstrying to undercutits value.

The Hong Kong Monetary Authority spent billions buyinglocal currency on the open market and convincing these money playersthat the government was willing to defend the dollar. In the end, the government won and drove off the speculators.

For now, Washington and other governments will keepinjecting money into available borrowing pools and looking at possible takeovers to deal with investor nervousness.

Given the jumpy state of Wall Street, however, that might take a long time, Sapp said.

"They are intervening to try to calm the markets until the uncertainty behind the true size of the risks can be resolved and banks and financial institutions will start to transact with one another again.This may take some time, though," he said.