So here we go again. When subprime homeowners stopped paying, the prices of the mortgage-backed securities used as collateral fell. Banks demanded that their borrowers pay up or cover their margins. Panicked selling by borrowers further lowered the securities' prices, triggering more margin calls and more defaults. Massive losses piled up at places like Citigroup, Countrywide, Merrill Lynch and Morgan Stanley, and cascaded back into the insurance companies. At the end of February, the huge insurer American International Group reported the largest quarterly loss, $5 billion, since the company started in 1919.

After some delay, the Federal Reserve Board last summer started lowering interest rates on loans to the banks. But in a phrase from the bank crisis of the 1930s, it was like "pushing on a string." The bankers' problem was not that money was too expensive to lend out; it was that they were afraid they wouldn't get their money back. When they did lend, they jacked up the rates to compensate for the higher perceived risks--even to solid customers. The Port Authority of New York and New Jersey suddenly had to borrow money at 20 percent. The State of Pennsylvania couldn't finance its college student loan program. Fannie Mae, the fund created by the federal government to support perfectly sound middle-class housing, struggled to sell its bonds.

In mid-March, after anguished discussions between Federal Reserve officials and Wall Street moguls, the Fed agreed to provide $400 billion in new cash loans to banks and investment firms. Days later came the shock of eighty-five-year-old Bear Stearns going belly up. In an unprecedented deal, the Fed immediately lent JPMorgan Chase the money to buy Bear Stearns, taking suspect mortgage-backed paper as collateral. Bear's stockholders had already taken a hosing when the stock crashed. The big winners were the company's creditors and insurers, who were saved from the consequences of their bad business judgment.

We are now staring into the abyss. The Bear Stearns bailout has created a presumption of a safety net under any major stockbroker, in addition to any major bank. Rumors are that Lehman Brothers and Citigroup may be next. The Fed could handle a Lehman crash. But the collapse of Citigroup, the world's largest bank, would be catastrophic, bankrupting businesses, other banks and consumers and cutting off credit for state and local governments. And it could stretch the Fed to the limit of its resources.

There is a widespread assumption that there is no bottom to the pockets of the Federal Reserve. Not quite. The Fed has a finite amount of actual assets--mostly Treasury obligations backed by the "full faith and credit" of the government, which is a commitment to raise taxes if necessary to pay the debt. These assets total about $800 billion, some $400 billion of which have been obligated to back up loans. If the loans default, the Fed has to sell the Treasury notes in order to settle. If there are enough of these failures, the Fed could exhaust its assets. It would then have to resort to really "printing money"--issuing promissory notes not backed up by anything--or get bailed out by the Treasury, putting taxpayers further in the hole. Long before the Fed is down to the last of its stash of Treasury notes, more skittish domestic and foreign investors will flee the dollar. Interest rates would balloon and prices of oil and other imports would skyrocket. Credit would freeze, investment would plummet and tens of millions of Americans would be out on the street, with neither a job nor a roof over their heads.

Unlikely? Yes, still. Unthinkable? Not anymore. Estimates of Wall Street's losses already run well up to $500 billion. A 20 percent drop in housing prices would translate into a $4 trillion drop in the value of housing assets. A large chunk of that loss would destroy the value that underlies the mortgage-backed securities the Fed has now agreed to guarantee.

But well short of such a worst-case scenario, the country seems headed for major economic damage that will severely test whatever we have left of safety nets. It took five years from the time the recovery began in 1983 for the unemployment rate to return to pre-recession levels. Once we reach the bottom of this trough, it could be a very long time before American consumers, whose spending accounts for some 70 percent of our economy, crawl out of the debt hole and back into the shopping mall. The Japanese have still not recovered from their similar housing/debt crash in the early 1990s.

Virtually everyone who has studied Japan in the 1990s and the United States in the 1930s concludes that in both cases the government acted too late with too little in order to stop the debt dominoes from tumbling through the entire economy.

But the American political system seems as seized up as the credit markets. As the Federal Reserve tries desperately to put an overdosed Wall Street on life support, President Bush remains dizzily detached, periodically repeating his moronic mantra against government intervention in the free market. At a press conference that is impossible to parody, Treasury Secretary Henry Paulson announced the Administration "plan" to safeguard the nation against a future crisis. It boiled down to a hope that the finance industry would do a better job of policing itself and that individual states would see to any new laws that might be needed. In what the New York Times dryly reported were his "most extensive comments to date about the credit and market problems," Paulson, formerly co-chair of the investment firm Goldman Sachs, firmly told reporters that he was not interested in finding "scapegoats." No kidding.

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