A big bang clean up, why didn't anyone think of it before?

The new Obama administration is preparing for a "big bang" financial clean up. Everything will be sorted out in one go; unmerited bonuses, toxic loans, undercapitalized banks and foreclosures. The hope is that after the big clean up, banks will be back in business, lending money, taking deposits and generally boosting economic growth.

The architects behind this plan hope that it will compare favourably to the lethargic response of the Bush administration and its discredited treasury secretary - Hank Paulson. Yet contrary to popular perceptions, the Bush administration was not made up of stupid people. So why didn't Paulson and the US Treasury put together a similar rapid response plan?

There are two answers to this question. First, there is the thorny matter of burden sharing. The "big bang" clean up plan will pile all the costs onto the taxpayer. It will be one huge unmerited and extremely expensive gift to the banks and their shareholders.

Paulson understood this and tried to limit the fiscal costs of the bailout. He knew that banks would exaggerate their difficulties and try to dump every dubious loan onto the taxpayer. He also recognized that once the banks got their hands on public money, other industries would immediately produce a similar begging bowl. He was, of course, right about that.

The second reason was the magnitude of the clean up costs. Once US treasury bondholders begin to comprehend the cost of a one-sided and over-generous bailout, they will begin to question US long run fiscal sustainability. Eventually, the risk of financing a huge fiscal shortfall will be priced into long run treasury yields. This would lead to a self-defeating cycle of higher interest rates, lower investment and consumption and ultimately lower economic growth.

A big bang financial clean up might seem a good idea right now, but just wait until bondholders and taxpayers see the price tag. Paulson understood the dangers of a hasty and ill-considered bailout. He knew that it would mean handing over the US treasury to the banking system. He also understand that if the banks took control of the process, the US economy would suffer the consequences for generations.