By Thomas I. Palley
Special to Press Associates

DETROIT (PAI) - Bankruptcy of the nation's Detroit-based "Big Three" automakers - who aren't as big as they used to be - poses a fundamental threat to the U.S. financial system's viability. That means funds from the $700 billion bank bailout law, called TARP money, can legitimately be allocated to the auto companies.

The question will come up again, because congressional Democrats, finding that the car company execs had no good plan for how to use the cash, sent them away to construct viable rescue plans for their firms - and told them to come back with the blueprints at the beginning of December.

But even if Congress agrees to allot money to rescue the firms - and, more importantly, their workers - congressional GOP opposition and the GOP Bush regime Treasury's opposition to the bailout is a monumental blunder. It is absolutely critical that the Big Three get help as quickly as possible.

The financial crisis that began in 2007 has been persistently marked by clouded thinking and haphazard policy making. Now, the Treasury is headed for a mistake of historic proportions with its refusal to bail out the Big Three automakers.

Make no mistake, if Detroit's Big Three go bankrupt, the perfect storm really will have arrived with a collapse in both the real economy and the financial sector. This financial threat means the TARP bailout funds authorized by Congress can legitimately be used to support the automakers. Treasury's refusal risks a general meltdown, the consequences of which will extend far beyond America's shores.

Proponents of a Big Three bailout, including the United Auto Workers, have emphasized the enormous job losses associated with a bankruptcy scenario. Those include jobs directly provided by the automakers, as well as jobs with parts suppliers, auto dealers, and the car transportation industry.

They also could include job losses among unionized workers in industries that supply raw materials that go into cars. Those raw materials include steel, rubber, plastic and - for consumption - oil.

These job losses will then be multiplied locally and nationally. Lost wages will reduce consumption, causing additional job cuts, while factory closures will reduce investment, thus hurting employment in capital goods industries. Lost incomes will also cause lower tax revenues, resulting in public sector employment cutbacks.

Other arguments for a bailout are that the automakers are essential for closing the U.S. trade deficit, and their demise could see another surge in imports. The automakers are also the backbone of American manufacturing, driving advances in manufacturing technology and they are needed if America is to be a world leader in the coming "green" transportation revolution.

Additionally, the Big Three are vital to national security, supplying important military transportation assets. Lastly, bankruptcy will impose massive costs on the government's Pension Benefit Guaranty Corporation (PBGC), further worsening the fiscal outlook.

All of this is true. But missing from this array of arguments is the damage Big Three bankruptcy will do to financial markets. In one fell swoop, the hard-won gains to stabilize the financial system will be blown away.

The Big Three and their auto finance associates (such as GMAC) are huge debtors whose liabilities are held throughout the financial system. The auto firms told Congress they have been talking to Treasury about financing for GMAC, Ford Motor Credit and Chrysler's financing arm, but have gotten nowhere.

If the car companies and their finance subsidiaries go bankrupt, the insurance industry will quickly enter a spiral of collapse as it is likely a large holder of these debts. Pension funds will also be hit, imposing further costs on the PBGC.

However, the greatest damage risks coming from the credit default swaps (CDS) market that brought down American International General, the huge insurer that is now virtually owned by the federal government. Huge bets have undoubtedly been placed on the bonds of GM, Ford, Chrysler, and GMAC, and bankruptcy will be a CDS "triggering event" requiring repayment of these bonds.

Moreover, a Big Three bankruptcy will bankrupt other firms, risking a cascade of financial damage as their bonds and equities fall in value and further CDS events are triggered. This is the nightmare outcome that risks replicating the Crash of 1929.

Opposition to the bailout is surfacing the worst of conservative economics that has already got us in this mess. Federal Reserve and Treasury opposition to hands-on intervention meant they were slow to understand the financial system could not be saved by just ring-fencing the commercial banks. Now, they are failing to understand the systemic financial significance of the Big Three.

Conservative hatred of unions is also on display, when it is union weakness that has caused wages to stagnate and forced America to rely on debt and asset price inflation as the engines of growth. Instead, the conservatives are demanding the UAW slash its members' wages and benefits to unrealistically low levels - even after the union and the car companies have already agreed on a two-tier wage-and-benefit system that significantly slams new workers.

Another conservative charge is a bailout would infringe "free trade" rules, but it is these rules that have fostered the trade deficits that destabilized and undermined the American economy - and the car companies. UAW President Ron Gettelfinger made that point in his congressional testimony. The reality is world trade will suffer far greater damage from the global economic fallout of a Big Three bankruptcy.

There's at least one Republican, Tennessee Sen. Bob Corker, who questions the need for three U.S. auto firms. How do we know the others in the GOP even want auto companies to survive?

Lastly, that old conservative favorite of moral hazard is again on display, with claims that American manufacturing will become a permanent beggar of government funds. The fact is business always lobbies Congress for favors and tax breaks, and the Lehman Brothers' experience should have taught the foolishness of mixing moral hazard parables with crisis management.

There are undoubtedly colossal problems in Detroit, and the Big Three could never be convicted of an excess of imagination. But "free trade" economic policy has also contributed to their current condition through trade agreements and an over-valued dollar that have promoted auto imports, as Gettelfinger pointed out to Congress. The car companies did not.

All of this must be fixed. But sacrificing the Big Three will accomplish none of this and risks the real prospect of an economic depression.

(The author is the former chief economist of the AFL-CIO and former chief economist of the U.S.-China Commission).