The economy will plunge, despite the AIG rescue

It may have left interest rates on hold last night, but the Federal Reserve isn't done dishing out money.

Just days after leaving Lehman Brothers to collapse, the Fed has ditched its concerns about moral hazard and stepped in to bail out insurance giant AIG, to the tune of $85bn.

We can't say we're surprised. While workers at Lehman might feel somewhat aggrieved, it seems the Fed decided that AIG really was too big to fail. "A disorderly failure of AIG could add to already significant levels of financial market fragility."

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So what's happened and what does this mean for the wider economy?

The Fed's decision to bail out AIG after apparently drawing a line under bail-outs with Lehman Brothers shows just how much more important it was to the financial system. The problem with letting AIG collapse is that the group's tentacles reach everywhere.

An update on the problems with exchange-traded commodities

On that point, before we go any further, one place where AIG exposure has cropped up was in ETF Securities, where yesterday trading was halted in a large number of the company's exchange traded commodities (ETCs). The ETFs backed by physical assets, including ETFS Physical Gold (LON:PHGP), and ETFS Silver (LON:SLVR) are fine, as are the oil securities backed by Shell. However, the securities based on futures contracts, including short securities such as the Short Oil (SOIL) ETF and agricultural securities are backed by AIG.

ETF Securities says that AIG has continued to fulfil all its obligations to the group. At the time of writing, trading in the affected ETFs is still suspended, though I spoke to the company earlier this morning and it did say that the AIG bail-out was "good news". In a further update it has now said that it remains in talks with its "market makers and the Exchanges" to "ensure that trading can resume and/or continue in an orderly fashion as soon as possible." We'll be bringing you more on this as and when we get it. Some of my own portfolio is in the affected assets, so you can be sure I'll be keeping a close eye on it.

What does the AIG bail-out mean for the wider economy?

It just goes to show how rapidly the threat to one company can spread in these interconnected markets. So does the Fed bail-out which involved AIG giving up a near-80% stake to the government, and cost the jobs of many senior managers, including chief executive Robert Willumstad draw a line under the credit crunch?

It doesn't seem likely to me. The markets will certainly be relieved that the Fed has stepped in to save AIG. As my colleague David Stevenson pointed out yesterday (Lehman won't be the last domino to topple is AIG next?) there was a lot more than the future design of Manchester United's football shirts at stake.

Yet it makes it much harder for the US authorities to justify their tough stance on other industries. Although AIG's woes were ultimately caused by its exposure to sub-prime mortgages, ordinary people aren't going to see it that way. Particularly when John McCain, for example, is whipping up populist support by arguing that taxpayers are saving Wall Street, while blue-collar industries like car manufacturing are being left to go begging.

McCain has a point. But the trouble is that now as Will Self pointed out in the Evening Standard yesterday even as Wall Street and the City collapses in on themselves, it's the "little people" who will suffer anyway. Every chief executive who walks away from a troubled bank has millions of dollars to cushion their bruised egos.

The administrative staff at Lehman Brothers aren't so fortunate. They'll be leaving their jobs (and might not even get paid a penny in outstanding wages), only to face a job market where the number of positions is falling even as the number of people chasing them is rising.

And this is why the idea that the fall-out from the financial economy won't have such a big impact on the real economy, is so ridiculous. In Britain, the real economy pretty much IS the financial economy. Most of our spending power has been built on rising house prices, which have been facilitated by ever easier credit flowing from the global financial markets. That supply of credit has been brutally shut down, and regardless of what the Fed, the Bank of England and the European Central Bank do to interest rates, or special liquidity schemes, or whatever, it's not going to open for business again any time soon.

The staff at Lehman Brothers have our sympathies but they are far from being the last to suffer in this crisis.

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