Secretary of the Treasury Hank Paulson (WDCpix)

The $700-billion financial-reconstruction package passed by Congress and signed into law last week is a key element in the stabilization of the U.S. financial crisis. But it has become a tremendous political problem. As have similar programs proposed in Ireland and Germany to deal with the increasingly dire state of European banks, many of which have substantial cross-border interests and activities.

These plans are all discussed in emotive terms: not a relief program, but a bailout. At stake are not troubled assets, but toxic assets. The transformation of financial tonic into a political toxin recalls not the well-managed Scandinavian rescue operations of the 1990s but some of the most tumultuous scenes from bank rescues in Europe in the 1930s.

Illustration by: Matt Mahurin

The current U.S. package has clearly become a captive of the the presidential and the congressional elections.

Had they signed on to the original plan of the Bush administration, which they were campaigning against, Democrats would have discredited their claim that the administration helped create the country’s financial crisis. So they needed to add measures to the plan that would give it a different look–and then trumpet it as a Democratic achievement. That’s precisely what House Speaker Nancy Pelosi (D-Calif.) did in introducing the bill Sept. 29.

On the other side, Republicans had a tough time accepting the massive government intervention that would be put into motion by the reconstruction package. Their fervor was fanned by the law’s overwhelming unpopularity among the public.

The result: The initial bill went down to defeat on what turned out to be Congress’ Black Monday.

This transformation of a financial tonic into a political toxin is not new.

President Herbert Hoover’s Reconstruction Finance Corp. of 1932 is now widely touted as a model for a government-support mechanism. It lent money to state and local governments, as well as to businesses, farms and banks, when other sources of financing had dried up. But it quickly became obvious that the money’s distribution was a payback to supporters of the government. The scheme became a huge political kickball.

During the Great Depression in Europe, financial bailouts were far larger and had far more disturbing consequences.

Chancellor Heinrich Bruening presided over Germany's bailout in 1931. (Wikimedia)

Faced by a complete meltdown of the German banking system in the summer of 1931, the government of the Weimar Republic acted swiftly to manage the crisis. In retrospect, the strategy looks quite innovative. Indeed, many of its ideas echo those put forth just last week to relieve the current financial crisis in the U.S.

Here’s what the German government did.

First, it reorganized the banks, merging the country’s two weakest banks and injected public money into all of them. Initially, the government had sought private financial help as well; there were intense negotiations with the leading figures of the powerful Rhine-Ruhr steel lobby.

But the country’s business leaders agreed to participate in the rescue plan only if the Weimar government kicked in more public funds and advanced them the money that they were supposed to invest in the recapitalization of the banks. Before Adolf Hitler came to power in 1932, the public owned large stakes in Germany’s banks.

Second, the central bank pushed for the creation of an institution that would allow it to discount bills from banks that could not be traded because the interbank market had stopped operating.

Finally, in December 1932, the government created a “bad bank,” to use Wall Street’s coinage, to take on its books all the financial system’s troubled assets that had no market and whose price was far below their par value. To secure the help of the “bad bank,” financial institutions had to show that “important economic interests” were at stake and that state funds had been used to support strategically vital enterprises.

The Weimar government’s financial rescue package opened the way for a huge — and hugely unpopular — bailout of Flick steel on Chancellor Heinrich Brüning’s last day in office.

And, politically, it led to the charge that the government was engaging in the “socialization of losses” to benefit a privileged elite, a charge that became a central element of the turbulent electoral campaigns of 1932.

A similar–though more expensive and extensive–bailout in Austria produced equally crippling effects. The collapse of the Creditanstalt in May 1931 triggered the wider financial collapse in Europe, and the government’s answer was to take over the bank and eventually merge it with other weakened Austrian banks.

The government subsidy amounted to 9 percent to 10 percent of Austria’s gross national product, an amount comparable to the projected costs of the U.S. government’s bailout of the financial system. Because the Creditanstalt held major stakes in most large Austrian firms, the government’s takeover of the bank meant that it was, in effect, running most of Austria’s businesses.

The bailout was accompanied by massive corruption, the revelation of which became the stock-in-trade of the opposition Nazi movement in Austria.

The political costs of these bailouts — even when they seemed to have been implemented promptly and with high efficiency, as in the German case — exceeded the simple fiscal arithmetic. They injected the state into micro-level decision-making–on the health of particular enterprises and on the fate of individual bank directors, for example–that was bound to be contentious.

But there was a far more dangerous consequence of the German and Austrian governments’ responses to their respective banking crises: They fanned the poisonous ideological anti-Semitism then current in 1930s Central Europe. In Germany and, more explicitly, in Austria, “aryanization,” first called “Germanization” or “Austrianization,” had set in even before the Nazis took power in the two countries, and they bailouts played right into it.

In retrospect, Germany’s and Austria’s attempts to manage bank failures look like the catalyst of state domination, corruption and even racial persecution that would combine to form an ever more menacing force in the world.

There is a clear policy lesson to be gleaned from this terrible and extreme history.

First, financial bailouts need to be depoliticized as much as possible.

Second, this can best be achieved by formulating financial relief packages in general terms — such as raising the amount of bank deposits covered by the Federal Deposit Insurance Corp. — and not as assistance targeted to specific institutions that are politically or economically sensitive.

We should also remember that, however hard the contours of the bailout are in a national political context, the difficulties are greatly magnified when they relate cross borders. For this reason, an American rescue is a piece of cake compared to a European one.

Harold James, a professor of history and international affairs at Princeton University, is the author of “The German Slump: Politics and Economics 1924-1936″ and “The Nazi Dictatorship and the Deutsche Bank”

Inflation in the Weimar Republic made it cheaper for this woman to burn money than firewood. (AdsD der Friedrich-Ebert-Stiftun)

Twentieth-century economic history generated two great bogeymen: the Great Inflation and the Great Depression. The memory of both continues to haunt policy-makers.

Only a few years ago, the talk was about the dangers of a world trapped in deflation by the addition of ever more efficient producers in the poor economies of Latin America and Asia.

Illustration by: Matt Mahurin

Today, the dramatic growth of those producers has pushed up energy and food prices, and economists now worry about world inflation. At the same time, America is anxious about dependence on inflows of foreign investments – whether as Chinese or Japanese central bank purchases of government securities, or controversial purchases of financial institutions by sovereign wealth funds.

These modern anxieties about inflation and dependence on foreign money have a frightening historical parallel in the early 20th century.

These modern anxieties about inflation and dependence on foreign money have a frightening historical parallel in the early 20th century.

The world’s most dramatic and most famous inflationary experience of the 20th century was Germany after World War I — though other central European countries had similar experiences. By November 1923, the German currency, the Mark, had fallen to one trillionth (1/10 12 ) of its pre-war value.

In the last stages of inflation, prices changed several times a day. Shopkeepers followed the foreign exchange rates, and immediately adjusted their charges. Vast amounts of paper money were needed to make even the smallest purchases. Instead of purses, people used first baskets and then wheelbarrows to carry their money.

Ultimately, inflation destroyed German savings, and made the economy of the unstable democratic Weimar Republic vulnerable to yet more shocks. It also had a dramatic effect on popular and political psychology.

The constant alteration of prices, the dramatic story of fortunes made and lost through speculation, made ordinary Germans vulnerable and neurotic. Because it played into old established clichés about Jewish dominance of finance, the inflationary uncertainty fueled anti-Semitism. Later on, some shrewd observers, like the scientist and writer Elias Canetti, concluded that the Great Inflation made the Holocaust possible — by creating a world in which large numbers seemed unreal and incomprehensible. Bureaucrats simply wrote down impossibly big sums without thinking of the human consequences.

The German postwar inflation and hyper-inflation of the 1920s had two fundamental causes: a low savings rate, and bad monetary and fiscal policy. One consequence of World War I was an erosion of incomes, and a dramatically reduced savings rate. But at the same time, at least for a while, Germans were able to sustain their living standard, and run large trade deficits.

They had this luxury because investors from around the globe bought German assets: currency, securities, real estate. British and American investors were gambling on a German recovery. After all, before 1914, Germany had been, with the United States, one of the world’s two strongest economies.

Only at a relatively late stage in the story of the German inflation, in the summer of 1922, did foreigners begin to realize that Germany was unlikely to be able to pay all its debts — including the financial reparations that the Allies demanded under the 1919 Versailles Treaty.

In the summer of 1922, the assassination of Foreign Minister Walther Rathenau underlined the political instability of the Weimar Republic. From that moment, foreigners no longer wanted to buy German assets. The big capital flow of the earlier period came to a stop. The Mark went into a free fall.

The second driving force of the inflation was the policy of the German government and the German central bank. Both were sensitive to political considerations. Both worried that rising unemployment might destabilize the precarious political order. So they were willing to do anything in fiscal and monetary policy to counteract economic slowdown. The government ran large budget deficits as it tried to keep up employment in the state-owned railroad and postal systems, and also to generate more purchasing power. It kept on looking for new ways to administer repeated fiscal stimuli.

Equally significant, the president of the central bank, an elderly Prussian bureaucrat called Rudolf Havenstein, boasted about his success in getting new printing plants (132 factories, as well as the bank’s own facilities), printing plate manufacturers (29) and paper factories (30) to meet the enormous demand for new money. He found more and more ingenious ways of stimulating bank lending to large businesses on ever more dubious securities. And he kept on saying that keeping the money presses rolling was a patriotic duty.

There was, in short, what would now be called a “Havenstein put” — in which the central bank would keep its interest rate at levels sufficiently low so that German business could continue to expand.

The United States today is clearly a different economy and society than Weimar Germany. But the same kinds of forces that blew up Weimar’s money are threatening.

First, there are persistently low savings rates, declining steadily since the 1970s. This is matched by higher rates of savings in fast-growing Asian economies and in Middle Eastern oil producing countries. The combination has produced a structural dependence on foreign capital inflows, and over recent years foreign investors have seen the U.S. as a good buying opportunity. There is a gigantic sucking sound of money flowing in. The United States accounts for about three-quarters of the world’s net capital inflows.

Second, the U.S. policy environment is extremely sensitive to downturns. American society was traumatized by the other 20th-century bogeyman — the sustained depression of the 1930s. We are deeply worried about recession and unemployment. We are even more obsessed with the fear that financial assets in housing or securities might be lost.

So far, as in Germany before the summer of 1922, there is not too much worry about rising inflation, because we think that foreigners will continue to keep us in the money. Like Germany then, the United States is a powerful industrial economy and there are plenty of reasons why it should attract inflows.

But we are, in consequence, vulnerable to a swing in expectations. If that took place, we might be closer to Weimar than we can ever imagine.

Harold James, a professor of history and international affairs at Princeton University, is the author of “The German Slump: Politics and Economics 1924-1936″ and “The Nazi Dictatorship and the Deutsche Bank”