Wall Street did not get to the beach this August, and the guys in good suits are looking rather pale. I don’t expect this financial crisis to turn into “the big one,” a total unraveling that makes the history books. But nobody knows, and that’s what makes it scary. In the past few weeks the magical computer programs that tell hedge funds and brokerages when to buy and sell stocks, bonds or more exotic financial instruments failed. And they took a lot of smart money right over the cliff, accompanied by some prestigious names. Bear Stearns had to shut down two imploding hedge funds. Goldman Sachs had to rustle up $3 billion to keep one of its hedge funds from collapse. Kohlberg Kravis Roberts (KKR), the notorious takeover firm that has cannibalized so many corporations, experienced similar embarrassment.

When the big boys get blindsided, it rightly scares the crap out of lesser players, who rush for the door but can’t get out. First they try to dump their fishy-smelling mortgage securities, but nobody will buy them. Then they decide to raise cash by selling some of their good paper. Nobody will buy this either. For the moment, sophisticated, overconfident financiers have lost confidence because they cannot calculate the value of their own product.

It is the oldest story in financial markets, the tug-of-war between fear and greed–and once again, fear is winning. This crisis is one more flashpoint reminding us that the country’s economic well-being is held hostage by the “modern” financial system, with its fallible computer models and extreme oscillations between excess and panic. Our dependence started with financial deregulation twenty-five years ago, but the dangers have grown steadily larger, still unaddressed by the political system.

Saturnino Fanlo, the chief executive who supervises KKR’s embattled financial fund, made a revealing comment to the New York Times on August 16. Fanlo said he has been through many financial crises, and “this is the most disturbing liquidity crisis, with real impact throughout the economy if it does not rectify.” How many times must we flirt with “the big one” before it finally arrives?

Our vulnerability is embedded in the new illusions created by the deregulated system. Basically, skeptical bankers overseeing loans were replaced with computer models. The abstracted market analysis knows how to crunch the numbers for the new financial instruments but is not so good at knowing the value of the underlying assets the “paper” stands for. The players who originally make the loans escape personal liability by bundling dubious mortgages into bonds and then selling them to financial markets. The downstream investors who buy these mortgage securities never see the houses or the homebuyers who borrow the money. The investors figure that if something goes wrong, they can always sell the paper to the next fool. Just in case, investors and financial firms purchase hedging “derivatives” from the banks, which supposedly protect them against risk. But derivatives are another financial time bomb. Nobody knows whether these gimmicks will actually work, especially when everyone is trying at once to collect on them. In a storm of defaulting loans, the flood of cross-claims could bring down the banking system.

The nation’s greater risk is that Wall Street’s gyrating hope and fear will end up poisoning the larger economy. The Fed has held credit tight for more than a year, but despite its official claims, the economy is not “robust” for ordinary people, only for capital and corporate profits. For months, the economic numbers for employment, incomes and consumption have been quite soggy. The CEO of Wal-Mart explained why his sales are down: “Many customers are running out of money at the end of the month.” Did anyone in Washington hear that?

Given Wall Street’s panic, business and consumers will naturally be more cautious about new deals, purchases and borrowing–the correct behavior for them. Unfortunately, it’s the wrong medicine for the economy, which is profoundly unbalanced in old-fashioned ways: Wages and salaries have fallen steadily as a share of GDP, while corporate profits have hit a forty-year high. The Federal Reserve and its complicity with the carefree financial markets has pushed the rewards in one direction for roughly twenty-five years, and it shows. Financial wealth soared, while consumer incomes faltered and failed to sustain people’s standard of living. As a national economy, we borrow to buy, both at home and abroad, and that elixir is losing its magic too.

Ben Bernanke, the new Fed chairman, may become the scapegoat for the crimes of his predecessor. Alan Greenspan favored capital over labor at every turn and was always oblivious to Wall Street excesses–except when the industry needed a bailout. This made the financial players more irresponsible, because they knew Greenspan would be there to save them [see Greider, “The One-Eyed Chairman,” September 19, 2005]. This time Bernanke may have been slow to act because he wanted to avoid another bailout. If so, this was a righteous position, but lousy timing. His discount-rate reduction is not enough. The Fed needs to skip the theory and act forcefully to stimulate the real economy.

In another era, the government would have responded aggressively by providing temporary relief to failing mortgage debtors and other innocent bystanders, cutting interest rates and shoring up the financial system with easy liquidity, then maybe punishing a few Wall Street rogues to show the country that irresponsible behavior would no longer be tolerated.

Given the government we have, that kind of Keynesian response seems less likely. The Fed is now loaded down with orthodox conservatives, even a few totally frothy right-wingers. Bernanke must find the nerve to dust off the regulatory powers and turn them on Wall Street. Make bankers open up their loan windows and start handing out easy credit to troubled institutions in finance and business. The Fed can clean up the mess later.

Congress should step up too and start re-regulating the financial system. I am not even sure if Democrats still understand how to do this sort of emergency stimulus, or if they still believe in it. For me, the political uncertainty is part of the potential crisis. This is a situation where the people are not going to condemn politicians for overreacting to the risks. But people will never forget a political party that failed to act in time.