The financial crisis that began in 2007 has been marked by muddled thinking and haphazard policy making. Now, the U.S. Treasury is headed for a mistake of catastrophic proportions by refusing to bail out America's Big Three automakers.

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

Proponents of a bailout for the Big Three have emphasized the enormous job losses associated with a bankruptcy scenario, including not only jobs directly provided by the auto makers, but also jobs with parts suppliers, auto dealers and in the transport and advertising industries.

These job losses would then be multiplied locally and nationally. Lost wages would reduce consumption, causing additional job cuts, while factory closures would reduce investment, hitting employment in capital goods industries. Lost incomes would also drive down tax revenues, resulting in public-sector employment cutbacks.

Moreover, the automakers are essential for closing the trade deficit, and their demise could bring another surge in imports. The automakers are the backbone of American manufacturing, driving advances in manufacturing technology that will be needed if America is to be a world leader in the coming "green" revolution. Additionally, the Big Three are vital to national security, supplying important military transportation assets. Lastly, bankruptcy would impose massive costs on the government's Pension Benefit Guaranty Corp., further worsening the fiscal outlook.

All of this is true. But missing from this array of arguments is the damage a bankruptcy of the Big Three would do to financial markets. In one fell swoop, the hard-won gains in stabilizing the financial system would 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. If they go bankrupt, the insurance industry would quickly enter a spiral of collapse. Pension funds would be hit, imposing further costs on the pension corporation.

But the greatest damage may come from the credit default swaps market that brought down AIG. 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 would bankrupt other companies, 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 bringing back to the surface the worst of the conservative economic thought that got America and the world into this mess in the first place. The opposition of the Federal Reserve and Treasury to hands-on intervention meant that they were slow to understand that merely ring-fencing the commercial banks could not save the financial system. Now, they are failing to understand the financial significance of the Big Three.

Conservative animus toward trade unions is also on display. But 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.

Another conservative accusation is that a bailout would infringe free-trade rules. But it is these rules that have fostered the trade deficits that have destabilized and undermined the American economy. The reality is that world trade would suffer far greater damage from the global economic fallout of a Big Three bankruptcy.

Lastly, conservatives have trotted out the old moral hazard story in order to argue that a bailout would turn American manufacturing into a permanent beggar of government funds. In fact, business has always lobbied Congress for favors and tax breaks, and the Lehman Brothers experience proved the foolishness of confusing parables about moral hazard with crisis management.

There are colossal problems in Detroit, and the bosses of the Big Three automakers could never be convicted of an excess of imagination. Economic policy has also contributed to their current condition as trade agreements and an over-valued dollar promoted auto imports, and incoherent energy and environmental policy stifled innovation.

All of this must be fixed. But sacrificing the Big Three would accomplish nothing while risking a tragic economic depression.