When Hank Paulson’s bailout bill tanked yesterday traders sold off US in a panic of epic proportions.

But Martin Hutchinson says the failure of the bill is a blessing for the economy. Propping up a rotten system will only reward failure and block creative innovation.

The worst case scenario now is that we’ll see the Dow slump to 5,000 points. This makes a defensive portfolio a must. Martin recommends invest in counter-market plays such as the SPDR Gold Trust ETF (NYSE:GLD) or the Rydex Inverse Gov Long Bond Strategy C (MUTF:RYJCX).

This from Money Morning:

At this point, it sure looks as if we can thank the good sense of the U.S. House of Representatives, and hope against hope that it will adjourn for electioneering without passing this legislation – or anything else that’s anything like it.

Back in December 1929, then-U.S. Treasury Secretary Andrew W. Mellon – one of the greatest to serve in that role, and the only treasury secretary to serve under three U.S. presidents – announced that the problem of the Wall Street crash could be met by liquidation: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate… purge the rottenness out of the system.”

The opposite path was taken by President Herbert Hoover with his Reconstruction Finance Corp. (RFC) – to a notably more unhappy result – just as the opposite path was chosen by Paulson and his acolytes. Borrowing $700 billion to invest in mortgage paper that has shown itself to be virtually worthless; it just reinforces failure and starves success of the capital it needs, which is the exact opposite of the recipe for success in a free market system.

The great Austrian economist Joseph Schumpeter said that capitalism was a process of “creative destruction.” You cannot have the one without the other, so pouring money down a rat-hole to prevent further destruction will kill creativity and turn the economy into a Soviet-style mess.

As for the stock market, it is becoming increasingly clear that it has been suspended for the last decade at an artificially high level by the immense bubble of cheap money created by Federal Reserve chairmen Alan Greenspan and Bernanke since 1995. U.S. stocks, therefore, were poised for a drop, to an equilibrium level that could be as low as 7,500 on the Dow (I arrived at that potential nadir by measuring from early 1995, and calculating based upon a belief that stock prices should increase approximately in line with gross domestic product, or GDP), or even 5,000, should the market’s “animal spirits” find themselves to be exceptionally depressed.

Yesterday’s sharp drop could mark the beginnings of a realization by the market that the world has changed since 2006, that the subprime mortgages and securitized assets it thought so solid in 2006 were speculative toys, or outright junk, and that a world of lower asset prices can still be a world of increasing incomes and economic growth.

Once stock prices are so low that stocks yielding 6% can be found everywhere, the U.S. middle classes will once again begin saving and investing in stocks. Only then will the U.S. payments deficit disappear (because imports will no longer be artificially inflated) and the funding problems of government will become manageable.

This will bring about other benefits. New-growth businesses in the U.S. economy will find funding from domestic savings, something that’s non-existent right now. Emerging markets will have higher costs of capital than the United States, because of their smaller capital bases in a world of scarcer money, so that outsourcing jobs and investments to them will take place only when there is a true comparative advantage in the poorer country, including proper recognition of the higher costs of capital there.

As I discussed last week, the optimal current investment strategy is a defensive one, with inverse Treasury bond funds (such as the Rydex Juno Inverse Government Long Bond Fund (RYJCX)), some gold, and maybe some other carefully chosen counter-market plays.

However, the failure of the bailout package, if it persists without a “rescue,” has made the moment when optimism returns considerably closer. For that we can be thankful.

Source: Although the Bailout Bill Was Rejected, It’s No Time to Panic