The Paulson rescue plan looks massive at first glance — US$700 billion of government money will be spent buying the shonky bonds that Wall Street sold to Main Street (and foolishly also kept on its books, hence the effective extinction of US merchant banks in the last month). Surely that will bring the crisis to a halt?

If only. While $700 billion sounds like big bikkies, it’s chicken feed compared to the scale of outstanding private debt in the USA of $41 trillion. Some of that is legitimate debt-money borrowed to finance production rather than speculation, and lots of it has gone “up in smoke” in the subprime meltdown; but what is left still dwarfs the size of this rescue.

And there’s the rub. While the rescue might keep what’s left of Wall Street solvent, and could provide a boost to Main Street’s economy, it will be dwarfed as the Great De-leveraging begins, as American families and corporations, by choice or by bankruptcy, start reducing their debts rather than piling them forever higher.

That has already begun. In September of 2007, private debt was growing at a rate of $4.75 trillion a year; nine months later, that growth rate had dropped to $1.8 trillion. That represents almost a US$3 trillion reduction in demand, which is a large part of the reason that US asset markets have tanked, and the real economy is moving rapidly into recession.

Some “back of the envelope” calculations I’ve done imply that, even if the rescue package totalled $2 trillion, and even if it were financed entirely by printing money (rather than selling newly minted Treasuries), the best it could do would be to boost aggregate demand by 5%. But the collapse in private borrowing could cut aggregate demand by 30%.

The beneficial impact would be negligible if, as is almost 100% certain, the “rescue” were funded by selling Treasuries to the public-Michael West’s column on this in yesterday’s SMH was spot-on.

So this rescue won’t bail out the Ship of Fools, but it will make the American Ship of State even more insolvent than it already is. Aggregate US government debt is now running at 92% of GDP (the Federal component is 53%), and another $700 billion will push it closer to 100%. As Michael West concluded yesterday with profound understatement, “America is in trouble”.