The bailout.

THREE YEARS AGO it was a cloud no bigger than a man's hand. Now, excepting World War II, the S&L bailout may be the most expensive federal undertaking in history: a $550billion transfer of income from ninety million hard-pressed taxpayers to a few million middle- and upper-class S&L depositors.

The seeds of the debacle were planted during the Carter Administration. The characteristic S&L risk-borrowing short while lending long-became life-threatening only after inflation exploded during the late Seventies. As inflation mounted, S&Ls lost deposits to higher-yielding money-market funds, most of them uninsured and unregulated. At the same time, S&L loan portfolios, consisting primarily of fixed-rate mortgages, plunged in value.

Had inflation been subdued, interest rates would have fallen and the S&L industry would have survived without the regulatory changes that eventually proved to be its undoing. But macroeconomics was not the Carter Administration's strong suit. Instead the government responded in 1980 by phasing out the Regulation Q interest-rate ceilings, allowing S&Ls to offer depositors market interest rates.

With the liability side of their balance sheets deregulated, but with their assets still restricted to home mortgages, S&Ls continued to go belly-up. So in 1982 the Garn-St Germain bill deregulated the asset side, allowing S&Ls to invest in a wide spectrum of speculative, tax-driven projects.

The damage might have been contained but for another unwise move during the Carter Administration's last year: the increase in the federal deposit insurance limit from $40,000 to $100,000. This attracted more deposits than the S&L system could reasonably invest, setting the stage for the con artists that eventually killed much of it.

Not that deposit insurance is inherently bad. In principle it can be privatized, with premiums varying according to the risk involved, much like auto or theft insurance. Such insurance would be quickly terminated whenever, in the eyes of the insurer, the risk became excessive.

The problem with federal deposit insurance is that premiums are the same for all lenders, conservative and high flier alike. As a result, incompetent S&L managers, engaging in the most irresponsible investment strategies, are being subsidized by risk-averse professionals. This subsidy also creates perverse incentives for depositors, who are induced to shift funds out of healthy S&Ls to the riskier institutions which typically offer higher rates. Subsidized insurance allows both the institutions and their depositors to play the "heads I win, tails you lose" game.

Unfortunately, in pounding out the bailout bill last summer Congress paid obsessive attention to whether the costs should be on- or off-budget, to capital requirements, and to junk bonds. Federal deposit insurance was, ominously, untouched.