Oct. 1 (Bloomberg) — Paulson versus Pelosi. Goldman versus Lehman. Obama versus McCain. Crises always alter the terms of power struggles.

Beyond the obvious contests, there's a less-discussed duel affected by the latest news. It is one between two capitals: New York and Washington. And this time, New York may well go down, with consequences for the nation that are even broader than those caused by, say, the death of Lehman Brothers Holdings Inc.

Consider the nature of the NYC-D.C. contest, essentially a federalist one. Just as Shanghai checks Beijing, Mumbai checks New Delhi and Frankfurt once checked Bonn, New York has long checked Washington. Most observers deemed the dynamic salubrious.

"New York is an imperial city," U.S. President Calvin Coolidge noted in 1925. Coolidge praised "the wisdom of the fathers in their wise dispensation which made Washington the political center and left New York to develop into its business center. They wrought mightily for freedom."

In the past decade, New York has held its own against Washington. If every hedge fund wasn't based in New York, the hedge-fund industry was still New York-like in culture. It provided evidence of what markets could do when Washington regulated less. Private-sector jobs proliferated. Crime in New York was lower than in the District of Columbia. The influence extended to the sartorial: Instead of the old florals, women in Washington began to don New York black.

Intense Mood

The political effect was also palpable. Hillary Clinton, Chuck Schumer, Al D'Amato weren't merely "D-NY" or "R-NY"; they were also "D-Wall Street" and "R-Wall Street." The anti-market mood at this hour is as intense as it has ever been. But it's worth remembering that Washington's children — Fannie Mae and Freddie Mac — have been at the center of the crisis along with the private sector.

Even before this month, the New York gladiator had weaknesses. Analyst Richard Persichetti of real-estate brokerage Grubb & Ellis Co. quantifies not only vacancies in commercial buildings but also "shadow space" and subleases — the millions of square footage New York companies lease, but find they can't themselves use. Last summer, the top 10 investment companies were holding 6 million square feet (557,418 square meters) of underused space. The shadow number, especially, was a meter of predicted growth that wasn't happening.

A budget trap also endangered New York's future. As E.J. McMahon of the Manhattan Institute's Empire Center points out, that trap was laid more than half a century ago. At a 1938 constitutional convention for the state, New York progressives determined that public-pension promises should never be "diminished" — the government couldn't renege on pensions it promised at the time of hiring.

$6 Billion

Courts interpreted that New Deal move broadly to mean that hiring someone into a certain category of public servant — right up to this day — locked New York City into paying that person the pension promised others in his category. This rule, combined with an aging workforce and other determinants, has boosted the city's annual payment into pension funds for public workers to $6 billion or so from about $1 billion in 2001.

Wall Street's very success also made the city vulnerable, for it supplied an outsized share of tax revenue. In 2006, the top 1 percent of taxpayers paid 48 percent of the income tax, up from 41 percent a decade ago and 34 percent a decade before that.

The Crash is like a second body blow after the one on Sept. 11. The offices will empty: Lehman alone represents 4 million square feet of space: 3 million occupied and 1 million in shadow or unleased offices. Persichetti predicts commercial real estate prices will drop 20 percent and sees average rents slumping.

Tax Increases

Without the tax infusions from Wall Street, the city will have trouble functioning. The inevitable increases in property, state and city levies will do their bit to discourage recovery and newcomers. Then there are the lost jobs. New York's sullied reputation will drive away yet more initial public offerings.

In a subtle way, it is the bailout package that is the greatest threat to Coolidge's "imperial city." The threat has to do with the bailout structure. There was a way for Washington to help Wall Street and spare the taxpayer, Charles Calomiris of Columbia University has argued: by sending capital to New York.

"If preferred stock had been injected, then the assets would stay in New York, and whether the banks had kept them or sold them to vulture firms, the workout process, and all the employees engaged in it, would have remained in New York," Calomiris says. The taxpayer would be spared, too, as he would be paid back before holders of common stock.

Migration to Washington

The Treasury plan to purchase troubled assets would effectively relocate financial-industry jobs, both clerical and management, to Washington. For starters, a large federal department will be needed to do the work. Private-sector financial jobs will also migrate south to be closer to their fund source and regulator. The broad discretion the Treasury plan allows in its oversight — Treasury officials will decide what companies live and die — will create a second "K" street of bailout lobbyists.

Though foreign investors are today incandescent with rage over lack of oversight, in the longer run they, too, will feel a loss if New York fades. If you don't believe this, try a thought experiment: Would India be more attractive with only New Delhi and no Mumbai?

It's natural for the world to scapegoat New York this week. There was already no love lost for New York in the hearts of many Americans, especially those in the Midwest or West. Yet all critics may want to consider that taking down New York also weakens them, by leaving Washington without opposition.

(Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

© Copyright 2008 Bloomberg