How Do We Pay For The Bailouts?

The Federal Reserve and Treasury are making a desperate attempt to prevent the kind of deflationary spiral that led to the Great Depression.  In such a spiral, creditors, coping with defaults on existing credit, refuse to lend or lend only at prohibitive interest rates . As less money flows through the system, people lose jobs and cannot spend. Others fear losing their jobs and become conservative in their spending. This reduction in spending further reduces the flow of money, resulting in further job losses.  It’s an ugly scenario.

A major focus of the prevention effort lies in purchasing the bad mortgage and credit card debt held by major banks. By exchanging bad debt for cash, the Treasury enables the banks to remain viable because their balance sheets will demonstrate cash in place of bad debt. When they are viable, the banks will resume lending. Lending will increase the flow of money through the economy, which in turn will cause a resumption of what mainstream economists refer to as “economic growth.”

It would be a good thing if these actions in fact prevent a prolonged recession or depression. But I want to briefly explain some rather disturbing consequences of what the government is doing. I’m afraid the discussion will be rather technical, but I believe that it is important for folks to understand some of the mechanics of money creation, debt, and currency valuations. So please bear with me.

Revenues from taxes do not provide the funds with which to purchase the bad debt from the banks. So the government has to borrow the money. To do so, the Treasury issues bonds. In 2009 the US government will have to find buyers for upwards of two trillion dollars in new debt.

China has been a major buyer of US Treasury securities. It had a surplus of American dollars because of its exports to the US. By exchanging the dollars it received from its exports for Treasury debt, China helped finance the US debt and, in a self-reinforcing cycle, enabled the US to continue importing China’s products.

But the reduced spending and imports by US consumers has diminished the amount of cash with which China can purchase securities. (This may explain recent slowdown in the growth of dollar- denominated debt instruments held by foreign countries.)  And now, China plans to spend over $500 billion on its own domestic  stimulus package. To finance this package, it may sell some of its dollar reserves. China may be poised to shift from being a net buyer to a net seller of US securities.

The supply-demand dynamics of the credit markets could counteract the Federal Reserve’s effort to increase money flow by lowering interest rates. When the level of debt to be sold exceeds the number of willing buyers, the buyers must be rewarded with higher interest rates. Very simply, the “investment” must be made to appear more attractive. But the Fed must avoid raising interest rates: high interest rates constrict the flow of money and impede economic growth.

The Treasury and The Fed can take a couple of different routes to financing the debt without increasing interest rates. the Federal Reserve can create money out of thin air. When no other buyer can be found, the Fed can “monetize” the treasury debt by exchanging it for money that comes into existence at the flick of a switch. When China purchased US Treasuries, it exchanged cash already in the system for those debts. The effect was to exchange existing money for the promise of future money. It did not increase the amount of money in the system. But monetization increases the amount of money in circulation. Thus the Fed’s inevitable purchase of billions of dollars in treasury debt will increase inflation significantly. Some observers believe that monetization has already begun. Indeed, by its own numbers, the aggregate base of money has increased in recent months by almost 800%.

A deliberate and coordinated devaluation of the dollar could also help with the debt problem. A dollar devaluation would enable foreigners to buy US debt at a discount due to the relative strength of their currencies, without raising interest rates. It’s not clear to me exactly how such a devaluation could be controlled, though unleashing the Plunge Protection Team on the currency markets might do the trick.

Both monetization and devaluation would hurt anyone who saves their money in the traditional “safe haven” assets: certificates of deposit and US Treasury securities. I have already said a good deal about how to protect one’s assets against this type of scenario in this blog. You might to review past articles to get a feel for these options.

© 2008 Philip Glaser