Bailout Questions – Answers from the Engine Room

from Professor Farrokh Langdana, Ph.D.

How will we pay for this bailout plan? And how come nobody is wondering 'where the money will come from'?

Supporters of the Bailout Plan have pointed out that this plan does not increase our net public debt, as the Treasury would be buying assets at fair value and holding them until such time as they can be sold for a reasonable return. So, both the Assets and Liabilities of the Government's account would be expanded together, with the primary effect being the leveraging-up of the Government's balance sheet by +$700 Billion.

However, the money to buy these Assets must come from somewhere… Well, where, exactly, will it come from ?

Even though the Government is obtaining assets in return, the funding classifies, basically, as an increase in government spending, G, by $700 Billion. The responsible way to fund this increase would be by borrowing. That is, the Treasury would sell (auction) government bonds (Treasuries) to domestic and foreign lenders. During the panic of last week as investors fled the stock market into Treasuries (CDs), Uncle Sam had no problems borrowing. But aside from this episode, borrowing has, in general, become very hard.

Before this latest crisis, the U.S.A. needed about $2.4 billion in foreign capital inflows every work day into Treasuries and of course into mortgage-backed securities (aka 'bags of oranges')—we certainly need a lot more inflow now. Most inflows came from China and Japan, followed by Brazil, and then petrodollars routed through London. This inflow began to sputter late in Fall 2007 as foreigners started cutting back their lending to the US. Eventually, they'd had enough of the toxic mortgage-backed assets and US government debt and did not show up for the Treasury auctions. In our language, the budget deficit has become very close to non-sustainable. And as the inflow into mortgage-backed securities stopped, our banks were left holding the rotting assets in a macabre game of musical chairs—hence, they are failing…

With no more (or very little) capital inflow, the increase in G necessary for the bailout plan will have to be funded by either:

a) Monetization. This occurs when the Treasury cannot find lenders and in sheer desperation it "sells" the government bonds (Treasurys) to the Fed who then creates money (out of thin air) to pay for them. Nothing backs this massive increase in M. Not gold, not exchange rates—only the history of monetary prudence of the Fed. Monetization is the First Deadly Sin in Macroeconomics. Virtually all hyperinflations begin with monetizations of non-sustainable deficits. This is a scary door, which is creaking open…

or

b) Tax increases are technically an option, but even a mention of tax increases would throw this fragile economy into death-watch mode. Remember, increasing taxes in the Great Depression from 25% to 63% only exacerbated the problems…

There is another option, which is:

c) Further borrowing from our biggest Creditor: Coming to an arrangement (publicly, or perhaps not-so-publicly) with the Chinese, who are sitting on 1.7 Trillion US dollars, to help out with a portion of the borrowing costs. A significant portion of China's savings are parked in the US, so it will be to their advantage to ensure that the U.S. does not go under.

(As every banker knows: If I owe you a million dollars and I can't pay you back, then, I have a problem. If I owe you $1.7 Trillion dollars and I can't pay you back, then, YOU have a problem!)

But how is Monetization different from just an increase in money growth (M) by the Fed?

When the Fed increases M to jump-start growth, it basically buys old—previously issued—government bonds from local banks and creates M. Monetization, in contrast, is when the Fed buys new—new—government bonds from the Treasury (not local banks), and creates M to pay for the increase in G. Big difference!! And now the Fed is not just buying bonds straight from the government, but has also bought billions of junk assets (aks 'rotten oranges'). Some have wondered if the Fed will buy baseball cards or comic book collections next….

So if we are indeed going to increase M to pay for this bailout, wouldn't inflation rise?

Yes. If there is monetization, watch the long end of the yield curve for early warning (bonds don't lie!). As expectations of future inflation (caused by debt monetization) increase, the long end will rise. Long-term interest rates (mortgages) will rise rapidly.