The US Bailout/Stimulus Plans: Are They Affordable?

Considerable concern has recently been expressed over the latest government bailout/stimulus announcements. In particular, many observers see the Federal Reserve’s plans to buy up $1 trillion of mortgages and long term Treasuries as being inflationary. In addition, the Congressional Budget Office is estimating the government budget deficit will total $9.3 trillion over the 2010-2019 period. Is the situation serious enough to warrant such steps? Are we really experiencing the worst downturn since the global depression of the 1930s?

Let’s consider a few numbers on the US economy with some historical data for perspective. In the first quarter of 1975, the unemployment rate reached 9.1%. In the first quarter of 1983, it got to 11.2%. The unemployment rate for February of this year was 8.1%, up from 5.8% in July. Over the last four months, the average monthly job loss has been 646,000. At this pace, the unemployment rate will reach 11.5% by August. Of course, the rate of unemployment increase might come down some as the government stimulus programs kick in. Even so, the situation is grave.

And as I have said in earlier posts, even if 75% of the problems caused by the global credit squeeze are behind us, the drop in income as a result of job losses and the consequent drop in expenditures are just kicking in.

More numbers: car and light truck sales have fallen from an annual rate of 17 million in 2005 to 9.1 million in February of this year; new orders for durables fell 22.9% in 2008 and fell another 4.5% in January; new orders for nondefense capital good fell 31% in 2008 and fell an additional 3% in January. The inventory of unsold homes continues to grow as foreclosures hit the market.

Remember too that this downturn is global, and that things are much worse in other countries than here. For example, industrial production fell 31% in Japan in 2008, 43% in Taiwan, 26% in South Korea, and 12% in the Euro area (the declines in the Euro area are only starting). These effects will be felt in the US as a reduction in export demand. Things are serious and will get worse.

Let’s now look at the US bailout/stimulus packages and the policies driving them. I start with a quote from an excellent article written by John Mauldin in early January (Muddle through on Hold” – http://www.frontlinethoughts.com/article.asp?id=mwo011009)

This you can take to the bank: If the Fed buys $500 billion in assets of various kinds and if the US government spends an extra trillion dollars and deflation is still a concern, they are going to double down and do it again. And yet again if they think it is necessary. They are not going to stop until the nominal economy is growing and inflation is above at least 1%…. As Bernanke said in 2002, he knows where the keys are to the room that has the printing press. And they are going to use it.

The latest announcements confirm that Mauldin is absolutely correct on the government’s intentions. Can we afford these efforts, and what are the risks? First, we need some background on the Federal Reserve and the US Treasury, the two main vehicles for these efforts.

The Treasury has the responsibility to finance the deficit of the US government. To do this, it offers US interest bearing IOUs (Treasury securities) of differing maturities. The Federal Reserve is responsible for the country’s money supply. It issues its own non-interest bearing IOUs – US dollars, and it can print as many dollars as it wants.

Consider first bailout/stimulus efforts going out through our Federal budget. Thes include TARP and the $787 stimulus plan recently enacted by Congress. How are these programs reflected in the budget? The budget has two parts – discretionary and mandatory. Mandatory includes Social Security, Medicare, Medicaid, etc., while the discretionary reflects funding for the various government departments, e.g., Defense, State, etc. Budget figures are summarized in the following table. They include estimates of both TARP and stimulus package effects.

US Government Budget

Item 2008 2009 2010
Expenditures (in bil US$)
Discretionary 1,135 1,246 1,362
Mandatory 1,595 2,588 2,135
Net Interest 253 170 172
Total 2,983 4,004 3,669
Receipts 2,524 2,159 2,289
Deficit 459 1,845 1,380
% GDP 3.2% 13.0% 9.7%

As can be seen from the Table, the deficit jumps from $459 billion in 2008 to $1.845 trillion in 2009, a very high number, both as a percent of government revenues and as a percent of GDP. How will it be financed? The Treasury will attempt to sell US government securities to cover these deficits. How feasible is this? Let’s look at the Treasury’s financials.

Treasury Debt Issue

Item 2004 2005 2006 2007 2008 2009 (est.) 2010 (est.)
Issued Treasury Securities (bil. US$) 4,166 4,473 4,659 4,809 5,472 7,317 8,456
Absolute Change 307 187 149 663 1,845 1,139
Percent Change 7.4% 4.2% 3.2% 13.8% 33.7% 15.6%

 

For the 2009 and 2010 estimates, I have assumed the Treasury will finance the deficits with new Treasury debt issues. As can be seen, this new debt finance will be a substantial jump from the past. A substantial jump? Five times more than the average debt issue of the last four years! Who will buy the new debt? There are three possibilities:

  • Domestic investors;
  • Foreign investors, and
  • The Federal Reserve.

Most of the debt will be sold domestically. This will absorb dollars just as the government is putting more dollars in the economy to stimulate demand.

In January 2009, foreigners owned 2.2 trillion of the US Treasury’s $5.5 trillion debt. The Chinese and Japanese governments own $740 and $635 billion respectively. For a number of years, they have been buying Treasuries to keep their currencies from appreciating relative to the dollar. Last week, the Chinese government expressed concern over the spiraling US government deficit. So the US is going to ask China to increase their purchases of Treasuries, maybe by as much as 500%? A tough sell.

Ultimately, the Federal Reserve could buy the Treasuries. Let us consider that option along with the other Fed initiatives to get the economy moving. As indicated earlier, the Fed uses its own IOUs, US dollars, to expand the economy. Consider the following data from the Fed’s balance sheet.

Federal Reserve System

Item March 2009 (in bil. US$)
Holdings of US Treasuries 474
Currency in Circulation 862

The Fed already holds $474 billion of Treasury debt. It could add to that amount by purchasing more with dollars. Currently, $862 billion of the Fed’s debt (US dollars) are in circulation. How much of this year’s $1.8 trillion government deficit do you want the Federal Reserve to buy? Maybe only $431 billion? That is about the purest form of printing money and that would only increase dollars in circulation by 50%.

But we must also consider the Fed’s other announced responsibilities for the stimulus/bailout:

  • Purchase $300 billion of long-term Treasuries;
  • Purchase $1.45 trillion in debt and securities issued by mortgage agencies;
  • Under TALF, purchase $200 million securities to spur student, auto, credit card, and small business lending.

This is a very tall order, given total dollars in circulation are now only $862 billion, and given the need to buy up some of the Treasury debt for the government deficit. Geithner talks about Government/Private partnerships. I he can develop a few. First efforts to get private partners with TALF have not been promising.

Financial people talk of “expanding the Fed’s balance sheet? What does it mean? Only two possibilities:

  • taking on more private sector loans such as the Maiden Lane series (Bear Sterns, AIG, mortgage-backed securities, and commercial paper) loans (asset) for more money in circulation (liability) or
  • more Treasuries for more money.

Is this a euphemism? Forget about “expanding the balance sheet. Look at the bullets above.

Might this lead to inflation down the road?

Inflation

Many are predicting inflation. There are two possible types:

  •  When an economy as at full employment and near full capacity utilization, an increase in aggregate demand will bid prices up: demand increases, supply cannot be expanded, so prices rise;
  • Think of dollars as a commodity: if the supply of dollars increases but the demand remains the same, the dollar price/value relative to other commodities will fall; this means more dollars will be needed to buy any other commodity which is inflation.

The first type of inflation mentioned above is not in the cards: right now, the world needs more demand. But go a bit further with the second possibility. The supply of dollars in circulation will increase dramatically. Won’t that decrease its value relative to other commodities such as other currencies and goods?

A Footnote: for the last 8 years, I have bet against the dollar by making most of my bets in other currencies. Why did I make these bets? Because for that period, the US trade deficit has averaged $655 billion annually. I thought that this increase in the global dollar supply would weaken the dollar. The dollar has not weakened by much, primarily because foreigners have used most of those dollars to buy US financial securities, mostly stocks and Treasuries. And for now, the dollar and Treasuries are strong because they are viewed as reasonably secure investments.

Look ahead just a bit. Suppose the reported stimulus efforts are made and the global economy starts to recover. At that point, the “safe haven” demand for dollars will fall off, while the global supply of dollars will have at least doubled. I am considering new bets against the dollar.

Conclusion

As Mauldin said, the Obama administration is going to get us out of this recession by spending and printing money. But what they are proposing to do is unprecedented. Hold on!

P.S. In my last post, I asked why there is so little outrage over the Merrill bonuses relative to the A.I.G. bonuses. I still don’t get it. Let us suppose US taxpayers have put $150 billion into A.I.G: that would mean the A.I.G. $165 million bonuses amount to less than one percent of the taxpayers’ bailout payments. In the case of Merrill, the “run out the back door” bonuses were $3.62 billion. Bank of America got $10 billion from TARP to “facilitate” the purchase of Merrill. That means 36% of the taxpayers’ bailout money to BofA to buy Merrill went to pay the Merrill bonuses. But as the great Gilda Radner would say, “Never Mind”

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of archive.org):
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