Even the most casual observer will have realized that the U.S. government is laying out a lot of money to combat the financial crisis. Which raises the obvious question: can we afford it?
The first important thing to keep in mind is that the U.S. government, unlike every other government in the world, has the ability to borrow virtually unlimited amounts of money. The U.S. dollar is still the world’s reserve currency, and Treasury bonds are still the risk-free asset of the global economy. In times of crisis, when smaller countries find it harder to raise money, the U.S. actually finds it easier, because investors are ditching whatever risky assets they are holding and buying U.S. Treasury bills and bonds instead. Currently, the U.S. is paying virtually no interest on short-term borrowing (and probably negative interest in real terms).
The second thing is that, while 12-figure numbers are thrown around routinely, these large numbers do not all amount to pure losses. The $700 billion for the Paulson plan was initially intended to buy mortgage-backed securities which would eventually be resold, probably at a loss, but not necessarily a huge one. In the current form, $250 billion of that money is going to buy preferred shares in banks that (a) pay a 5% dividend and (b) will also be resold, in this case probably at face value (if the banks don’t buy them back after 3 years, the dividend goes up to 9%). On the other hand, guaranteeing the obligations of Fannie and Freddie, and new bank debt, also create additional potential exposure, but in each case it’s not as if the government has to borrow additional money now. In each case, the financial institutions being guaranteed have assets to match those liabilities, and the calculated expectation is that only a small proportion if any of these guarantees will ever be triggered.
So as others have put it, the government is in some ways acting as a bank. It is borrowing money by issuing more Treasury bonds to a market that wants lots and lots of Treasury bonds, and hence the cost of borrowing is not going up. Then it is using the money to buy financial assets from financial institutions. For the government, these assets may go up or down in value. For the financial institutions, they now have the cash that the private credit markets are unwilling to lend to them. In the current situation, this is an excellent use of the government’s unique borrowing power.
Still, the inevitable stimulus package will require yet more money, either in increased spending or reduced tax revenues. Some will no doubt protest that this is an unsupportable expansion of an already large and growing national debt. And it is true that the more money we borrow, the closer we come to the point where foreign investors and central banks may start looking for safe havens other than the U.S. dollar. But given that we are facing what could be the worst recession in thirty years – and given that the $100 billion stimulus implemented earlier this year wore off after one quarter – the government needs to err on the side of providing too much rather than too little stimulus. If there ever was a time for deficit spending (and I realize that there are people who think there is never such a time), this is it.
Besides, you don’t have to believe me; you can believe the latest Nobel Prize winner.
Update: The Economist points to two stories on the growing consensus that increasing the national debt is the way to go.