Can We Afford the Bailout?

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.

6 thoughts on “Can We Afford the Bailout?

  1. You are either incredibly naive or a politically motivated apologist. Using the criteria of WHETHER we can borrow now to proxy for whether we SHOULD borrow for the long-term is false-reasoning. It is clear based on history that the breaking point of U.S. borrowing on the economy will only be discovered AFTER it has been crossed.

    The U.S.’s current borrowing rates are artificially subsidized as you note, however, to blithely assume that this condition will persist indefinitely is absurd. Our government can certainly borrow a lot of money TODAY (the statement “virtually unlimited” is also absurd and a dangerous kind of “magical thinking”), but your line of argument is illogical. Functionally, U.S. Treasury Securities are currently a giant “mattress” where the rest of the world is stuffing its excess dollars for safekeeping. The fact that the rest of the world has such a huge amount of U.S. dollars to invest/protect is driven by our profligate borrowing and spending as a nation the past 10 years, not by the considerably lower need for U.S. dollar (hard currency) reserves. The only way this source of artificially cheap funding can continue to grow is if we continue to aggressively borrow and spend as a nation, which will necessarily and inevitably result in a further deterioration in the credit-worthiness of the U.S. The end point of course is that questions as to the quality of the full faith and credit of the U.S. will result in foreign countries hedging that risk by accumulating other hard currency reserves (EUR, JPY, GBP, etc.). Using common sense, we should realize that there is not an infinite demand for U.S. dollars. Once the demand for dollars wanes (through hedging currency risk, changing reserve currencies, reduced consumption by Americans who can borrow no more) our borrowing costs will return to normal.

    Furthermore, common sense dictates that the U.S. economy has a finite capacity to SERVICE debt. One could make a pretty strong argument that if our interest rate for borrowing were at historically normal levels we would be testing that limit right now – real interest rates cannot remain negative forever. A look back to the 1980’s and 1990’s shows how much of a burden interest expense on a much smaller amount of national debt became on taxpayers.

    Finally, the terms of the government’s bail-out were significantly below market and do not, as you state, allow taxpayers to potentially share in the upside of a rebound. While we did not need to force financial institutions to write all assets down to their fire sale values, we should at least have required market rates of return on our taxpayer dollars (see Goldman Sachs deal with Warren Buffet). Anything less is a guaranteed taxpayer subsidy and a true “moral hazard” that rewards poor risk management.

    Articles like this serve to obfuscate the serious nature of the problem that we as a country face in the long-run.

  2. Steve,

    Harsh yet real comment. Thanks.

    Do you believe that we ultimate face rising yields at the long end of the curve as a reaction to:

    a) massive treasury issuance to fund these rescues
    b) if outsiders ever do question the credit worthiness of the US; similar to how the bond insurers credit rating was downgraded by the markets WELL BEFORE the ratings agencies ever realized their modeling was flawed
    c) if friendly foreign funders become unfriendly OR decide to slow down or worse, sell their treasury holdings
    d) rollover maturing treasuries demand higher yields

    I have a feeling the end game is higher rates! How will that help housing in the years to come? Thoughts?


    Noah @

  3. Wow. I’ve never been called naive, absurd, and illogical all at once. I’ll just make two responses.

    Obviously the larger the national debt, the higher the cost of servicing it. And you are right, there is a point at which the dollar will start losing its magical properties. But we are not yet near that point, as evidenced by the behavior of the entire world over the last month. The deficit as a percentage of GDP is still lower than it was in the 1980s, although of course it is higher than it was in the 1990s.

    I’ve written many times that the government was not going to get a market-rate deal in the bailout, and that the deal it got was not as good as Buffett’s (a comparison I specifically made). The reasons for that were twofold: first, Paulson needed to get all nine banks to agree on Monday (in the US, the government is not allowed to expropriate property from banks); second, the government wanted to encourage private capital to invest in the banks. I think the government should have put in more money and gotten better terms, but the deal that Paulson got is within a reasonable range.

    OK, three points. It’s nice to rail about the need to face the long-term problem – if you want to pile on, you might as well mention Medicare and the looming retirement crisis – but are you arguing that the government should not be borrowing more money to (a) stabilize the financial system and (b) stimulate the economy to shorten the recession?

  4. Back to the discussion on incentives.
    Executives decision are (also) driven by the stock price. Assuming the the stock price is (also) driven by the rating of a bank, would it make sense to have a rating done by some international institution, like the IMF, would has no conflict of interest like the current rating agencies? They could also concentrate more on the risk evaluation side of the global financial system.

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