Can America's latest rescue package really work?
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Associate Editor
David Stevenson Mar 27, 2009
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The US government has unveiled its latest plan to save the economy. But will it work? David Stevenson isn't hopeful.
"The Bank never goes broke. If the Bank runs out of money it may issue as much as is needed by writing on any ordinary paper." - The Rules of Monopoly
The Monopoly rules were written more than 60 years ago. But they describe the attitude of the US authorities unnervingly well. America has never been the most thrifty country. But the bewildering array of ever costlier 'initiatives' to beat the depression have pushed the country's debts ever higher. And the situation is only going to get worse.
American public debt has hit $6.6trn, up from $5.3trn just a year ago. That doesn't include the $5.3trn in liabilities of bailed-out mortgage giants Fannie Mae and Freddie Mac. Nor does it include all the broader Federal Reserve and Treasury guarantees, such as the $29bn in Bear Stearns' debts and $301bn in suspect Citigroup assets. Then there's President Obama's stimulus packages and his new big-spending budget, which will add another "$3trn-$4trn in new borrowing over the next two or three years, and that's if the economy recovers smartly", reports The Wall Street Journal.
Where's all this money going to come from? We'll get to that in a minute. For now, the problem is that all this spending doesn't seem to be doing much good. Efforts to get the banks lending again by guaranteeing their dodgy debts – from Hank Paulson's $700bn Troubled Asset Relief Programme (Tarp) to the $200bn Term Asset-Backed Securities Loan Facility (Talf) – aren't working so far. So now US Treasury Secretary Tim Geithner has unveiled the latest plan to relieve banks of the toxic assets plaguing their balance sheets.
The new Public-Private Investment Programme (PPIP) is split into two separate schemes. One targets 'toxic' credit securities bought by banks, such as the subprime-mortgage-backed derivatives that caused the initial blow-up. The other focuses on bad real-estate loans held directly by the banks themselves. The Treasury will use $75bn-$100bn of the original $700bn Tarp funds, and team up with private funds to buy these troubled loans or securities. The combined public and private equity will then be 'leveraged up' – in some cases by as much as 20:1, reports The Daily Telegraph. The extra borrowing will be guaranteed by the Federal Deposit Insurance Corporation (FDIC), which is ultimately backed by the US taxpayer, in the case of loan purchases, and by the Fed's Talf scheme for securities. In other words, private investors will be able to put in a small sum of their own money, then leverage it up using government funds to buy problem assets that may or may not turn out to be profitable in the long run. The whole thing will apparently generate $500bn in purchasing power, with the potential to grow to $1trn.
The plan is very flawed and amounts to robbery of the American people
The US Treasury reckons this latest plan is better than other methods so far dreamed up for banks to unload their toxic assets, because it puts some of the risk back on private capital and allows "private-sector price discovery". That's another way of saying that the government hasn't a clue what these dodgy loans are worth, so it's giving someone else a go at valuing them. It's also clearly quite happy to risk vast amounts of someone else's money, ie US taxpayers' cash, in letting Wall Street sort out its mistakes.
Global stockmarkets soared on the news of the plan. But that might be less to do with its chance of success and more to do with the fact that this PPIP scheme looks like just another case of more jobs for the boys on Wall Street. Nobel-prize-winning economist Joseph Stiglitz for one said that the plan was "very flawed" and "amounts to robbery of the American people", says James Quinn in The Daily Telegraph. The taxpayer is underwriting the downside risk, while the private sector gets any future profits that might emerge. As the FT's Gillian Tett puts it, "the sheer size of public money being handed to private investors could spark outrage", particularly after the anger over bonuses at the likes of AIG.
But perhaps a bigger problem is that it might not help the banks in any case. The trouble is, if investors aren't willing to pay over the odds for these assets – and why should they? – then the banks will end up no better capitalised than before, as Tracy Alloway points out on FT Alphaville. So at best the plan might force the banks to address the cesspits on their balance sheets. But they could well end up needing further public money even after the bad assets have been bought. This is the real problem with the plan, agrees another Nobel winner, Paul Krugman. "This is more than disappointing. In fact, it fills me with a sense of despair." Instead of financing the private purchase of illiquid dodgy assets, Krugman believes the US government should guarantee many bank debts and take control of 'insolvent' firms to clean up their books, as Sweden did in the 1990s after its property bubble burst. It took years to unravel the mess amid a deep recession, but at least it worked.
So America's banking sector still looks a long way from resolving its problems. But perhaps a bigger long-term worry is the US authorities' other new plan to boost the economy. A few days before PPIP was unveiled, the Fed introduced the latest stage in its quantitative easing (QE) plans. The Fed has been 'doing' QE – central bank speak for 'printing money' – for more than six months now, but it has just stepped up a gear.
Clearly impressed by the Bank of England, which earlier this month waded into the bond market with a £75bn cheque to buy gilts (UK government bonds) and corporate bonds, the Fed last week said it would purchase $300bn of US Treasury stock from investors, effectively swapping bonds for cash. The immediate effect was dramatic as a huge new buyer entered the market. Yields on ten-year US Treasury bonds plunged from 3% to 2.5% within seconds, the biggest one-day move since 1962.
This asset buying, added to earlier measures, will inflate the Fed's balance sheet to "something like $4.2trn", says Capital Economics. That's "equivalent to 30% of annual US GDP". That would be by far the highest level ever. It would mean that the US monetary base – the total of bank reserves plus notes and coins in circulation – will have risen nearly five-fold from last September's collapse of Lehman Brothers. This $300bn "may be just the opening salvo", says Capital Economics' Paul Dales. "If the economic news continues to deteriorate, the Fed could easily ramp up its Treasury purchases."
The aim, just as with the PPIP, is to "get credit flowing again", says President Obama. The trouble is, there's no guarantee that commercial banks, because of the mess they're in, will be willing or able to lend out the extra cash raised by selling their Treasuries. So it's possible that Fed chairman Ben Bernanke's policies won't make much difference. "The Fed's balance-sheet expansion is large, but compared with the $8trn de-leveraging" – paying down debt – "of the US household and business sector we believe is underway, it only cushions the impact. It doesn't stop it," says Riccardo Barbieri at Bank of America Merrill Lynch.
In plain English, while the Fed might be pumping lots of new money into the system, we can't know for sure how much of it will actually result in new lending and spending, and how much will go on paying down debt, or be hoarded in case of future emergencies. This would be similar to Japan's experience with QE, which apparently did little to push the country out of deflation.
But it could have a more serious impact, warns Barclays Capital. The world's central banks have made it so clear that they want inflation to rise that this could feed through into the 'real' economy without lending necessarily shooting up. As inflationary expectations rise, investors have already been piling back into the commodity markets. As commodity prices rise, that fuels inflation, but it won't contribute to economic growth – in fact, it would "be a negative for future activity".
The currency is being so badly debased that there's a risk of dollar holders losing faith in it
It gets worse. "Obama is now endorsing a sort of Keynesianism" – increased public expenditure – "that argues that any government spending is an economic stimulus," says The Wall Street Journal. "This is so manifestly false, we doubt Mr Obama really believes it." The tragedy of Obama's $787bn 'stimulus' and his $410bn spending blowout for 2009 is that "they spend principally on income maintenance and transfer payments" – like rent subsidies – "that have little or no growth payback". It all adds up to extra trillions being printed, and spent, but pushing up inflation more than economic growth.
Then we come to the really nasty bit. The American currency is being so badly debased that there's a growing risk of dollar holders losing faith in it as a medium of exchange. Initially this shows up as inflation, but eventually trust in the currency itself is lost altogether. Richard Koo described the problem in his book about Japan's deflation, The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession. "Economists like Ben Bernanke and Milton Friedman have argued that if worst comes to worst, one could always scatter money from a helicopter, which would surely turn the economy around. But it's extremely doubtful whether such a policy would bring the desired results."
Why not? Because "helicopter money is almost always pitched from the perspective of buyers of goods and services – and almost never from sellers". The trouble is, when people get offered money that they no longer trust for things that they're selling, they refuse to accept it and demand an alternative. "No sane person would exchange goods and services for, or know the value of, money raining down from the sky," says Koo. "Eventually sellers close their stores… and the economy collapses. It could easily plunge the country into a world of bartering – if not hyperinflation." Even if it doesn't come to that, returning inflation together with the vast supply of new American bonds that will need to be issued to fund those soaring budget deficits will prove a venomous mix. Investors will demand ever-bigger incentives to buy US Treasuries, which will force long-term bond yields and interest rates much higher. China is already concerned about the value of its dollar holdings. We look at this, and what it all means for the greenback, below.
The dollar's bad; the rest are worse. Buy gold
American government spending has gone into overdrive. And the Federal Reserve is creating extra cash like crazy. Surely that must be very bad news for the buck? In isolation, of course, it would be. If the US was the only country in the world to be printing money through quantitative easing (QE), then we'd expect to see the dollar nose-diving against its peers. And in the longer term, the sheer scale of US government borrowing and money printing means that it probably will.
But currency markets are a 'zero-sum' game – that is, if one is sold, the proceeds must go automatically into another. A country's currency acts as an economic and financial yardstick of how good things are looking. Right now, as Hong Kong-based asset manager Gavekal has long been saying, the currency markets are an "ugly contest" where investors have to pick the "least worst" option.
Short-term alternatives to the dollar are looking thin on the ground. The yen is being buffeted by Japan's dependence on foreign markets, which means that its economy has been one of the worst-hit by the global downturn. Japanese exports have almost halved from a year ago, a record plunge that puts the world's number-two economy on course for its worst recession since World War II. "Japanese exports are unlikely to recover soon", says Ryohei Muramatsu at Commerzbank, "and it's difficult to foresee a rapid recovery unless the global financial crisis eases". So no joy here – if anything, the Japanese central bank might be tempted to intervene directly to weaken the yen to try to prop up its exporters.
At first sight, the euro looks a better bet. It has been boosted by the refusal (so far at least) of the European Central Bank to join the QE club. But it has to contend with a whole range of growing problems. German business confidence has just slumped to its lowest level in 26 years, while Portugal, Ireland, Italy, Greece and Spain are at various stages of going bust. Furthermore, eastern Europe is fast turning into European banks' own subprime meltdown.
Meanwhile, sterling is rapidly becoming a basket case. After this week's higher-than-expected inflation figures, it seems we've got the worst of all possible worlds – "slump-flation".
But back to America – and the dollar. America now has a debt problem so large it's almost impossible to comprehend – over $11trn (if you include social security commitments as well as outstanding bonds) and counting. With all President Obama's 'stimulus' packages and 'initiatives', that could require new borrowing of almost $9.3trn over the next decade – even on official estimates. This would "not be sustainable", says White House budget director Peter Orszag. It would exceed 82% of GDP by 2019, which "threatens the nation's stability", says Lori Montgomery in The Washington Post. For now, the dollar is the world's reserve currency – ie, it's held in large quantities by many governments as part of their foreign-exchange reserves – so America has the rare privilege of being able to borrow and repay its debts in its own currency. But reserve-currency status isn't a birthright and it can vanish when nations lose the plot.
Indeed, Chinese Premier Wen Jiabao created a stir two weeks ago when he said he's a "little bit worried" about the safety of US assets – that is the $740bn of US Treasury bonds (up 46% in 2008) his country owns – and called on the US "to guarantee the safety of China's assets." That may be political sabre-rattling. But the US administration showed how sensitive it is on the subject by responding fast, with presidential spokesman Robert Gibbs saying "there's no safer investment in the world than in the United States". Obama himself added that: "Not just the Chinese government, but every investor can have absolute confidence in the soundness of investments in the US."
Yet China's call this week for a new international reserve currency – to replace the dollar – shows it's not convinced by all the talk. What Mr. Wen is really saying is that even the US national balance sheet has its limits. The Americans may not like the idea – both Geithner and Bernanke publicly rejected it this week – but long-term, don't bet on the dollar keeping its reserve status forever. And when that goes, who'll want to hold America's currency then?
It all points to a familiar MoneyWeek refrain: buy gold. As confidence evaporates in other global currencies – and if calls for a new reserve currency gain strength – then gold can only go up. A quick and easy way to get exposure is via the ETF Securities Physical Gold ETC (LSE:PHAU).
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