Last night I wrote a longish post, and the system ate it.  Probably I had not established a firm connection with the server, and when I hit the publish button, it disappeared.  My main point was to ask where the limits were for all of the borrowing and spending  going on from the Treasury, and all of the lending going on with the Fed.

I have talked about this before in articles like It is Good to be the World’s Reserve Currency.  Both China and OPEC have their political reasons for lending to the US, and those keep the dollar afloat for now.

I began last night’s doomed post by declaring to readers that they were part owners in the largest hedge fund (or CDO) in the world — the US Government.  Very distant from the founders’ designs, the government lends to private enterprises in a big way, clipping a spread, while still being exposed to default.

The US government has absorbed many private debts into the government’s debt in exchange for many private debt and equity claims.  Given that the government is clipping a spread, and borrowers are obtaining better terms than the market could give, could there be any problem?

Yes, there are several problems:

• The federal credit is not infinite — dare we risk the survival of our government to rescue special interests?
• The ability of the Fed to stretch the currency is not infinite — price inflation has not come yet, but when it does come, it will likely accelerate from all of the promises made.
• There is some degree of favoritism in who gets funds.  The larger banking firms have been bailed out at their holding companies, which is a travesty, because only regulated subsidiaries are to be protected, not the interests of holding company stock and bondholders.  Small banks have been left to fail.
• Private lenders who would lend at higher rates are getting cheated by the government, who has no business being a lender.  (Yes, I know, they have been doing it for decades, but that does not make it right.)
• There is little ability for the government to know whether they are offering fair terms or not as far as the taxpayer is concerned.  What is the right tradeoff between offering more loans, and taxing the populace more?
• The FDIC trades on the creditworthiness of the US.  They offer guarantees using the Federal credit, rather than surcharge the banks to make up for losses.  Letting banks lend to them at Treasury rates is clever to replenish the reserve funds, but what happens when there are more large defaults?  The hole will be deeper, and the climb out more challenging.
• So long as the productive capacity of the US is not expanding, arguing about how it is financed is not a fruitful endeavor.

Leaving aside the mutual suicide pact of those that own a disproportionate amount of US Treasuries, the risks that exist stem from an over-indebted economy, and the inability of consumers to resume their role of excess consumption, with accumulation of debt.

Aside from that, should we have a resumption in the decline of housing prices, an acceleration in corporate defaults, or commercial mortgage defaults that affect the big banks, it doesn’t matter that the government is clipping an interest spread, because the losses will be worse.

As a final note, let’s watch the end of the Quantitative Easing from the Fed.  Together with the Treasury they already own over 30% of all 30-year GSE-conforming mortgages, if not more.  What?  Do we want the government to absorb every bad debt?  Where is the responsibility to those that contracted the loans, expecting profit or pleasure?

This will not end well. The only question is whether it ends in inflation or greater taxation.  Name your poison.

This entry was posted on Friday, September 25th, 2009 at 2:10 am and is filed under Bonds, Currencies, Fed Policy, Macroeconomics, Real Estate and Mortgages, Stocks, Structured Products and Derivatives, public policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.