Obama’s advisers are focused on rescuing banks and the insurance company, AIG. They perceive the problems as solvency and paralyzing uncertainly or fear. Financial institutions, unsure of their own and other institutions solvency, hoard cash and refuse to lend. Credit is needed to get the economy moving, and the Federal Reserve and Treasury are doing their best to inject liquidity and to remove troubled assets from the banks’ books.
This perception of the problem and the “remedies” being applied, might be causing a greater problem for which there is no solution. Obama’s approach, and that of the previous administration, requires massive monetization of debt by the Federal Reserve and massive new debt issues by the Treasury.
The unaddressed question remains: Is the US dollar’s status as world reserve currency threatened by the massive debt monetization and multi-year, multi-trillion dollar issuance of new Treasuries?
Obama’s advisers believe that the US can monetize debt and issue new debt endlessly, because America’s capital markets are the deepest and most liquid. The dollar is strong, Obama said at his press conference.
But already cracks and strains are appearing. The day after Obama’s press conference, an auction of UK bonds, known as gilts, failed when bids fell short of the supply offered and interest rates rose. This is a bad sign for Prime Minister Gordon Brown’s plan to market an unprecedented amount of new debt during the current fiscal year.
Normally, Fed purchases raise bond prices, thereby lowering interest rates. However, the inflation and interest rate implications of the unprecedented supply of new Treasuries necessary to finance the multi-year, multi-trillion dollar budget deficits are beginning to be recognized in bond and currency markets. Everyone knows that the Federal Reserve will monetize the new debt issues rather than allow a Treasury auction to fail. Recently, America’s largest creditor, China, expressed concern that the value of its massive holdings of US dollar investments is in danger of being inflated away.
The Fed cannot monetize new Treasury issues without the word getting out. If and when this happens, the US dollar’s exchange value is likely to drop while interest rates and inflation rise.
To avoid a crisis of this magnitude, the US needs to focus on saving the dollar as reserve currency. As I previously emphasized, this requires reducing US budget and trade deficits.
Despite the near-term budget costs of ending the occupation of Iraq and the war in Afghanistan, terminating these pointless military adventures would produce immediate large out-year budget savings. Closing many foreign military bases and cutting a gratuitously large military budget would produce more out-year savings. The Obama administration’s belief that it can continue with Bush’s wars of aggression while it engages in a massive economic bailout indicates a lack of seriousness about America’s predicament.
Rome eventually understood that its imperial frontiers exceeded its resources and pulled back. This realization has yet to dawn on Washington.
More budget savings could come from a different approach to the financial crisis. The entire question of bailing out private financial institutions needs rethinking. The probability is that the bailouts are not over. The commercial real estate defaults are yet to present themselves.
Could this massive debt issue be avoided if the government took over the banks and netted out the losses between the constituent parts? A staid socialized financial sector run by civil servants is preferable to the gambling casino of greed-driven, innovative, unregulated capitalism operated by banksters who have caused crisis throughout the world.
Perhaps the Federal Reserve should be socialized as well. The notion of an independent, privately-owned Federal Reserve system was never more than a ruse to get a national bank into place. Once the central bank is part of the state-owned banking system, the government can create money without having to accumulate a massive public debt that saddles taxpayers’ and future budgets with hundreds of billions of dollars in annual interest payments.