We still do not know the details of the $500 billion to $1 trillion plan to acquire mortgage-backed securities from US firms. But enough details have emerged that we can discuss some of the possible outcomes of this unprecedented intervention in the markets, something that might be called the ultimate triumph of Keynesian economics. Te US government has now nationalized more of the economy that any in our history. The word "unprecedented" doesn't seem powerful enough. Although I am no economist, I have a number of questions and thoughts about the likely unintended consequences of this intervention. I do not decry the intervention; it is long past due. However, it seems likely that big actions produce big reactions. Below are a few that have occurred to me.
- The US Treasury plans to buy directly from US financial institutions mortgage-backed securities (MBS) at about 50% on the dollar. If Treasury is correct in their estimates, then they will be acquiring at least $500 billion of MBS. Treasury plans to pay about 50 cents on the dollar. Many people are saying that the bill will be more like $1 trillion. We are already in for around $600 billion. Where will this money come from? Well there are only two sources of Treasury money: taxes and borrowing. Since taxes aren't going up any time soon, Treasury will be going into the market to borrow the money. This is a pretty huge amount of money. Foreign lenders will be demanding a premium. On this basis, I would expect interest rates to climb. The bailout also represents and injection of cash into the system. Increased money supply tends to increased inflation. Another reason for increased interest rates. The problem with this is that it is likely to generate more non-performing loans and therefore a greater demand on Treasury funds, which may then have the effect of increasing interest rates further, and, well, you get the idea.
- Treasury will not buy from foreign institutions. If you head a German bank that holds US MBS today, what would you do? Suddenly, the value of your holdings have been cut in half by the Treasury plan. But worse, you can't really unload them. Maybe to US firms who can then sell them to the Treasury Dept. The US institutions could pretty much offer anything they like - 10 cents on the dollar maybe - and make a profit by selling them on to the Treasury at 50 cents on the dollar. I have to assume that Treasury is awake to this ploy. But it does raise the question of what other countries are going to say about US policy. We are going to be exporting some pain. That's not going to make us very popular. There may be restrictions placed on US firms operating in Europe, etc. At the worst, there could be a kind of financial protectionism as various countries try to shield themselves from the US crisis. Capital controls are an option. I think this is not so likely, but in this environment, it's not wise to say never.
- Foreign US currency holdings. My understanding is that there is around $2 trillion of US currency outside the country. If you were a Kuwaiti and held a lot of US dollars today, what would you be thinking? Perhaps you would want to dump US dollars until the crisis resolves a little. If a significant portion of that $2 trillion came flooding back into the US, it would only add to the strong inflationary pressures triggered by the extra cash in the economy from the Treasury intervention.
- Foreign Investment in the USA. As Krugman famously observed, the US economy 3 years ago seemed to consist of people selling each other houses with borrowed Chinese money. One might expect sovereign and other foreign funds to be considerably more wary for some time about investing in the US financial markets. However, the opportunity to buy some major banks and investment firms at knock-down prices is quite a temptation. I suspect that these investors will now be asking a pretty serious premium for any investment in the USA. Since a number of these funds a sovereign funds, the governments that control them may attach some further non-monetary conditions, depending on how bad things look in the USA.
The bottom line perhaps is that increased interest rates and increased inflation simultaneously may be the way in which we experience the consequences of this economic crisis. Since I am not an economist, I would welcome any thoughts and comments on this diary. I wrote it because, rather than flinging blame around like John McCain, we need to have a sober discussion of the possible outcomes of the Treasury plan before we hold hands and sing Kumbaya.