Bailout Question from Bill

Bill, a relative of mine that recently got in touch with me through the internet, has started reading my blog and emailed me this question:

HELLO Preston,

    I just ordered a copy of your book. Reading your blog, I really like
your writing style so I’m sure I will enjoy the book.

    I really don’t know very much about economics, I wish I did. I took a
course in Agriculture Economics in college but about all we talked about was
the commodity market. I have been reading everything I can find here lately
about credit default swaps and collateralized dept obligations — OH MY GOD,
Did anyone think this <stuff> would really work??

    I don’t know very much but I recognize a Ponzi scheme when I see one.
How in the world did they get away with it for this long??

    I think our government does one thing better than anyone else. They
play “don’t look over there, look over here”. Every time something happens
that they don’t want to explain they use all their powers to get us looking
in a different direction. They are blaming this on sub prime loans but it
looks like we were headed like lemmings to a cliff even if the loans had
been good.

    In the 1980’s Ronald Reagan sent the Marines to Lebanon and many of
them were killed in a bombing. I remember a politician talking about the
Marines going before the bombing. He said “if they are sending them to fight
they are not sending enough, if they are sending them to die, they are
sending too many”. That always stuck with me. I seems to me that if they are
spending 700 billion to pay off bad loans they are spending to much, if
they are trying to cover the hedge funds and derivatives they are not
spending near enough. Is there enough?????? 


Bill asks a good question. Is there enough money to pay for the bailout. As with all things in our modern economy, questions involving money can be a bit confusing. The simple answer is “Yes there is enough money for the bailout” because, as Ben Bernanke has so astutely observed, “the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” So, as our illustrious central banker has pointed out, the government can simply run the printing press to generate the needed cash to pay for the bailout. Problem solved. 

Or maybe not. For one thing, $700 billion is a lot of money to pull from thin air. And since it’s a purchase from banks, it would show up to the banks as “high powered money” or money that they could then loan against. In a fractional reserve banking system, $700 billion in high powered money could be loaned out to borrowers who then deposit it back into the banking system in the form of checkbook money which can then be loaned out again. In this way, the money can be pyramided many times over. Using the reserve requirement of 10% as a guide (which I believe is the correct figure for the United States) an injection of $700 billion in high powered money would result in $7 trillion dollars of new money injected into the economy by the time all that lending was done.  As you can figure, $7 trillion is a huge wall of money to hit the economy, and it doesn’t take a genius to see that we would see runaway inflation. 

Now, were the US government to borrow the needed $700 billion, then it wouldn’t show up as high powered money so the immediate impact wouldn’t be quite so inflationary. The question is, of course, who exactly is going to loan us this money, and that’s the question few people seem to be asking. Currently the other nations of the world seem to be fighting their own problems in this economic downturn, and I’m not sure how readily they are going to want to part with $700 billion dollars of new US Government bond issues. I’m predicting that the interest rates needed to attract this kind of cash are going to be higher than the government would like.  Higher interest rates will show up in higher mortgage rates, which will further exacerbate the housing downturn. 

All of this ignores your other question as to whether the $700 billion price tag is realistic. The true answer to that is, as you already suspect, unknowable. As we say with Japan, bailing out banks that have lots of bad debts on their balance sheets tends to transform an painful collapse into a long slow death. I sincerely doubt that the $700 billion dollar price tag will be the last we see of this, but that’s assuming that we ever get that far. Raising this these funds is going to be the real test of whether our economy is allowed to suffer on a bit longer or whether we start to see an implosion of value as the dollar loses values and interest rates escalate. 

Should be interesting. I’d say that the next few months will provide you with all the education in economics that you’re going to need.

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