Betting on a Bubble, Bracing for a Fall

For example, if Congress votes on a billion dollars of spending, and the Treasury issues debt to finance this spending, the Fed might buy that billion dollars of Treasury debt and create a billion dollars of currency to pay for it. But notice that from the standpoint of the public, the end result is still a billion dollars of government liabilities, that was explicitly authorized by Congress. The Fed was never involved in spending decisions, which is fiscal policy.

Contrast this with what the Fed has done in this instance. It has taken its balance sheet up from about $800 billion two years ago (almost exclusively in Treasury securities) to over $2 trillion today, mostly in Fannie Mae and Freddie Mac liabilities. The government's backing of Fannie and Freddie debt was always implicit - they do not have the full faith and credit of the U.S. for their full maturity. If Congress chooses to restructure that debt after 2012, the Federal Reserve will have created money without an offsetting asset of equal value on its balance sheet. It will have spent money out of thin air to pay off the holders of Fannie and Freddie securities. This would constitute a fiscal policy decision that was not actually voted on by elected representatives in Congress.

Having discussed economic policy before with Congressman Garrett, it's clear that he has a strong understanding of the economic challenges we are facing. As a political independent, I rarely inject electoral politics into these weekly comments, but I have no stronger endorsement for the coming election cycle.

A short-term fix at long-term expense

We don't seem to have many representatives in Congress that are willing to challenge the bailout mentality of Bernanke and Geithner, both who have done this nation a disservice. While hundreds of billions of dollars in bailouts and Fed purchases of insolvent mortgage debt have saved bondholders from any need to restructure bad loans, the fact is that the public is now on the hook to make them all whole. The crisis of confidence and the resulting job losses in recent years did not occur because bondholders stood to lose money. There are always eager investors who are willing to recapitalize financial institutions once the FDIC has made them solvent by cutting away the bondholder and stockholder liabilities. But this is not what happened. We bailed out the bondholders and stockholders.

The crisis occurred because credit froze up, and credit froze up largely because of the incessant self-serving warnings from the heads of major financial institutions that a second Great Depression would result if they were allowed to "fail" - which in fact means nothing but that the operating entity changes hands (as occurred with Washington Mutual), and the stock and bondholders of the company appropriately take a loss. The government has issued trillions of dollars in new debt in the attempt to sustain the previous misallocation of capital - trying to prevent bad loans from failing; to keep elevated home prices from adjusting to normal levels relative to income; to maintain unsustainable consumption habits; and to subsidize purchases of autos, homes and other big-ticket items that have weak intrinsic demand because people already have too much debt. Huge chunks of national savings that should have been available for productive economic activity have been diverted in an effort to maintain an inefficient status quo.

We now have corporations sitting on a mountain of what seems to be "cash." But in fact, they are not holding cash. They are holding a pile of government debt that was issued during this crisis, which somebody has to hold until the debt is retired. Corporations just happen to be "it" in this game of hot potato. Bernanke and Geithner have done nothing but incur public losses in order to defend private interests. This is not skilled leadership - it is misappropriation.

Moreover, we've failed to address the underlying problems - the need to ultimately restructure debt obligations so that they are in line with the cash flows available to pay them; the need for prices and production to shift in a way that reflects a different mix of consumption, investment and financial activity. The markets appear to be crossing their fingers that this won't happen - that the combination of opaque disclosure and massive fiscal deficits will simply make the problem go away; that a big enough "stimulus" package will "jump-start" consumers to their previous habits. The historical evidence on this is not encouraging. In the meantime, we've created yet another mountain of debt. Given the fresh deterioration our Recession Warning Composite and other leading measures of economic activity, our economic challenges seem likely to persist much longer than they should have.