Is the Bail Out
Breeding a Bigger Crisis?

A Future of Inflation, High Interest
and a Hollow Dollar?

Paul Craig Roberts
March 26, 2009

At his March 24 press conference President Obama demonstrated that he is
capable of understanding issues as presented to him by his advisers and able
to pass on the explanations to the press. The question is whether Obama’s
advisers understand the issues.

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
threatened by the debt monetization and multi-year, multi-trillion
dollar issuance of new Treasuries?

The United States has become an import-dependent country. The US is
dependent on imports for energy, manufactured goods including clothes and
shoes, and advanced technology products. If the US dollar loses its reserve
currency status
, the US will not be able to pay for its imports. The ensuing
crisis would dwarf the current one.

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.

It is also a bad sign for Obama’s similar plan. In the US, interest rates on
US Treasuries have risen in anticipation of unprecedented new Treasury
issues despite the Federal Reserve’s recent announcement that it intends to
purchase $300 billion of existing Treasuries held by the banking system.

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

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.

Would it be cheaper for government to buy the shares of the banks and AIG
at the current low prices than to pour trillions of taxpayers’ dollars into
them in an effort to drive up private share prices with public money? The
Bush/Paulson bailout plan of approximately $800 billion has been followed
a few months later by the Obama/Geithner stimulus-bailout plan of
another approximately $800 billion. Together it adds to $1.6 trillion in new
Treasury debt, much of which might have to be monetized.

Could this huge 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 public debt that saddles taxpayers and future budgets
with hundreds of billions of dollars in annual interest payments.

Free market ideologues will say the government would inflate. However,
the government has been inflating for generations and is now set on a course
for hyperinflation. Monetization of troubled financial instruments by the
Federal Reserve is just beginning. In addition, there are the multi-trillion
dollar budget deficits which probably cannot be financed other than by
monetization of new debt issues.

The US money supply as measured by cash in circulation and demand
(checking accounts) is currently about $1.4 trillion. If this year’s
budget deficit is monetized, the money supply doubles. If next year’s budget
is monetized, the money supply would have tripled in two years.
Inflation would explode. The combination of high unemployment and high
inflation would be devastating.

In contrast, protecting depositors is not inflationary. It merely prevents
monetary contraction.

If the Obama administration can think about socializing health care as a
single-payer system, it should be able to think about socializing the banking
system. Currently, Medicare is paid for by taxpayers, Medicare beneficiaries,
healthy retirees, and doctors. Beneficiaries have to pay substantial premiums
for supplemental coverage whether ill or healthy, and doctors are paid a
pittance from the schedule of fixed prices. The insurers are the ones who make
money, not the medical service providers. The single-payer system would
shrink costs by the amount of the health insurance industry’s profits and the
enormous paperwork and enforcement compliance costs.

The trade deficit is even more difficult to address. The American economy
lost much of its manufacturing leg to offshoring. It has now lost its real estate
and financial sector legs. Real incomes for the average family have not
increased. The consumer-demand-driven economy became dependent on the
accumulation of consumer debt, which has reached its limit.

When the production of goods and services for the domestic market is moved
offshore, Americans lose income and the economy loses GDP. When the goods
and services produced offshore return to be sold to Americans, they
constitute imports that widen the trade deficit.

The US finances its trade deficit by turning over to foreigners ownership of
existing US assets and their future income streams, which, of course,
increases the flow of income away from Americans.

The claim that low prices in Wal-Mart compensate for all these costs is
ridiculous. Nevertheless, the Obama administration, corporation executives,
and the economics profession remain committed to offshoring.

The claim, expressed by Obama at his press conference, that retraining
programs are the solution to manufacturing and IT unemployment caused by
offshoring is also ridiculous. For a decade the only source of American job
growth has been domestic services that cannot be offshored, such as hospital
orderlies, barbers, waitresses and bartenders. Retraining is simply a
government subsidy to educational institutions, a subsidy that insures their
continued support for offshoring.

The enormous trade deficit that has been created by the pursuit of
short-term corporate profits can only be closed in two ways. One is to stop
the offshoring and to bring home the offshored production. Possibly, this
could be done by replacing the corporate income tax with a tax based on
whether value added to a company’s output occurs domestically or abroad.

The other way the trade deficit can be closed is by the inability of Americans
to pay for imports. If debt monetization wrecks the dollar and drives up
import prices, Americans will have to learn to live with less imported energy
and manufactured goods. American annual consumption would shrink
by the amount of the trade deficit.

The Bush/Obama approach to the crisis in the financial sector is to monetize
existing debt and to accumulate enormous new debt that will likely also
require monetization. The monetization threatens inflation, high interest
, and depreciation of the US dollar and loss of its reserve currency role.
The accumulation of new public debt implies larger annual interest
payments that could make future deficit reduction problematic. Clearly, the
Obama administration needs to broaden its perception of the predicament to
which financial deregulation and offshoring have brought the US economy.

Paul Craig Roberts was Assistant Secretary of the Treasury in the Reagan
administration. He was Associate Editor of the Wall Street Journal editorial
page, Contributing Editor of National Review, columnist for Business
, and Scripps Howard Newspapers.. He is coauthor of The Tyranny
of Good Intentions
. He can be reached at:
[email protected]