One little noticed but vitally important component of the new Geither plan: It doesn't require Congressional approval. The new bailout plan doesn't appropriate any new money, so Congress is out of the loop, but it does include non-recourse loans. Unless the toxic assets we're buying are worth a lot more than any sane person thinks, some of these non-recourse loans aren't going to be paid back. This means that what are in appearance loans are in many cases going to turn out to be subsidies. And when that happens, Congress will have to appropriate money to retire the Treasury's debt. This means that the Treasury is engaged in what is in effect deficit spending.
The big policy news this week has been the Fed’s decision to buy $1 trillion of long-term bonds, going beyond the normal policy of buying only short-term debt.
. . . Now, the Fed isn’t taking on any serious default risk — Treasuries are backed by the full faith etc of the US government, and agency debt is de facto backed by the same, although the market doesn’t seem to believe that. Anyway, the Fed is for these purposes a government agency itself, so all this is debt between different parts of USG.
The Fed is, however, creating a new liability: the monetary base it creates to buy these bonds. In effect, it’s printing $1 trillion of money, and using those funds to buy bonds.
. . . The problem may come when the economy recovers, and inflation starts to become a problem rather than a hoped-for outcome. Basically, there will come a time when the Fed wants to withdraw that extra $1 trillion of money it created. It will presumably do this by selling the bonds it bought back to the private sector.
But here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent, where it was before the crisis. Then the price of those bonds will have dropped significantly.
And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created. So the Fed will have to sell additional assets; if the rise in interest rates is at all significant, it will have to get those assets from the Treasury. So the Fed is, implicitly, engaged in a deficit spending policy right now.
This may all be good, and I hope it is, but no one seems to be paying any attention to it.