The Long Term Consequences of Unending US Bailouts of Private Sector Companies

This is the first part of a loosely-envisioned two part series of posts.


The larger topic, which will be the subject of the second post, concerns the long sweep of US economic and business experience from post-WWII to now. How our larger corporations and senior business executives have had incomplete, sheltered and misleading experience such that, in times of challenging circumstances, few of them are qualified and experienced to manage through this environment. And, most importantly, since the days of FDR's Social Security program and the Truman-led wage and price controls during WWII, our society has engaged in deferred promise-making on a scale never before seen in recorded history.


What happens when those two themes collide, and our society cannot possibly fulfill economic promises made by various groups to each other, and, sometimes to ourselves? When promises made in anticipation of straight-line GDP growth and naive hopes of everlasting corporations meet realities of economic cycles, coincident capital market panics and economic recessions, bankruptcies, and temporary value destruction in both real and financial assets?


But, to today's topic,

What might be the global implications and consequences of the ongoing, large-scale US Federal government's Federal Reserve and Treasury outpouring of US dollars, through both borrowing and printing?

I've been pondering this since the TARP bill was conceived and fought over in Congress.

If one were viewing the global financial implosion of the past year from outside of the environment, like some sort of Einsteinian 'thought experiment', what would one have seen, and what conclusions might you draw?

On a broad scale, the US financial markets would have begun to dramatically lose value, beginning with the 'mark to market' impacts on and of the two failed Bear Stearns mutual funds in the summer of last year. As trading ceased in various structured financial instruments composed of mortgages, the most recent of which were increasingly lower-quality 'alt-a' and subprime in nature, the market value of many financial assets plunged, as financial institutions began to sell better assets in order to either raise cash for redemptions or take gains to offset 'mark to market' losses in the structured financial instruments.

Having started, globally, with above-average leverage, financial institutions bearing these losses had comparatively less equity capital with which to absorb the now-outsized losses on exotic securities and, increasingly, more mainstream equities.

As confidence lost in structured finance instruments spread to those institutions operating outside of the Federally-supported banking system, i.e., investment banks, brokerages and hedge funds, their equity values plummeted, counterparty risk rose, and leverage across the entire global financial system effectively began its inexorable shrinkage.

Since leverage, a function of debt, implies confidence in the future returns of loans placed with various enterprises, its unwinding corresponds to a loss of such confidence. The forced reduction in this leverage began, understandably, with the short-term borrowing instruments of both financial and non-financial instruments- commercial paper, most notably.

As this massive de-leveraging of fixed income instruments occurred, the simultaneous drop in real estate values and equity market values caused several consequences.

First, large-scale losses in US, and other nation's market, i.e., societal capital stocks, valued notionally, plunged. Those who previously owned the capital suffered large losses. In the US, the Treasury and Fed moved to support the Federally-registered banks via direct preferred equity purchases and, separately, takeovers of Fannie Mae, Freddie Mac and AIG.

From our external perspective, then, it was as if, following the observance of massive equity and debt capital losses in US society, and others holding US instruments, the US government, choosing to believe that earlier, higher values, were justified, to some extent, simply printed more money and issued liability instruments in order to reflate the financial sector and, indirectly, the business economy.

Whether those choosing to hold US government debt would feel this was purely inflationary, or merely a transfer of wealth from those whose capital value had evaporated, to the US government, is, to some extent, still to be determined.

Yesterday's plunging T-bill yields suggest that, for the moment, the market seeks safety in notes issued by the government of the globe's largest, most free economy, more than it cares about the debauching of the value of the dollar.

The second major consequence of the calamitous drop in price of many stores of value- real property, equity, debt- coupled with the deleveraging, was the cessation of bank lending. Thus, a financial crisis, partially unleashed by a narrowly-defined 'mark to market' rule in a single US law, Sarbanes-Oxley, led to the real effects on non-financial sectors of the US economy. As banks struggled to deleverage their assets in order to both conserve remaining equity from further losses, and abide by regulatory capital requirements, lending suffered. This became a self-fulfilling act, as, starved of normal, short-term operating liquidity, more and more businesses began to reduce operations and cut staff.

The third unforeseen consequence, then, to complete the circle, was the rising joblessness as the economy was already softening, of its own accord, by early 2008.

This last link in the circle of economic causes and effects has now driven a dramatic drop in consumer spending, due to: rising unemployment, lower home values as a source of personal household net worths, and lower financial asset portfolios as a source of personal household net worths.

Viewed again from a perspective outside the global financial and business system, the effect of the market and economic events of the past 18 months has been to dramatically reduce overall investor and consumer confidence in near-term investing and employment conditions, leading to rapid deleveraging and, thus, a reduction in effective money supply.

Since, by Fisher's equation, MV=PO, the fall in the effective quantity of M, assuming, at best, a stable V, must drive a reduction in physical output, price levels, or both. It is now becoming both.

To reverse this effect, as any economics student, Treasury Secretary or central bank chairman knows, assuming velocity has fallen, as has been observed via the freezing of bank lending, M must rise at the rate which one desires PO, or global nominal GDP, to rise.

And that is why central banks are flooding the globe with liquidity, heedless now of later inflation. And, given the notional destruction of so much original capital value, as of early 2007 levels, it is not clear that there will be a consequent inflation. There's simply less market-valued capital and current production available to drive said inflation.

Thus, having fleshed out this thought experiment thus far, to our current situation, what might be the most likely answer to my initial question?

For now, it seems that the flood of US-government-printed dollars will not lead to near-term inflation. And, absent another country of with a democratically-elected government, reasonably-stable protection of property and other rights, the economic size and diversity of the United States, it seems global investors have little choice but to buy and hold the dollar for the foreseeable future. What are their other options, the Euro or Yuan? Hardly.

If there had remained an investor or consumer group totally outside of the now-globally-interdependent economic and financial services web, the US might soon experience a rapid decline in the dollar's value, skyrocketing interest rates, and a loss of appetite for US debt- publicly and privately issued. In short, a severe comeuppance for the largest single economy on the globe.

But that doesn't actually appear to be in the cards, thanks to such tight, fast global interdependencies.

How the US government conducts its retreat, assuming it makes one, from the various large-scale intrusions into the financial and banking sectors, and exchanges its investments for cash which is returned to the Federal Treasury, will govern how the longer term effects of its massive funding efforts have an impact on US and global inflation.