Thursday, February 12, 2009

Aftermath of Spendulus

The present form of this stimulus plan is probably about the best that one could expect from Beltway politics. Whether this spending contributes to a productive recovery that outweighs the increase in public debt remains to be seen. I also think that it risks being a dead letter unless more progress is made cleaning out the banking sector.

The key to these matters lies in the Geithner speech on Tuesday, which indicates a continuation of the US authorities’ policies to fudge and delay in cleaning out the banking system to put things in order. For political reasons the preference has been to keep large banks alive on taxpayer money. When Geithner revealed the massive additional bailout sums in mind, I believe this really frightened the financial markets. These sums make the Obama Stimulus Plan pale in comparison and add to the major issue of the future: how these massive federal deficits and increase in public debt are going to be financed and the eventual debt monetization. Even Summers and Geithner concede this is an issue.

The longer the US delays in repairing the financial system, the more likely an L-shaped recession with a prolonged period of economic stagnation. I suppose the Beltway is praying that the Stimulus Plan will somehow reverse things and soften the bank losses so they will avoid having to resort to more orthodox means to clean up the financial mess and face potentially losing most or all of the taxpayer money already injected in many sick banks.

The conundrum down the line is how - if an L-shaped recovery of prolonged sluggish growth emerges - the US is going to monetize its significantly increased public debt load that moves to EU levels of GDP?

The US Authorities have been placing heavy bets against this scenario. If the dice fall against them, they will have the unenviable choice of either raising taxes in a sluggish economy or tolerating a policy of high inflation to devalue the government debt. The inflation path will jeopardize the public debt refinancing with foreign creditors.

The EU with high public debt and large entitlement programs has been locked into this misery for many years now. They are partially subsidized by the US for their defense spending needs. They are permanently constrained to relatively tight money and an overvalued currency to be able to roll over their large public debt loads. How will the US face this scenario plus the substantial weight of military expenses that their allies are unlikely to share?

I would add that there is likely to be less future capacity in major markets for US treasuries. The ME is suffering from low oil prices and the aftermath of their grandiose real estate and refinery projects. There is heavy speculation on rising oil prices in the futures markets, however.

More significantly the FE has been burned from the collapse in their export markets. Countries like China are diverting their cash reserves for their own stimulus programs to shore up domestic demand; otherwise they face dangers of social unrest. With this and a collapsed export market, they have less to lend to the US. Longer run they may have less incentive to continue to do so, seeing their interest to develop their own domestic markets as a more reliable base for their economic expansion.

I think that we live in a period of challenges and rapid changes.

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