Tuesday, June 9, 2009

Economic Stimulus: Part 3 – Why Government Spending Will Not Work

Government spending will not lead us out of the current recession. The economy of the United States will eventually recover but government spending will not “prime the pump” to use FDR’s words. This recession was caused by too much debt. So much debt that it couldn’t be paid back or serviced by overextended borrowers.

Citizens have started saving, paying down debt, and in some cases defaulting on it. This must happen. The level of debt must come down to historically normal levels as a percentage of incomes in order for a recovery to sustain itself.

Since the federal government’s income from taxes is falling, and since the government has zero savings, the expansion of government spending is funded with borrowed money through the selling of Treasury Bonds.

With the yields (the effective interest rate based on the price paid) of Treasury Bonds creeping up past 4.0% there are not enough buyers. The Federal Reserve (Fed) is, therefore, buying Treasury Bonds for its own account in order to keep the yields from rising higher and faster.

However, when the Fed buys Treasury Bonds they don’t use real money. The Fed pretends to have the money. They literally just send data indicating the amount they are supposedly paying for the bonds to the accounts of the US Treasury Department. Individuals who attempt this are guilty of a felony; bank fraud jumps to mind.

The financial press, when referring to this process, say the Fed is “printing money”. The Fed doesn’t actually print it – they make fraudulent accounting entries; Sarbanes-Oxley jumps to mind.

In addition to the purchases of bonds by the Fed, many bonds and the shorter term Treasury Bills are purchased from outside the United States - especially by foreign governments – especially by China. Foreign purchases have the same effect as purchases by the Fed; more dollars become available for circulation in America.

All of these dollars are briefly in the hands of the federal government.

The idea is that since the people are spending less (they are busy paying down debt) the government must spend enough to make up for the lack of private spending. The problem is two-fold. (1) Government is creating public debt faster than people and corporations can pay down private debt so the total debt problem continues to grow. (2) Government borrowing from overseas, and from the Fed’s creative accounting, increases the number of dollars in circulation without increasing goods and services available to buy.

Government is also diverting some economic activity to low priority projects not previously deemed worthy of funding. The people, meanwhile, still must pay down their debt. So, consumer spending will remain suppressed as the excess dollars find their way into circulation. Eventually price and wage inflation will become noticeable - and then alarming.

Inflation will help some people service their debt since fixed debts like 30 year fixed rate mortgages will remain unchanged while wages increase. These people will have more dollars available to make the same monthly payments. Their debt will be a smaller portion of their inflated income.

People with variable debt (adjustable rate mortgages and credit card debt for example) won’t be so fortunate. Their interest rates will rise - perhaps faster than their wages. Inflation will also hurt the banks as their portfolios of fixed rate loans lose value.

Independently of government spending and inflation issues, banks and housing prices are already queued up for another round of mortgage defaults. There is a large group of mortgages out there with balloon payments or major payment resets due in 2010 and 2011.

It’s an open question whether these mortgage payment resets will, by themselves, delay the recovery and the ensuing inflation, or whether the recovery and inflation will start first and the new mortgage resets, and subsequent defaults, abort the recovery and throw us into a double-dip recession.

Another possibility is that the second round of mortgage defaults will join the inflation in progress - resulting in recession with inflation similar to the “stagflation” of the late 1970’s and early 1980’s.

The least likely possibility is a recovery without inflation and without a double-dip recession. The probability of this rosy scenario is slightly higher than a snowball’s chance in Hell.

Links to Other Topics in the Special Report: Economic Stimulus

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