There is a reason why credit spreads widen. It is to more adequately compensate savers for taking risk. Adequate compensation for risk forestalls panic by providing an incentive to those with liquidity to supply it. In contrast, extremely loose monetary policy is procyclical and drains liquidity from economies. How can extremely low interest rates and quantitative "easing" create such a counter-intuitive result?
Widening banks' net interest margin by dropping rates to near zero at the low end of the curve will temporarily create accounting profits at banks. However, as inflation takes hold, this seeming "quick fix" will decimate the real economic value of financial institutions' mortgage portfolios and any bonds with a duration of over 10 years. Even with a full suspension of mark-to-market, the real economic book value of many insurance companies and banks may be catastrophically eroded (Buffett observed this years ago with insurance firms during stagflation). This could have the effect of removing liquidity from the system at precisely the point our economy needs it.
Moreover, we cannot afford for the government to be glib about the value of the dollar. Dangerously, given China's recent push for IMF SDRs, the Treasury does not understand that America's profligate borrowing cannot rest on a nebulous concept of our specialness. Our ability to fund our deficit rests squarely on our ability to borrow in our own currency. Once that option is taken away, all bets are off. Policy flexibility will no longer exist. The tipping point will have been reached.
Even if we can continue to borrow in dollars, our policies may have counter-intuitive effects. As a country, we need to understand the dynamics of non-linear effects surrounding interest rates. Just as at some point, higher interest rates no longer compensate the lender for increased risk on the part of the borrower, but actually increase defaults, low interest rates often have the opposite of their intended effect. Extremely low interest rates can vacuum liquidity out of nations. Japan has been referred to as a nation where loose monetary policy was like "pushing on a string." There was no push. It was a pull. Liquidity was sucked out of the country as the Yen became the world's carry trade currency of choice.
Borrowing in a currency is the opposite of investment. It is liquidity-draining to the carry trade currency nation. For all of the talk about about using monetary policy to dampen the business cycle, no result could be more damaging or procyclical.
Policies which create macroeconomic imbalances make it harder for good institutions to chart their own course. The buffeting forces of procyclical policies simply become too great. What institution, no matter how well run, could survive a debt crisis, hyperinflation, the decimation of its bond portfolio, and a sinking economy?
The very credit spreads that the government seeks to narrow may burst at the seams if the Fed and Treasury maintain their current course. Perhaps that is what it will take for lasting liquidity to be restored to our financial system. We may actually need to take our medicine. However, Americans may finally realize that there is a free lunch after all--we will be supplying it as speculators borrow in our low-yielding currency to invest elsewhere.
