There's No Happy Ending to This Bailout

As of the time of this writing, the Emergency Economic Stabilization Act of 2008 is scheduled to be introduced in the House of Representative on Monday, September 29th. As I had no special insights on the bailout, I have so far avoided commenting on the situation.

Was foreign pressure the REAL reason for the bailout?
However, there is something that not many have talked about that makes me compelled to speak up. While some have pointed to the breakdown in the credit markets as the compelling reason for a bailout, there is gathering evidence that the US authorities succumbed to Chinese pressure to “make them whole”, so to speak, on China’s investments in US paper.

The Washington Post recently reported [emphasis, mine]:

As U.S. officials were deciding in August whether to take over Fannie Mae and Freddie Mac, the Treasury Department held informal talks with officials from the People's Bank of China, the country's central bank. At that time, investors in Fannie Mae and Freddie Mac in China were dramatically reducing their holdings. The U.S. side told China that a cash infusion was in the works; China said that it expected the U.S. government to "do whatever is necessary" to protect the investments.

As an indication of further pressures, China also signaled that it could shift away from USD assets. Given the size of the US current account deficit, a buyer’s strike of USD paper would send long rates soaring and the economy would nose-dive into a serious recession, if not another Depression. In that case, the US authorities may have caved into Chinese pressure and chosen to bail out Agency paper.

Two unpalatable choices
To finance the bailout, the United States has two choices. It can either monetize the debt or go to its lenders, hat in hand, to finance the bailout at whatever terms it can get. As any first year economics student can tell you, any monetization of debt of this size would be inflationary.

If the US chooses the latter path, the Washington Post article reported that:

Ibuki, the Finance Minister, said Friday that Japan would consider funding the International Monetary Fund or other international lending agencies to help with bad debt.

IMF mandated adjustments have always been very painful. Whatever path is taken, this bailout is destined to end in tears.

Comments

[pochovilla:]

I borrowed $100 from my best friend with a promise to pay it back when I deposited my next paycheck. When I went to return it, he wasn't there so I gave the $100 to his wife. She called her girlfriends and spent the $100 at lunch and while they were out she charged $200 on her credit card.
Tears?

2008 Sep 29 04:30 AM

[Steven Hansen:]

not sure about this Cam. china had as much to lose as the usa so i do not think it was a threat. i bet they were pretty vocal though.

inflation would not be anywhere near the top of my list of current economic worries.

2008 Sep 29 05:50 AM

[msoori:]

These issues of foreclosure will continue till we address the real underlying issues of job creation. We are putting band aids at wrong places. Read more at xmplary.blogspot.com

2008 Sep 29 08:32 AM

[TinyTim:]

Finally we're getting to the real reasons for the bailout. It's not credit and liquidity. This article is one of the few that goes to the actual reason Paulson, et al are in such a panic about wall st. It may well be the end of the "deficit without tears" i.e. USD loses its defacto reserve status. When the dollar is devalued to 10% like some Third World country, how embarassing for us.

The other reason for the panic is the preservation of the SWF's. If they ever start thinking there is a better / safer investment out there than the US, the dollar is sunk. Globalization is the great equalizer. Devaluation will bring the US economy abruptly to the true level that the Feds have been trying to hide or ease into. Forcing China to eat their poor investments might even be considered an act of war.

So it's less about Main Street and more about The Hill.

2008 Sep 29 09:54 PM