Saturday, September 20, 2008

Uncle Sam's Growing Tab

America was facing the mother of fiscal time bombs before this week. Now, it faces another. The government's plan to take hundreds of billions of dollars in bad loans from stressed banks could cause the national debt to rise through the end of this decade. That is nicely timed to coincide with the enormous cost of shoring up Medicare and Social Security, as baby boomers retire.

Don't be surprised if the dollar and Treasury bonds weaken as the fiscal math gets done. The numbers could get scary.

Excluding the bad-loan plan, the feds had already made more than $600 billion available for bailouts for Bear Stearns, American International Group, Fannie Mae, Freddie Mac, underwater homeowners and money-market funds.

The extra cost of relieving banks of their toxic assets could be between $500 billion and $1 trillion, going by preliminary reports.

It is impossible to guess the final cost. But $1 trillion would be equivalent to 7% of GDP and more than 10% of the outstanding national debt. To wit, after seizing Fannie and Freddie, the government now stands behind $5 trillion of mortgages, or nearly half of all home loans outstanding. And the government now appears to account for more than 80% of new mortgage lending.

While this should hurt Treasurys and the dollar, a simple, straight-line sell-off is unlikely. During the current uncertainty, Treasurys will continue to attract flight-to-quality buying. The greenback also will find some support from looming problems in Europe and Asia.

Also currency markets might see the fiscal cost as a good trade-off against the bigger risk of letting the U.S. slip into a deep recession. After all, Japan let its government debt soar in the decades after its late-1980s bubble from under 20% to more than 90%. Yet the yen didn't go into long-term decline and interest rates hardly went through the roof.

The big difference, though, is that Japan had a current-account trade surplus, while the U.S. has a big current deficit, financed in part by foreign-capital inflows into things like Treasurys. Uncle Sam, with possibly $1 trillion of new commitments to add to its baby-boomer bill, is now even more reliant on the kindness of those foreigners.

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