More backwards thinking on spending

Cost of U.S. Crisis Action Grows, Along With Debt (Update1)

By Matthew Benjamin

Oct. 10 (Bloomberg) -- The global financial crisis is turning into a bigger drain on the U.S. federal budget than experts estimated two weeks ago, ballooning the deficit toward $2 trillion.

Bailouts of American International Group, Fannie Mae and Freddie Mac likely will be more expensive than expected. States are turning to Washington for fiscal help. The Federal Reserve said this week it will begin buying commercial paper, the short- term loans companies used to conduct day-to-day business, further increasing costs. And analysts now say the $700 billion bank- rescue plan passed by Congress last week may have to be significantly larger.

``I always assumed they would be asking for more money along the way if it was necessary, and it looks like it's going to be necessary,'' said Stan Collender, a former analyst for the House and Senate budget committees, now at Qorvis Communications in Washington. ``At the moment, there's nothing happening here that's positive for the budget. Nothing.''

The 2009 budget deficit could be close to $2 trillion, or 12.5 percent of gross domestic product, more than twice the record of 6 percent set in 1983, according to David Greenlaw, Morgan Stanley's chief economist. Two weeks ago, budget analysts said the measures might push deficit to as much as $1.5 trillion.

Yes, and the 6 percent in 1983 presaged strong economic growth, so 12 percent has the potential of being even more stimulative. The deficit during WWII ran up to 40 percent of GDP. Did the U.S. economy collapse? On the contrary, that deficit spending fueled huge growth that carried us for 20 years.

Yields to Rise

That means a lot more borrowing by Treasury, which will push up interest rates, said Greenlaw. ``The Treasury's going to be ramping up supply dramatically over the course of coming months to meet this enormous federal budget obligation,'' Greenlaw told Bloomberg this week. ``The supply will trigger some elevation in yields.''

Japan's debt is twice as large as the U.S., yet interest rates remain near zero. The government spends the money first (puts it into the economy) and the Treasuries are purchased with the funds the government has already supplied. There is little or no effect on interest rates.

Treasuries have fallen the past four days even as stocks sank, a sign investors are preparing for bigger U.S. government borrowing. Benchmark 10-year note yields rose to 3.82 percent at 7:49 a.m. in New York, from a close of 3.45 percent Oct. 6.

Payments the government allocated to keep vital companies solvent are beginning to look insufficient.

They can always do more and likely will, along with a fiscal package that addresses demand.

AIG, the giant insurance company that was taken over by the government in mid-September, said this week it may access $37.8 billion from the Federal Reserve Bank of New York, in addition to the $85 billion the government already loaned it to stave off bankruptcy.

``You're in for a dime, you're in for a dollar on this one,'' said David Havens, a credit analyst at UBS AG.

The financial health and earnings prospects of Fannie Mae and Freddie Mac -- seized by the government on Sept. 7 to prevent them from failing -- worsened in the second and third quarters, the companies' government regulator said this week.

These entities have effectively been nationalized and therefore are not at risk. In addition, they are being allowed to exist because of a political desire to foster home ownership. This is a public policy issue and so far, there is no sign that the U.S. wants to abandon its drive for universal home ownership. If it did, these entities would be closed or wound down.

Price Declines

The companies and regulators are recalculating the value of all of their assets to factor in price erosion. That may mean the government will have to spend more to keep the firms solvent.

Again, a public policy choice: supporting home ownership. In our society we deem that as a good thing.

Earlier this week the Fed announced it will create a special fund to buy commercial paper, the credit that businesses use to finance payrolls and other ongoing expenses. The Treasury will deposit money into the Fed's New York district bank to help set up the new unit. A Fed official said Treasury funding for the program could be ``substantial.''

The $700 billion is only 5 percent of GDP. We're talking single digit percentage levels of investment.

California, Alabama and Massachusetts are urging the Fed and Treasury to include their securities in rescue plans designed for banks and businesses. The $2.66 trillion U.S. market for state and city bonds has been all but frozen since Lehman Brothers Holdings Inc., weighed down by losses in mortgage-backed bonds, declared history's largest bankruptcy on Sept. 15.

Yes, we're lucky. We have a Federal Gov't to back our states. Europe doesn't. Individual countries there potentially face an Argentina-like situation  under the current structure.

California has said it needs to sell as much as $7 billion in notes to maintain its schools, health system and other public services. The Bush administration said it is reviewing the states' financial positions.

Plan for Banks

Meanwhile, Treasury Secretary Henry Paulson indicated two days ago that he is considering buying stakes in a wide range of banks in coming weeks to help recapitalize them.

This has been the "kiss of death" for bank
stocks. Because of this ridiculous notion of "taxpayers being on the hook," the Treasury is punishing existing shareholders every time they take
an equity stake. Stupidity in the extreme!!!

Such a move is allowed under the $700 billion bailout package Congress passed last week. Edmund Phelps, winner of the 2006 Nobel Prize for economics and a professor at Columbia University, said such action is necessary -- and will likely turn out to increase the measure's cost. Spending beyond the amount set in last week's bill would require further Congressional approval.

Congress will resist additional spending because an
ignorant electorate sees it as putting "taxpayer money at risk," and
bailing out Wall Street fat cats.

``We have to recapitalize the banks,'' Phelps told Bloomberg Television this week. ``I don't imagine that there's enough money in the first Paulson plan to be able to do all that needs to be done in that direction.''

The additional borrowing could push the national debt well past 70 percent of GDP, the highest since the immediate aftermath of World War II, when the U.S. was still paying off war debt.

That would still be far less than Japan's 200 percent of GDP. Is Japan a Third World nation? Hardly.

Debt Limit

Gross U.S. debt, which includes debt held by the public and by government agencies, this year reached about $9.6 trillion, or about 68 percent of gross domestic product. The rescue legislation increased the government's debt limit to more than $11.3 trillion from $10.6 trillion.

The debt limit is a politically imposed constraint not an operational constraint. Only petulant idiots like Newt Gingrich and his band would shut down the government and expose us to real default because of such a meaningless thing.

On top of all that, budget watchdogs say the sheer size of the interventions is making Washington more profligate than usual. To attract votes in Congress, leaders added several costly items to the $700 billion rescue, including extensions of some tax credits and tax breaks for makers of wooden arrows and stock- car racetrack owners.

This is a political sideshow--an attempt to smear an
economic rescue.

Under normal circumstances, there would have been more resistance to such expenses, said Robert Bixby, executive director of the Concord Coalition, a non-partisan budget watchdog.

The rescue legislation ``creates a mask for all sorts of fiscal irresponsibility,'' said Bixby. ``It covers up a multitude of sins.''