Sunday, September 28, 2008

This bailout is destined to end in tears

As of the time of this writing, the Emergency Economic Stabilization Act of 2008 is scheduled to be introduced in 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 nosedive into a serious recession, if not another Depression. In that case, the US authorities may have caved into Chinese pressure and chosen to bailout 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 it 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.

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