Give It A Rest Already — Another $2 Trillion?!

I keep trying to stop writing about these things so I don’t sound like a broken record, but it’s not my fault that they aren’t giving us even a single day of rest. Apparently they are now talking about buying up to $2 trillion worth of bad debt in order to try to spur lending again; an amount that should “take care” of the problem once and for all. This is an awful idea for many reasons.

The most obvious reason is that right now it doesn’t look like they are seeking any form of restitution. In fact, they are bending over backwards to give them hundreds of billions without trying to interfere at all. This is ridiculous, and like I’ve said before, outright theft from the tax payer. Even $700 billion is more than enough to create a completely new chain of banks, and $2 trillion is about 30% more than the entire banking system had before the start of the writedowns. If they are seriously thinking of trying to “start over” then it should be done in a way where all the existing banks that deserve to fail, fail.

All my prior writings show other reasons why I’d be against it, and while I won’t repeat those, I was reminded of a very concrete reason by this excellent comment at Obsidian Wings:

But right now it looks like our ability to raise addition funds selling to the long end of the yield curve is very limited, because foreign central banks are shifting their porfolios towards the short end of the curve (they would be fools not to). See this post by Brad Setser for some very scary graphs showing how rapidly foreign demand for long bonds (note that Setser is graphing not just T’s but Agencies and corp bonds) is tailing off (hat-tip: Nemo, who unpacks what this means in plainer language).

What this all means is that we can only finance a stimulus up to a maximum amount equaling the size of current year foreign demand for short dated Treasuries. It isn’t US domestic politics that is in the drivers seat to determine this number, but rather our Chinese banking overlords and how long of a leash they are willing to put us on.

Briefly, his quote “they would be fools not to be” refers to two things. First, there is a growing risk of a US Government default within the next 10-30 years, so holding long dated bonds is risky. More prosaically, with all this spending and all the Fed’s efforts to create a lot of inflation (because they erroneously think it will help) it becomes very dangerous to hold ten or thirty year bonds because they may drop in value a lot due to inflation. The result is that major players are now selling the long dated bonds (in fact the 30 year dropped the most in history last week) and moving the money into short term bonds.

Not being able to sell long term bonds is problematic for the government. If we have to finance all our adventures on the short end of the curve, then we will have to roll over the debt often and pay the prevailing interest rate — which by definition will be a lot higher than it is now if we start to successfully change things. This means that the interest payments on the debt we are occurring could easily be 2-3x current projections. If you factor in the increased rates on our existing debt, I could see this action easily increasing annual interest payments by stimulus sized amount ($300-$400 billion) which of course means at some point taxes have to be raised that much or programs cut. The other problem is that when the debt rolls over we have to convince the buyers to roll the money back into treasuries, and if they don’t want (or are unable) to, we have a huge problem. There could easily be a new liquidity crisis, except with government debt this time.

On a consumer level, the rise in long term rates also will cause mortgage rates to rise, exacerbating the housing downturn, and business funding costs to rise, deepening layoffs. The Fed’s response to this is that they could then buy the long term treasuries, but this would have to involve printing a lot of money, blowing up their balance sheet even more, and perhaps making them lose control of the money supply which would make the dollar plummet.

The banks got in trouble because they assumed they would have access to cheap short term credit forever, and then made dumb long term loans. That is exactly what the government is trying to do, and we will have all the same problems, except there will be no larger entity to help. I’ve said it so much that it’s become tiresome, but once again, by putting all our eggs on the “Depression Must Be Avoided At All Costs” square, we won’t be ready when a different number is hit. How was that for a tortured mixed metaphor? But one that captures this crazy time.

Update: “Chinese Premier Wen Jiabao squarely blamed the U.S.-led financial system for the world’s deepening economic slump…Beijing is re-examining its U.S. investments.” Assuming the world will support our growing need for debt indefinitely is a very dangerous game to play. There are increasing murmurs that they will stop supporting even much of our existing debt, especially as things get worse and they question whether it’d be better taking a one-time economic hit. All our models don’t account for the fact that China may just decide that it can live without us and use force to maintain domestic order until they get through the transition.

Update #2: The 10 year yield has skyrocketed nearly 0.3% in the last two days. It is now 0.8% above the low mark, while the 30 year is up over 1.0%. The shorter dated bonds have risen about 0.2% in that same time. It will be interesting to see if this is the beginning of a new rise in yields or whether it’s temporary, but the immediate reaction is very bad.

Update #3: Maybe $2 trillion isn’t enough…$4 trillion?