The bailout of Freddie Mac and Fannie Mae seemed like a sideshow diversion compared to hurricanes and elections, but it could actually have been the biggest news of the week. Untold (really - nobody knows!) billions of dollars will be required from taxpayers to maintain the company solvency.
While shareholders (including a surprising number of small banks) are out of luck, debt holders are sort of protected. And as Tyler Cowen explains, this is a regrettable but necessary thing.
But let's say that the Treasury did not support the debt of the mortgage agencies. The Chinese bought over $300 billion of that stuff and they were told that it is essentially riskless. The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly. The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket. [More]
Well, that's certainly happy talk! Others feel a government default isn't the end of the world and could force more responsible government borrowing. It will certainly be more expensive. (My favorite analysis here)
The other problem is what Cowen points out: China will not be amused. Can you imagine how our goverment and economy would function if we had to earn our own money instead of importing it?
Finally, in a cruel piece of bad timing, the CBO points out our budget deficit is already zooming out of control.
In its summer budget update, the nonpartisan budget office said the federal deficit would likely double this year compared with last year, and remain at about 3% of gross domestic product for the next two years.What these two events suggest to me is it will be hard to continue to cut (or retain current tax cuts) taxes unless the economy miraculously roars to life. It also means our additional borrowing will strain available global savings and our interest costs will rise to meed our borrowing needs.
For 2008 fiscal year (which ends at the end of the month), the CBO forecast a $407 billion deficit, or about 2.9% of GDP. The deficit should rise to $438 billion in 2009 and $431 billion in 2010.
The medium-term projections now assume continued spending on the wars in Iraq and Afghanistan, and also assume that the 2001 and 2003 tax cuts will expire on schedule.
Unlike the February update, which showed the budget roughly in balance through 2018 under favorable assumptions, the September projection now sees deficits totaling $2.3 trillion over the next 10 years. Those projections assume that the 2001 and 2003 tax cuts expire and that the alternative minimum tax is not changed.
If the tax cuts are extended as the White House and the McCain-Palin ticket want, the deficits over the next 10 years would be $4.2 trillion higher than now projected, CBO said. [More]
I smell serious inflation in the wind.