Recession's grip induces the United States to flood the world with even more dollars.
finances by Rich Miller | Bloomberg News
The world needs more dollars. The United States is preparing to provide them.
In an all-out assault on capitalism's worst crisis since the Great Depression, the U.S. is taking on the role of both lender and borrower of last resort for the global economy.
The Federal Reserve, which has already pumped out hundreds of billions of dollars, might formally adopt a policy of flooding the world financial system with even more money. The Treasury, on course to borrow some $1.5 trillion this fiscal year, may tap global capital markets for even more to finance a fiscal stimulus package of as much as $700 billion and provide additional bailout money for banks.
"You want to do everything you can when you're facing the threat of a deflationary breakdown of the economy," says Michael Feroli, a former Fed official who is now an economist at JPMorgan Chase & Co. in New York. He sees the central bank cutting the overnight lending rate to zero in January and holding it there throughout the year.
Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson are being forced to pull out the stops because the extraordinary actions they've taken so far have failed to gain much traction. Credit markets are collapsing, stock prices are plunging and the world economy is sinking into a recession.
As the economy deteriorates, deflation - a sustained decline in wages and prices - is emerging as a new threat. U.S. government figures last week showed that consumer prices excluding food and fuel costs fell in October for the first time since 1982.
Investors, shell-shocked by the turmoil, are piling into super-safe Treasury securities, even as the U.S. government ships more supply out the door. Three-month bill rates dropped last week to 0.01%, the lowest since at least January 1940, and yields on Treasuries maturing in two through 30 years all fell to the least since the government began regular sales of the securities.
And the dollar has risen as loss-ridden banks worldwide husband their resources, even after receiving generous dollops of liquidity from the Fed. The U.S. currency has surged about 17% against the euro - signaling demand for still more dollars - in the two months since the crisis deepened after the failure of Lehman Brothers Holdings Inc. Meanwhile, gold is down almost 25% from its peak in March.
To help fight the worldwide dollar squeeze, the Fed has set up currency swap lines with more than a dozen other central banks. Some arrangements, including those with Europe, Britain and Japan, are open-ended, allowing the Fed's counterparts to draw as many dollars as they need. The U.S. has also established individual $30 billion swap lines with Brazil, Mexico, South Korea and Singapore.
In a speech to a banking conference on Nov. 14, Bernanke characterized these efforts as an "internationally coordinated approach" among central banks to fulfill their function as lenders of last resort.
As the Fed has stepped up its efforts to combat the credit crisis, its balance sheet has mushroomed. Assets rose to $2.2 trillion on Nov. 19 from $924 billion on Sept. 10, just before the bankruptcy of Lehman Brothers shook the global financial system.
The central bank's holdings are likely to increase further. "I would not be surprised to see them aggregate to $3 trillion - roughly 20% of GDP - by the time we ring in the new year," Dallas Fed President Richard Fisher told the Texas Cattle Feeders Association on Nov. 4.
Only the start
That may be only the start if the Fed cuts its benchmark rate, now at 1%, to zero and adopts what economists call a policy of "quantitative easing." Under such a strategy, it would concentrate on expanding the amount of reserves in the banking system because it could no longer reduce the cost of that money.
The Bank of Japan followed this policy in the early part of the decade as it struggled to rescue the world's second-largest economy from the grip of deflation. Its balance sheet eventually rose to the equivalent of about 30% of gross domestic product, says Tom Gallagher, head of policy research for International Strategy and Investment Group in Washington.
"The Fed could blow through the BOJ's ceiling," he adds, ballooning the central bank's holdings to more than $4 trillion.
The Treasury is also heading into uncharted territory as it taps capital markets for cash to help finance its bailout fund for the banking system and plug holes in the federal budget caused by the weak economy.
Much of that money will come from abroad. "Foreigners don't seem to be interested in any kind of risky U.S. assets," says Brad Setser, a former Treasury official now at the Council on Foreign Relations in New York. So, "instead, they are buying Treasuries." That includes China, which recently passed Japan as the biggest holder of Treasuries.
On Nov. 3, the department tripled its estimate of planned debt sales in the final three months of the year to a record $550 billion. Paulson told a conference in Washington Nov. 17 that the U.S. will issue some $1.5 trillion worth of Treasury securities in the fiscal year that began Oct. 1.
That number, too, could grow. Lawrence Summers, Treasury secretary under President Bill Clinton and an adviser to President-elect Barack Obama, told the same conference that the U.S. needs a "speedy, substantial and sustained" stimulus package to aid the economy.
More government spending
"Government may have to spend $600 billion to $700 billion next year to reverse the downward cycle," Robert Reich, another Obama adviser and a professor at the University of California at Berkeley, wrote in his personal blog Nov. 9.
Kenneth Rogoff, a professor at Harvard University in Cambridge, Massachusetts, and former chief economist at the International Monetary Fund, says the new administration will also have to ask Congress for more money to repair the financial system, over and above the $700 billion already authorized for Paulson's Troubled Asset Relief Program.
"By the time all this ends, the TARP is going to be closer to $2 trillion than $1 trillion," ISI's Gallagher says.
Paulson has already committed $290 billion from the program to buy preferred shares in banks and troubled insurer American International Group Inc.
There's always a danger the Fed and Treasury may go too far, setting the stage for a big rise in inflation or another asset bubble down the road as the economy revs up and investors get back their nerve. That's what happened in the early part of the decade as ultra-easy Fed policy and Treasury tax cuts helped fuel a credit boom since gone bust.
Bernanke and Paulson might welcome a bit of that exuberance right now - even at the risk of higher inflation later - as they try to prevent the biggest credit catastrophe in decades from sending the economy into a deflationary nosedive.
"It's true that, over the long run, too much money creates inflation," says Lyle Gramley, a former Fed governor now at the Stanford Group Co. in Washington. "But they're trying to keep the economy from going over the precipice and into the abyss."