Ouch… the cost of stopping a financial crisis and the business cycle

CNBC has been keeping a tally of the cost for this bail-out and it already over $4.28 trillion. Much of this cost is from the Fed programs which are actually increases in the money supply, but the numbers are staggering. The impact will not just be today but will carry over for years as the unwind takes place.

Using Japan as an example of the long-term costs, the size of the public debt skyrocketed to well above 150% of GDP but there has not been a strong effort by the government to close this huge number. Growth has never been high since the lost decade so the Japanese economy has not been able to grow their way out of public debt. Taxes have not been increased to offset the debt so the financing costs of government output have not been eliminated. This cost has not been as large a problem for Japan as it might be for the US. Savings is very high in Japan so much of the debt is held internally. The US will have to at some point will have to increase taxes to retire the cost of this debt.

The problem in the long-run for any economy that finances a bail-out is twofold. First, the public debt from the bail-out will have to be reduced through higher taxes. Unlike Japan, the long-run cost of the public debt is higher because it is not a temporary wealth transfer between borrower and lender. A high portion of US debt is sold to foreign investors which is a net interest outflow to the rest of the world. The foreign financing have ramifications on currency moves and politics. Politically, the United States will be potentially controlled by the buyers of the debt. The currency impact is unclear because of the special status of the dollar as a reserve currency; nevertheless, the capital account will be in deficit which potentially will have to be adjusted through currency depreciation.

The explosion of the Fed balance sheet has been helpful for stemming the liquidity crisis. Using the quantity theory of money as a simple explanation, we could say that the reduction of private credit is the equivalent of lowering the velocity of money. The only way to maintain the GDP is to increase the money supply in order to offset the declining velocity. The problem will be the transition of Fed lending to private funds once the velocity of money starts to increase. The Fed will have to withdrawal funds and this process may be as sticky as the injection. The best firms will be able to get private financing and the lower quality firms will still be dependent on the Fed. The credit risk will be taken by the Fed.

Why worry about the long-run as opposed to the here and now? Expectations are forward-looking so markets will react before the actual impact. Markets also will respond to the incentives and structures that are placed before them. High deficits and exploding money supply will have an impact on the financial system in ways that we cannot fully understand given the overall magnitude of the adjustments.

Government Entity Sum in Billions of Dollars Federal Reserve (TAF) Term Auction Facility 900 Discount Window Lending Commercial Banks 99.2 Investment Banks 56.7 Loans to buy ABCP 76.5 AIG 112.5 Bear Stearns 29.5 (TSLF) Term Securities Lending Facility 225 Swap Lines 613 (MMIFF) Money Market Investor Funding Facility 540 Commercial Paper Funding Facility 257 (TARP) Treasury Asset Relief Program 700 Other: Automakers 25 (FHA) Federal Housing Administration 300 Fannie Mae/Freddie Mac 350 Total 4284.5

Note: Figures as of Nov. 13, 2008