Crowding out in full swing

By all estimates, the Federal government will seek to raise well over one trillion dollars via Treasury instruments to fund a variety a bank rescues and spending programs. Where will the money come from? Indications are that central banks spent most of 2008 readjusting their portfolios, mostly by selling their existing holdings of corporate and agency bonds to purchase treasuries, and increasingly on the short end. Some central banks were less lucky and were battered with capital flight, which depleted their dollar holdings, but the money ended up in the treasuries anyway. With the rapid slowdown in global trade, it is unlikely that oil states and exporters will be adding significant treasury holdings, especially against the backdrop of capital flight.

The Fed was able to finance a large portion of its Treasury issuance in ’08, but at the expense of other financial markets. The collapse in the equity markets wiped off trillions in household wealth, inducing a sudden drop in consumption and bill payment from American households. The credit market certain suffered a heart-attack. And large states like NY and Cali are facing budget short falls in the tens of billions in the current fiscal year. Unless the Fed uses the money that it raised to refinance sovereign debt, countries in South America and deficit countries are looking at defaults as well.

Which brings us to this point: If the Fed is successful in raising the full amount of Treasuries without having to monetize the debt, the world’s financial markets will again stare in the face of bankruptcy. Private enterprises and nations will be shut out of the capital market, causing massive defaults in the private sector. Consequence would be dire if the US government choose to use this money for long term infrastructural projects, which does little to provide goods and services that people need today. A political consequence could be that nations friendly to the US may get special treatment in the form of currency swaps so that they can effectively finance their external obligations with their own currency indefinitely. And the corporations that operate the largest workforces may get friendlier responses to requests for access to working capital from the Treasury than smaller ones. The potential for political abuse is unlimited. Lenin could not have dreamed this one up any better.

As I have been saying from day one, the Fed needs to systematically insure all classes of debt in order to avoid the scenario where it becomes the central allocator of capital of the world.

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