I’ve been thinking mostly about the global portion of the loop—how the dollars we send abroad on the current account (and now, just a bit, on net private capital outflows) are returned to us—and its operation under the Paulson plan. The Fed/Treasury team is proposing to allow this recycling to proceed under an asset cleansing program: the Fed removes the bad assets from our creditors’ portfolios while the Treasury replaces them with nice, reliable T-bills. (Metaphor: TARP as a giant mollusk in the sea of finance.) So far so good.
But this is only part of the picture. The other part is the domestic sector. Our current account deficit says that, as a country, we consume about 6% more than we produce, where “consume” in this context means total demand and not just the household piece of it. So the recycling process has to actually get the money into the hands of those who will spend it. This means credit expansion of some form. To be more specific, capital spending is very weak at present, and households are now holding up the tent. They have been borrowing against largely fictitious real estate equity and, to a lesser extent, running up credit cards and drawing down savings. If the popping of the housing bubble and the retrenchment of consumer credit mean that these channels are no longer available, how do we keep the engines running?
Basically, there are two channels still open: fiscal deficits and further drawdowns of savings. In the case of the former, it is important to be able to identify how the deficits will enter the spending stream. I worry that much of the eleven-figure disbursement will simply keep financial institutions, now highly risk-averse, afloat. This maintains existing wealth for the small minority that holds most of it, but it doesn’t translate into effective demand. And eating up savings can go only so far. Say what you want, the asset bubble(s) promulgated by earlier rounds of recycling at least propped up domestic spending. I worry that, even if the bailout keeps the global loop in operation, it will not be able to reconnect it to the domestic loop. The result will be a monster recession.