Funding the bailout – nation of debtors & foreign creditors

The US is a nation of debtors and once again the US plans to fix its troubles with nothing else but more debt. According to the US Department of the Treasury’s September 20 Fact Sheet, the $700B proposed “bailout” of mortgages and other troubled assets will be funded through the Treasury’s general fund.

Funding. Funding for the program will be provided directly by Treasury from its general fund. Borrowing in support of this program will be subject to the debt limit, which will be increased by $700 billion accordingly. As with other Treasury borrowing, information on any borrowing related to this program will be publicly reported at the end of the following day in the Daily Treasury Statement. (http://www.fms.treas.gov/dts/)

As of the end of July 2008, $2,676 billion of US treasuries were held by foreign governments and institutions. Nations of Savers are leading the way; Japan and China hold $593B and $519B in treasuries respectively. A similar cast of characters will be the likely purchasers of the bailout financing. Multiple concerns arise from the increase in US national debt balance: (1) Our children will pay for our mistakes in the form of interest; (2) The increased debt burden, debt service and interest, will continue to make balancing the budge more difficult; (3) Significant holdings of US treasuries may have negative implications for the US in the form of a strategic bargaining position.

The January 2008 CRS Report for Congress, “China’s Holdings of US Securities: Implications for the US Economy,” highlights the concerns of many economists with the high level of foreign debt held by our, at times less than friendly, neighbors. The report focused on the comments of two Chinese officials regarding China’s ability to tank the US dollar by liquidating large blocks of US Treasuries. This ability could be used as a bargaining chip in strategic trade negotiations, such as the US protection of the steel industry. A flood of US dollars in the market place would create a rapid deterioration of the US Dollar and an increase in interest rates (bond price declines à increase in bond yield). A decline in the US Dollar would increase the price of imports and put substantial pressure on an economy dependent upon foreign imports. A systematic depreciation in the US Dollar (as noted in my previous post) could lead to a reduction / elimination of the trade deficit (positive), but a sudden drop coupled with an increase in interest rates would make the necessary expansion of exports difficult (negative).

China probably would not have a credible threat. The US accounts for 30% of all Chinese exports, if the US Dollar depreciates substantially verse the Yuan, the US will reduce purchase of said exports. The fourth largest foreign holder of US Treasuries is “Oil Exports” (South American and Middle Eastern nations) many of which are unfriendly. Who needs who more? The US has substantial dependence on Middle Eastern oil; however, oil is denominated in US dollars. As long as oil is denominated in US dollars, major oil exports have an incentive NOT to see a precipitous depreciation in the US Dollar verse major foreign currencies.

Budgetary impact – Prior to the proposed bailout, net interest expense is expected grow by more than 8% in 2008 and 2009. Additionally, net interest accounts for nearly 2% of the US GDP. While near term the added interest expense ($700B x ~3% = $20B in annual interest expense) would have a negative impact on the current budget, the total cost is unknown, as it is unlikely for all the troubled assets to go to zero.

I am certain of two things: (1) While I do not know what, something needs to happen to restore confidence in US & Global financial institutions; (2) Americans need to start saving.