Simply put, yes it can. In the days following the bailouts of Fannie Mae (FNM) and Freddie Mac (FRE) there have been countless pundits on television and many articles on Seeking Alpha and other investment sites proposing the misplaced thesis that we should worry about the US government's finances following the recent bailouts. The prevailing idea is that if the market's bad debts are transferred to the government than the government will be the one having the problems.
The responsibilities piling onto the government include the Bear Stearns liabilities, the Fannie Mae and Freddie Mac liabilities and potentially Lehman Brother’s liabilities. While these are significant issues and will likely act as albatrosses around the neck of the next administration they were necessary actions that will support the financial framework of not only the United States but the world as well.
Below are some of the more common questions that have appeared around the financial community over the last several days:
- How much can the government add to its $9.6 trillion debt before it too cannot handle its own liabilities?
- When will foreigners refuse to let the US government borrow money?
- When will the dollar truly collapse?
The people asking these questions misunderstand the nature of money and the function of the dollar in the modern global economy. So, how much can the government add to it's $9.6 trillion debt before it too cannot handle its liabilities? The answer is the government can borrow as much as it wants and that it will never be unable to service its debt.
There is a prevailing view that people want to look at government in the same way that they look at a business. People mistakenly look at tax receipts as revenue and government spending as an expense. When the government has a budget deficit and is borrowing money to make up the difference people think the government is losing money.
Certainly, if a business's expenses were greater than its revenues for the last 150 years the business would go bankrupt and people would at some point refuse to lend money to a failing business. The key difference between a private business and the government is that the government has infinite access to money, since the government can literally print its own money. If foreigners will not buy US government debt to make up the budget deficit the government will always have the ability to print money to make up the shortfall. Fortunately, foreigners will not stop buying our debt because they have no other choice.
Take China for example. China's economy is built on selling products to the US. If China stops selling products to the US, China would face a terrible recession, which would cause severe political unrest for the country’s political authorities. As a result, China is going to keep selling its products to the US. When China sells its goods to the US, China is literally trading goods for US dollars. At the end of the day, China always ends up holding a huge and growing number of dollars. China has few options on what to do with these dollars. The country can either hold them and earn no interest, buy US treasuries and earn interest, buy other US financial assets, other US exports or sell the dollars for another currency. Holding dollars and earning no interest simply is not sensible. China can also buy US financial assets and US exports, and it does that. As for selling the dollars, what would China sell the dollars for? Euros? Yen? If this were done, China would be left with the same set of choices all over again. The real bottom line reason that gives the dollar value to foreigners is the products and services that you can buy with dollars, namely US exports. Despite the fact that we are a net importer the US is still the highest gross exporting country and this gives us substantial leverage in world affairs that is routinely understated. China can either spend all of its dollars now or it can save those dollars for later by purchasing US treasuries.
The idea of the government printing money for any purpose is frightening to many. However, it is not as bad as one might first assume. Printing more money is inflationary, which is one of the main principals that worry people. However, for a better perspective on the issue we should look at the Fannie and Freddie bailouts. If Fannie and Freddie were to have gone bankrupt (instead of being placed into conservatorship), their debt probably would have become worthless and the value of the mortgages that they insure would have droped substantially. If this happened it would set about a self-reinforcing trend beginning with nearly all financial institutions having severe problems supporting their own liabilities which would force them to stop lending. This would cause economic activity to grind to a halt which would further worsen the health of the banking system. Bill Gross described this scenario as a “systematic debt liquidation” and I talked in greater detail about such an event here. As a result, we are faced with the choice of either possibly causing some inflation at a future date or allowing another Great Depression to happen. One should not have to think too long about which alternative one would prefer. This is especially true when you consider that things can be done in the future to fight inflation, such as raising interest rates or raising taxes net of spending. Given the fact that the current credit crunch is deflationary the inflation caused by the expansion of the government’s balance sheet is likely to be a good thing in the near term.
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