The $1 Trillion Solution: Will It Work?

The numbers have gone so high that they’ve become inconceivable. Now Paulson and Bernanke are proposing a government fund or funds to buy up failed securities and prop up the financial system. The size of the bail-out funds: Roughly $1 trillion, give or take a few hundred billion.

There’s going to be a lot of debate about the details of the funds. But here are the two real questions: Will this plan work? And will it avoid a deep recession? The short answers: Yes it will work, and no, a deep global recession is inevitable.

Here’s why. The root of the problem is that American consumers overspent and overborrowed by roughly $3 trillion over the past ten years (I’ve written about this multiple times, notably here, here, and here). We can argue to the cows come home about how this happened. Probably the blame is shared among greedy financial institutions, weak regulators, and profligate consumers (after all, nobody made Americans spend).

The subprime crisis started people realizing that part of this excess debt wasn’t going to be repaid. In fact, this $3 trillion in debt overhang is all going to have to be dealt with, in one way or another.

The first step in the process: The global financial institutions holding the debt started taking losses. At first they were small amounts, and then they got bigger and bigger. I haven’t seen a recent number on the total size of the write-offs in the financial sector globally, but call it $1 trillion. Eventually the financial sector couldn’t handle any more, and the collapses started.

So that left $2 trillion in potential losses. In steps Bernanke and Paulson. At first they shoveled in $20 or $30 billion at a time for Bear Stearns. Then it was $80-100 billion for AIG. Now they are upping the ante to $1 trillion or so in the new funds.

So the second step in the process: The government takes $1 trillion worth of debt onto its own books. Where does the money come from? Borrowing from overseas, of course. More about that later

But that still leaves $1 trillion in excess debt. And in the end, that will be paid back by American consumers, as they tighten their belts and cut back on spending. Or more likely, if cutbacks are inflicted on them by tighter lending standards and lost jobs. The consumer crunch is here.

The depth of the recession will depend on how fast consumer have to cut back. That $1 trillion is worth roughly 7% or so of GDP. If those cutbacks are taken all at once, that’s a very short and deep recession. If they are spread out over several years, that leads to a shallower but still nasty downturn.

The real joker in that deck is the source of the $1 trillion in government funds. The U.S. government can’t raise it by taxes, so instead will have to borrow it from overseas. In effect, foreign investors will get a chance to make a bet on the future of the whole U.S. economy.

I think the rest of the world will be willing to invest in the funds, if only for their own self-preservation. Far better to invest in the economy as a whole, rather than individual financial companies. But the global economy is not out of the woods yet.

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