Obama wary about bailouts adding to growing debt pile

The much-dreaded W-shaped recession continues to haunt the current US administration. The "W" refers to the graph of possible GDP over the next few quarters.

In an interview recently, President Obama revealed the kind of unenviable anxiety about the economy that his administration must face.

When pressed about the prospect of another bailout package, this time for the American consumer and small businesses, he responded cautiously, saying: "I think it is important though to recognise that if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the US economy in a way that could lead to a double-dip recession."

Despite the words of confidence over the intrinsic strength of the US economy by Indian Prime Minister Manmohan Singh, the Obama administration faces four principal policy responses.

The first is the President Harding-type response from the 1920s. Guided by a conservative principle that there is no easy way out of this mess, reduce government deficits and national debt, slash taxes and lower government spending.

The human-welfare impact of such a course is unfeasible for any government, far less the left of centre US government.

The second option is to continue to monetise debt, and let the Federal Reserve continue to purchase private debt. The expanded flow of money into the economy would lower interest rates and arguably spur economic demand.

The impact of such a mad-monetisation on the global confidence in the dollar is questionable. More importantly, whether such a move would spur US consumer demand actively is suspect given the structural constraints involved over the next 12 months.

Deficit spending

The third option is the simultaneous application of the deficit spending and debt monetisation. The idea here, associated with Paul Krugman, is to aggressively commit and convince the market that inflation is what the government is committed to.

This would result in high inflationary expectations and thus a lowered incentive for individuals to hold onto cash. Presumably, this would result in greater spending and the restarting of the economic engine.

The fourth option is purely deficit spending, i.e. spend more on government infrastructure, employment schemes and fund the individual's bank account while leaving the banking system to sort itself out.

While the last three choices are being debated, three other issues emerge. One, the possibility of any such bailout package going through the House and Senate. Two, the likelihood of such a bailout package spurring greater consumer demand.

Third, and perhaps most vexing, the impact of such a bailout on the dollar, Treasury debt and US credibility. The first is a political issue; the second is economically difficult to assess.

It will take at least three or four quarters of data to convincingly measure the impact of such a bailout package. The third issue, the likely impact on the financial markets, is worrisome.

Treasury officials face rising interest payments (around $700 billion per year (Dh2,520 billion) estimated by 2019) despite strong global demand for Treasuries. However, any federally funded bailout package will result in a spike in dollar depreciation over a short term.

Alongside, two concurrent factors converge. One, with increased speculation on the fate of the dollar-denominated debt, there will be a "wait-and-watch" global sentiment on the rise.

Second, with more "normal" circumstances and risky investments on the rise to abate inflationary fears, the Fed will eventually raise rates. Any subsequent borrowings, therefore, would end up having to pay more.

In essence, any such bailout package is replete with serious risks.

As Bill Gross said: "What a good country or a good squirrel should be doing is stashing away nuts for the winter. The United States is not only not saving nuts, it's eating the ones left over from the last winter."

Unless policymakers can communicate effectively on how such a bailout effort would spur demand, this package would be a Napoleonic effort to conquer Russia in winter.

The columnist works for a major European investment bank in New York City. You can follow his tweets at:http://www.twitter.com/ks1729