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VIDEOThe Botox Economy, Part 2
Policy makers assume that liberal application of liquidity represents a permanent cure.
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Bad Fiscals
From late 2008 onwards, government intervention, on an unprecedented scale, has been a dominant factor in economic matters.
Governments have spent aggressively, going into or increasing deficits to increase demand within the economy to offset weak private-sector consumption and investment.
Central banks have maintained low interest rates, pumped liquidity into the financial system, and "warehoused" toxic assets to support the financial system. In the US, Fed holdings of MBS reached around $1 trillion. The purchases provided much-needed liquidity to banks and reduced potential write-down on these securities. They also helped keep interest rates low and maintained the supply of housing finance.
The takeover of and government support for Government Sponsored Enterprises (GSEs), such as the Federal National Mortgage Association (FNMA or Fannie Mae (FNM)) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac (FRE)), was an integral part of the process. The US government has now agreed to provided unlimited support to Fannie and Freddie.
Governments and central banks around the world followed US lead, implementing similar measures. Even emerging markets introduced aggressive cash transfer and make-work schemes allowing their fiscal positions to deteriorate. Brazil expanded its popular "Bolsa Familia" assistance scheme for poor families. India also expanded a program guaranteeing 100 days public work employment scheme in rural areas.
Financing these initiatives presents significant challenges. In the five quarters ending September 30, 2009, US Treasury borrowing and outstanding GSE-guaranteed MBS increased by $2.8 trillion, a rise of around three times from the level of previous years. The UK and European countries increased public debt by similar or higher amounts (in percentage terms).
In 2009, investors readily bought large new issues of government debt, despite relatively low interest rates. Rating agencies maintained sovereign debt ratings, especially for major countries despite deteriorating public finances. Credit default spreads on sovereign debt for most issuers decreased in line with the general fall in credit margins. There were no outright auction failures.Central bank purchases under "quantitative easing" (QE) (read: printing money) programs helped the market absorb the volume of new issuance. According to estimates by Morgan Stanley, Fed purchases of assets, QE programs, and other liquidity support programs reduced private-sector net purchases of new Treasury issues to $200 billion in 2009. In 2010, in the absence of continued Fed support, private buyers will have to absorb $2,000 billion.
Large deficits are likely for some years. Continued spending and reduced tax income will ensure significant ongoing financing requirements. In the absence of a sharp and significant return of growth, the budgetary position will remain difficult. In many countries, the deficits are structural and not entirely related to the GFC.
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