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Another Way to Finance the Deficit   June 22nd, 2009
Killing the stock market could finance Obama's spending       


More observations...

I and many others have been wondering for months about the seemingly impossible situation that makes it nearly impossible to finance as much borrowing and spending as President Obama has planned. It seemed that the Federal Reserve and the administration were trapped in a situation where the only possible solution available to them was fiscal conservatism: Reduce deficit spending. There may be another way.

Obviously the first option was for the government to borrow money as it normally does, selling bonds. However, with foreign investors investing less in the U.S. and Americans not earning as much money in a recession, and using any extra money to pay down debt before they start to save, Americans don't have that much money to loan to the U.S. Government, either.

The second option was confirmed by the Federal Reserve within two months of the beginning of the administration: They were going to start printing money to finance the deficit spending. In the absence of adequate money to borrow from ourselves and the entire world, seemingly the only option was to print the rest.

However, interest rates have started to climb under the weight of all the borrowing. The Federal Reserve continues to try to push rates down by printing money, but the general consensus is that they can't pull this off much longer--and their actions have already raised the specter of inflation and the dollar has lost about 12% of its value since the announcement. Caught between the rock of increased interest rates and the hard place of increased inflation and a devalued dollar, it seemed the only solution to avert financial calamity would be for Obama to adopt fiscal conservatism--or at least significantly scale back his borrow, print, and spending policies.

There is one other option, however.

When the stock market goes down, investors often cash out of many of their stocks and invest their money in U.S. bonds. That is the famous "flight to quality" where investors believe that their money is safe in U.S. bonds. That's what initially drove bond yields and interest rates so low at the end of 2008--investors were so scared of losing their money in the declining stock market that they loaned their money to the U.S. instead. The stock market lost value but the U.S. government was flooded with so many offers to borrow money that they essentially didn't even have to pay interest.

Clearly the annual savings of the world is not enough to finance the annual deficits we're running right now. But there are enough investments that, if liquidated and loaned to the government, could finance those deficits.

In other words, if the stock market gets so scary (like the last few months of 2008) that people look for a safer place to put their money, all the sudden money may come streaming out of the stock market and get invested in U.S. bonds. Since there are trillions of dollars invested in stocks there's certainly plenty of money parked there that could be used to finance the deficit spending.

The only way to get investors to loan increasing money to the government is to either pay them a higher interest rate (which has the negative side-effect of raising mortgage rates and other consumer debt rates) or for the stock market to be so questionable that the meager rates paid by U.S. bonds look tempting simply because they're "safe." The government doesn't want to pay higher interest rates and drive up the cost of housing due to higher interest rates and it doesn't want to stop borrowing and spending, so that leaves the stock market.

But how to get the stock market to become more scary?

Worries about the economic slowdown dragged on stocks Monday morning, after the World Bank said the global recession has worsened...

The World Bank cut its 2009 forecast, predicting that global growth will shrink by 2.9% versus its earlier forecast for a 1.7% contraction. Global trade is expected to plummet 9.7% this year, it said. Developing countries have been especially hard, with the exception of booming China and India.

What about those supposed "green shoots?" I suspected they might be rather questionable last month and now it seems the World Bank is confirming that.

That's certainly bad news for the world and U.S. economy. But it's good news for the Obama administration since that means that the money coming out of the stock market may very well be loaned to the U.S. Government. That means there's more money for the government to borrow without having to print it.

So perhaps that's how we're going to finance Obama's plans--by liquidating much of the value stored in the stock market. If that's the case then get ready for a big dip in the stock market--I predicted that last month but for different reasons.

If anyone sees any other "out" from the current situation aside from fiscal conservatism or driving investors out of the stock market into the open arms of government bonds, please let me know. I'm certainly open to other perspectives. But the "milk the stock market" approach is one I hadn't previously considered.

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