ECONOMIC SCENE

The danger of ignoring reality

By David Leonhardt

Published: October 8, 2008

E-Mail Article

Printer-Friendly

3-Column Format

Translate

Text Size

NEW YORK: Thirty billion dollars to keep Bear Stearns from collapsing. Another $85 billion for AIG. Hundreds of billions, here and there, lent to banks.

All told, the U.S. Federal Reserve has pumped $800 billion into the financial system, Ben Bernanke, its chairman, estimated Tuesday. That figure doesn't include the untold sum that the Fed now plans to spend buying short-term debt so that companies can continue to pay for their daily operations. And it doesn't include any of the money the Treasury Department is laying out, like the $700 billion bailout fund or the $200 billion that could be spent propping up Fannie Mae and Freddie Mac.

After 14 months of financial crisis, the U.S. government - which means the U.S. taxpayers - has put serious money on the line. As a point of comparison, the entire annual U.S. budget is about $3 trillion.

Just how are Americans going to pay for all this?

The short answer is that the budget problems the country seemed to have a year ago are now even worse. The deficit for next year (relative to the economy's size) will probably be the biggest since 1992, and maybe since 1983. Taxes will have to rise or government spending will have to fall, if not both. Trying to contain the mess created by a bubble costs serious money.

Yet this is also a case in which the short answer isn't the full answer, or even the best answer.

As expensive as the damage control may be, it isn't likely to cost anywhere near as much as the headline numbers suggest. More to the point, the alternative - not spending some serious money to deal with the crisis - would probably end up costing a lot more. As it is, the various bailouts are not the main reason the deficit is growing. The deteriorating state of the economy is.

So if you want to conjure up some doomsday stories about the U.S. budget, I'm happy to play along (and will do so momentarily). But those stories aren't mainly about the credit crisis. They're about the dangers of ignoring economic realities - which, when you think about it, is how we ended up in this credit crisis in the first place.

The most newsworthy part of Bernanke's lunchtime speech Tuesday was his sober overview of the economy. He called the financial crisis "a problem of historic dimensions" and indicated that the Fed would soon cut its benchmark interest rate once again, as it did Wednesday.

But the bulk of the speech was a catalog of the extraordinary steps that the Fed and the Treasury have taken since August and the delicate line they have tried to walk along the way. To try to restore some confidence to the credit markets, they have lent enormous amounts of money to banks and trumpeted those efforts. Fed officials have pointed out that they are nowhere close to being out of bullets, either. They work for the central bank, after all. They can always print money.

But Bernanke and Henry Paulson Jr., the Treasury secretary, have also emphasized that they are not being too generous.

They are mainly making loans and investments, and they expect to recoup much of the money they're spreading around.

Outside the government, economists differ about whether Bernanke and Paulson have been too aggressive or not aggressive enough and whether they have been aggressive in the right ways. But there is not much concern that they are taking on additional debt - or even about the amount of it.

"The policy actions are not likely to have a large effect on the budget over the next 5 or 10 years," Douglas Elmendorf, who has become a go-to Democratic economist during the crisis, told me.

John Makin of the rightist American Enterprise Institute said: "The last thing I'm worried about right now is additional government indebtedness. There really isn't an alternative."

Makin pointed out that during the long malaise in Japan, the government passed a stimulus package almost every year that was equal to more than 2 percent of the country's gross domestic product (equivalent to about $400 billion in the United States today). But interest rates in Japan remained low, a sign that economic weakness, not deficits, was still the problem.

That being said, ever-expanding bailouts do create some dangers. You have probably heard the term moral hazard, which is shorthand for the idea that the government's rescues may lead investors to take new, unwise risks - and ultimately require yet more rescues.

The Fed is also setting itself up for tough decisions about when to end its various emergency programs. If it waits too long, it could leave so much money sloshing around the economy that inflation will take off. Fed officials have suggested they understand that they made precisely this mistake after the 2001 recession, when they kept interest rates low and added to the mania in the housing market.