The Pin in the Monetary Hand Grenade

Bill Bonner, The Daily Reckoning, www.thedailyreckoning.com  07/31/08

Yesterday, George W. Bush signed the housing bill – in which up to $300 billion is to be spent bailing out naïve homeowners, caddish mortgage lenders and Wall Street geniuses. It is packaged as a reserve against catastrophe. If everything is hunky dory from here on, only a few billion here and there will be spent. If housing continues to sink, on the other hand, the bill starts toting up. The Congressional Budget Office gave the odds at only 1-in-20 that $100 billion of this money would be spent propping up mortgages. The bill also allows the feds to give money to state and local governments, so they can buy houses and fix them up themselves.

We’re happy to see the federal government taking some dramatic action. It reaffirms our faith in our fellow man – he’s an idiot; as we knew all along. And it confirms our opinion of the political class – they’re grifters, chiselers and opportunists.

Here is a case where many, many people did dumb things. Homeowners bought houses they couldn’t afford. Lenders lent them the money to do it. And then investors bought the loans as if they were good investments. Naturally, the whole thing blew up. The smartest thing to do would be to let it happen. As quickly as possible. Get it over with.

But “change” is the one thing people most don’t want – not when it involves paying for past mistakes. The homeowners don’t want to give up their houses. The lenders don’t want to go out of business. Investors don’t want to lose money. And so they all hope for a miracle. And along comes the miracle worker himself – Uncle Sam.

What makes it possible for the federal government to perform miracles, as Ben Bernanke might explain it, “is a little technology called the printing press. [The feds] can create new dollars at almost zero cost.”

How do the feds get any real money? They can only take it away from real people. The net effect to the economy is zero. The only way they can add to the total supply of money is to...well...add to the supply of money. They have to create it – out of thin air. Otherwise, they are just taking money from people who didn’t make mistakes in order to keep people who did make mistakes from being forced to own up to them.

As we said yesterday, we haven’t seen any real estate agents offering to return the commissions they made by selling houses to people who couldn’t afford them. Nor have we seen any Wall Street slicks returning their bonuses – much of it earned by sinking people so deep in debt they could never get out. This $300 billion spending bill helps us all forgive and forget the whole thing – by making someone else pay for it.

But wait...there’s a wrinkle... Who’s really paying? Since Americans don’t have any money, the U.S. government – and consumers too – look overseas for financing. Every day, about $2 billion goes out of the United States and ends up abroad. But the U.S. government...and the U.S. economy...desperately needs that money in order to keep spending beyond their means. This new $300 housing bill is just more of the same – the U.S. spending more money it doesn’t have and depending on the kindness of strangers overseas to pay for it.

But why do the foreigners lend? Why do they want U.S. dollar credits, when the dollar has lost so much purchasing power in the last five years?

They’re probably making a big mistake. But when you have that much money, it’s not easy to invest it. The U.S. Treasury market is the biggest in the world. And why not lend money to the U.S. government? At least, you’re sure that the feds will pay you back – even if they have to create the money to do it out of thin air.

Ah...there’s the rub. There’s no assurance that the dollars you get back will be worth as much as the dollars you lent. And there’s the pin to this post-Bretton Woods monetary hand-grenade. At any moment, the foreigners could conclude that the “safety” they’re looking for in Treasury bonds is a swindle...and that it’s actually “too risky” to hold them. Then, they’ll pull the pin and the whole thing will blow up.

The Paulson Doctrine – Treasury Secretary Paulson is no dope. He knows that the U.S. economy – with its extravagant delusions and its expensive bailouts – needs financing from overseas. And he knows, too, that the foreigners are getting worried.

In a free market economy, Fannie and Freddie might be allowed to go under. Investors and lenders would both suffer...but the economy would go on and be strengthened by getting rid of its nasty carbuncles and tumors. But this is not a free market. It is a market where the big players always seem to manage to get an edge for themselves. For example, since 2003, Wall Street paid out a quarter of a trillion in bonuses – most of it on dubious, debt-drenched transactions that were never completed. And then, when the debt goes bad, in comes the U.S. government to bail out the whole system. The Wall Street pros keep their bonuses, with not even a “thank you” to the feds.

Fannie and Freddie can’t be allowed to go under – largely because their debt is held by foreigners. Don’t get us wrong. The feds would love to stiff the foreigners. But they can’t...not yet. The Chinese, for example, are the single largest lenders to U.S. government agencies – including Fannie and Freddie. And the feds desperately need that flow of juice from the Far East to continue. So Henry Paulson came up with what is known as the “Paulson Doctrine” – we’ll let the stockholders take a loss, but not the bondholders.

The Paulson Doctrine will hold until it is no longer needed. When will that be? We’ll tell you – the foreigners will lose their money when inflation has already turned them against more dollar credits. That is, when inflation has finally convinced them to dump the dollar and refuse to lend more to U.S. government agencies, the feds will have no further use for foreign lenders. Then, they will turn their backs on the Paulson Doctrine and stick it to foreign dollar holders hard...