Breathing More Easily
Government intervention seems to have stopped economic free fall, but hard choices lie ahead.

Sunday, August 16, 2009

THE U.S. ECONOMY appears to be stabilizing. It is estimated to have shrunk at an annual rate of just 1 percent in April through June -- bad, but much better than the frightening 6.4 percent drop in the previous quarter. Unemployment remains too high at 9.4 percent, but job losses, too, are decelerating. Credit markets have begun to thaw. Home prices, though far from bouncing back, are no longer in free fall. Banks are once again raising private capital; there may be no need to expand the Treasury Department's $700 billion Troubled Assets Relief Program or for a big toxic assets buy-up program. So, exhale: There probably will not be a Great Depression II.

The U.S. has avoided that disaster, however, only by means of a nearly unprecedented level of government intervention, of which the $1.8 trillion budget deficit, fueled in part by TARP and a $787 billion stimulus package, is only one manifestation. The most radical therapy has been administered by the Federal Reserve, which doubled its balance sheet to just under $2 trillion in the past year. To be sure, the Fed announced last week that it will finish buying $300 billion in Treasury debt in two months, a sign that it feels the economy can get by without any new support programs. But the central bank still anticipates keeping the federal funds rate near zero indefinitely, while adding to its already astonishing stack of $542 billion in mortgage-backed securities and leaving other support programs for private-sector credit in place.

Meanwhile, the Federal Housing Administration now insures $560 billion in mortgages, four times the amount it backed three years ago. With FHA, Fannie Mae, Freddie Mac and other programs, the federal government now stands behind the vast majority of new mortgages. TARP is on the hook for $549.4 billion in support to banks, AIG, automakers and mortgage relief. Then there's the $300 billion Federal Deposit Insurance Corp. guarantee of Citigroup's troubled assets, in return for which the government took a stake in the bank. And so on.

In short, the U.S. economy has been saved thanks to a giant federal refinancing operation, in which Washington assumed responsibility for a huge quantity of risk that the private sector either could not or would not handle. The money for that refinancing comes not only from the savings of Americans, who invest in Treasury debt and other government bonds, but also, to an uncomfortable degree, from the governments of Japan, China and other nations. Their continued holdings of U.S. debt amount to a kind of forbearance, prompted by their own interest in a strong U.S. market for their exports. It's alarmist to underestimate foreigners' willingness to keep holding dollars; it's foolish to count on it forever. The financial future of the United States depends on winding down the government's vast commitments before global markets do it for us.

Fed Chairman Ben S. Bernanke has already outlined his ideas for a Fed pullback, which would include preventing inflation by paying banks higher interest to keep their reserves at the Fed. But Congress and the Obama administration must also start addressing the government's bleak medium-term fiscal situation. An additional stimulus package, for example, seems especially risky in view of the recent economic data. They must also make tough choices about housing finance, including a new structure for Fannie Mae and Freddie Mac, and reducing the concentration of risk in the FHA. The long-promised reckoning over tax and entitlement reform can't be postponed, either.

Given the alternatives, a government bailout of the tanking U.S. economy was a necessary evil. But the short-term fixes must not become permanent. Even if the specter of Depression has not been totally banished, it is not too early to begin charting a return to financial normality.

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