The current economic situation is likely to get worse before it gets better. That’s because policy makers are taking us in the exact opposite direction than we should be going. Many think that government can bail us out of the current financial mess we find ourselves in, but government doesn’t have the resources to do it. The federal government was already projected to run an near $300 billion dollar deficit this year and since Americans aren’t saving, all of this must be borrowed abroad. If there is to be any bailout, it will be foreigners who will have to do it, that is if they are foolish enough to buy more U.S. debt.

Out of control borrowing abroad will ultimately have dire consequences. Eventually foreigners will be unwilling to accept low U.S. dollar denominated yields while the dollar continues to slide. A 4% yield on a U.S. treasury bond is no bargain if the dollar is declining by 10% per year.

The standard monetary approach to such a crisis of confidence in a nation’s currency is to dramatically raise interest rates to “prop up the currency”. We must give foreigners a real rate of return to their investment, yields greater than the pace at which the dollar is declining. But, if the FED were to do this right now, we would be replacing the word “recession” with “depression”.

We can’t let the dollar crater because foreigners are afraid of U.S. debt, but we can’t push interest rates up to the level necessary to support the dollar. What then is to be done? The answer for government is to cut spending and raise taxes, not spend more with tax revenues falling. This is a tough choice, but it is the only way out. We must eliminate the federal government deficit as quickly as possible, not add to it by further bailouts coupled with more tax rebates.

The U.S. is likely to end up borrowing abroad almost $1 trillion dollars this year, the amount equal to our nation’s total savings deficit. Already, international governments are warning their citizens and financial institutions about the risks of both private and public U.S. securities. The way to bring back confidence in U.S. debt securities (and hence the dollar) is to stop issuing more and government must take the lead. Instead, we continue to borrow in a panic to try to plug up the dike. It won’t work. The dike will fail.

Ironically, the U.S. today faces the same dilemma that the Pacific rim nations faced in the late 90s. Because of banking and currency problems, the U.S., using the IMF and World Bank as its surrogates, forced countries like Indonesia, Malaysia and Thailand to dramatically raise interest rates to support their currencies and to adopt austere government budgets. The bottom line is that our demands were an overkill. The result was a depression-like economic environment with unemployment rates comparable to the U.S. in the 1930s. All that was really necessary for these governments was fiscal and regulatory responsibility. That is what’s necessary for the U.S. today.

Bernanke frets over inflation as though it were a monetary problem today. It is not. Because of the illiquidity of most U.S. banks, credit is not being excessively extended and as a consequence money growth is not out of hand. The problem is out of control fiscal policy and a willingness to spend even more money the government hasn’t got. Despite disclaimers from my own profession, we continue to apply inapplicable, even dangerous, Keynesian economic thought to a problem that Keynes never had to confront. If we keep following the present course, all bets are off for a recovery any time soon.

Dr. Barton Smith
Director, Institute for Regional Forecasting