Business Insider

Peter Crabb: Program will succeed as long as investors continue to put faith in U.S.

Plan C. The U.S. Treasury and Federal Reserve on Tuesday announced new efforts to jump start the credit markets. They will do it by creating an even larger, more levered financial institution.

The Fed and Treasury will take approximately $20 billion from the $700 billion rescue program earlier approved by Congress in the hopes they can bolster consumer spending. And it looks as if this may be just what the customer ordered.

Also on Tuesday, the Commerce Department issued a revised estimate of third-quarter Gross domestic product showing the consumer is indeed struggling. GDP dropped at a seasonally adjusted 0.5% annual rate during the third quarter of this year (July through September). The original estimate for the third-quarter was a 0.3% annual decline. The data revision is due primarily to reluctant consumers. Third-quarter spending by consumers dropped 3.7%.

The new government plan should make additional consumer loans available. These loans are, in turn, packaged and resold to investors. As the New York Times reports the new government programs create a highly leveraged government bank. Only $20 billion of Treasury funds are being used as collateral for extensive Fed lending.

Under a program entitled the Term Asset-Backed Securities Loan Facility, or TALF, the Federal Reserve will loan nearly $200 billion (ten-to-one leverage) to the asset-backed securities market, which includes student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA). But it doesn’t stop there.

The Fed will also purchase up to $600 billion in mortgage-backed securities backed by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. If fully funded, the total programs announced create a fifty-to-one leverage ratio in the Federal Reserve.

How can they pull this off? - Low cost financing in the government bond market. Funds continue to flow into U.S. Treasury securities. The return on short-term Treasury Bills remains near zero, and the 10-year Treasury debt only pays investors around 3 percent.

When times have been bad in the past, investors have moved their money to real assets, such as gold and real estate. That’s not what has happened in this global crisis - Oil and gold prices fell again early Tuesday. Global Investors continue to pour more and more into U.S. government debt, providing a very low cost funding source for the government. However, this cheap source of financing may dry up soon.

Continued flows into U.S. Treasuries are only possible because households around the world have extensive savings. As other countries experienced strong economic growth this past decade they saved much of their new found income in the United States.

The World Bank says this party may be over soon. In an updated report on the Chinese economy issued Tuesday, the bank lowered its outlook for 2009 gross domestic product growth in China to 7.5% from 9.2%. While certainly still high, lower economic activity will slow the growth in global savings.

This new borrow-to-spend program from the U.S. government will only succeed as long as investors from other countries continue to put their faith in the U.S. The government certainly hopes so.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.