The current situation looks bad and unfortunately it will probably get a lot worse. I have a huge interest in US financial policy both because I work for an American company and since Canada’s economy is so tightly tied to the US due to the huge amount of trade.

Here’s a glimpse of the situation:

  • The US government has put itself on the hook for an extra $500 billion to possibly $1 trillion in these recent bailouts
  • The US federal government is running a deficit of around $400 billion per year
  • The US has a lot of debt, both direct (almost $10 trillion) and (scarier) unfunded future liabilities (almost $60 trillion)
  • The growing trade deficit is being funded, in large part, by other countries taking on US debt

If I was looking at investing money in a company with those financial fundamentals, I’d run away as fast as possible.   Now, I’m no economist, but looking at the above my thought would be “How is the US economy not already in the tank?”   One simplified answer to this is that the US federal government is running a very delicate balancing act right now.  Federal monetary policy is always a balancing act, but at this stage it’s much more difficult.

Put another way, the US monetary system is currently built on a bubble of debt.

What’s worse is that the only way to keep the balance going is to feed the beast.  We’ve seen the start of the bubble bursting with these financial failures.  A bunch of debt in the bubble went bad, so the house started to fall over, but guess how they “fixed” it?  Try to deflate the balloon a bit to reduce the effects of the bad debt?  Nope.  Injected more debt.

The linchpin in this whole thing is the value of the US dollar.  Pretty much everyone has an interest in keeping the value of the dollar high.  The US wants to keep the value high so, among other things, its credit rating stays high, meaning other countries are willing to loan it more money.  The rest of the world wants to keep the value high because they’re currently holding many trillions of dollars of it, and for every percentage point drop in value they lose a heck of a lot of money.  Further, they all fear a US economic collapse because their economies are growing due, in large part, to massive US consumer spending fueled by what?  You guessed it, debt.

Unfortunately, this dance can’t continue forever.  Most economists believe (and point to many historical cases) that the US federal government will eventually have to start printing a lot more money to repay its debt.  The side-effect of this, of course, is massive inflation.  Inflation means lower value for the dollar, which means creditors will freak out and dump their holdings, which will devalue the currency further, which ends in a downward spiraling currency.  This has happened in all other similar historical examples.

However, although this is the most likely outcome, it’s difficult to predict when.  The US federal government still has a lot of tricks up its sleeve.  I personally don’t believe the tricks do more than delay the outcome, and therefore make the crash bigger, but I’m neither an economist nor policy maker so my opinion matters about as much as all that bad mortgage debt.

A few interesting reads:
Is the US going broke?
Bailout reality check: Taxpayer tally