"Is America too big to fail?"

The headline of this International Herald Tribune article (hat tip reader Saboor) is a real sign of the times. The short answer is our policies assume the answer is yes, but if we don’t course correct, that assumption is likely to be tested.

Specifically, the argument goes, our trading partners will continue to be willing to finance our trade deficits because they depend on the US as an export market. But the flaw in that logic is that our friendly money sources are not only providing the dough for the trade deficit, but also for the interest we pay on their debt. As our external obligations keep growing, a higher proportion will go to interest. At some point, the benefits are going to look less clear.

From the International Herald Tribune:

In the narrative that has governed American commercial life for the last quarter-century, saving companies from their own mistakes was not supposed to be part of the government’s job description….

So it made for a strange spectacle last weekend as the current Bush administration, which does cast itself in the Reagan mold, hastily prepared a bailout package to offer the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. The reasoning behind this rescue … The mortgage giants were too big to be allowed to fail…

Commercial banks from South Korea to Sweden hold investments linked to American mortgages. Their losses would mount if American homeowners suddenly couldn’t borrow. The global financial system could find itself short of capital and paralyzed by fear, hobbling economic growth in many lands…

All through Japan’s lost decade of the 1990s and afterward, American officials chided Tokyo for its unwillingness to let the forces of creative destruction take down the country’s bloated banks and the zombie companies they nurtured. The best way out of stagnation, Americans counseled, was to let weak companies die, freeing up capital for a new crop of leaner entrants.

But as Japan’s leaders engaged in bailouts and bookkeeping fictions to keep banks and companies breathing, they offered those words of justification now heard here: The companies were too big to fail…

Today, among strict adherents of laissez-faire economics, the offer to bail out Fannie and Freddie is already being criticized as a trip down the Japanese path of putting off immediate pain while loading up the costs further along.

For one thing, this argument goes, taxpayers – who now confront plunging house prices, a drop on Wall Street and soaring costs for food and fuel – will ultimately pay the costs. To finance a bailout, the government can either pull more money from citizens directly, or the Fed can print more money – a step that encourages further inflation.

“They are going to raise the cost of living for every American,” said Peter Schiff, president of Euro Pacific Capital, a Connecticut-based brokerage house that focuses on international investments. “The government is debasing the value of our money. Freddie and Fannie need to fail. They are too big to save.”

Using public money to spare Fannie and Freddie would increase the public debt, which now exceeds $9.4 trillion. The United States has been financing itself by leaning heavily on foreigners, particularly China, Japan and the oil-rich nations of the Persian Gulf. Were they to become worried that the United States might not be able to pay up, that would force the Treasury to offer higher rates of interest for its next tranche of bonds. And that would increase the interest rates that Americans must pay for houses and cars, putting a drag on economic growth.

Meanwhile, as American debts swell and foreigners hold more of it, nervousness grows that, someday, this arrangement will end badly. The dollar has been declining in value against other currencies. Some foreigners have begun to hedge their bets by buying more euros.

“Obviously, this is going to come to an end,” Schiff said. “Foreigners are not charitable organizations, and they’re going to demand that we pay them back.”

No single country owning large amounts of dollar-based investments is inclined to dump them abruptly; nobody aims to start a panic. But fears have begun to grow that one day a country may get spooked that another is about to dump its dollars – and that could trigger pre-emptive panic selling.

“Foreigners could decide it’s just not worth the risk and sell,” says Andrew Tilton, an economist at Goldman Sachs. “The really dire scenarios have become a lot more likely than they were a year or two ago.”

Still, as Tilton and others are aware, one fundamental reality continues to offer assurances that foreigners will still buy American debt: In the global economy of the moment, the United States itself is too big to fail.

The logic for that assurance goes like this: The American consumer has for decades served as the engine of world commerce, using borrowed cash to snap up the accouterments of modern living – clothes and computers and cars now manufactured, in whole or in part, in factories from Asia to Latin America. Eliminate the American wherewithal to shop, and the pain would ripple out to multiple shores….

In other words, in the estimation of people in control of money, the United States cannot be allowed to collapse, just as Fannie and Freddie cannot be allowed to fail. Too much is riding on their survival.

The central truth of that logic still seems to be apparent as the Treasury keeps finding takers for American debt.

So the government offers its rescue of the mortgage companies, and foreigners keep stocking the government’s coffers. “They don’t want the U.S. to go into the worst downturn since the Depression,” Tilton says.

But all the while, the debt mounts along with the costs of an ultimate day of reckoning. Debate grows about the wisdom of leaning on foreign credit, and about how much longer Americans will retain the privilege of spending and investing money that isn’t really theirs.

Bailouts amount to mortgaging the future to stave off the wolf howling at the door. The likelihood of a painful reckoning is diminished, while the costs of a reckoning – should one come – are increased.

The costs are getting big.

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  1. Anonymous

    “So it made for a strange spectacle last weekend as the current Bush administration, which does cast itself in the Reagan mold, hastily prepared a bailout package to offer the government-sponsored mortgage companies, Fannie Mae and Freddie Mac.”

    “STRANGE”? Pas du tout! George W. Bush has been a replay of Lyndon Johnson’s inflationary guns ‘n butter policies, though under a different party banner.

    Such a spectacle is strange only to those who believe there are real differences between the two U.S. parties. The IHT, as an accredited member of the MSM, of course must promote this long-running myth to receive its official favors and subsidies. You and I are free to take a more jaundiced view.

  2. bigD

    Things were so much easier when their was the Evil Empire. Countries were either for us for them (OK, I exaggerate).

    But now, things are murky. What is the new world order? Do we still offer the scientific and technical know-how that created America’s Golden Age. I would posit that the aftermath of WWII gave us a head start. But now the Chinese and Indians have surpassed us intellectually. Thank goodness, they don’t have the supporting infrastructure to capitalize that knowledge. What do we have? Twenty-five percent of California students not graduating. MIT is a backup school for wealthy Indians that can’t get into IIT… But at least we’re numero uno in terms of arable land. Oh wait, the GCC are entering into long term state agriculture contracts with South Asia.

    American Exceptionalism no more..

  3. Anonymous

    Is America too dangerous to continue?
    might be the counterpart question.

    High Paranoia for the day.
    Say that some heads of state after the Bush re-election got together and decided that a well armed nuclear supreme US was a danger to the world.What would they or could they do?
    What ever the reason we are being drawn irresistibly (I hope) to have to choose butter over guns.

  4. Anonymous

    “They don’t want the U.S. to go into the worst downturn since the Depression,”

    Irrelevant. When there’s a bank run, depositors don’t want to see the bank fail either.

  5. Lee

    This issue is no longer about economics. What’s so scary, and infuriating, is that we simply cannot come to grips with the way we live. We consume what we don’t have, we’re classic addicts. It’s called denial and on an individual level denial almost always ends very badly. We’ll see if that’s true for a country.

  6. Anonymous

    the main flaw in this argument is that america has already failed.

    we have failed economically
    our infrastructure is a failure
    our banks are failing (literally)
    our foreign policy clout is non-existent
    our people are broke debt slaves
    our children are uneducated
    our adults are ignorant
    our political apparatus wavers from total apathy/ignorance to ideological zealotry
    we even discern the difference between legitimate and illegitimate war
    our journalists are so ignorant that presidential campaigns have been reduced to a never ending blooper real, rather than analyses of real substantive issues
    our currency has become a laughing stock. even kudlow calls it the “US peso,” which is an insult to mexicans
    we have a nation of people who still can’t tell the difference between a debt and a liability
    this is a nation where suze orman is considered to be an insightful guru for some heretofore unknown reason

    i could go on.

    but america has already failed.

  7. Anonymous

    Nonsense. In twenty years the world will be richer than it is now. We are masters of productivity, and it’s benefits will continue to spread throughout.

  8. AK

    I happen to be taking a break from reading the Aeneid so no, we are not too big to fail: Troy fell; Rome fell. We can too but the die is not cast yet. We do need to start living witin our means and stop taking prosperity and strength for granted: you have to keep earning them otherwise you loose them.

  9. ScottH

    Anon @ 11:56

    I trust you are being facetious. What we are is masters of consuming that which we cannot afford, at the individual, local, state and federal levels. When we pull out our pockets there is lint there. And the phone is ringing.

    The only productivity miracle happening these days is squeezing more and more out of our elders with phony CPI numbers.

    Massive, wholesale destruction of credit does not a productivity miracle make.

  10. Anonymous

    The very essence of Reaganomics is using taxpayer money to subsidize private sector losses.

    The ‘too big to fail’ concept can be traced directly to the Reagan admin bailout of Continental Illionis Bank in the summer of 1984 (also a re-election year).

    As with the BSC bailout, the shareholders were wiped out. But all depositors funds (including interest) were protected (far in excess of the then FDIC limits). All bond holders were protected.

    Institutional depositors had flocked to CINB lured by high rates. The Reaganites told us that it would ‘catastrophic’ to the markets for these investors to lose any of their funds.

    It could be argued that bailout was the day we made our tryst with destiny.

  11. a

    I have to say I just don’t understand the logic of those who think America is too big to fail. It seems to be like this: “Foreigners will continue to sell us things and buy our debt because if they stopped selling us things, they’d have unemployment.” Well, if foreigners are happy to work with only worthless paper in return, they can begin to dig holes in the ground and then fill them up again – same type of work, same payment.

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