On October 3, 2008, Congress authorized government spending of $700 billion to buy up the bad investments
of banks and other financial institutions that are clogging the financial system and creating a credit crisis. The Treasury acquired the necessary funds through the sale of new securities to the public.
the Treasury will sell the investments back to the public to recover
the funds it spent. If the investments sell at the price
originally paid by the Treasury, there would be no net fiscal imbalance
on completion of the bailout. But suppose the Treasury could recover only $200
billion on the sale, and thus leave $500 billion worth of
Treasuries in the hands of the private sector. That would be the net increase
in Federal debt due to the bailout.
Obviously there are individual winners and losers. The winners are those who sold
their bad investments to the Treasury for more than they were worth in the open market, even though they probably
lost relative to what they originally paid for them. However both
winners and losers will be losing much less than they would have
if there had been no bailout.
What is the net long term effect of the increased debt on the economy as a whole? For simplicity, assume that we start with a balanced budget, and consider the following analysis with all amounts in billions of dollars:
= 10,000 (taxable part)
= 4,000 (held by the public)
interest on the
debt = 200 (based on 5% average rate)
spending = 1,800
spending = 2,000
revenues = 2,000
suppose the bailout adds 500 to the debt, and to keep the budget in
balance the government increases the tax rate by 0.25% on national
income. Other things equal, the result is::
interest on the
debt = 225
spending = 1,800 (unchanged)
spending = 2,025
revenues = 2,025
We can now make the following observations:
1. The interest payments and tax
revenues increase equally while the amount of other government spending
remains unchanged. The bailout therefore need have no impact on existing
2. Since the increase in taxes is
covered in the aggregate by the additional interest payments, the money
supply remains unchanged.
3. The new Treasury securities issued in the
bailout increase the net financial wealth of the private sector by $500 billion.
4. If the economy grows in nominal
terms by 0.25%, tax revenues would increase by 0.25% and there would be no need for a
tax rate increase to maintain a balanced budget.
5. In normal times, the nominal growth rate of the
economy averages about 5%, comprised of 2% real and 3% inflation. Thus
tax revenues over the long term will increase due to economic growth far more
than what is needed to support interest payments on the additional debt.
6. If the interest rate on
Treasuries remains unchanged, maturing securities can be rolled over
indefinitely without additional taxes regardless of the debt, and without
affecting individual financial wealth.