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.  

Later 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:

national income = 10,000  (taxable part)

government debt = 4,000  (held by the public)

interest on the debt = 200  (based on 5% average rate)

other government spending = 1,800

total government spending = 2,000

total tax revenues = 2,000  

Now 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::

national income = 10,025

government debt = 4,500

interest on the debt = 225

other government spending = 1,800  (unchanged)

total government spending = 2,025

total tax 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 government programs.

   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.

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