The financial crisis in two dimensions

There are lots of ways to think about any problem. One way of thinking about the current financial crisis is to conceive it across two dimensions -- the national and the global.

Dimension one, the national level, has to do with the relations among our country's national and regional banks and the Federal Reserve. The problem here is that, even as the Fed prints more and more money, national and regional banks are lending less money between themselves and to individual consumers. They are holding on to capital, citing a paucity of acceptable borrowers. So dimension one has to do with individual firms and their lack of trust in one another, as well as in the American consumer. The key actions are the printing and lending of money, more specifically, the expansion or the contraction of printing and lending.

The international issue runs along dimension two. Here the US position in the global economy structures thinking. In this dimension, minds are tuned to the situation the country as a whole faces in terms of the global flow of wealth and economic power. Considerations have to do with the credit-worthiness of the Treasury, the value of US debt, and the capacity of the American consumer. Is American debt perceived, around the world, as generally valuable? Is the American consumer burned-out or on a short-term hiatus? The problem here is that, as a result of the collapse, the nation's collective debt could appear less attractive in the eyes of our foreign lenders, and the American consumer could be less dependable as well.

The actions the US government has taken to fix the first problem -- actions like the massive expansion of the country's monetary base as well as the risky holdings taken on by the Federal Reserve balance sheet -- are, I believe, legit, that is, designed to solve a particular problem. Namely, to solve dimension one. The goal is to print enough new money to provide the capital needed to make lending among our nation's banks acceptable again. However, I think this monetary expansion, taken on to fix problem one, potentially exacerbates problem two, the international issue.

What do I mean? Take this Bloomberg report. It discusses the FOMC meeting today and tomorrow, portraying a general belief among analysts ("Fed watchers") that fixing the liquidity crisis requires intensifying an already hyper-aggressive expansion of the money supply and of Federal Reserve assets.

The Federal Open Market Committee, gathering today and tomorrow in Washington, needs to redouble its efforts after the central bank’s balance sheet shrank 17 percent from a $2.3 trillion December peak, Fed watchers said.

. . . .

“It takes massive balance-sheet expansion to generate significant easing in financial conditions,” said Andrew Tilton, an economist at Goldman Sachs Group Inc. in New York who used to work at the Treasury. “More needs to be done.”

Here's my issue: what impact will this type of monetary expansion have on the way foreign investors interpret their investment in US debt? Will it make the dollar look over-burdened, risky, less attractive? That's a question to which, to my sense, nobody but the foreign actors themselves has a real good answer. And they probably have a thousand questions of their own.

The point is that we might have to, at some point, consider that these two dimensions -- increasing the money supply so dramatically while trying to retain credit-worthiness in the eyes of foreigners -- might not share the same solution, and may even have contradictory solutions. And then we might have to make a serious decision about which dimension to prioritize.

In anticipation of such a case, the fundamental question we might want to begin pondering could be something like this: Do we inflate the dollar and use monetary-induced economic growth to weaken the value of our debt (and risk turning off future foreign investment)? Or do we strengthen the dollar and contract the economy, so that upon stabilization we can become credit-worthy again and take on more debt (and risk heading into an all-out depression that would last a few more years)?

My guess: We are first going to engage in money and welfare expansion, so as to avoid an all-out depression. Then we will transition to what will be a fairly taxing regime of fiscal responsibility: new taxes, new regulations, higher interest rates. Former Fed chairman Paul Volcker -- the noted fiscal disciplinarian -- waits in the wings of the Obama administration. I continue to think he's there for a reason. But I think Volcker will stay tucked away until President Obama sees a firm ground for future economic growth emerge from his stimulus and budget programs.