Grandinite

Here’s my question: as the U.S. government bails out failed institutions, it can be assumed they are falling under state control. The Federal Reserve bank system serves as the lender of last resort, but who will bail out the Fed if or when it, too, feels financial perturbations?

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Flashback to a classic paper at the St. Louis Fed by L.J. Lotlikoff entitled:

Is The United States Bankrupt?

Fast forward to present: Kotlikoff, writing for Forbes reiterates his question (although slightly modified):

Is the U.S. Going Broke?

The earthquake will come via a collapse in the market for U.S. government bonds as domestic and foreign investors realize that the only way Uncle Sam can meet his future spending obligations is to print massive quantities of money. The result will be sky-high inflation and interest rates and, most surely, a prolonged reduction in output and employment. This could happen today. It could happen tomorrow. But it will happen here just as it has happened in every other country that tried to spend far beyond its ability to pay.

Today, we see the People’s Daily of China (which may or may not express party views) calling for a “New Financial Order” not dependent on the United States.

China is a major buyer of U.S. Treasury bonds, and through its sovereign wealth fund it has taken stakes in two large U.S. financial institutions.

In July 2005, China revalued the yuan and freed it from a dollar peg to float within managed bands. But the yuan and China’s trade remains tightly linked to the fortunes of the dollar.

The commentary suggested China must brace for grave economic fallout and look to alternatives, saying the crisis brings to mind the Great Depression of the 1930s.

“Lehman Brothers announced bankruptcy will not only have a domino effect on the global financial world, it will bring a shock to the world economy,” the front-page comment stated.

That’s China’s vote of non-confidence in the system.

The Fed has drawn a line in the sand in allowing some institutions to fail (ie, Lehman). Bailing out every financial institution carries a risk of moral hazard because lending institutions can afford to take riskier positions knowing the nanny state will be there with a healthy dose of socialism for the rich when they do fail. Slowly, this is emerging with the AIG deal - why take a market-valued deal if you can extract more from the Fed?

Bloomberg.com: Allianz, Flowers Said to Have Bid for AIG Before Fed Takeover

This may prove to be a double-edged sword. The Fed’s efforts to prevent moral hazard from creeping into the system is intended to compel the survivors of the subprime apocalypse into being more conservative with their investments. Subjecting them to the rigors of the market (the threat of bankruptcy) is aimed at bringing about more discipline. Sadly, this may run counter to the Fed’s goals of injecting liquidity into the system; banks will now be throttling back on loans by intesifying their lending requirements.

However, as the IMF has stated, the worst is yet to come. In subjecting the subprime survivors to market discipline (being allowed to fail), we could see some reverberations as a domino effect works its way throughout the entire system.

“The roots of the crisis are behind us, the roots being the fall in housing prices. The consequences for some financial institutions are still in front of us. We have to expect that there may be in the coming weeks and coming months other financial institutions with some problems,” he said.

As MSNBC chronicles, there have been 13 bank failures since the credit crunch hit in August, 2007, with potentially 1,000 (likely smaller) banks waiting in the FAIL line.