Rogoff: America will Need a $1,000bn Bail-Out

Kenneth Rogoff hopes the rest of the world retains its optimistic stance toward the ability of the US to overcome the problems it is facing. If that optimism fades, things could get much worse:

America will need a $1,000bn bail-out, by Kenneth Rogoff, Commentary, Financial Times: One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 64-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but ... it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

It is true that the US government has very deep pockets. ... It is also true that despite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account ... nationalising ... Freddie Mac and Fannie Mae, the costs of ... bail-out of ... Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet ..., and finally, yesterday’s $85bn bail-out of ... AIG.

Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending ... an amount closer to $1,000bn to $2,000bn. ...

[A]t this juncture, there is every possibility that the credit crisis will radiate out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury’s most determined efforts, the political pressures for a much larger bail-out ... are going to be irresistible.

It is hard to predict exactly how and when the mega-bail-out will evolve. At some point, we are likely to see a broadening and deepening of deposit insurance, much as the UK did in the case of Northern Rock. Probably, at some point, the government will aim to have a better established algorithm for making bridge loans and for triggering the effective liquidation of troubled firms and assets... Of course, there also needs to be better regulation. ...

It may prove to be possible to fix the system for far less than $1,000bn- $2,000bn. The tough stance taken by regulators this past weekend ... certainly helps. Yet I fear that the American political system will ultimately drive the cost of saving the financial system well up into that higher territory.

A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.

The shrinking financial system will also undermine ... the strength of the US economy. And it is hard to see how the central bank will be able to resist ... allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.

It is a very good thing that the rest of the world retains such confidence in America’s ability to manage its problems... Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.