LONDON If the United States bails out the financial system by buying mortgage debt directly, the price just might be surging inflation and a dollar crisis.
Calls are increasing for the government, either directly or via the Federal Reserve, to cut the knot of the credit crisis at a stroke by buying up mortgages that banks and investment banks are finding difficult to finance.
If the United States bought mortgage debt at or very near 100 cents on the dollar, despite the fact that much of it is trading well below that, it would allow banks to pay back loans used to finance these holdings.
If done in sufficient size, say $800 billion (400 billion pounds) or $1 trillion, it would relieve the terrible pressure on bank balance sheets and allow other credit markets, like those for corporate loans, to return to something approaching equilibrium.
That in turn would make Fed monetary policy more effective in the sense that banks would be able to increase lending and pass on interest rate reductions.
Of course this is a radical step, and way beyond the Fed's already extraordinary policy of swapping mortgages held by banks and some investment banks for easy to finance Treasuries.
It is also hugely risky in terms of the Fed's obligation to maintain stable prices. Putting aside moral hazard -- many foolish borrowers and lenders would thus be given a free ride -- and depending on how such a bailout was done, it could stoke inflation to levels intolerable to foreign creditors, provoking a sharp fall in the dollar as they sought safety elsewhere.
Such a bailout would either have to be paid for by taxes, which seems unlikely, or would involve issuing more government debt or effectively expanding the money supply.
"There would be an inflationary impact because of the huge introduction of credit," said Philip Gisdakis, strategist at Unicredit in Munich.
"It's not $50 billion; we are talking about more like $1 trillion. This injection of capital you need will have consequences for the U.S. economy."
A bailout of that size is very likely to stoke inflation, which is already uncomfortably high, by effectively creating more dollars and putting them into circulation.
"If it's too big there will have to be an element of monetisation, with the Fed financing it," said Tim Drayson, economist at ABN AMRO in London.
"Monetisation is rising from what was a small likelihood to what is now an increasing risk."
To be sure, there is no political consensus for a major bailout, which is openly opposed by the Bush administration and would face serious difficulties gaining agreement in an election year. The U.S. Treasury said on Wednesday that proposals it had seen would do more harm then good.
That is partly why there has been such a startling turn around on allowing Fannie Mae FNM.N and Freddie Mac FRE.N to take on more risk and buy more mortgages. While their debt has an implicit government guarantee, they are shareholder owned.
But the $200 billion in new lending allowed to Fannie and Freddie by their regulator, The Office of Federal Housing Enterprise Oversight, might not prove enough.
IMPERFECT WORLD, IMPERFECT OPTIONS
The Fed's current policy of financing mortgage bonds, involving another $200 billion, has its limits as well. When that sum is exhausted, analysts estimate that it will have $300-400 billion of balance sheet capacity left before it either has to issue debt or purchases become inflationary.
If that happens, it would undoubtedly be with explicit approval of the Treasury.
"That would be a big expansion in the monetary base, which would have serious inflation consequences, not least foreigners' perception of the U.S. and the credibility of the Fed," said Drayson.
"You could see widespread dumping of dollar assets which would make the inflation self-fulfilling."
The question of how deep a dollar fall that implies is really in the hands of the United States' foreign creditors, like China and the Gulf states. Because they peg their own currencies to the dollar, exporting more to the United States than they import, they are regular dollar buyers.
A falling dollar causes inflation for them, a price thus far they have been willing to bear as a cost of a profitable trading relationship.
But eventually, if inflation and a dollar fall interact toxically, support from abroad might just dry up.
"If (foreign creditors) decide that they are not going to accept the inflationary policies of the Fed, you could see a pretty disorderly collapse," said Drayson.
"If we are talking a trillion dollars plus (bailout), it will be quite hard to avoid inflation as a consequence of that."
There are, of course, also consequences to the alternative course, which may lead to a round of failures by financial institutions.
In either event, the stakes are high.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)