Crisis Exposes Flaws in U.S. Economy, Tarnishes Image (Update1)

So I am in the dark but this is my first attempt at starting a discussion on the economy:

http://www.bloomberg.com/apps/news?pid=20601170&refer=home&sid=aXRPsaQU9ybY#

Crisis Exposes Flaws in U.S. Economy, Tarnishes Image (Update1)
By Rich Miller

Sept. 18 (Bloomberg) -- The rapid-fire rescues of financial firms may end up tarnishing America's free-market reputation as the moves expose defects in the U.S. economy, undermining its standing with foreign buyers of the dollar and U.S. Treasury securities.

The government's actions might add hundreds of billions to a budget deficit already expected to hit a record next year. The salvage operations, which include Tuesday's takeover of American International Group Inc., also raise questions about the U.S. commitment to a free-market economy that, until recently, was the envy of the world.

America's credit ``profile is now weaker because contingent risks have become actual risks to the U.S. government,'' said John Chambers, managing director of sovereign ratings at Standard & Poor's in New York.

The result: Foreign investors may demand higher compensation for providing the money the U.S. government and economy depend on. That, in turn, could translate into lower living standards for Americans as borrowing costs are pushed higher and the dollar is pulled lower.

There's not much evidence that any of this is happening yet. The yield on the 10-year Treasury note fell to 3.4 percent yesterday from 3.9 percent two months earlier as investors sought refuge from the recent turmoil in financial markets. The U.S. currency, meanwhile, has strengthened to $1.43 per euro from $1.59 on July 17.

Hedge Against Losses

Yet in what may be a sign that the complacency won't last, the cost to hedge against losses on U.S. government debt rose to a record yesterday after the Federal Reserve's rescue of insurance giant AIG. Benchmark 10-year credit-default swaps on Treasuries increased 4 basis points to 30, more than double those on government debt sold by Austria, Finland or Sweden, according to BNP Paribas SA.

Until now, the U.S. has enjoyed a special status among investors, thanks to the size of its economy, the power of its military and the depth of its financial markets. The dollar supplanted the British pound as the world's reserve currency after World War II, enabling America to borrow freely from abroad and run up big trade deficits. All this fed the country's sense that the U.S. was exceptional, destined to be the global political and economic leader.

America can no longer take its privileged position for granted. It has already lost some of its diplomatic luster because of President George W. Bush's go-it-alone foreign policy and the invasion of Iraq.

Dollar's Rival

The successful introduction of the euro a decade ago has created a rival for the dollar as the world's main currency for trade and investment. The rapid growth of emerging markets, particularly China, has also undercut America's attractiveness to the world's financiers.

That's why the ongoing financial turmoil is so dangerous. The meltdown has created ``a crisis of confidence in the U.S. government,'' said Jim Leach, a former Republican U.S. congressman from Iowa who is now a professor at Princeton University in New Jersey. ``The twin pinions of American strength -- our politics and our finance -- are under the gun today.''

Estimates of the eventual price the U.S. government will have to pay to end the credit crisis vary widely, ranging as high as $2 trillion. Many are lower than that, at roughly a half-trillion dollars -- equal to about 4 percent of gross domestic product. Kenneth Rogoff, an economics professor at Harvard, wrote in the Financial Times today that the U.S. may have to spend between $1 trillion and $2 trillion.

Facing Liabilities

While such a bill would be more than twice what the U.S. paid in today's dollars to resolve the savings-and-loan crisis in the early 1990s, budget experts said it would be manageable to finance on its own. The trouble is, the federal government already faces liabilities in the tens of trillions of dollars as baby boomers retire and begin collecting Social Security and medical benefits.

Joshua Rosner, an analyst with research firm Graham Fisher & Co. in New York, said the costs are unclear partly because the Treasury is effectively keeping some of them off the government's balance sheet by parking them at the Fed. That's the same sort of practice that got Citigroup Inc. and other banks in trouble during the now year-old credit crisis.

Fed Chairman Ben S. Bernanke and his colleagues committed $29 billion to back the takeover of Bear Stearns Group by JPMorgan Chase & Co. in March. Treasury Secretary Henry Paulson followed with a pledge this month of as much as $100 billion each for Fannie Mae and Freddie Mac to ensure that the two mortgage companies continue supporting the battered housing market. The Fed then kicked in an additional $85 billion this week for AIG.

Reassure Investors

Harvey Pitt, chief executive officer of Kalorama Partners in Washington and former chairman of the Securities & Exchange Commission, argued the rescues would help reassure foreign investors that the U.S. isn't prepared to accept a free-fall in financial markets. The bailouts, unfortunately, also do something else: They highlight the fragility of the U.S. financial system.

``The foreigners are torn right now,'' said Mohammed El- Erian, co-chief executive officer of Pacific Investment Management Co. in Newport Beach, California. ``On the one hand, they are stunned by what is happening to the U.S. financial system. On the other, they are impressed that we are getting a policy response that is relatively fast.''

Sovereign-wealth funds invested just $900 million in new capital in U.S. and European financial institutions so far this quarter. That's down from $6.43 billion in the second quarter, $19.7 billion in the first and $28.5 billion in the final quarter of last year, according to data compiled by Bloomberg News.

Increasing Uncertainty

Nobel Prize-winning economist Joseph Stiglitz said that the haphazard nature of the bailouts may discourage investors from putting money in the U.S. because it increases uncertainty about who will survive and who will fail.

``We used to believe that America was a country or a government that was based on the rule of law,'' the Columbia University professor said in a Sept. 16 interview on Bloomberg Radio. ``Today, we appear to be a law of discretion. Who gets bailed out seems to be totally up to the discretion of Paulson, of Bernanke.''

William Poole, a senior economic adviser at Merk Investments LLC and former St. Louis Fed president, said in a Bloomberg Television interview yesterday that the market system would be hurt by increased regulation in the wake of the rescues.

`Heavier Regulatory Hand'

``It is likely that we will see a much heavier regulatory hand that, in the end, is going to saddle lots of companies with unnecessary costs and damage our market system,'' said Poole, a Bloomberg News contributor.

Foreigners' appetite for investing in the U.S. may also be tempered by the impact of the crisis on the economy. Allen Sinai, chief economist at Decision Economics in New York, said the U.S. is in for an extended recession as the financial- services industry -- a major source of increased productivity growth in the past -- consolidates.

``The federal government assumes that it can borrow whatever it wants from foreign lenders at low interest rates for as long as it wants,'' said David Walker, former comptroller of the U.S. Government Accountability Office who's now head of the Peter G. Peterson Foundation in New York. ``That's an imprudent assumption.''

To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net

Last Updated: September 18, 2008 07:13 EDT