U.S. Financial Bailout Meant to Stem Defaults
By late Sunday night of the past weekend, many observers were breathing a sigh of relief over the financial bailout package that had been negotiated by the White House and a bipartisan group of elected and appointed officials. To be available in stages totaling a potential $700 billion USD, it would have helped to settle down Wall Street and ease Main Street's anxieties over family finances.

Not addressed, however, were the so-called "second wave" of loan defaults looming on the horizon and the longer-term implications. These were part of the reason for the enabling legislation failing to receive passage when the bill was introduced on the floor of the House on Monday. There was also the matter of trying to offload more of the responsibility and risk onto the private sector. Some background analysis is warranted.

Unnatural Factors

The bailout package was in response to unnatural factors that came to the fore during the expansion phase of the last economic boom. It was designed to take care of a subprime mortgage mess that was initiated by money being given to people without the incomes to handle a downturn in the economy and an up-tick in interest rates.

It would also have cleaned up the cesspool of debt instruments that proliferated using such flaky assets as collateral. The whole issue of transparency and legitimacy with regard to derivatives, collateralized debt obligations, interest rate and credit default swaps is another matter that will be addressed through increased oversight and regulation.

Helping Wall Street does give Aid to Main Street
Helping Wall Street does aid Main Street (as the politicians are so fond of calling it) in that freeing up credit and encouraging banks to lend to each other and to business again is essential for many firms to continue operations. Many businesses keep their doors open through short-term borrowing to meet regularly scheduled payments in such key areas as rents and salaries. Without some form of bailout agreement, many workers' wages are in direct jeopardy.

There are remaining doubts and questions, however, concerning what comes next. This weekend's bailout package included neither stimulus for future economic growth nor relief for consumers facing job losses and future difficulties in meeting mortgage payments, credit card debt, student loan obligations and so on. This has been termed the "second wave" problem that the financial sector will have to deal with as the slowdown/recession continues.

Second Wave Problem — Due to Natural Causes
Such a second wave of problems will have a quite different complexion from the first wave, however. It will be due to natural causes — i.e., the business cycle. The political and social environment − also known as the "safety net" in the form of unemployment insurance and the like − is accustomed to dealing with such a contingency. Furthermore, on the financial side, accounting rules are different.

Transparency and Accounting Changes
Part of the reason that U.S. investment banks have fallen so quickly has been a change in the way that assets have been recorded. "Mark-to-market" accounting, in the move to transparency, has caused assets to be listed at current market value, as opposed to historical cost. In the second wave, it will be the commercial banks that will bear the brunt of the loan defaults and they have huge depositor bases that help with capitalization requirements. Also, their business model is based on accruing revenue and expenses and this helps to smooth over the ups and downs.

The U.S. now Needs Inflation, but Where does this Lead?
Therefore, a "second wave" may not be as debilitating as some analysts fear. However, there is a longer term implication of any major financial bailout that should be considered. The United States now "needs" inflation. Or more accurately, inflation might not be seen (by some in authority) as such a bad thing due to the role it can play in reducing debt. A run-up in prices is one way that governments traditionally deal with huge debt. In addition, inflation would help to stop the slide in home prices that is one major factor inhibiting consumer spending.

The bottom line is that there might well be a "relaxation of discipline" when it comes to the money supply. What would be the consequences, longer term, of such a turn of events? It would worsen the goods and services trade deficit that has proven intractable around $700 billion. This is currently being financed mainly through capital infusions from China and Japan. The increase in U.S. debt is already a concern in terms of the rating of U.S. Treasury bonds. More inflation, a larger trade deficit and bigger government debt can really only point in one direction — higher-than-normal interest rates.