On October 3, 2008, Congress authorized government spending of $700 billion to buy up the bad investments of banks and other financial institutions that are clogging the financial system and creating a credit crisis.  The Treasury will acquire the necessary funds through the sale of new securities to the public.  However it cannot sell that much at one time without causing interest rates to soar.

Assume therefore that it sells $50 billion worth, and then uses the proceeds to buy that amount of the bad investments.  By repeating this until it has spent the full $700 billion, the maximum amount of loanable funds it would draw from the private sector at any one time would be a manageable $50 billion. 

Later the Treasury will reverse the sequence, incrementally selling those investments back to the public, and using the proceeds to buy Treasuries in the open market.  If those investments sell at the price paid by the Treasury, there would be no net fiscal imbalance on completion of the bailout. 

But suppose the Treasury could recover only $200 billion on the sale, and thus leave $500 billion worth of Treasuries in the hands of the private sector.  That would be the net increase in Federal debt due to the bailout.   

Who wins and who loses in that case?  The winners are those who sold their bad investments to the Treasury for more than they were worth in the open market.  Even though they probably lost relative to what they originally paid for them, their net worth would improve relative to what it was before they sold them. 

And the losers?  Contrary to conventional wisdom, in the long run there are none.  The notion that the bailout is at taxpayer expense is an illusion.  In reality, the bailout is paid for with newly issued Treasury securities, not taxpayer money.  The two are not the same.

Consider the following example, all amounts in billions of dollars:

For simplicity we will assume a balanced budget to start with:

national income = 10,000  (taxable part)

government debt = 4,000  (held by the public)

interest on the debt = 200  (based on 5% average rate)

other government spending = 1,800

total government spending = 2,000

total tax revenues = 2,000  

Now suppose the bailout adds 500 to the debt, and to keep the budget in balance the government increases the tax rate by 0.25% on national income.  Other things equal, the result is::

national income = 10,025

government debt = 4,500

interest on the debt = 225

other government spending = 1,800  (unchanged)

total government spending = 2,025

total tax revenues = 2,025

We can now make the following observations:

   1.  The new Treasury securities issued in the bailout increase the net financial wealth of the private sector by $500 billion.

   2.  The interest payments and tax revenues increase equally while the amount of other government spending remains unchanged.  The bailout therefore need have no impact on existing government programs.

   3.  Since the increase in taxes is covered in the aggregate by the additional interest payments, the base money supply of the private sector remains unchanged.

   4.  If the economy grows in nominal terms by 0.25%, tax revenues would increase by 0.25% and there would be no need for a tax rate increase to maintain a balanced budget.

   5.  The nominal growth rate of the economy averages about 5%, comprised of 2% real and 3% inflation.  Thus tax revenues over the long term will increase due to economic growth far more than what is needed to support interest payments on the additional debt.

   6.  If the interest rate on Treasuries remains unchanged, maturing securities can be rolled over indefinitely without additional taxes regardless of the debt, and without affecting individual financial wealth.

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