As consumers closed their wallets, Uncle Sam opened his with one of the biggest spending programs in history, roughly $1.5 trillion in less than a year. Some $700 billion went to shore up shaky banks; another $787 billion paid for tax cuts and a surge in spending on new roads, green technology and a host of other projects designed to pump dollars into a shrinking economy.
A separate alphabet soup of money transfers from the Federal Reserve added another $1 trillion, much of it to guarantee loans and buy up bad investments from banks that couldn’t sell them, freeing up cash for them to lend.
The strategy seems to have worked, and much of the planned direct government spending is still in the pipeline. The hope is all that federal spending gets the gears of the economy turning again with enough momentum that as the federal spending spigot starts to slow down, other sectors of the economy will take up the slack.
But that plan comes with potential pitfalls. At some point, the Federal Reserve will have to unwind its trillion-dollar infusion of cash or risk igniting another asset bubble or nasty round of inflation. If it unwinds too quickly, it risks setting off another panic in the financial markets. If it leaves its policy in place too long, bankers will assume they can keep making risky loans and sell them to the Fed if they go bad.
“I believe they will continue to wind those (Fed backstops) down gradually,” said William Isaac, a former head of the FDIC. “We need to take sort of baby steps: take them down a little bit, see what happens, and take them down some more. Because we need to wean the markets off of these things. We can't keep them there forever.”
The government’s direct spending is being funded entirely with borrowed money, which is fine as long as investors keep buying U.S. Treasury debt. If they begin to lose their appetite, that could force interest rates higher, creating a big problem for businesses and consumers who need to borrow money.
