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September 26, 2008

The magical money machine in Washington has produced yet another wonder of fiduciary slight of hand. This time it was Treasury Secretary Henry Paulson taking his turn in front of the crowd, inspiring awe as he pulled close to a trillion dollars out of his hat.

Like alchemists and sorcerers of old, Paulson wishes to conjure value from nothing. The aim is to transform tottering mortgage holdings into secure assets by merely changing what name appears at the top of the balance sheet unfortunate enough to have them as a constituent part. If the risk of mortgage defaults was there before, it doesn't disappear because the pea has turned up under another cup. The risks now reside with the U.S. taxpayers, and the true magnitude will only become apparent over the next several years.

But the show doesn't end there. The massive amount of new debt required to pay for the bailout has effects of its own.

At any given time, a limited amount of capital is available for investment. Private firms and governments at all levels vie for those scarce resources. Because people tend to believe (rightly or wrongly) that the United States government is not apt to default on its obligations, U.S. debt securities will often find buyers at the expense of other entities' offerings. This crowding-out effect reduces the funds firms could use for expansion, research, or other productive activities. With recessionary pressures building, anything that would hamper business is likely to create a protracted downturn. The audience wants to be thrilled, but not like that.

So how will Paulson the Great avoid the crowding-out calamity? He'll avoid it by turning to his compatriot, Ben Bernanke. Bernanke is the chief swami at the Federal Reserve, or the Fed, for short. The Fed is an institution shrouded in mystery. From its paranormal inception in 1913 to today, it has been the man behind the curtain through ups and downs. Bernanke can help reduce crowding out by making it appear there is more capital to be had than really exists. He'll accomplish this by pumping new money into the economy. Like pixie dust, this added liquidity will send signals indicating economic activity can soar as if the savings were really there to bolster it. Unfortunately, it will be an illusion.

Absent the real savings necessary for economic growth, much of any induced growth will be short-lived. Monetary inflation sends false signals to the market, which cluster and manifest in the boom-bust cycle the Fed has been causing for years. The very bust Paulson and Bernanke are trying to avert now is the result of the extended boom inflation wrought. Attempts to delay the downturn, which is a readjustment to reality, will heighten the severity of the inevitable slump.

Furthermore, foreigners may not be as smitten by the prestidigitating pair. Monetary inflation is, by definition, a weakening of the currency. Rising prices in our country are but one effect. Increased pressures to avoid holding dollars or dollar-denominated assets are another. The U.S. dollar has acted as the reserve exchange medium for half a century. That preeminence masked the full effects of prior inflation because excess dollars were absorbed into overseas accounts and held. Confidence in the United States kept the status quo. If that confidence lapses and dollar positions are liquidated, then the house of cards will fall. The great unknown is how much U.S. government debt it will take to shake the faith. Officially, the debt will exceed $11 trillion by next year. That doesn't take into account potential mortgage defaults and present unfunded obligations. Once confidence evaporates, no amount of hypnotic prowess will be able to rekindle it.

Henry Paulson and Ben Bernanke are summoning the two most frequently used spirits governments call upon to bend reality: debt and inflation. Neither option is singly beneficial. Together they are toxic. The antidote is not more smoke and mirrors; it is instead a return to sound money and fiscal responsibility.