Giant Government Debt Buyout: Will it Save the Economy?

Announcement of a huge government program to take over billions in bad mortgage debt capped a tumultuous week on Wall Street. But will federal actions avert more bad economic news?

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

Beth Belton, Senior Economics Editor, The Kiplinger Letter

September 19, 2008

It's historic, it's dramatic and it will avert a threatened financial meltdown. The government's plan to take over banks' bad debt will pour much needed lubricant into a credit market that's seizing up.

But it probably won't turn around the U.S. economy. A comprehensive government plan to isolate billions in bad, or at least dubious, mortgage debt and free the wheels of commerce reduces the odds of an economic contraction that lasts for two or more consecutive quarters -- a recession by anyone's definition. It won't spark a strong recovery. We expect GDP growth to be very weak next quarter and chalk up no more than a 1% gain in all of 2009.

All the fundamental weaknesses remain. Overall consumer spending lacks any oomph, and is likely to shrink in the coming quarter. And because energy and food prices are still elevated by historical standards, they will continue to eat up a bigger share of income than usual. That leaves less available money for spending on autos, apparel, home furnishings, travel and leisure and all kinds of other goods and services.

Wage gains lag inflation, so most Americans find they can't buy as much with their paychecks today as they did a year ago. And while disposable personal income has grown in real terms -- after wringing out inflation -- it hasn't been by much: a mere 1% increase this year.

What's more, consumers are buried in debt. By the end of this year, they'll owe a total of $2.6 trillion on credit card, auto and other loans, not counting mortgages. That's nearly $8,500 for every man, woman and child in the country. Credit card debt alone is nearing $1 trillion -- an average of about $8,200 per credit-card-holding household.

Meanwhile, more and more folks are out of jobs. By early next year, unemployment will hit 6.5% or so, and the number of net jobs lost each month will get worse before it gets better. The economy won't begin to add net jobs until late next year.

The housing market is still a huge negative. The massive federal takeover of mortgage-backed debt will help bring about a bottom sooner rather than later, as clearer market values are established, foreclosure rates stabilize and the number of mortgage workouts increases. But the big steps Uncle Sam is prepared to take won't eliminate the huge overhang of unsold homes, won't prevent further declines in home sales prices and won't give back to consumers the equity they have lost.

Don't expect any lift from business spending, either. Business managers are becoming even more cautious, and capital spending won't grow at all next year. Tighter credit will make it tougher even for businesses that want to expand. As we outlined in last week's Kiplinger Letter, Main Street banks -- although largely unscathed by Wall Street's meltdown -- will nevertheless keep a tighter hold on their purse strings in coming months.

Even the brightest star in the economic firmament -- exports -- is dimming. Weaker global markets mean they won't grow as swiftly in the coming year. We expect slowdowns in European economies, Japan and Canada to shave a percentage point or so from growth in U.S. sales overseas next year, holding it at roughly 7%, compared to an 8% increase this year.

Federal spending will push higher, of course, as the government absorbs the bad debt. But the red ink it will spill in the effort won't provide a direct economic kick. In fact, the increase in the budget deficit diminishes the odds of tax cuts or other fiscal stimuli. And state and local governments, suffering from lower tax receipts, won't do anything to pick up the slack. They'll be forced to cut back themselves.

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