Wider U.S. Financial Bailout Could Fuel Inflation

If the U.S. government bails out the financial system by buying mortgage debt directly, the price might be surging inflation and a dollar crisis.

Calls are increasing for the federal government, either directly or through the Federal Reserve, to cut the knot of the credit crisis at a stroke by buying up mortgages that banks and investment banks are finding difficult to finance.

If the government bought mortgage debt at or near 100 cents on the dollar, even though much of it is trading well below that amount, it would allow banks to pay back loans used to finance these holdings.

If done in sufficient size, say $800 billion or $1 trillion, it would relieve the terrible pressure on bank balance sheets and allow other credit markets, like those for corporate loans, to return to something approaching equilibrium.

That, in turn, would make Fed monetary policy more effective in the sense that banks would be able to increase lending and pass on interest rate reductions.

Of course this would be a radical step, and way beyond the Fed's already extraordinary policy of swapping mortgages held by banks and some investment banks for easy-to-finance Treasuries.

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