Greenback floods globe

Bloomberg

The world needs more dollars. The United States is preparing to provide them. In an all-out assault on capitalism’s worst crisis since the Great Depression, the U.S. is taking on the role of both lender and borrower of last resort for the global economy.

The Federal Reserve, which has already pumped out hundreds of billions of dollars, might formally adopt a policy of flooding the world financial system with even more money. The Treasury, on course to borrow some $1.5 trillion this fiscal year, may tap global capital markets for even more to finance a fiscal stimulus package of as much as $700 billion and provide additional bailout money for banks.

"You want to do everything you can when you’re facing the threat of a deflationary breakdown," says Michael Feroli, a former Fed official who is now an economist at JPMorgan Chase & Co. He sees the central bank cutting the overnight lending rate to zero in January and holding it there throughout the year.

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson are being forced to pull out the stops because the extraordinary actions they’ve taken so far have failed to gain much traction. Credit markets are collapsing, stock prices are plunging and the world economy is sinking into a recession.

As the economy deteriorates, deflation - a sustained decline in wages and prices - is emerging as a new threat. U.S. government figures last week showed that consumer prices excluding food and fuel costs fell in October for the first time since 1982.

Shell-shocked
Investors, shell-shocked by the turmoil, are piling into super-safe Treasury securities, even as the U.S. government ships more supply out the door. Three-month bill rates dropped last week to 0.01 percent, the lowest since at least January 1940, and yields on Treasuries maturing in two through 30 years all fell to the least since the government began regular sales of the securities.

And the dollar has risen as loss-ridden banks worldwide husband their resources, even after receiving generous dollops of liquidity from the Fed. The U.S. currency has surged about 17 percent against the euro in the two months since the crisis deepened after the failure of Lehman Brothers Holdings. Meanwhile, gold is down almost 25 percent from its peak in March.

To help fight the worldwide dollar squeeze, the Fed has set up currency swap lines with more than a dozen other central banks. Some arrangements, including those with Europe, Britain and Japan, are open-ended, allowing the Fed’s counterparts to draw as many dollars as they need. The U.S. has also established individual $30 billion swap lines with Brazil, Mexico, South Korea and Singapore.

As the Fed has stepped up its efforts to combat the credit crisis, its balance sheet has mushroomed. Assets rose to $2.2 trillion on Nov. 19 from $924 billion on Sept. 10, just before the bankruptcy of Lehman Brothers shook the global financial system.

Central Bank holdings swell
The central bank’s holdings are likely to increase further. "I would not be surprised to see them aggregate to $3 trillion - roughly 20 percent of GDP - by the time we ring in the new year," Dallas Fed President Richard Fisher said on Nov. 4.

That may be only the start if the Fed cuts its benchmark rate, now at 1 percent, to zero and adopts what economists call a policy of "quantitative easing." Under such a strategy, it would concentrate on expanding the amount of reserves in the banking system because it could no longer reduce the cost of that money.

The Treasury is also heading into uncharted territory as it taps capital markets for cash to help finance its bailout fund for the banking system and plug holes in the federal budget caused by the weak economy.

Much of that money will come from abroad. "Foreigners don’t seem to be interested in any kind of risky U.S. asset," says Brad Setser, a former Treasury official now at the Council on Foreign Relations in New York. So, "instead, they are buying Treasuries." That includes China, which recently passed Japan as the biggest holder of Treasuries.

On Nov. 3, the department tripled its estimate of planned debt sales in the final three months of the year to a record $550 billion. Paulson told a conference in Washington Nov. 17 that the U.S. will issue some $1.5 trillion worth of Treasury securities in the fiscal year that began Oct. 1.That number, too, could grow. Lawrence Summers, Treasury secretary under President Bill Clinton and an adviser to President-elect Barack Obama, told the same conference that the U.S. needs a "speedy, substantial and sustained" stimulus package to aid the economy.