Wall Street has been able to look beyond the earnings flu and the swine flu to presumably healthier conditions in the second half. Little by little, the bears are capitulating. We wonder, however, whether a systemic debt problem caused by a global credit bubble can be adequately addressed by increasing debt? We will not know the final answer to that economic question for several years, but how one answers it today will strongly influence one’s tactics and strategies in the intermediate term.

Detail

Over the last few weeks, the market has been punishing the skeptics by pretending to faint and then staging a series of brilliant surprise rebounds. Why the resiliency? Wall Street’s attention is focused well beyond the headlines that belabor contagion from toxic assets and swine flu. Is the optimism justified? The Federal Open Markets Committee thinks so. The august body in charge of regulating the flow of money and credit in the U.S. economy stated this week that despite the obvious short-term risks,

“Nonetheless, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.”

Liquefy!
The Fed has been a force for optimism throughout the credit crisis, even at the cost of underestimating it. The Fed is not only seeking price stability, but also emotional stability, as fear and banking don’t mix well. Banks are always highly leveraged (8-12: 1), so a sudden lack of confidence among depositors is quickly fatal. As we have seen over the last year, banks can go under over a weekend, and Chairman Bernanke appears committed to avoid a run on any large bank.

During the Hoover administration, Treasury Secretary Andrew Mellon became famous (or infamous) for his policy of aggressive forced liquidation. Rather than trying to purge the rottenness from the system by a policy of “liquidate, liquidate, liquidate,” Bernanke and the Treasury are attempting the reverse: liquefy, liquefy, liquefy.

Due to an inconvenient shortfall of cash, however, the government is borrowing the funds. In just the last week, the Treasury sold a record $26 billion in 7-yr notes, a record $40 billion in 5-yr notes and another $40 billion in 2-yr notes. Next week a record $70 billion in long-term Treasuries comes to market. Net government borrowing for Q2 is slated to be 27 times larger than in the year ago quarter. The question naturally arises, “Can a systemic toxic debt problem be permanently cured by increasing debt, or is it only a stop-gap measure?”

That question is probably the most important one that could be asked in these challenging times, but the answer will not be revealed for quite a while because the full faith and credit of the U.S. is still worth something.