So the federal bailout package is taking shape.  The President is asking Congress to approve $700 Billion for the Treasury to buy pretty much anything it wants to over the next few years.  The theory behind this approach is that buying up bad assets will result in banks resuming business with each other and once again extending credit to businesses and consumers.

Even if this works it will be painful because of the implications for interest rates, the US dollar, and inflation.  Adding $700B to $1 trillion (counting Fannie, Freddie and AIG commitments) to the government debt will require a significant hike in interest rates to get folks to buy the necessary bond issues. At present there is about $5.5 trillion of publicly held debt, so you are talking about an increase of 12-18%.  The new issues and the interest rate increase will add tremedously to the annual government deficit due to big jump in interest payments.  There could also be legitimate worry that at least part of this will ultimately be financed by printing more money.  Any such excpectation would put downward pressure on the dollar and result in increased inflation with in turn further upward pressure on interest rates.

If the plan does not work, then all bets are off.  For instance, if lending does not resume, or even if lending resumes but nobody wants to buy homes, then house prices will decline further and the government will become the owner of many homes (some say the US could wind up owning 10 million houses or more).  In such a scenario there might be serious questions about the US’s ability to repay its debt.  Any significant doubt of that form would lead to an ugly debt spiral for the US, which in the extreme case could lead to hyperinflation (if the US were to decide to print money in a big way).  Admittedly, that’s a fairly low probability event, but then again most of us would have considered the events of last week a low probability event.

What all of this means for startups is to make sure that they have no interest rate and exchange rate exposure and to watch out closely for signs of inflation.  If there is a serious uptick in inflation your cash reserves are effectively shrinking.  At that point something inflation indexed will be the only way to go (if you can find it).

So the federal bailout package is taking shape.  The President is asking Congress to approve $700 Billion for the Treasury to buy pretty much anything it wants to over the next few years.  The theory behind this approach is that buying up bad assets will result in banks resuming business with each other and once again extending credit to businesses and consumers.

Even if this works it will be painful because of the implications for interest rates, the US dollar, and inflation.  Adding $700B to $1 trillion (counting Fannie, Freddie and AIG commitments) to the government debt will require a significant hike in interest rates to get folks to buy the necessary bond issues. At present there is about $5.5 trillion of publicly held debt, so you are talking about an increase of 12-18%.  The new issues and the interest rate increase will add tremedously to the annual government deficit due to big jump in interest payments.  There could also be legitimate worry that at least part of this will ultimately be financed by printing more money.  Any such excpectation would put downward pressure on the dollar and result in increased inflation with in turn further upward pressure on interest rates.

If the plan does not work, then all bets are off.  For instance, if lending does not resume, or even if lending resumes but nobody wants to buy homes, then house prices will decline further and the government will become the owner of many homes (some say the US could wind up owning 10 million houses or more).  In such a scenario there might be serious questions about the US’s ability to repay its debt.  Any significant doubt of that form would lead to an ugly debt spiral for the US, which in the extreme case could lead to hyperinflation (if the US were to decide to print money in a big way).  Admittedly, that’s a fairly low probability event, but then again most of us would have considered the events of last week a low probability event.

What all of this means for startups is to make sure that they have no interest rate and exchange rate exposure and to watch out closely for signs of inflation.  If there is a serious uptick in inflation your cash reserves are effectively shrinking.  At that point something inflation indexed will be the only way to go (if you can find it).