Since the onset of the financial crisis, the assets and liabilities of the U.S. banking system have increasingly been consolidated onto the balance sheets of the Federal Reserve and the U.S. Treasury.

Even before the Troubled Assets Relief Program (TARP) is put into effect, the Treasury has borrowed unprecedented sums in the money market, deposited $500 billion of surplus cash with the Federal Reserve, and in turn enabled the central bank to extend more than $600 billion in special credits to commercial and investment banks, insurers and swap lines with overseas central banks.

In effect, Treasury has borrowed the money banks themselves are unable to raise at present, substituting the full faith and credit of the United States for the impaired credit of the banking system.

Almost all the money has been raised through the issue of very short-term cash management bills. In a normal month, the Treasury typically issues no more than $50-70 billion worth of management paper to meet temporary mismatches between spending and revenues before the next regular funding auction of longer-term bills and notes. But as the crisis intensified, the Treasury's issuance of management paper has soared from $66 billion in August to $320 billion in September and $270 billion so far in October. Some $499 billion of the proceeds has been deposited into the Fed's new supplementary financing account.

The problem with the Treasury borrowing program is that it is taking debt levels close to the statutory ceiling approved by Congress. The statutory ceiling has already been raised twice this year from $9.815 trillion to $10.615 trillion in July, and again to $11.315 trillion in October as part of the Emergency Economic Stabilisation Act.

Total debt outstanding is already up to $10.229 trillion, just $1.086 trillion below the new limit. The Treasury is already committed to raising $700 billion to fund bank capitalizations and asset purchases under TARP.

That leaves just $386 billion of debt-raising authority that has not been used or already committed -- far less than the $648 billion the Treasury has already borrowed in the last six weeks. There is not much scope for further bank capitalizations, new liquidity facilities or additional help for homeowners beyond what has already been announced.

The Treasury will therefore need more borrowing authority than remains to fund the regular operations of the federal government in the coming year. Even before the onset of the crisis, the non-partisan Congressional Budget Office (CBO) projected the federal government would run a deficit of $438 billion in fiscal 2009, while the White House Office of Management and Budget (OMB) forecast a gap of $482 billion.

But as the crisis works its way through to the real economy, the deficit is set to worsen alarmingly, even before Congress considers a new economic stimulus package to help troubled homeowners and restart growth. Lower household incomes and corporate profits will cut tax receipts substantially, while higher unemployment will boost spending. Income tax receipts have already fallen by 1.5 percent ($18 billion) in fiscal 2008 compared with fiscal 2007, while corporation taxes are down 17.8 percent ($66 billion), and spending on unemployment insurance programs has risen 32 percent ($10.4 billion).

Moreover, the Stabilisation Act itself contains items that will worsen the deficit further, including a requirement for the Fed to pay interest on certain bank reserves, as well as various tax breaks.

The Treasury will therefore have to return to Congress within the next few months for a further increase in the debt limit, perhaps by as much as $1 trillion. There is no doubt that legislators will vote the increase: Congress has been chastened by the plunge in equity markets when the House of Representatives voted down the TARP first time around. But the third rise in less than 12 months will dramatize for both policymakers and the markets how quickly the government's financial position is deteriorating.

The bigger problem is funding. Most of the additional cash has so far been raised through issuing short-term management paper. The Treasury has taken advantage of the huge influx of safe haven money to place an almost unlimited amount of paper at annual interest rates of less than 30 basis points. In effect, investors have been willing to lend to the Treasury for almost nothing to avoid the credit risk of placing funds with a bank.

But the short-term paper has to be rolled every few weeks, and will gradually need to be replaced by longer-dated bills and notes. Despite the collapse in equity values, growing concerns about corporate creditworthiness and deteriorating outlook for the economy, the market's appetite for a flood of new Treasury issues is highly uncertain.

Since the end of August, rates for four-week Treasury bills have fallen almost 160 basis points, while rates on 1-year bills are down around 100 basis points. But rates on 5-year notes are essentially unchanged and rates on 10-year paper have actually risen 25 points. The market is anticipating that yields will have to rise to absorb this wave of new paper, or that the government may be tempted to tolerate higher inflation or a dollar devaluation to ease the burden.

Adding to its problems, the Treasury has become increasingly reliant on foreigners to fund the budget gap. In the year to August, it sold about $380 billion of debt securities to the market (net). More than half the increase was absorbed, directly or indirectly, by foreign central banks.

But central banks show signs of increasing nervousness about their over-exposure to the United States and the consequent risk of devaluation or inflation. Their appetite for more paper is likely to be lukewarm, at best, though they may have little choice but to absorb it if they want to avoid a meltdown in the market that would cut the value of their existing holdings sharply.

The Treasury and the Fed therefore face a stark choice.

To place this mountain of new debt at low yields, they will have to convince domestic and foreign investors the government will keep the regular budget deficit under control; the Fed will keep inflation down; and neither will allow a further depreciation of the dollar.

If there is even a scintilla of doubt, investors will start to demand much higher risk premiums, escalating borrowing costs for everyone.

The Treasury bailout thus marks the end of an era.

For eight years, the United States has observed a strong dollar policy and commitment to price stability in theory, but deviated from it in practice. The dollar's role as a reserve currency created a gap between theory and practice that the U.S. authorities have exploited to the hilt to pass stabilisation packages and support growth by keeping interest rates low.

But as the crisis bites and confidence in the U.S. financial system weakens, the Fed's and the Treasury's room for maneuver is narrowing. The scope for fiscal and monetary stimulus will be much less in future. From now on, the strong dollar and price stability mandates may have to be strictly observed, and the market will almost certainly test the authorities' resolve.

Policy will have to be above suspicion - just like Caesar's wife. (Editing by Ruth Pitchford)