A solution to our financial crisis

I received quite a few critiques of my “provide analysis but no solutions” policy.  So here are my recommendations, based on guesses about the course of events.  Being neither an economist nor financial guru, this describes the broad policy actions I suspect are needed — but not the details.  These measures are consistent with the posts I have written over the past year about the end of the post-WWII geopolitical regime, and will allow us to adapt to that inevitable evolution.

The policy response of our leaders has been inadequate, up to and including the Paulson Plan.  Their actions have been incremental and reactive nature.  While each step has been larger than its predecessor, all have been reactions to the past dimension of the crisis — not the future.  That is, our leaders have been “behind the curve.”

Paulson and Bernanke have taken actions that would have been effective if applied 2 or 3 quarters earlier.  Borrowing a metaphor from emergency medicine, they have squandered the “golden hour“, since the crisis started with the collapse of the mortgage brokers in December 2006.

Correcting this flawed procedure is the first step.  Doing so at this late date will require immediate and drastic actions.   The severe effects of the recession — now affecting the developed nations, perhaps soon the entire world — will soon be felt, further destabilizing the economy and the financial system.

To determine the scale of the necessary measures, try a thought experiment (Gedankenexperiment).  Assume the scenario I describe.  If we implement the Paulson Plan, what measures will be necessary in Q2 of 2009?

Recommendations

  1. Stabilize the financial system.
  2. Stabilize the economy.
  3. Arrange long-term financing for steps #1 and #2 with our foreign creditors.

A conclusion follows, explaining why we will not implement such measures and the the possible consequences.

I.  Stabilize the financial system

No modern economy can survive the meltdown of its financial system.  There are many ways to do this, illustrated by the following.

(a)  Recapitalize the financial sector by a transfer of wealth from the taxpayers to banks and brokers – This is probably the key element of the Paulson Plan, done by the government buying assets at above market prices.

(b) Close defunct or weakening financial institutions under new bankruptcy legislation, under which the courts could act with extraordinary speed and authority.  This should involve replace managements.  New managements could be selected by a bi-partisan committee of business leaders; which should have only a minority of members from the financial industry.

(c)  Outright nationalization — As done the defunct Savings and Loans during the early 1990’s, and today with the GSE’s and AIG.  Large scale nationalizations might be required.  If so, our political regime’s survival might depend on how this is done.  Not just their acquisition, but their operation and eventual privatization (if any).

Creation of an agency like the Depression era Home Owners Loan Corporation, as recommended by Nouriel Roubini, can play a role in any of these policy choices.

II.  Stabilize the economy.

(a)  Why wait?  Set up the job training and education programs now, rather than throw them together in haste when they are needed yesterday.  There will be many unemployed, and this is an opportunity to upgrade their skills for the next cycle.

(b)  Many local governments will go bankrupt, as so many are vulnerable (e.g., NYC).  Work with the States now to prepare the necessary legal and financial apparatus to handle these.

(c)  Implement a massive monetary stimulus, such as taken by Japan at the start of their dark decade after the 1989 crash.  That means near-zero interest rates (far below the level of inflation) and a rapid increase in the balance sheet of the Federal Reserve.  The government has not taken these steps because they might lead to currency flight from the US Dollar, and the government does not want to take the necessary measures to prevent this (see III).

III.  Arrange long-term financing for steps #1 and #2 with our foreign creditors

This means a negotiated agreement with the foreign central banks who are our primary creditors, with the appropriate support from Congress.

We will need to reschedule our debt and obtain new financing.  Our government will have to rollover roughly $500 billion/year, plus the trillion or so in additional borrowing (as tax revenue declines and expenses skyrocket) for the next two years (perhaps longer).  Plus measures will be needed to stabilize the value of the US dollar, allowing a orderly decline.

These extraordinary negotiations will be inherently destabilizing, putting in question both the US Dollar’s role as reserve currency and America’s role as global hegemon.  This is the price paid by our past folly, getting us into this crisis.

Obtaining and executing this agreement must be concluded successfully.  It is a jump across a chasm to a new world.  But the chasm lies ahead of us, and must be crossed eventually.  Let’s strike a dal while we can negotiate from a position of strength.  Rather than waiting until we are desperate.

The cost will be high.  An agreement will be in the best interest of all, but that does not mean that we will not have to make concessions.  To give just one example, China might ask that the US break our relations (esp military) with Taiwan.

Conclusion

I believe that the downturn can be mitigated by immediate and decisive action.  Building public support for these measures and avoiding panic will require the highest level of statesmanship by our leaders — and responsible citizenship by us.

Of course we will not take such actions in a timely fashion.  Our leaders’ happy talk was intended to maintain spending and investment during a brief slowdown.  The unintended consequence is that the American people are psychologically unprepared for this crisis.

Worse, our Observation-Orientation-Decision-Action loop is broken.  Despite years of warnings (see this list) we have not seen the danger ahead.  Now that it is upon us, our fixed optimism prevents us from orienting ourselves to changed conditions.  I doubt that our leaders can either formulate adequate plans or execute them.

As so often in American history, we must fall back on the resourcefulness of the American people.  Our ability to act together, to force our leaders onto the right path, to have the resilience to weather difficult times.


Originally published at Fabius Maximus and reproduced here with the author’s permission.

3 Responses to "A solution to our financial crisis"

  1. Gloomy   September 27, 2008 at 12:34 pm

    You are so correct, but I fear your hopes are but dreams. Would that we could have a smooth sensible transition, as you suggest. I fear chaos and darkness instead.

  2. Guest   September 27, 2008 at 12:52 pm

    It is true that there should be nationalization. The nationalization should particularly be of the Central Bank called The Federal Reserve which is a private enterprise largely responsible for the situation that exists today. Support HR 1755 ABOLISH THIS FED.

  3. Guest   September 27, 2008 at 4:45 pm

    “The cost will be high. An agreement will be in the best interest of all, but that does not mean that we will not have to make concessions. To give just one example, China might ask that the US break our relations (esp military) with Taiwan.”China could invade Taiwan like Russia went into Georgia … I highly doubt China feels threatened by the US-Taiwan relationship. And given that the majority of Chinese people believe that Taiwan is part of China, a US invasion of China in defense of Taiwan will make Iraq look like a cakewalk.