New recommendations to solve our financial crisis (and I admit that I was wrong)

Summary:  Please vote, and do so carefully!  This could be one of the most important elections in American history, as continued economic crisis might require a massive (and hopefully temporary) expansion of government power — unlike anything we have seen except during wars. 

On September 25 I sketched out A solution to our financial crisis, in three parts.

(1)  Stabilize the financial system – Being attempted, probably now it’s too late.

(2a)  Stabilize the economy with monetary stimulus– Rates are coming down and money printed, but probably with relatively little effect.

(2b  Stabilize the economy with fiscal stimulus — Just now being considered; will work but slow to implement and slow to have effect.

(3)  Arrange long-term financing for steps #1 and #2 with our foreign creditors – Unacceptable to our leaders at this time.

Parts 1 and 2 are being implemented, much as described.  Part 3 was described as necessary at some point in the future.  I said that these probably would not work over the medium to long term, but would mitigate the downturn (slow or even reduce the economic decline, and alleviate the resulting suffering).

I was wrong.  The rate of decline — destabilization of the global financial system – has become so great that these measures will prove insufficient.  In my opinion (these are, of course, guesses).  Since I doubt our leaders have a Plan B, here is a suggestion.

Extreme mobilization by the government of our economic resources, as we have done during wars.

For deep theoretical reasons our financial system is collapsing.  I have discussed some of the reasons (see below for links), but the causes are irrelevant now.  Whatever the cause of a cardiac arrest, the paramedics job is not to advise dieting and exercise — but to restart the heart.

The US economy is sliding into deflation.  Perhaps the global economy as well.  The evidence is all around us.  Just to mention a few: collapsing commodity prices, the price of gold falling, and the collapse of yields on one-year Treasury Inflation Protected Securities (TIPS).  All are extraordinary.  TIPS were priced for inflation a month ago.

The center is cracking (the US, the EU, and Japan).  So are some nations on the fringes (e.g., Eastern Europe, Argentina, Pakistan).  And points in between, also (e.g, Iceland, South Korea).  This is a tear in the fabric of the global economy, which accelerates as it grows.  So far only the financial markets have felt its full force, but soon we will see the real world impacts on trade, employment, incomes, etc.

Markets

Panic is the danger, as more people realize the danger.

Bourses have stopped trading for some period this month in Austria, Brazil, Iceland, Indonesia, Romania, Russia, Thailand, and Ukraine (sources here and here).  Markets provide liquidity to individuals, not to everyone at once.  Panic liquidation would likely force any exchange to close; the closing of a major exchange might spread the panic and force others to close.

Panic means people save more and spend less.  Businesses too, cutting both routine spending and investments.  Keynes called this the “Paradox of thrift“.  A gradual rise in savings rates can help an economy’s long-term performance.  A sudden rise in savings rates just reduces everybody’s (i.e., aggregate) income.

Main Street

More savings, less debt, less investment, a flight to safety.  If occurring on a large enough scale, as we see today, these mean that businesses are starved of revenue and capital.  No spending, no risk capital by lenders or investors.

As everyone scrambles for the safety of government bonds, the government gains the ability to borrow massive sums at low rate.

The result:  by default the government becomes the primary economic actor.  It’s spending and investment decisions drive the economy.  Not just immediately, but — as a result of the investments it makes — for many years after normal processes are restored.  We saw this in Japan during the 1990’s.  It borrowed and borrowed, but frittered the money away on largely unnecessary projects (e.g., bridges to nowhere, train stations in the middle of nowhere).  This kept their economy rolling, but the debt remains and they have little to show for it.

Now we are Japan.  Interest rates must go to near-zero.  Government spending programs must be rapidly initiated on a scale not seen since WWII.  Government decisions will determine what America looks like for the next two decades (at least).  Who gets loans, what kinds of infrastructure to build, what kind of training programs for young people and the older unemployed … it is a long list.

Trillion dollar spending programs for 2009-2010.  Plus a trillion or so in capital infusions into the financial system.  While other nations do the same.  The global savings pool might not suffice for to provide so much capital, and the effects of such massive borrowing might destabilize interest rates and currency values.  Hence the need for my recommendation #3:  the “Master Settlement of 2009“ – a meeting of the major nations to, among other things, reschedule America’s debt and form a new geopolitical and financial global regime.

Alternatives

I doubt any government experiencing these conditions — and there probably will be many — will do otherwise.

Libertarians and laizze-fair capitalists will advocate elaborate plans for doing little or nothing.  What would happen if they took power in January?  Who knows?  I have little interest in contrafactuals.  One might just as well ask what would happen if the Blue Fairy waved her wand and increased the human race’s average IQ by 50 points.

Comparison: now vs. the Great Depression

One advantage we have over the folks of 1930:  we know this song.  The response of government leaders since the crisis started in December 2006 (when the mortgage brokers began collapsing) has been slow, reactive, and incremental.  In many ways similar to that of President Hoover’s administration between 1929 and 1932.  While recognition of the danger has been slow, action following recognition will be fast.

Also, we understand economics better.  Keynes wrote The General Theory of Employment, Interest, and Money in 1936 (although the ideas it presents we in circulation much earlier).  Plus we have the work of others during the past 70 years, such as Hyman Minsky and Milton Friedman.  The gross policy errors made during the 1930’s — such as raising taxes and trade barriers — are far less likely today.

Only extreme statists will rejoice at these measures.  The need for such result from the accumulated policy errors of the past half-century (or more), a bipartisan orgy of folly.  We must do as our ancestors did during adversity:  stay cool, make the necessary decisions as best we can, and move on.

Lessons Learned about government for the next cycle

Since 1929 everybody knows that close regulation of banks and brokers is necessary to prevent serious financial crisises.  We had a bank crisis in the early 1980’s, as they almost went broke due to feckless lending to emerging nations.  We had a bank crisis in the early 1990’s, as many folded due to feckless real estate lending.  And here we are again.  All this despite a large and well-funded state and federal regulatory apparatus, to which we granted draconian powers over the finanical sector.

We made a mistake.

“You f**ked up, you trusted us.”

— Otter advising Flounder, from the film Animal House


Originally published at Fabius Maximus on Oct 23, 2008 and reproduced here with the author’s permission.

10 Responses to "New recommendations to solve our financial crisis (and I admit that I was wrong)"

  1. Guest   October 23, 2008 at 6:37 pm

    I have a new rule. I’m not going to read articles on this web site after 9:00 pm. Otherwise, I can’t sleep. I just watched an ABC news piece. According to them, everything’s gonna be alright by mid-2009. That’s not so far away now is it? Then I come here and I see Dr. Roubini is predicting a halt to the market and Fabius Maximus is talking about financial cardiac arrest. Many people out there believe the mid-2009 mantra. I wish I did.

  2. 2cents   October 23, 2008 at 9:01 pm

    Hey Fab, I’m a little blue fairy and I hope to up your IQ by 50 pts!I agree that plowing money into needed infrastructure is better than nothing, but it must be infrastructure that will make us more productive down the road. New roads, bridges, dams and airports mostly don’t need to be built. Certainly old ones need to be upgraded or replaced, but the question becomes do we fix existing infrastructure because it absolutely needs it, or do we look for projects that will pay off bigger for the economy down the road. If so, what are those types of projects my fabulous friend?You see, otherwise your gov’t programs become nothing more that a crutch for a wounded nation. If there is no payout then I say doing nothing is the route to take.

  3. enzo fabio arcangeli   October 24, 2008 at 3:25 am

    Hei FabI always read your blog and I quote it, suggest it from mines.Thanks for the self-critique, actually more convincing than Greenspan’s…I agree on a war-like mobilization for the immediate short term, a sort of OBAMA NEW DEAL or even more than that. The war metaphor is important in the US, where only military Keynesianism is allowed by the “public opinion” and pop culture.And beyond?I can’t see thow this severe recession and credit meltdown might not to go into sharp deflation and then depression, until wealth redistribution is taken seriously and DRASTICALLY into account.YoursFabius Minimus

  4. Lloyd Gillespie   October 25, 2008 at 2:47 pm

    Great post FM. I’d just like to state the obvious, WW II was no more than a giant public works project/infrastructure project. Why haven’t the powers-that-be ever realized this simple economic/financial fact? Oh, that’s right___They’re ideologues.May I suggest, for full information on solving the coming debt-deflation problem, go here: http://econ.bus.utk.edu/davidson.html and please read all posts, then buy Paul’s books, for the full stories… He’s our only chance of survival…

  5. Ben There2   October 25, 2008 at 11:49 pm

    What all “experts” are saying is that the world economic engine’s fuel is US consumer spending. Ok- then allow the people to SPEND SPEND SPEND THEIR EARNINGS! Radical OLD IDEA-NO INCOME TAX! Just think what could happen if the worker becomes the “DECIDER” and purchases what he NEEDS and WANTS. Government agencies would have to go “out of business”!Mal-investment would decline and over time WANTED goods and SERVICES would replace the useless, wasteful, ENSLAVING, purchase choices (ie: Military-Industrial-Congressional-Medical-Financial Complex) that political “DECIDERS” profit from. Radical NEW IDEA-IRS becomes ERS(External Revenue Stimulus) mission- to return all past taxes to owner.

  6. df   October 28, 2008 at 9:03 am

    I seriously doubt your main argument “we know this song”.Try to remember : Karl Polanyi told us in plain and simple text about the massive errors of the “laissez faire” era of the end of 19th century, he explained how market, while efficient to trade goods and services can not be trusted to create money, allocate people to jobs, and create an efficient use of land.That is just one example. All Austrian writers warned us against the risk of debt.Keynes wrote mostly in the deflation era, but if you read his works you understand clearly that money emission can not be left to the bankers, those are always stupid and rationaly so, as keynes proved.Yet “we” did allow the boom. By “we” of course, I did not, but Greenspan, But elected political leaders. And who voted for them ? And who bought houses with credit ? Most of us. Not me. Most of us.Yet we had information available about the historical level of housing prices and stock prices. We all could know, if only we wanted to, that the PER has been over its historical norm constantly since 1997. We all chose not to trust greenspan blame on irrational exhuberance.So knowledge has approximatively no power in itself, not when the mob wants something. The mob rules untill you create rules and an independant authority to apply it. Notice that muslims, christians and jewish alike oppose lending money or strictly regulate it. Catholics and muslims are the 2 groups who oppose the most strongly to credit emission. But remember that the Lord s prayer ends with and redeem us our debts as we forgive to our debtors. Because debt and sin are a common word in arramean.The problem is with the mob. And anywhere you look you ll see people asking for tougher barriers on the borders. Tougher barriers relative to human migration, to goods exchange (be it through environmental tax, social insurance tax, trust me, people we ll be innovative in inventing those tax. Besides its pretty easy to curb foreign exchange, it is presently subsidized. You drive your car, you pay a gazoline tax, especially in europe, but if you take a plane to fly overseas, you don t, same with boat travel.”The US economy is sliding into deflation. Perhaps the global economy as well. “Let s face it, deflation will hit harder those who rely on exports, those who are the heater of global economy : China, south east asia, oil exporting countries.Deflation is everywhere because the boom in housing and stocks was everywhere.We humans collectively piled up debt to form a new babel tower, it now is collapsing, and as usual, we lose our common language alongside our common goals, and we become foes. That is what is happening, and it ll take much more than knowledge to bar it.Because if knowledge was enough, then the debt fueled boom would not have been allowed to happen.

  7. DF   October 28, 2008 at 9:16 am

    gee my post has been lost.I simply want to add, the financial system has been deregulated in the 80 s and this has created this mayhem.I recommand a maximum on private debt.Households should not be allowed collectively to have a debt higher than 70% of GDP, private organisations not more than 80%, and public non federal institution no more than 20 (and only for investment spending).As for the federal government it should not be allowed to have any debt at all, if it need more money than it can tax, then it should print it. This will also boost inflation which is good as it forces asset holders to put them to productive use.

  8. Guest   November 1, 2008 at 4:43 am

    When Roosevelt assumed office in 32, his administration attempted to prop up the existingstructure by supporting prices. The famous photos of milk being dumped into sewers, whilepeople starved, were of this period.Only later, in 34-35 did FDR’s admin tackle the issue of household income. The result was a plethora of three letter programs, WPA, CCC, TVA, BPA, and others. By 37 GDP exceeded that of 29.It must be painfully apparent by now that a laisses faire fractional reserve banking system, coupled to asset based lending is inherently unstable. Certainly 500 years of boom-bust economies must be sufficient proof of that.Analysis from Pisquatwa Research shows that maintaining the US System’s growth required either an annual 13% increase in household debt, or an annual 5% increase in household income. Given the Republoan phobia regarding increasing household incomes, debt was chosen, and debt reached the limit of sustainability, hence the current deflationary collapse.In my view, housing prices will revert to levels of previous bottoms ie: 3X household income. With household income plunging, to 40,000/ yr. we can expect mean housing prices to drop to ~ 120,000, or a further 40%. What this will do to the banking sector need only be imagined.Rather than using scarce resources to save “Humpty Dumpty” from this results of his “Fall”, I believe the funds better served in support of the nation’s households. Therefore I propose the following:1. Create a Single Payer Health System ala France, with an annual premium of $2700/ per person(including children), by mobilizing all MD’s younger than 50 as officers in the US Public Health Service, and mobilizing all hospitals ( for which existing legislation would suffice). This system wouls cost only 20% more than the combined expense of existing federal programs, and half the current system. This would unburden firms from health liabilities, enabling them to conserve cash. This would also deal with the very real public health risks the US faces with nearly 30% of the population not receiving regular medical care.2. Eliminate Income Tax…. period.3. Modify Social Security to eliminate wage ceilings, make the tax progressive from 5% of wages below 25000/ yr up to 50% of wages > 250,000 / yr, and give all qualifying households a base grant of 20,000/yr(130% of poverty line for 2 persons), from which the medical premium is deducted, and which counta as a credit against tax, and which replaces ALL current income maintenance programs. A qualifying household is one headed by a person who has completed 6 years national service, or worked 40 quarters. Households headed by a person who did both national service and worked 40 quarters, or who worked 80 quarters receive a base grant of 30,000/yr. (This to replace all pension programs, whose assets will revert to the system)4. Create a Goods and Services tax, with three categories dependent upon the practices of firms, and with a progressive structure from 5% for small firms up to 50% for multinationals. Category A would be for the self-employed, and firms where the top earner makes no more than 35 X the lowest earner, the work week is 32 hours, vacations are > 4 weeks/ yr. Category B top earner < 100 X lowest, work week 40 hours, and vacations 2 weeks/ yr. Category C top earner > 100 X lowest, work week > 40 hours, and vacations , 2 weeks / yr. Category A is base rate, Category B is 1.5 X base rate, and Category C is 3X base rate. Rate is 5% for < 1 million in annual sales up to 25% of sales > 100 million/ yr.5. Reduce DOD spending to < 50 Billion / yr.Regards,Dr. George W. Opriskogoprisko@iway.na

  9. Guest   November 1, 2008 at 5:08 am

    Regarding the banking system, recognize that preserving household savings is of criticalimportance to a recovery, and financial system stability. Hence FDIC must function.Increasing the coverage beyond 100,000/account to 1 million/ account would adjust coverage for inflation, go a long way toward eliminating bank runs, and reduce system stress.It is vital to recognize that most banks will fail, and use triage, and use Chapter 11 to reorganize those worth saving. To that end, it must be accepted that 2 banks per each of the 1100 US counties should remain to provide retail banking services, and these must have at least one statewide bank in each state to provide correspondent services, and that the federal Reserve Banks can function as regional banks to provide services on a regional basis, and to serve the needs of large firms.Glass Stegal must be reinstated, as an amendment to the Constitution, to ensure it is not repealed in the future.All off balance sheet vehicles must be banned. All loans must be discounted to the Fed or to onw of the GSEs as follows:FNMA, GNMA – mortgages limited to < 4X average household incomeFABA – Farm LoansFIBA – Loans to heavy IndustryFEBA – Loans to Energy CompaniesFSBA – Loans to Small BusinessFTBA – Loans to Transportation FirmsIt is also vital to deal with infrastructural issues:The US rail bed should be nationalized, and maintained by the Govt as the road network is. The rail system should be electrified ( all 36,000 miles of mainline ahd trunk routes). All mainline should be double tracked. A high speed rail corridor should be built between all state capitals ( 150 mph ala TGV in France, or trains in Russia, China ) All freight should revert to rail. This will save 6 million bbl/day in fuel imports.The US canal system should be modernized and extended where it makes sense. The Intrac oastal waterway on the US East Coast needs much work, as does the midwestern rivers corridor.The US electrical Grid needs total R&R, to support wind energy development, and more than 6000 existing dams should be converted to produce hydro power(estimated to produce more than 50 Gwe in total)The big three automakers should be allowed to die. Sheetmetal bodies are a thing of the past. Carbon taxes and fuel taxes should increase fuel costs to > $12/ gallon, driving demand to HyperCars ala Amory Lovins, and most travelers back onto mass transit.Dr. George W. Opriskogoprisko@iway.na

  10. Anonymous   November 1, 2008 at 11:19 pm

    It appears that the currencies of the world areimposing their own trade barriers — withoutexplicit government actions.I fear that much of the 1930’s problems will be repeatec.