This is the 2nd of a 3 part series on:

1.        How the current economic crisis occurred,

2.        What needs to be done to fix it and

3.        Tracking how successful the government is in taking the needed steps

 “Eyes Wide Shut” Economic Plans won’t stop the Greater Depression

My businessman’s mind is amazed by the lack of fact based, goal oriented solutions from our political leaders for the current economic crisis.

What’s been done so far to fix the economy duplicates the efforts of Hoover as the economy spiraled downward from 1929 to 1932 and it is easy to project that if this keeps up we are heading to the “Greater Depression.”  In the calendar of the Great Depression, today (January, 2009) is January, 1931 and the worst is yet to come – in 1932 GNP fell 13.4%. 

Secretary of the Treasury Paulson has failed to prevent the crisis because he tried to save the stockholders in current banks and investment firms (just like Hoover) and did not implement the regulatory structure needed to rebuild confidence in our market system. Banks are toast because of huge exposure in unregulated derivatives (Credit Default Swaps, just one type of unregulated derivative are $54 trillion, that is 12 zero’s, compared to a bank capital base in the billions.)  As soon as a regulated market is established for these derivatives, banks that hold them will go bust and need direct investment from the government that will wipe out stockholders.  If we do it quickly we might avoid the “Greater Depression.”

Many politicians are standing in the way of any program that does not contain at least a dash of their political ideology.  Republicans seem to accept any stimulus program as long as it involves tax cuts even though the last 8 years have proved these are unaffordable (tax cuts only give, at best, 50 cents on the dollar of stimulus.)  Democrats are pushing for jobs programs, infrastructure building, welfare extensions and some consumer mortgage relief that seem to mostly be the things that didn’t work for Japan during the 90’s and start to raise “welfare society” issues.

All of the current solutions seem to be based on what politicians think are politically salable to their base.  The people are not fooled: The Conference Board Consumer Confidence Index™ reached a new all-time low in December 2008 of 38.0 (1985=100). 

What we need is economic leadership that will recognizes what is actually happening, kind of like Petraeus did when he used a different “hearts and minds” strategy to make the surge work in Iraq. (Note:  Petraeus led the 2^nd surge in Iraq – the first, with equal troop strength but using conventional tactics and strategies that ignored the realities on the ground, didn’t work.)

We’ve seen the type of leadership we need: FDR gave the leadership the USA needed in the Great Depression when he stated that “all we have to fear is fear itself” to calm public fears that were causing runs on banks and subsequent bank failures.  He combined this with a bank holiday (during which banks were suppose to be inspected for fiscal soundness, an impossible task) so he could implement FDIC insurance and give banks the stability needed to start lending again. 

Three areas need to be addressed to solve this crisis (see my previous post for reasons why.) These can be considered the nation’s objectives:

1.       Stop Deflation

2.       End the Banking Crisis and Restart Lending

3.       Rebuild Consumer Confidence to restart spending

There are a lot of ways to achieve these objectives and later blogs will track the government’s success. Here’s just a few ideas:

Stopping Deflation – The primary cause of deflation was the decline in housing prices.  Stock market declines have happened in the past and not led to deflation so they are not the cause of the current deflation. Below are 2 different tracks that can be taken to reverse deflationary pressures, one that is obvious and another that is less so:

1.       Demand and supply adjustments for housing:  

o   Reduce foreclosures/defaults to reduce the supply of homes for sale

§  Government Bailout of mortgages that are above current home values.    Rational homeowners should abandon houses where the mortgage is greater than the home value.  By bailing out homeowners with negative equity, bank balance sheet would be strengthened and the amount of distressed homes coming on the market would be reduced.

o   Government purchase and demolition of substandard housing.  The government should make an active program of purchasing distressed houses and demolishing those that are substandard.  A sub program could be the refurbishing of better houses for subsequent auction or low-cost housing usage.  These will increase employment as well.

o   Reduce mortgage rates. Reducing mortgage rate will increase the number of potential  buyers but may not be effective if the perception is that housing will continue to decline.

2.       Devalue the dollar by increasing the price of gold.   

·         This was one tactic FDR used to stop deflation during the Great Depression.  Devaluing the dollar against other currencies is what should be done but it is impossible because of manipulation by foreign governments.  Gold is a currency equivalent so an obvious rise in gold would mean that the dollar is declining and deflation has stopped.  What is great about gold is a psychological inflation indicator that is disconnected from the real economy:  inflation in gold will not cause inflation in anything expect jewelry. 

·         Note: Paulson’s Treasury appears to be continuing inflation control efforts that are keeping the price of gold it down!!  Simply removing the manipulation would probably allow a sufficient rise in the price of gold to reduced deflation expectations.

Ending the Banking Crisis and Restarting Lending-The banking crisis was caused by excessive leverage and poor regulations that allowed investment in unsafe assets such as collateralized mortgage obligations (CMO’) and resulted in reduced lending as bank’s capital bases were vaporized. Some solutions are:

·         Emergency legislation forcing bank lending-this can include government supplements on real estate and some business loans so that banks can be compensated for the greater risk of lending during a fiscal crisis.  This is necessary as we are currently in a “Liquidity Trap” where normal lower interest rate stimulus won’t work.

·         Establish regulated markets for all derivatives.    This is today’s equivalent of FDIC insurance.  Establishment of fair markets will eliminate fiscal instability but probably result in many Credit Default Swaps being worthless causing the bankruptcy of more investment firms and banks necessitating:

·         Rebuilding of bank capital bases with direct government equity investments.  The plan should include a requirement for the government to sell their equity ownerships once banks were stable.

Rebuild Consumer Confidence to Restart Spending:  Nothing lets people spend today than the feeling that they don’t have to worry about tomorrow. Today, all they have is worries.  They don’t really worry about the economy per se, it’s jobs and financial security concerns that are at record highs.  Here’s some potential fixes:

·         Jobs – are purely a matter of spending in the economy.  If consumers don’t spend enough to keep everybody working then the government can step in and spend without causing inflation, as long as it is on productive infrastructure and it is done while the crisis is still occurring.  Milton Friedman proved that most government stimulus doesn’t work because the crisis is over by the time it kicks in, so no tax cuts as they work really slowly, if at all.  Pick the wrong stimulus or do it too late, of course, and here comes inflation.

·         Financial Security– In China, where there is no social safety net, savings is a 30% of income and the government is trying everything it can to try to get them to spend more to offset the decline in export to the USA.  In America, consumers have started saving and paying off debt at an amazing rate due to rapid declines in their wealth that started with the housing and stock market declines and was brought into focus by the gas price spike.  Before they start participating in our debt, consumers need to secure about:

o   Paying for Gas/transportation:  Gas prices doubled in 3 months and are the reason that other retail spending plunged.  A stable long term transportation solution is needed.

o   Educating their kids:  College is necessary for kids to have a better future than their parents and the price has gone 247% in the last 20 years, making it almost un affordable.

o   Paying for Healthcare:  Illness and healthcare expenses are involved in half of all bankruptcies.

Next in this series will be evaluation of economic plans of the US government and their actual effectiveness in solving the crisis.