In college we learned that the 1929 crash did not lead to the Great Depression. It was the policy mistakes in the aftermath of the crash that led to economic disaster. Surely, such mistakes would never be repeated.
Such analysis does not seem too re-assuring right now. Before the markets crashed last fall, the fractured government regulatory structure meant that no one was in charge of controlling overall leverage in the banking and financial system. To make matters worse, the SEC in 2004 lifted leverage restrictions on investment banks. When the cracks appeared, Secretaries Paulson and Geithner took out their sledge hammer and finished off Lehman Brothers in what is now widely regarded as a colossal error.
This produced a disastrous chain reaction in the credit markets. With the largest intermediary in short-term corporate lending gone, it became harder for companies like General Electric and American Express to finance consumer loans and finance other operations. Not surprisingly, their stocks tanked and wiped out billions. At the same time, money market funds lost money on Lehman debt obligations. One big fund “broke the buck”, and fears that other funds would lose money as well led to a run on money market funds. In normal times, such funds are the lubricant that keeps our financial engine well-oiled by making short-term loans to banks and corporations so that they can make longer term loans to others, finance inventory or pay bills. Paulson and Geithner destroyed this whole system of credit. Paulson apparently knows he goofed big time, so he’s changed his story from “not one dime” to “we didn’t have the necessary legal authority” to save Lehman. He didn’t explain why Bear Stearns or AIG or Citigroup or others were different. Not confidence inspiring.
Paulson’s second set of mistakes were changing course with TARP funds. The program was designed to buy assets whose prices and fallen sharply to get them off the books of banks. But in less than a month, he changed to direct injections of capital even to banks that didn’t want it. Then the government says as long as you have our money, we control your pay. The predictable result? Bank executives, wrongly, are more focused on paying back the government than they are on using that capital to make new loans. More credit contraction, weaker economic growth; another lose-lose end result.
Now comes the new team. So far, the approach seems scattershot when it should be very focused on a few critical issues. Instead, we seem to be spending money on every project that every congressman has ever dreamed about. Investing in special education is certainly humanitarian, but I wouldn’t say it is an optimal form of economic stimulus. I’d rather take the same dollar and tell a bank to use it to lend ten dollars. That’s what banks do, and how they use leverage in a sound way to create ripple effects that grow the economy. So-called investments in the public sector tend not to have the same ripple effects.
So Job One is to stabilize the banks and the broader lending system. You stabilize the banks by injecting capital where it is wanted, with an exit strategy. Then you halt the downward spiral in asset valuations by modifying the accounting rules that require you to value your assets at fire sale prices even when you know you can sell them for a reasonable price in a reasonable amount of time. Finally, you revitalize the broader lending system by bringing back asset-backed securities – but this time with a requirement that the originator of any subject loan retain a 20% economic interest in it. This will return us to sound loan underwriting standards. It was the loss of those standards that led to the creation of securities that predictably became toxic. Since these securities have accounted for about 70% of all lending, we need to bring them back. Otherwise, we’ll have fewer mortgage loans and almost no car loans or student loans.
Job Two is to do what we can to stabilize mortgages and keep people in their homes to the extent possible. I would use TARP money or other funds now allocated to pork barrel spending to allow mortgage lenders to take a hit to their capital by renegotiating mortgages. The government’s sole role would be to allocate this capital to mortgage lenders. Let them decide which loans are the most viable and worthy of revised terms. It makes no sense to create a bureaucratic mess where overburdened bankruptcy judges are making decisions on individual mortgages.
Job Three is to institute or restore rules that will stabilize financial markets. Hedge funds should not be permitted to sell short stock that they cannot borrow. Nor should hedge funds or other speculators be permitted to buy credit default swaps. It is akin to letting a neighbor buy fire insurance on your house. Billions of our tax dollars are being used to pay off speculators who bought credit default swaps from AIG. Taxpayer money is being given to wealthy masters of the universe with nary a protest from our elected representatives. Crazy. When I listen to some of the questions that senators and congressman have been asking at recent hearings, it is frightening how little they seem to understand about the workings and failings of the modern banking system and the broader economy.
Job Four is to avoid becoming the Weimar Republic, where too much government spending (including war reparations) led to a run on the currency and high interest rates. If we are not careful, a plunge in the dollar could be the next shoe to drop. Congressmen say that all this stimulative spending will allow us to grow our way out of the current mess. But some of this spending will produce little if any growth. We are in a race against time where we cannot afford mis-steps that might buyers of our debt to question our approach. If foreign buyers of US Treasury debt lose faith in the dollar, we could be in far bigger trouble. Let’s not allow fiscal irresponsibility to invite that result.
In golf, the object is to hit the ball as far as you can without it going too far to the left or right. Our economic policy seems to be lurching from too far right to too far left. We can’t seem to stay on the fairway. We’re already in the rough. There is a way out. Let’s not let stupid policy decisions make it rougher.