The Stimulus Bill: Did the Government Break Our Leg and Offer Us a Crutch?

Free market advocates have a lot to answer for these days. A lot of people have lost their jobs and anyone with a significant investment in the stock market or private bonds has lost 25 to 50% of their money. In terms of leadership, the free market advocates couldn't have asked for more. We had a Federal Reserve Chairman who drank tea in Ayn Rand's apartment, a Treasury Secretary who came from the most swashbuckling Investment Bank, and a President and Vice President who had clear and unapologetic free market tendencies. And yet by the end of 2008 some very bad things were happening.

Serious people now have to ask themselves serious questions. Should the U.S. move its political and economic affairs in the direction of the Soviet Union, Cuba, or the more socialist states of Europe to avoid the extreme outcomes of a capitalist economy?

I personally am not willing to come to the conclusion that all of our current problems would have happened in a society with minimal government intervention. Although I would admit a free market can tend to the extremes (a reflection of the individual personalities that make up that economy), I would argue that our current situation would have been much milder without government interference in the marketplace. A free market system is flexible and resilient, but it is not infinitely so. The items below are the high level bits that pushed the world and the U.S. into our current economic difficulties:

Fannie Mae (FNM) and Freddie Mac (FRE) made the Housing Blip into the Housing Bubble:

Mortgage money is the gasoline that lit the housing fire. I want to provide some anecdotal evidence to support my theory that Fannie Mae and Freddie Mac (gov't sponsored entities that could not have had the impact they did on the housing market without their government guarantee) had a very large influence on the housing bubble.

I work for a financial institution. I don't work in this area but I happened to hear this story. In the state of Montana, Countrywide was willing to lend home buyers 300k to 400k but their deals were falling out of bed because the Home Insurers didn't like the credit of the borrower. If anyone can protect themselves from bad credit, it is the Home Insurer. If they don't get paid, they cancel the home insurance.

And yet Coutrywide was willing to lend these obvious credit risks 300k to 400k of their money, why? Because Countrywide knew they could sell the mortgage to Fannie Mae or Freddie Mac. Mozillo was very involved in lobbying congress on behalf of Fannie / Freddie and even made below market loans to members of Congress with his "Friends of Angelo" campaign. Fannie Mae and Freddie Mac hold or guarantee over half the mortgages in the U.S.. The subprime lending collateralization was done by private parties, but Fannie and Freddie had the size and heft to influence the entire mortgage market in a non-optimal direction. As strictly private companies Fannie and Freddie would not have been able to do this.

The Federal Reserve tried to Micro Manage the Economy:

The Maestro (Greenspan) was very good at kicking the can down the road. Internet Bubble burst? Lower interest rates to 1%. The Federal Government just spent 300 billion it didn't have? Buy Treasuries from private parties and monetize the national debt. Latin America in over its head? Bail them out. He was so good that he left his office after 20 years with the economy humming and many people grateful to him for the full employment he mostly accomplished. His heart was in the right place, his knowledge of the economy was first rate, but no one can make a silk purse from a sow's ear forever. By increasing the charter of the Federal Reserve to include the amelioration of any uncomfortable economic effects, Greenspan created an unsustainable situation in the long run.

Deficits as Far as the Eye Can See:

The Federal Government has been running significant deficits, on average, since the Johnson administration (Lyndon not Andrew). Sure, the capital gains of the Internet Bubble (unsustainable) balanced the budget for a few years at the end of the 20th century but the prevailing trend is large and growing deficit spending. Can it be healthy for any entity, an individual, a company, a government, to persistently spend money it doesn't have? I resist the idea that the Federal Government can spend money it doesn't have with no negative effects whatsoever. Apparently, U.S. deficit spending finally outran the tail wind of the Dollar's status as the world's Reserve Currency, and we are now paying the price.

No Clearing Mechanism for Balance of Payments between Countries:

Container ships go from the U.S. to China with the containers largely empty, they return completely full. In the late 1960s and the early 1970s the world made a conscious decision to move to completely fiat currencies for all countries. The U.S. purchases large amounts of valuable goods from China and Japan, dollars build up in those countries, China and Japan buy U.S. government bonds with the proceeds.

Where and when does it stop? Prior to the '60s, at least lip service was paid to a gold standard that required precious metal transfer between countries to compensate for trade deficits. This placed a constraint on countries that ran chronic trade deficits. A more modern mechanism needs to be developed so that trade deficits are balanced in a timely manner.

People of good will who wish to avoid the economic extremes of a capitalist economy should be requesting the following from their government, rather than the current Stimulus Package, which spends money we don't have:

1) The Federal Reserve's Charter should be Only to provide a Stable Currency:

Money is the unit by which all economic activity is measured. Give one institution the Charter of preserving its value and let other organizations (Treasury, Commerce) fine tune the economy if that is desired.

2) Put in place Legal mechanisms that Guarantee a Balanced Federal Budget

It is clear to me that the mostly honorable people we send to Congress, when subject to the pressures of modern government, can't balance the budget voluntarily. This is a clever country. There must be some combination of legal, technical, and political mechanisms that can be put in place to force an actuarially balanced Federal budget and free the individual representatives from the burden of having to do so. I am thinking of something like taking the budget that was passed and automatically reducing it proportionally to that tax take as a solution.

We live in serious times, serious decisions have to be made. When I see a country that maintains a stable currency, has government spending only equal to taxes taken in, and has the government involved in only the rule of law and the defense of the nation, and that country has severe recessions every 3 years and Depression every 30 years, I will reconsider. At that time I will consider giving up the ideas of Alexander Hamilton, Benjamin Franklin, Fredric Hayek, Ayn Rand, and Milton Friedman. I will then consider the ideas of Karl Marx, Fidel Castro, and Barney Frank, but I haven't seen that country yet.

Investors must be wary as countries fight for the title of "Chief Currency Debaser", either because they want their exports cheaper or they feel they have to have Stimulus packages of their own. Cheapening the national currency will affect the country's currency and its stock market. We may see a world where all fiat currencies debase together, not changing much in relative value to each, but buying less real goods and services worldwide.

It is important to recognize, only the dollar and the euro (individual Euro countries have deficit constraints) can lay claim to "Reserve Currency" status. All other countries with their own currencies run significant government deficits to their peril, as Greece, Ireland, and Zimbabwe are finding out. Pressed to name some countries that may be more responsible than others I would say Germany (EWG) and Singapore (EWS).

The financing of the government deficits is of big concern to the large indexes (DIA, SPY, VEA, etc.) Stimulus funded by real taxation transfers money from the healthy parts of the economy to the politically connected. Stimulus funded by genuine borrowing transfers payment responsibilities to our children. Stimulus funded by printing fiat money (mostly electronic fiat money) taxes the general society and those financially unprepared for unexpected inflation. With peak to trough values of the major indexes down close to 50%, has the market already priced in a period of Keynesian influenced economics? My guess is we are close to the bottom but as the bloggers say "imho".

Disclosure: The author is long dia, spy, ews.

Comments

[atlasman:]

An honest balanced budget (cash in >= cash out) would probably send us in to a decade long depression between as the governement would be forced to unwind a significant portion of their entitlement projects. Lets compromise and allow for a deficit of 2-4% of GDP.

Feb 09 07:38 AM

[socrateazz:]

Hmmm! Extreme capitalist system huh!...All from a point of view! on a scale of 1 to 10 with ten being all capitalistic and 1 being totally Socialistic I Put the current US economy at a four. The 1980's economy at a seven. The 1800's between 7 and 10. Why is the current economy anywhere near extreme Capitalism? I would place it closer to Socialism. Does the Market make more decisions than goverment does? If the governments decisions have more influence than the market then you are not strongly Capitalistic. The more decisions which are made by so called Government the more Socialistic a country is! I say a balance is best. But leaders tend to believe they can control that which they do not understand causing violent reverse reactions in some future period of time. The serious bubbles one sees today are mostly reactions to actions taken at an earlier time! The some control is good. But try to control economic conditions and you end up with times like the Great depression or like is currently happening! If the economy is left alone the wild swings will weaken and we will hit an equilibrium with some swings in the economy. Wild economic moves usually result from somebody trying to control things. The more one succeeds in controling anything the more of an opposite reaction one can expect.

Feb 09 09:29 AM

[Insiderman:]

George Bush a free market person? He allowed more government intervention in more ways than I ever thought possible. Compound that with unsustainably large budget deficits and you call George "free market?"

The credit crisis was caused by unintenteded consequences of government programs to help minority and low income borrowers, Wall Street greed that allowed synthetic securities and swaps to counter the risk in an unregulated market, contributions from the regulated to members of Congress that head committees that regulate them, and Fed-determined low interest rates after 9/11 that made ARMs irresistable.

Feb 09 09:53 AM

[kelm:]

What has happened over the past couple of decades is we have replaced market regulation with government intervention. In the name of freeing the markets we deregulated the financial industry, allowed highly leveraged financial instruments to flourish with no clearing house to provide transparency and a belief that self interest on the parts of the banks would ensure that no systemic threat developed. Then when ever the market got into the least bit of trouble the government stepped in (the Greenspan put) resulting in the excesses being pumped up further.

What we need to migrate towards is a free market that has the minimum complete and correct regulations in place across ALL financial institutions to ensure that the markets operate within a stable, non-bubble inflating range of activity. When the market needs to correct, as they always will, government needs to stay out of it.

Feb 09 10:41 AM

[Thomas J. G...:]

kelm,
good comments. write an article. tell us what your thoughts are about responsible financial regulation.
insiderman, Concerning the Bush deficits. I have come to the conclusion that very few people vote for people who balance budgets. This leaves the Republicans in a position of being the constant and nagging naysayer if they insist on balanced budgets. I think this is what is really behind the famous Cheney comment that "deficits don't matter". Until something really bad happens that people can directly associate with deficits, deficits aren't something a politician gets rewarded for by paying attention to them.

Feb 09 02:00 PM

[sabre_jenn:]

A market that hangs on the every word of a central economic planner is not a free market. Alan Greenspan might have drunk tea with Ayn Rand, but if he actually believed in free markets, he would not have spent the last 40 years (starting with Nixon's Council of Economic Advisors...) working for government.

A mortgage market that is completely dominated by government sponsored entities is not a free market

A banking system where corrupt Congress members use "red line" laws to blackmail banks into making loans to people who can't pay them back is not a free market

An economy where Federal, state and local government spending adds up to a third of GDP is hardly a free market system. Add in all the "off balance sheet" government entities, like FNMA, FHLMC, TVA (Tennessee Valley Authority), the Turnpike Authority of each state, the Metro Transportation authority of each city, the electrical and water utilities everywhere --- government easily controls more than 50% of the economy.

Your first paragraph sounds like what the news media wants you to think -- not what is actually happening on the ground

Feb 09 02:39 PM

[mediapro:]

I agree that the author overall provides a decent analysis and some hard-to-stomach solutions. Though I disagree with the need for a fully balanced budget, I wish that the author had run through the economic thought that got us into this mess. That would have supplied some direction towards what needs to be changed. My two cents:

Flash back to the neo-con's answer to 1970's stagflation and Milton Friedman's Shock Economics Theory he plied so well in South America for right wing fascists.

Roll tape a bit forward to the Gipper. Cut taxes, spend on defense out the wazoo, run record deficits, de-regulate markets and watch Uncle Milties' magic work.

While every right wing neo-con tape loop is buzzing with out-of-control GSEs, we all seem to conveniently ignore how all of this silly and frightening theoretical economic approach played out around the world through the likes of the IMF, World Bank, Halliburton, and their ilk.

Look at any country where this supply-side, trickle down, deregulated gambit has played and look at how eeiry is the similarity between those countries and this one:

1. The top 1% control 40% of all financial wealth in the U.S. The top 20% another 52%, leaving the rest of us (80%) America's financial wealth at a whopping 8%.

2. In terms of inherited wealth only 1.6% inherit more than $100,000. 91.9% receive nothing. Yet the "death tax" was/is the highest priority on the ultra-conservative agenda.

Now for some sobering reminders:

Under Clinton we enjoyed a $287 Billion SURPLUS that's now an ever-growing DEFICIT that at last peek was nearing $1.4 Trillion and national debt that has grown from $5.7 Trillion to $10.2 Trillion in just seven years.

It wasn't because Clinton was an economic genious. He simply returned out-of-control revenue reduction (tax cuts) back to the Reagan rates and chose folks who shared his philosophy of government and its role. I'll put my money in the hands of the guys that believe that it's the government's job to invest in the 80% of us that need practical ways to grow our own wealth (smart energy policy, infrastructure development, education).


On Feb 09 02:00 PM Thomas J. Gordon wrote:

> kelm,
> good comments. write an article. tell us what your thoughts are
> about responsible financial regulation.
> insiderman, Concerning the Bush deficits. I have come to the conclusion
> that very few people vote for people who balance budgets. This leaves
> the Republicans in a position of being the constant and nagging naysayer
> if they insist on balanced budgets. I think this is what is really
> behind the famous Cheney comment that "deficits don't matter". Until
> something really bad happens that people can directly associate with
> deficits, deficits aren't something a politician gets rewarded for
> by paying attention to them.

Feb 09 05:55 PM

[James Wilson:]

Fannie Mae and Freddie Mac had less than 4% in bad home loans on thier books before being FORCED to assume the loans from failing banks.

Paulson broke their legs and handed them a broken crutch.

Bush did not want them to go thru the loans and look for Fraud. The FBI limited their proscutions to $250,000 or more because there were so many cases of Collusion, Fraud and actually breaking the RICO ACT by companys like Country Wide.

PUT THEM ALL IN JAIL TAKE THEIR HOMES, CARS EVEN THEIR MISTRESSESES CARS AND HOMES THEN SELL THEM AND PUT THE CASH IN THE TREASURY !!!!!!!!

Feb 10 03:39 AM

[Thomas J. G...:]

James,
I'm not saying anyone at fnm/fre did anything unethical. I am saying that they were a distortion to free market mechanisms because of their gov't guarantee. Friedman always talked about them as an "off balance sheet liability" (a liability to the gov't that could one day bite us). We got an interesting outcome here. The problem more was that fnm/fre exacerbated the housing bubble, rather than just that the gov't had to bail them out (although it did bail them out).

Feb 10 12:01 PM

[magicsound:]

As a systems engineer, I view the economy in mechanical and relatively ideology-free terms. Seen in this way, there are two important characteristics that are relevant to this discussion of our current economic crisis:
1) the advent of electronic trading and communication has decreased the time delay of the economy; markets respond faster than ever before to news and events. In the classic model of oscillating systems, this causes greater swings and instability of the system. See a pioneering paper on this at www.systemdynamics.org...
An outside push on the system such as a policy (or lack of one) that permits unregulated leverage of credit, can further increase the amplitude of swings.
2) Real-world oscillating systems have an 'excursion limit' - how far the swings up or down can go before something breaks. It looks to me that we're perilously close to that point. If that's the case, a new economic system must be built from the ground up, using whatever parts can be salvaged. A good engineer learns valuable lessons from such events, though there are sadly few economists who follow this path. Here's one who offers a clear and constructive set of solutions: scottjberry.com/2008/1.../

Finally, as long as financial professionals and institutions derive income from commissions and arbitrage, they will have no short-term interest in stabilizing the system. This is clearly a situation where stricter regulation is needed to keep the economy from self-destructing.

Feb 10 02:36 PM