Economic Policy: Don’t Fight The Next War With The Last War’s Tactics

The NY Times business section had several articles yesterday on the effort by the Bush administration and Congress to address the financial problems facing the US economy. I read them all on the plane out to LA.

The Bush administration is looking to push through policies that they used in 2001 to address the last economic downturn. Treasury Secretary Hank Paulson says, “The research I’ve seen indicates that the programs in 2001 clearly worked.” Those programs include a tax rebate of $300 to $600 per household and a tax incentive for businesses to invest in plant and equipment.

Those measures may have worked in 2001, but I am not sure they will work this time. When treating a patient, doctors focus on the problems a patient is currently facing, not what they were facing seven years ago.

In late 2001/early 2002, the economy was suffering from the triple whammy of a stock market downturn including a full-blown meltdown in the NASDAQ, the shock induced by 9/11, and uncertainty around our government’s response (which was resolved by the invasion of Iraq). Businesses were holding back from hiring and investing and the consumer was holding off from spending. So it makes total sense to me that a tax rebate and business incentives were the proper stimulus.

This time around, we are facing very different issues. The primary problem our economy faces is a financial system that is badly damaged by the implosion of the housing bubble. In addition, consumers have lost a lot of paper wealth in their homes. This paper wealth was a large source of funds for the consumer in the past five years via home equity loans and other forms of mortgages. The banking system is in a risk adverse phase and it is unlikely that consumers will be able to tap other forms of debt like credit cards to make up for the loss of home equity finance. We have a credit crunch on our hands.

The large financial institutions have gone overseas to fix their balance sheets, tapping the growing pools of capital in the middle east and asia. But just because they have shorn up their balance sheets doesn’t mean they will start lending again.

Meanwhile the US government is also in a bit of a pickle. We have large budget deficits that we have also been funding with debt bought by foreign investors and governments. The US dollar has been falling for six years against most of the major currencies and US government debt is worth less and less every day because it is dollar denominated. I suspect the US government is also facing its own credit crunch.

We can try the economic stimulus that worked in 2001/2002. Maybe it will make consumers feel better and they’ll start spending again. Maybe that’s all it will take to get the housing market to bottom and banks and other financial institutions will start lending again.

But I think we need to focus on measures that will address the credit crunch for consumers and our government. And they are different problems that require different solutions. We need a very easy monetary policy right now. We need to make it so that banks and other financial institutions can make a lot of money lending right now. Only then will they re-open their balance sheets and start lending.

I think using fiscal policy to address the economic problems we face is a mistake. We should not go deeper into debt as a country. First and foremost, we need to restore confidence in the US economy and government credit. We need to balance our budget and stop living beyond our means (as a nation and as individuals).

Back in the late 80s and early 90s, the Soviet Union essentially went bankrupt because it could no longer afford to keep pace with the United States militarily and economically. Many point to the Afghanistan war as the straw that broke the camel’s back.

The US is in a similar position with our war in Iraq. We are burning through billions of dollars fighting a largely unilateral war in Iraq that we can no longer afford. We must leave Iraq as soon as possible as a first step in getting our financial house in order.

We must also tax our citizens at a rate that is necessary to cover our expenses. We can reduce our government expenses if we have the political willpower to do that. But if we don’t then we need to tax our citizens to cover our bills. Since the early 80s (with a short and successful departure in the Clinton/Rubin era), our government has taken the approach of reducing taxes in advance of reducing spending. We’ve never gotten the corresponding reduction in spending and instead have borrowed trillions from overseas. That must stop.

And we must have economic policies that incent our citizens to save instead of spend. I think its time for rethinking our entire federal tax system. What if we eliminated the income tax for taxpayers who make less than $250,000 per year (indexed with inflation)? What if we replaced the lost income with a broad based sales tax? And what if we stopped taxing income from investments of less than $250,000 per year per taxpayer (again indexed with inflation). Want to think radically? What if we stopped allowing taxpayers to deduct any form of debt including home mortgages?

I am not saying we should do any of these things. All of them will cause huge market dislocations and it's certainly not time to make homes less valuable by removing the mortgage deduction. But we are a debtor nation. We have a balance sheet problem as a country and as citizens. We need to wake up and realize that and do something about it.

These are difficult choices that I am certain we do not have the political will to implement without serious pain. So instead we’ll put a bandaid on. And it might work in the short term. But it won’t work in the long term. I think we are headed toward bankruptcy in this country, on a governmental level and on a consumer level, unless we change our stripes.

Comments

[Trader T:]

Your thesis is fine until paragraph 6. The US government has grown by over 1000% since 1980 and needs to be radically reduced in size as well as spending. Each government job 'created' results in the loss of private sector jobs as well as businesses fleeing oversees.

Regarding the terrorists we are now engaged with in Iraq, there is far less economic impact fighting them there than in lower Manhattan. If we leave before eliminating them, they will simply follow us home through our open borders. Our military outlays, including the war, are less as a percent of GDP than we spent in the 80's and is near record lows.

2008 Jan 20 04:39 PM

[Reinko:]

To trader T: Why should the so called terrorists wait for a withdraw of the US military from Iraq if they could use the open borders right now? And since folks like you only expect that after the military withdrawal they would even have the element of surprise?

To Fred Wilson: We are on the same page, with most of what you write I do agree. I also see a bit tidal wave of bankruptcies coming, I expect it to be in the US financial sector because elementary calculations indicate they need 2500 billion US$ more debt in 2008.

And on the consumer level stuff is also clear; when on average there is so much expensive credit card debt and when you read that in certain cases Heloc debt spending was up to 20% of total consumer spending (in California for example) you know one thing for sure:

This picking up of more debt on all kinds of level of society will hit the wall hard. That is trivial to understand.

2008 Jan 20 06:23 PM

[David White:]

You seem to have left out perhaps the most important item, the trade deficit. It is currently about $60B per month (about $700B per year). All of that money is draining directly out of the U.S. economy. If that same money were being recycled into the U.S. economy, it is very unlikely that we would now be on the brink of a recession. Experts are all saying that a $100B to $150B stimulus package would help the economy immensely. If we had a zero trade deficit, that extra $700B would do wonders for the U.S. economy. On top of that, we keep building up the debt because we have to pay the interest on all of our prior debts too. This is the single most important thing that we need to bring under control. The war in Iraq, etc. is just a part of that. You could even say that that money is still going into the U.S. economy, so it's really not as bad as the trade deficit debt.
The biggest issue in the trade deficit is probably the energy trade deficit. With other world economies far outgrowing the U.S. economy, the price of energy and other commodities is rising swiftly (and the dollar is devaluing). The U.S., being the largest energy consumer, will find itself facing an escalating debt crisis. We are just now starting to wake up to this fact. Bringing our spending on imports under control should be our highest priority. If we can do this, this will stimulate the economy. The more robust economy will provide more money in taxes, which will allow the state and national governments to balance their budgets. The top priority in reining in the trade deficit should be to do everything we can to decrease our dependence on foreign energy. Solar energy is part of the answer. We are not the leader in solar energy adoption. That honor belongs to Germany, whose engineering prowess we always seem to admire. We are instead the leading energy consumer and importer. We need change our perspective here. We need to conserve where we can (i.e. be as efficient with energy as we can). However, we need energy to continue growing. Hence we need to grow our energy production as quickly as we possibly can. Leading in the adoption of solar energy would be a big step in this direction. The government should sponsor the development of all types of energy as much as it possibly can. Conservation alone will not be enough to allow the U.S. to continue to be a leading world economy.
The other areas of the trade deficit should be addressed also. Imported cars, textiles, consumer electronics, etc. all play a part in the downtrend of the U.S. economy compared to other world economies. Energy just sticks out like a really sore thumb!!!

2008 Jan 20 10:13 PM

[User 142410:]

Former Republican Candidate Duncan Hunter has it right when he claims much of the job los and migration of the manufacturing sector overseas is due to an unfair bias in tax laws. Here in the US we tax domestic companies that produce goods and have no tariff against imports. Japan and China subsidize companies that export to the US and tax imports from the US. Our government has cut a deal that destroys manufacturing in this country. It is hard to pay back debt with no means to produce income - and without income where will the tax revenue come from. Yeah, kill the mortgage deduction - Brilliant!

2008 Jan 21 09:46 AM

[David Lentz:]

The idiots driving the nation have a plan in mind, the same one that they've been steadily applying and will continue to do so.

They plan to continue borrowing to fund an ever-larger government, and devalue the dollar all the way to zero to be able to pay back the debt with worthless dollars.

Patting themselves on the back, they congratulate themselves on being so clever.

This will not change until the U.S. can no longer borrow from foreigners, which will come sometime after we have pledged enormous items of value as collateral. If gold does shoot upward past $2000 as the gold bugs predict, perhaps they will restore the dollar to the gold standard, and use the contents of Ft. Knox as the collateral necessary for continued borrowing.

I gotta believe we deserve this -- we elected the idiots, and refuse to take any action to get them out of the drivers seat.

Enjoy the ride.

2008 Jan 21 01:03 PM

[sbenard:]

Good thoughts all, including those of the comments here. I can't add much, except that I would also point out to Trader T, just as Reinko did, that only WE are deceived into thinking that fighting terrorists in Iraq vs. them following us here is an either/or scenario. The terrorists are NOT so deceived! The two are not mutually exclusive. Fighting against the uneducated peons of the Muslim world in Iraq is just the distraction that the leaders of Al Qaeda are counting on. They hope we will spend countless trillions sending our men there to fight against the uneducated millions they can recruit from their world. Meanwhile, they will plan in their hideaways to attack us here with their more educated (like Mohammed Atta and the others who carried out 9/11) foot soldiers. They will send them across our borders (Canada or Mexico) and will wait for the perfect opportunity to strike again. They will only strike when we are unprepared, unexpectant, and when they can kill millions. Their patience is their greatest advantage. This will happen while we have more military divisions in Iraq than we do here protecting and securing the borders of our own country. We are playing right into their hands with your thinking that if we fight them there, we can avoid them killing us here. Mark my words; history will prove out that we were distracted and that we misdirected our military resources away from securing our borders. Unfortunately, it will cost many American lives to teach us this lesson -- and they won't be military live in Iraq, either! They will be civilian lives lost -- and they'll be HERE in America!

2008 Jan 21 01:51 PM

[Eurotrader:]

I agree with the author on many fronts, but believe that we have to go a big step further.

Much of the consumer madness in this country and around the globe has been driving unsustainable trends in terms of business models that put a premium on producing goods cheaply by only attaching direct production costs, rather than including indirect costs, such as complete carbon emission cost and above all the negative value of all of those goods that are overproduced without finding a true market.

This massive global overcapacity of production is unsustainable in terms of capital allocation as well as in terms of the finite resources our planet has to keep driving this madness.

Topping it all off, the consumer is driven to excess consumption by the 20 year-plus availability of extremely cheap credit, resulting in the current crisis of intense proportions, where a large number of US consumers live well beyond their financial means. To me, 30 - 40% of the US consumers are financially defunct without realizing it. Moderating US consumer's insatiable appetite for conspicuous consumption would be the responsible thing to do, but this takes leadership and the current poilitical and economic stakeholders are in no way interested in doing this, as they want to keep the gig going....
IN addition, this country is hooked on the economic growth theory, come hell or high water, hence the current ANGST over the potential for recession.

Without being told just how tenuous his position is, US consumers will one day wake up and realize that they cannot extract themselves from the mess they unwittingly helped to create without a big change of attitude towards consumption versus savings. If this country experiences any kind of substantial job loss in the US, the credit edifice that has been built in the past 20 years will collapse with millions of bankruptcies. The current housing crisis in this sense is only the proverbial tip of the iceberg.

The remedies that the Treasury and the Fed have at hand are very limited. I agree with the author that there should be immediate action to dramatically reduce the Fed Funds rate and create positive carry. This would at least keep the banks liquid in the short-term and preserve confidence in the system.

However, over the longer term, this country needs to come to grips with its allocation of credit to consumers and consumers need to come to grips with their relationship towards conspicuous consumption. The current systemic problem cannot be solved by pouring more credit on a consumer already hobbled by his inability to service the credit he currently has on his books.

The fact that the US is no longer productive enough to fund its own investments in research and development via internal capital markets due to the negative savings rate has to be driving most economists mad. The point will come when foreign stakeholders will no longer male available cheap enough credit for pure unfettered consumption without the guarantee that those funds will be repaid in full.

Without a major change in money consciousness in this country by both consumers as well as the political class and the economic stakeholders, the economic model of buy now, pay later will be driven against the wall. Had this nasty consumer credit bubble been allowed to be deflated gently (via higher rates in 2002/03/04) rather than with the current bang (the housing crisis), we might have been able to prevent the massive acceleration in housing prices which proved to be too juicy for way too many people to stay away from and thus hooked many consumers (and, alas, banks) into the largest single credit excess in history. What strike me most negatively in this entire context is the fact that those Americans who are saving money, are the ones who are being sacrificed due to the sharply contracting interest rates, thereby being penalized for doing the right thing in terms of national economic theory. What a terrible example to set for the country!!!


Back to the change in business modeling:
If new business models were created that could measure and analyze true consumer demand quicker on the local level and produce goods more to that tune and in synch with total carbon cost attached, then we would see not only more local jobs emanate, as the lead-time to satisfy new demand could only be met by local production (when the total carbon footprint cost were calculated and included in the price of consumer goods), but we would as well see a more sustainable management of the finite global resources. But I guess, such a system would be termed as Un-American by politicians as well as economic stakeholders, inclined to maintain their grip on power and keep their fiefdoms....

It will be interesting how this current crisis will play out - and if the political will can be summoned to fashion a more moderate approach towards consumerism that can survive in sync with the dwindling resources of this wonderful planet.

P.S. : The book Affluenza describes the current crisis/ malaise best in terms of its total cost to the society we live in.

2008 Jan 21 02:11 PM

[Reinko:]

To David White:

No, I did not forget the trade deficit but that deficit is traced by for example the money traders. But, just an example, if the US financial sector picks up 580 billion US$ from just 2007 Q2 to Q3 I think that debt problem is bigger than the trade deficit numbers.

And when you realize that most interest is paid by picking up more debt, you see that problem is very big yet ignored on all markets.

On the other hand, the trade deficit shows are very nasty thing:

If indeed the US economy is really that strong, then why should the USA have a trade deficit with Europe? It is about 8 to 9 billion a month, so what explains that one?

Is it really a strong economy or is it just a debt driven consumer economy?

2008 Jan 21 03:47 PM

[David White:]

You seem to have missed my point. As simply as I can, the economy would be a lot stronger without the trade deficit because all of the money going out of the economy would be going back into it. This extra investment money would lead directly to a more vibrant economy (more productive). The extra productivity would lead to greater tax revenue without raising taxes or cutting spending -- both actions which would tend to make the economy contract. Oil -- energy -- is a major factor in our trade deficit. We should act on this. I actually had no argument with the idea of balancing the budget. However, some actions you take to balance the budget are harmful to the economy. While actions which would lead to a lower trade deficit would help the economy, and they would also help balance the budget. You have to look at the bigger picture to see how all the different parts interrelate.

2008 Jan 21 04:31 PM

[David White:]

In the immortal words of FDR during the depression of the thirties, "we have nothing to fear but fear itself." Essentially he mean that if you stopped spending because you were afraid, no one would have a job because no one would be buying anything. Running scared of a recession/depression is very possibly the worst thing you can do. That being said, I am very much in favor of doing away with inefficient, overly costly, questionably needed, parts of the government programs. That can only be good for the economy in the long run.

2008 Jan 21 04:41 PM

[User 86999:]

The same FDR who ripped people off by confiscating their gold at a much lower mandated price, and then reselling it at a pretty high multiple?

2008 Jan 21 06:02 PM

[Toto-13:]

I like your thinking.
Rob,
WallastonInvestments.c...

2008 Jan 21 10:46 PM