A Proposed Admirable Response to the Crisis

John Maynard Keynes recognized the importance of aggregate demand; then he went ahead and defined it.  Recognition is important since aggregate demand is the objective towards which we must work.  Definition is important as it allows identification of the sick parts and good diagnosis is the first step towards a return to health.

Simply put, aggregate demand is consumption, investment, government expenditure and foreign trade and investment. 

Consumption is the private spending on goods and services today. It does not matter whether it is financed through earnings or debt, it is simply what is spent and not saved. 

What is not spent by the private consumer must be saved and what is saved is invested.  It represents deferred consumption.

Government expenditure is public spending today, regardless of whether financed by seigniorage (creation of money; inflationary in the times of Keynes, perhaps more so in our world of fiat currencies), debt or taxes.

Foreign trade and investment is domestic consumption of foreign goods and services net of foreign consumption of domestic goods and services.  It also includes net capital (investment) flows.

In the United States, the consumer is in pain. One of the primary sources of pain is the reduction in wealth due to the housing crisis.  A house was multi-functional; it provided shelter and a place to invest savings.  The ability to draw down on savings as property prices rose elevated consumption.  Consumption was funded in part through debt, the reduction in asset values restricts access to savings and thus reduces (and even makes negative) funds available for consumption. 

With consumption under pressure, the motivation to invest is low.  In addition, a higher percentage of declining income is spent on necessities; this will reduce savings and thus investment.  It comes at a bad time because past savings and investments in real estate are no longer readily accessible; they are illiquid.

Government expenditure is already high.  With the war efforts financed through debt and seigniorage, deficits are at record levels.  With the consumer under pressure, it is difficult to enhance investments funded by taxation.

Foreign trade and investment is the one glimmering star.  With a currency at historic lows, domestic goods and services are more competitive in the global markets.  In addition, investments overseas have generated vast, albeit recently contracted returns.

So far the government response has been credible; even impressive.

Firstly, monetary policy has been used to try and stimulate investment.  It has not worked due to excessive fear because of perceived levels of risk.

Secondly, access to capital has been increased considerably through the federal reserves window.

Thirdly, risk perception has been addressed through tackling solvency issues through the government nationalization of Freddie Mac (FRE), Fannie Mae (FNM) and AIG (AIG).

Fourthly, risk perception is being addressed through tackling solvency issues through the tentative plan to acquire illiquid debt.

The former two are typical monetarist responses.  The latter two are very Keynesian because it involves the government taking on risk shunned by the private sector during a time of crisis.

Even the Democrat proposal to package in relief for home owners is credible because it provides liquidity and solvency to the recently neglected consumer.

What remains to be seen is how the government investments are financed.  I believe further seigniorage is a very bad option.  Increased taxation is bad too; it hurts the consumer, the principal driver of the main street and the real economy.  That leaves borrowing.  Borrowing to invest in times of crisis is a privilege available to few; in the long term, if the assets acquired are disposed off wisely, a significant profit shall result; and that shall be good news for the deficit situation. 

The question of whether the government should over-pay for assets acquired has arisen.  And the answer is no.  But remember, the mark to market value is not necessarily the fair value of an asset, except for in an accounting sense. 

When a company acquires another, it virtually always pays a significant premium over the market value of the company.  The target has a certain value to a buyer, which goes beyond its present worth; some of it comes from synergies post acquisition; more of it might come from the acquirer's ability to use and profit from the acquired asset.  In determining the transaction value, the price should fall somewhere between the market value and the value to the buyer.  Keep in mind that in this case the buyer is United States.  The principal deficiency causing collapsed market values is confidence; with a buyer such as the United States, confidence to an asset class returns and the asset is immediately more valuable.

On a closing note, what has disappointed me in the handling of this crisis is that tax policy has not been used to full effect.  It is true that there were one off tax refunds intended to shore up the consumer.  This was good; but what about tax policy to stimulate investment? 

Today, major US corporate houses have accumulated vast cash resources internationally.  If they bring that cash back to United States, they keep only 65% of it; for this reason it is liquidity largely not available in United States.  Since liquidity is one significant issue harming the economy, would it not make sense for tax policy to be amended to permit tax free unrestricted return of overseas earnings, gains and profits?  I believe such an act would significantly enhance private investment participation in the resolution of this crisis.

Comments

[citetez:]

The true problem in the credit crunch seems to be the accounting rule requiring mark to market. By making people write down assets because there is a temporary market lock up is ridiculous. Any asset priced a s if it must be sold tomorrow rather than in an orderly fashion (hold to maturity value discounted for market interest expectaions) causes the stated "value" to crater. Once the process starts, it snowballs. CDOs and similar products can not be valued because the market dried up. There is no market because everyoe is afraid of what the "mark to market" requirement will do to their balance sheets. If we get rid of the "mark to market" rule, the market will return, and stabiltiy will come back to the financial markets. Such an approach avoids the need to have the government create and finance a market.

2008 Sep 24 07:30 AM

[xsuddensam:]

citetez,

The true problem, pure and simple, is fraud. If investors on Main Street can't trust Wall Street and Washington, there can be no confidence.

2008 Sep 24 08:56 AM

[John Lounsbury:]

Excellent article. It amazes me that Keynesian theory suddenly regains credibility in times of crisis and is ridiculed by many in better times.

The basic problem with mark to market is that there is no market transparency with daily transactions on a bid and ask basis. Proper oversight would require a marketplace be in place for all financial instruments of publicly traded companies.

2008 Sep 24 09:31 AM

[keithofrpi:]

This is an intelligent article, but I think you overlook one key advantage that the government has, and could use to solve the valuation problem. Very simply, it is to buy the "bad" assets at a price that is partly determined by the long-term value. Pay something now, perhaps 25% of the cost of the asset, and promise to split--in some equitable fashion--the increase ultimately realized. Few if any other entities could be trusted to make such payments, but the government can. In the meantime, the government holds and works to unwind the assets, freeing the financial market to return to supplying credit. Ultimately, everyone wins.

I do not agree with your idea of eliminating taxes on repatriated profits. We do not suffer from a shortage of funds; we suffer from a shortage of trust that investments will be profitable. Relieving firms of tax burdens does not change that trust; it simply hands the firms another windfall profit.

2008 Sep 24 09:34 AM

[billp37:]

"As I was looking over the Paulson plan for the fifteenth or sixteenth time (what the hell -- it's only three pages long), I was struck, yet again, by its incredible vagueness. Moreover, watching the good secretary battle Congress and hearing the statements of various Congressional lobbyists, I continue to be amazed by the degree to which Wall Street seems to be trying to defraud the American people. According to Paulson, placing caps on executive compensation (aka "golden parachutes"), subjecting the Secretary's decisions to judicial oversight, giving the government an equity stake in the companies that it helps, and setting a firm end date to the program are all "deal breakers." In other words, the Secretary is convinced that companies will refuse to accept a federal bailout if these conditions are attached."

www.bloggingstocks.com.../

cheers

I am a technical writer

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2008 Sep 24 10:29 PM

[Steven Hansen:]

Profits returned to the usa are already tax free as foreign tax credits are normally larger than the usa tax obligations.

2008 Sep 24 10:50 PM

[cyberman:]

And if your plan went through and you were and over paid executive with billions to possibly bring back, would you in fact bring it back to a country that is on the verge of a financial melt down? One that has allowed a financtical right wing white house and congress to destroy responsible governmental oversight and encouraged the "ownership society" for the few and the XE$^ with the other 98% may of whom believed and tried - but failed to become owners.?

I'd eschew the U.S.A. for a while but what the heck do I know.

Foreign tax credits? At least for some individuals, there can be a cap on tax credits for foreign taxes paid and one can end up paying taxes to two countries on the same income.

Hey how about that GS stock jumping up just before the Buffet investment was announced? Think there was some insider trading maybe a la Bear? This is what is wrong with America. The SEC and the FBI are sound asleep. Shhhh don't waken them. Give Pauly our 750 B and watch the greedmasters find a way to profit from it in ways not intended by congress. "So far the government response has been credible; even impressive." Yeah sure. Where there is so little trust in financial institutions, and in government the responses you praise are only putting band aids on problems that should never have been allowed to develop. It isn't "impressive" it is purely a series of desperate reactions to a snowballing crisis.

2008 Sep 25 02:32 AM

[Shiv Kapoor:]

The Hand - what you say is incorrect. A well planned company will pay well below the 35% US rate. International taxation is a complicated area, but perhaps not so complex as is made out. Just think of a Super Holding Company located in a haven jurisdiction, owning several patents & earning royalties from a check box subsidiary located in the country of foreign operations. Result is a tax deduction in the foreign locale & no tax on income in the haven jurisdiction.

2008 Sep 25 01:31 PM