A simple explanation of the cause of the current economic problem: For 25 years, we have had enormous increases in consumer credit, much of which was neither necessary nor could the consumer pay back. When these consumer loans started going massively unpaid, the crisis erupted and it has led us to deflation of prices, which has led to recession and probably will end in depression.

A more professional explanation of the cause for the economic problem: Economists, particularly at the Fed, focus on the “private credit aggregates”, which includes all household and non-financial company debt used to finance consumption and investment (mortgages, auto loans, home equity loans, credit cards, etc). Then economists compare this to the nominal GDP (gross domestic product).

The Obama stimulus plan is based on providing massive amounts of money to banks and the general economy in an effort to return the economy to growth. While the private sector is deleveraging and reducing debt generally, the public sector is trying to provide economic stimulus with government funds. The intellectual origins of stimulus go back to Lord Keynes in the 1930s who first proposed this type of stimulus. Today, the leading advocates of the Obama stimulus program are Ben Bernanke, Larry Summers and Paul Krugman.

It should be noted that this article focuses on financial stimulus through the banking system and does not refer to job creation programs such as building roads or bridges.

The US financial stimulus plan is based on two central concepts. The first objective is to get more money into the banks so that they can lend to their customers and be seen by their customers and bank counterparties as a safe depository of funds. The second is to get prices up, particularly in housing and financial instruments, so that many do not go broke, particularly including banks and homeowners. These policies have failed. The purpose of this article is to explain why they could never succeed. Furthermore, until there is a consensus that the current policy of stimulus cannot succeed, we cannot move on to more effective solutions to our problems.

This article is part 3 of a series. The first was “Obama Wants a 'Better Plan'? Here's One: Bite the Bullet” , which was a call to arms to get better policy for fixing US economic problems. The second, “Replacing Government Bank Liquidity Programs with Orderly Shutdown of Bankrupt Banks”, provides the outline for one part of the solution to the problems. This article focuses on why current financial stimulus policy does not and cannot work. Until we leave behind this failed policy, we cannot even begin to implement effective solutions.

The government is trying to stabilize banks through liquidity programs such as TARP, TALP and PPIP. These programs will fail for the reason provided below. These programs should be replaced with a program to shutdown failed financial institutions in an orderly and socially responsible way. This change will shorten the readjustment period of the recession/depression by years and will reduce the total cost of the government adjustment plan by trillions of dollars

This article is an extension of my earlier article “Obama Wants a 'Better Plan'? Here's One: Bite the Bullet”. Readers asked for more details on how we do this. This article provides some insights on implementing “Bite the Bullet”.

In view of the growing clamor against many basic aspects of the economic stimulus plan, President Obama has said “give me a better plan”. I think a real discussion of a better plan should be held.

The present stimulus plan proposes to get the economy going again by pumping into the economy massive amounts of money, nearly all of which is created at the Fed. Many people worry about the risk of hyperinflation. It is clear that much, perhaps most, of this money will be lost on ill conceived bail out schemes. Future generations will inherit staggering debts from this approach.

FT had a remarkable article Saturday explaining what is behind the write-downs in December for Merrill Lynch. Briefly, the article says that Ken Lewis sent his chief financial officer Neil Cotty to review the Merrill finances in the fourth quarter of 2008 and it is Mr. Cotty who decided on the write-downs to be taken. Here is a reasonable explanation of these events.

The logical thing to do when you are buying a company is to write-off all the bad news before you buy so that it does not affect your own bottom line. It is logical that Ken Lewis sent Neil Cotty, his chief accounting officer, to clean things up before finalizing the purchase in December. This is a normal process. It seems that Neil Cotty essentially decided on what write-down should be made. This is also normal. Thus we come to the first major variance with a lot of B of A (BAC) public announcements. Contrary to public announcements, B of A probably decided on the reserves to be taken in the fourth quarter in Merrill Lynch. That is to say, B of A actions decided what would be the bad public news about Merrill’s losses. But in the real world, this is normal.

Government policy is to assist banks through government intervention. Basically providing money or guarantees through such programs as TARP, the government aspires to create confidence in the public that the banks are solvent and also to stimulate the banks to increase their lending to needy customers. However, there is an increasing prospect that the result will be the exact reverse of the intended objective.

There is a scenario where there will be three types of banks: 1) Nationalized banks are government funded banks such as Citigroup (C). Nationalization means in effect means the US government is the sole life support system to keep them from collapse. The formalities of acquiring stock are less important than who puts up the money or guarantees to keep them alive. Citigroup (and AIG) are nationalized by this definition. 2) Independent banks. These are banks that do not take government money. Banks like Goldman Sachs (GS) are working towards returning money so that they will not be under government control. B of A (BAC) would like to be in this group, but it is doubtful that B of A will make it. The presumption of this scenario is that if banks do not need government money, they must be OK. 3) TARP assisted banks. These are banks that have government money but which are not really in either of the other two groups. The government hopes TARP money will reinforce their position in the investing public.

US government policy is attempting to build a floor under housing, principally through programs to refinance homes and keep people in their homes. However, a fundamental tenet of problem solving is to have solutions that solve the underlying problems at their root cause level. The current government programs do not meet that condition.

The fundamental problem is reduced demand for housing, which in turn is based on reduced expectation of profit from buying a new home, reduced capacity to pay, and reduced ability to finance. Here are the major elements which must be dealt with in finding an effective solution to the housing problem.

Over 95% of investors claim not to have seen the current downturn coming nor do they accept the probability of a coming depression (at least they did not by the end of 2007). There continues to be conversation whether we are near a bottom. Much money on the sidelines is eagerly waiting to go back into the market or more likely, existing investments with big book losses waiting for the market to recover. Yet when our probable course is viewed in historical terms, there is a very clear and likely path, much further reduction in the value of everything particularly including real estate, equities, bonds and most commodities (gold is shaping up as a hedge against the problems). What does history tell us?

Most views of history do not go back further than 5 years. In late 2007, I went to numerous prominent investment advisors to look for suggestions. Not one of them gave me recommendations where they would provide investment records that went back more than 5 years, the bottom of the 2002 downturn (Very convenient! I would call this deceptive advertising). The truth is that you need to look at investment histories over three hundred years for many realities to simply jump out at you. You see clearly that history repeats. You see clearly during three hundred years that there are major repeating cycles. You see clearly that ideas like buy and hold make no sense when you look at things over several decades. You see clearly that diversification does not really work when measured in terms of decades. (Commodities almost always bottom within three months of major bottoms of stock indexes.)

Secretary Geithner has proposed the formation of a “bad bank” to buy $1 trillion or more of troubled loans and securities off the books of banks and get credit moving. This idea deceives the public, will not work and provides all the wrong incentives to bankers. This is a rehash of the idea former Secretary Paulson first proposed and then quickly abandoned. A good idea is to create a “good bank”. Let’s first look at why I am opposed to Secretary Geithner’s idea for a “bad bank”.

Geithner hopes the purchase of toxic assets by the “bad bank”, funded in part with private capital, will get the banks to lend again. He is not even making the claim this makes economic sense. This is a fatal flaw causing the idea to fail from all points of view.

Bernie Madoff took dishonestly about $50 billion from investors through a Ponzi scheme. A 20 times greater amount, about a trillion dollars, has been taken from naïve investors (both bank and non bank) who invested in subprime loans in a way which is as dishonest as the Madoff Ponzi scheme, at least in a moral sense. The only big difference between the two scams is that the Madoff scam we can blame on Madoff, but Subprime is the fault of the system. While no one individual is responsible for the Subprime problem, the general greed for profits led all the bankers to deceive themselves and their investors. Government must be held responsible for not having fundamental regulation to protect its banks and investors from the stupidity of the banks that promoted subprime.

First, let's look at the claim it is dishonest, at least morally. Subprime is a specific type of transaction more generally called CMO's (Collateralized Mortgage Obligations) and CDS (Credit Default Swaps). Subprime depended basically on brokers who did not care whether the borrower could pay his loan because they got paid their commission at closing, on banks that also did not care much whether the borrower could pay since the loan was being sold off, on packagers of loans who cut and sliced the packages of loans so that some could be called AAA rated loans (generally called CMO's). They paid credit rating companies to put triple A ratings which could not possibly be justified with any analysis of the underlying package of loans. Finally, they paid credit insurance companies to give guarantees (Credit Default Swaps) that they would cover any default when the credit insurance companies did not have the financial ability to pay if called on to pay. To make it even better, everyone seems to have had the idea that real estate prices would always go up. Finally, we even had President Bush saying all this was good because we were increasing housing without looking at the inevitable results. This is brilliantly shown on a YouTube video called "The Subprime Primer."

Secretary Paulson’s plan to fix the economy fails because he has not understood the problem.

What has been his plan? Get money into the hands of financial institutions so that they could continue to lend. Financial institutions initially were commercial and investment banks, but have been expanded to include insurance and even corporate borrowers that are important to the commercial paper market. This solution means that he assumed the prior asset values of say late 2007 and the related financial leverage was acceptable. He believed the problem can be solved by getting more money in the financial intermediary hands and let them work out the problem. In reality, this is equivalent to giving a drunk another drink in the morning to fix his hangover.

Leverage is wonderful when the markets are going up, as they did for years. If you can borrow for 4% and earn 6%, 10% or 20% (pick your own numbers), you dramatically increase your profits. Every major asset class has used leverage extensively, and in many cases has used leverage to grotesque extremes.

Citigroup (C), along with Band of America (BAC) and JPMorgan (JPM) have been setup by the government as too big to fail. Yet the price action on the Citi stock indicates that the market is getting very close to declaring Citi a failure. Look back to the price action of Bear Stearns preceding its failure. If we soon get massive withdrawals by concerned borrowers, the game is up. No one wants that.

Yet, the Fed and Treasury must be in a panic trying to think through how they deal with this situation. There is not another US bank that could buy Citi. Nor is it likely to find a foreign buyer, particularly one that would be acceptable to US authorities. Bankruptcy probably really is unthinkable for Citi.

Today the world faces its largest economic challenge since the Great Depression of 1929. Ben Bernanke, who has been an avid reader of the causes and solutions to the Depression of 1929, has concluded that throwing a lot of government money at the problem will stimulate the private economy and help us work our way out of the problem. It worked pretty well in the Great Depression.

However, this time it will not work. The risk we face with a continuation of this strategy is destroying the value of the US dollar and causing a greater problem, hyperinflation, than we had with the 1929 Depression. The plans presented by Secretary Paulson and the Fed Chief Bernanke are not viable and will not achieve the objective of stabilizing the economy, preserving the banking system and promoting employment.

The automobile companies, or at least, initially, General Motors (GM), should be put in a prepackaged bankruptcy with preannounced debtor in possession financing from the US government. The following objectives would be achieved immediately through this prepackaged bankruptcy.

1. All labor costs, both on worker and executive levels, would be restructured to assure that the company can operate with costs levels that are competitive with worldwide car manufacturing costs (i.e. Toyota (TM)).
   • This means that unionized workers will end up with salaries that are significantly less than now, but at least they will have a future and a job which pays much more than McDonald's. Salaries will probably be arrived at by a model which creates an economically viable company and then backs into what can be reasonably paid to the workers. GM executives say they have a structure which by 2010 should make GM worldwide competitive; this should be determined by independent analysis.
   • Likewise, executive pay must be reasonable compensation. No big bonuses or contractual payouts.
2. The current debt holders must take major write-down on the value of their debt holdings. These might be 50% to 75% reduction of the current face value of the debt. The rest of the debt will be written off in the bankruptcy so that the company can reasonably become cash flow favorable. (Any plan which does not result in GM being cash flow positive is wasting money)
3. Currently, equity holders will only receive a very small value of the residual company, say 10%, of the future equity. The rest will be held by the new investors, hopefully including private equity firms who know a good plan when they see it. For example, the new equity distribution could be 10% current shareholders, 20% current bond holders who take a 75% reduction in their debt holdings (this is an addition to the 25% of their original debt holding) and 70% for new equity investors including the US government and private investors willing to bet on the new restructuring.
4. A plan will be created (and hopefully exists in the car companies) to make the investment necessary to make them competitive in future low-cost, fuel efficient models and the plant capacity necessary to do this. This plan must determine the monies necessary to implement it.
5. The government must create or approve the plan to fund the company based on the above principles. While a significant part of the funding will come directly from the government, private bank financing should be available for a well thought out plan, especially if warrants or other kickers are provided to private equity financiers.
6. This plan creates financial losses for almost everyone associated with GM. But it also does not destroy anyone associated with GM. It builds for the future and does not depend on favoring one sector over another (banker vs. employee vs. bond holder vs. equity holder). This writer believes all other plans will provide temporary relief for one sector or another, but ultimately these alternate plans will cost everyone much more.

How does this plan compare to the currently most discussed options in the press?