Stimulus, Capitalism Style

There is much talk of Barack Obama and the newly enlarged Democratic Congress passing shortly after the inauguration a large stimulus plan, perhaps $500-700 billion, with the expectation that such a plan will mostly rely upon new government spending. This plan shares a key premise with the stimulus plan passed earlier this year, which comprised tax rebates: if the government puts money in people's pockets, it will stimulate economic activity.

The problem with such efforts is that the money has to come from somewhere. Specifically, both efforts are paid for with additional government borrowing, which means there is less money available for other forms of investment or spending. So the impact is not nearly as great as it seems.

Instead, an economic stimulus plan can be crafted that can change the behavior of individuals, businesses, and investors to increase economic activity. An across-the-board cut in all income tax rates, including corporate, capital gains, and dividend tax rates, increases the incentives for everyone to make new investments, start new ventures, and in general work harder - since the payoff from all such efforts is now greater.

Yes, such a tax cut puts money in taxpayers' pockets like a tax rebate or infrastructure spending, but it does much more by encouraging effort and risk-taking - which is the key to stimulating real economic growth.

John McCain did a poor job in the campaign explaining why his plan to cut corporate tax rates was so beneficial. The reason such a tax cut promotes economic growth is simple. When companies make decisions to build a new factory or R&D facility, they compare many variables, all with the goal of maximizing their after-tax income from the investment. If corporate tax rates are reduced for investments in the U.S., then companies (both domestic and international) will be find investments in America more profitable and hence more likely to make such investments in America.

Ireland has experienced dramatic economic growth by using a low corporate tax rate to induce companies to locate operations there. And since the U.S. corporate tax rate is now among the highest in the world, cutting that rate will make investing here more competitive. That will mean more jobs, and more tax revenue, generated in the U.S.

A 30% cut in all such tax rates would cost the government approximately $500 billion, before any stimulating effects of higher economic activity are considered. For individual taxes, the 15% tax bracket would be 10.5%, the 25% tax bracket would become 17.5%, and the 35% tax bracket would be 24.5% - all dropping by 30%. The corporate tax rate of 35% would be 24.5%, which when adding in state taxes would make it about 29% - higher than many countries but much more competitive than today.

A second important element of a pro-growth stimulus plan is to expand free trade globally, rather than threaten to reduce trade as Barack Obama did during the campaign by suggesting he would change the terms of NAFTA or refuse to approve free trade agreements with Colombia, South Korea, and Panama as the Democratic Congress has done. Approving these trade agreements and in general seeking to expand free trade will send a strong signal of America's commitment to expanding trade - which will encourage economic activity as businesses seek new opportunities that more open trade permits.

A third element of a pro-growth stimulus plan is to look to cut regulations that impede economic activity. The auto industry has long been hamstrung with fuel efficiency standards and limits on rationalizing its dealer network. Reducing or eliminating those restrictions won't immediately solve the auto makers deep woes, but will help - and are an example of the type of constraints that limit business activity throughout the economy.

Lastly, pro-growth government policies would not be attacking businesses and Wall Street to score PR points. Creating an atmosphere of fear is not conducive to executives taking risks on new investments.

All of the above suggestions stand in sharp contrast to the policies pursued during the Great Depression, when taxes were raised significantly; free trade was devastated with high tariffs; new regulations were unleashed; and business leaders were subject to verbal and legal assault.

Contrary to the popular mythology of the New Deal, all of these policies exacerbated the crisis of the 1930's and prevented a full recovery from occurring for over ten years. After six years of the New Deal, unemployment was about 19% - down from 25% in 1933 but still at depression levels. Note that today's unemployment rate is 6.5%.

Let's not repeat the same mistakes again. Pro-growth policies, consistent with our capitalist heritage, give us the best chance to begin a sustainable recovery.

Fear and Loathing in Washington, aka The Cover Up

Senator Tom Harkin (D-Iowa) has introduced a bill to treat all over-the-counter derivatives as futures contracts, requiring them to be to be traded on regulated futures exchanges. He seems to prefer to do more when he recently said, "Shouldn't we just outlaw all of these fancy little things?"

This legislation reflects the concern often expressed recently about the complexity of sophisticated new financial instruments, such as credit default swaps. Much has been implied that these are a significant cause of the financial crisis.

Nothing could be further from the truth, and focusing on an incorrect cause deflects attention from the real problem and risks repeating the same mistakes in the future.

Banks and other financial institutions are suffering from enormous losses in the most traditional investment for banks: mortgage loans. As the bubble in housing prices has burst, housing prices have collapsed - and due to the high percentage of a home's purchase price that a mortgage typically represents, the mortgage holder faces severe losses. The traditional arrangement where the mortgage provides 80% of the purchase price illustrates that home buying is really a leveraged buyout (LBO), involving a home instead of a business.

Securitization facilitates the spreading of mortgage loans widely, but doesn't change the basic calculus that the lenders, or investors in loans, suffer if housing prices drop significantly.

So the real question is: why did so many lenders and investors pour money into the housing market, both driving up home prices and lending against the value of those inflated home prices?

For any given investment, people make mistakes all the time and suffer losses - but don't produce an economic crisis. But something more profound and fundamental needs to occur to produce a financial crisis of the depth and breadth across the globe that we are currently witnessing.

The main culprit was the extraordinarily accommodating monetary policy that the Federal Reserve pursued beginning in 2002, reducing its base interest rate to 1.00% - an unprecedented low level. The purpose of such low interest rates was to encourage borrowing, and boy did it ever. Banks could borrow at low rates, and pass on the low interest rates to borrowers.

That's why the Fed lowers interest rates. Alan Greenspan and other Fed officials can't escape that fact.

Such low interest rates, for such a long period of time, encouraged lenders to offer, and borrowers to accept, mortgages with ever more aggressive terms. Mortgages with low interest rates for the first year before later resetting to higher rates became more common.

As example, imagine a family can afford to pay $2,000 a month in mortgage payments. At a 6% interest rate, the size of the mortgage loan would be $333,000. But at a 3% rate, the mortgage loan that monthly payments of $2,000 support is $474,000. And that higher borrowing capacity allowed buyers to offer sellers higher prices as they bid for homes - in this example, the buyer could increase the price by $141,000 and still "afford" the house.

This higher borrowing capacity as a result of low interest rates directly fueled the bubble in home prices.

Of course, once the interest rate reset, the mortgage became unaffordable. And as this happened across the economy, housing prices began to drop. Then, lenders and investors realized their mistake and stopped making such loans, further contracting home prices.

Illustrating this was an economy-wide problem, a similar phenomenon developed in leveraged buyouts of corporations and commercial real estate. Large losses have arisen in those markets too, but are dwarfed in size by the housing market.

Alan Greenspan, the architect of this low interest rate policy, elected to blame banks and investors for not exercising greater discretion in their lending and investment decisions. And some banks, and some investors, elected not to participate in this frenzy and are doing well today. But Greenspan should understand market participants react to signals, and there was no bigger green light flashing "Go" then the extraordinary low interest rates that the Fed pursued.

Back to Washington, you will be hard pressed to find politicians who bemoaned low interest rates at the time. The Wall Street Journal editorial pages did, so it isn't as if this problem wasn't recognized at the time.

Moreover, low interest rates facilitated an important public policy goal - promoting home ownership. Fannie Mae, Freddie Mac, and other government sponsored entities (GSE) were pushed by activists and Congress to expand lending for subprime mortgages to increase home ownership among less creditworthy borrowers who in the past couldn't qualify for a mortgage.

This added fuel to fire, with the blame squarely on the shoulders of the primarily Democratic politicians who pushed these policies and defended the GSEs against primarily Republican efforts to regulate them to limit the scope of their activities.

So the assault on sophisticated financial instruments represents both the fear of the new, as well as an attempt to deflect scrutiny from the real causes of this crisis.

If this history isn't understood, we are doomed to repeat it.

Getting Serious

It is good to see Barack Obama is getting serious about the economic situation. After initial speculation that Obama would announce his economic team quickly after the election to assuage markets, the primary rumors and leaks on cabinet appointments involved key political figures: Hillary Clinton, Bill Richardson, Janet Napolitano, Tom Daschle, and Eric Holder. In most presidential transitions, focusing on political appointments is entirely appropriate - to satisfy supporters, appeal to broader constituencies, and build up the careers of future leaders.

But in the economic turmoil we are facing, such a path raises concerns in markets about the seriousness and direction of the new administration. Witness the 25% drop in the S&P 500 from Election Day to November 20, before the market began to rebound with leaks of well-regarded economic policy appointments including Tim Geithner as Obama's nominee for Treasury secretary.

While the market drop is probably not entirely attributed to concerns over the future direction of the economic policy of a government controlled by Democrats, market confidence clearly ebbed due to the fear of higher taxes, increased regulation, bailouts of the auto makers and other supplicants, potentially radical environmental policies, the weakening of free trade, and the bashing of business leaders.

Confidence in future economic policies, when there is a serious question as to their direction, is an important factor in whether businesses make new investments and consumers commit to large purchases such as homes and cars. If Barack Obama could inspire markets even modestly as compared to how he inspired so many voters during the election, he would go a long way to facilitating a recovery.

Confronting Iran?

The recent collapse in the price of oil eliminates one of the constraints in confronting Iran's nuclear program with a military strike - the fear that such a confrontation would lead to catastrophically high oil prices, which was a significant concern over the past 18 months when oil was racing upward to $145 a barrel.

But unless George Bush stuns the world, it looks likely he will pass on to Barack Obama the burden of confronting Iran militarily.

This is not the outcome one would have predicted in 2002 and 2003, when Bush included Iran in the axis of evil and clearly outlined his rationale for dealing with threats before they materialized - and no threat would be higher on that list than Iran's nuclear ambitions.

But unless Bush delivers a shocker, he will have bowed to the pressure of Democrats and the international community and not degrade or destroy Iran's nuclear program. Moreover, I suspect he sees advantages to Obama having to deal with the issue, betting that Obama will launch a military campaign against Iran rather than risk political devastation in the 2010 or 2012 elections by "letting Iran get the bomb."

Because if Obama does confront Iran with military force, two good things will happen from Bush's perspective. The fundamental tenets of Bush's foreign policy will have been adopted by the Democrats. And it will begin the political rehabilitation of Bush and his legacy.

I think this scenario, more than any other, is what Joe Biden had in mind during the campaign when he told supporters that Obama might surprise them, and would need their patience and support, when dealing with a foreign policy crisis.

All things considered, I think George Bush will win this bet.

Congress is Hurting Big Three By Offering Hope of a Bailout

Congress is doing GM no favors by offering the hope of a bailout but not providing one.

Here's why.

In better credit markets, bankrupt companies can often obtain debtor-in-possession ("DIP") financing which allows a company to obtain a new loan to fund its operations in bankruptcy. Because the DIP market has dried up in the credit crisis, GM needs to use its own cash balances to provide liquidity in bankruptcy. Each day GM delays in filing is another day of losses draining its cash reserves - hence the need for an immediate Chapter 11 filing.

So if there were no hope of a bailout, GM would most likely have already declared bankruptcy, to preserve as much of its cash as possible to give it the best chance of emerging from Chapter 11 as a profitable company.

On balance, Congress is hurting GM's chances of survival with its talk of a bailout.

GM Admits it Makes Lower Quality Cars

One of GM's arguments to support a bailout is that if it declares bankruptcy, consumers won't buy its cars for fear that GM won't be able to satisfy warranty claims.

If GM's cars are so bad that buyers won't buy them without a strong warranty, that sounds like a compelling case against a bailout.

Viva La Revolucion!

Which political figure said: “You never want a serious crisis to go to waste”?

a. George Bush
b. Adolph Hitler
c. Vladimir Putin
d. Hugo Chavez
e. Rahm Emanuel

If you said George Bush, then you are probably a lefty who thinks George Bush used 9/11 as an excuse to invade Iraq, destroy civil liberties, and win elections.

If you said Hitler, Putin, or Chavez, you are probably right – and if you count what they thought, I’m sure you’re correct. Whether it was Hitler taking advantage of the Depression to rise to power, Putin using a Moscow apartment bombing to launch the second war against Chechnya, or Chavez ranting against America to tighten his grip over Venezuela, tyrants have often used a crisis (real or manufactured) to expand their power.

But the correct answer is Rahm Emanuel, Barack Obama's Chief of Staff, in a Tuesday meeting. It was said when discussing Obama's desire to impose draconian reductions in greenhouse emissions, which will have a deeply negative impact on economic growth. And if it speaks to a broader mindset, it is one of the more disturbing comments I have ever heard in American politics.

We need good policies based on sound judgment that are consistent with preserving and enhancing our liberty - not radical measures to reshape society that couldn't pass without the fear and anxiety that economic difficulties can induce.

The Line of Pigs at the Trough Gets Even Longer

Even more industries are lining up for government tax breaks or spending to fund normal business investment as discussed in the Wall Street Journal.

Railroads are lobbying for new tax incentives to expand tracks to ease congestion. Utilities want incentives to expand the transmission grid. Telecommunications firms want tax breaks to expand broadband service. All of this falls under the rubric of "infrastructure" but is really private firms looking for a subsidy.

In some cases, government regulation may be limiting investment in these areas - in which the case the solution isn't to provide a subsidy, but to remove or modify the constraint.

If the U.S. government doesn't reject an auto bailout, expect ever increasing numbers of companies and industries to look for their turn at the trough.

A Whale of an Idea

The Supreme Court's recent decision to allow the U.S. Navy to train in anti-submarine warfare off the California coast, despite the potential harm to whales, led the New York Times to express grave concern with the 5-4 decision, saying:

The Supreme Court showed extreme and troubling deference to the views of the military, deciding to lift two restrictions on the Navy’s use of sonar in training exercises off the California coast.

And what about the Times' "extreme and troubling deference" to the whales?

To make matters worse, modern diesel-electric subs are very quiet and hard to detect with sonar, particular in the waters of the Persian Gulf where high traffic adds to the background noise levels.

With the risk of military confrontation with Iran on the horizon, such training becomes all the more critical.

The Line of Pigs at the Trough Gets Longer

For any who are inclined to support an auto industry bail out, it is important to note there is no logical reason it should be limited to GM, Ford, and Chrylser. There are many auto parts suppliers who are also suffering in the downturn, and sure enough, they are looking for a hand out as covered in today's Wall Street Journal (subscription may be required).

Of course, these companies aren't as famous as the Big Three nor as politically powerful, but if the government agrees to fund the auto makers, the parts' suppliers won't be far behind in securing their piece of the action.

New York Times to Buy GM?

Today's New York Times has an editorial with its take on an auto bailout. It makes what is now the obligatory points on firing management (which may or may not be a good idea, depending on the willingness of capable executives to step forward in these awful circumstances); not paying dividends to shareholders (they will have to eliminate dividends under any plausible scenario); and limiting executive pay (if the Times wants new management hired, will limiting their pay result in the best people getting hired?).

But the most interesting item of note is the Times' central point, which is that any bailout must require the auto companies to pursue a specific, aggressive plan to improve fuel efficiency. This perfectly demonstrates the Times' hubris, as well as the multi-decade effort to impose public policy objectives on the auto companies which itself has contributed to their current predicament.

For the Big Three to have any chance of survival, they must be solely focused on returning to profitability. Perhaps that does mean building the most fuel efficient cars they can, if that is what consumers want. But if it means building trucks and SUVs, so be it.

Consumer demand is fickle, and the enthusiasm earlier this year for fuel efficiency was clearly influenced by record high gas prices. The recent drop in gas prices has already led to a shift in demand toward trucks/SUVs. Misjudging this is costly. As example, Ford indicated the other day it cut truck production too much in the third quarter, adding to its losses.

For decades, the auto companies' role in the economy led to the imposition of many regulatory constraints to achieve public policy goals, the most prominent of which has been government imposed fuel efficiency standards (known as CAFE). Adding to this burden, and in a less well-known aspect of CAFE, the CAFE rules count each company's fuel efficiency for its domestic production separate from its imported production. This was done to help the UAW keep jobs in the U.S. by giving auto makers an incentive to make smaller, more fuel efficient cars in the U.S. to offset the lower fuel efficiency of truck/SUV production- since without this rule, the auto companies would have had an incentive to shift production of smaller cars overseas where they could be made more cheaply (and hence more profitably).

In other words, this rule cut into auto companies' profits, and encouraged them to substitute cheaper components in these unprofitable cars to lessen the losses imposed on them. This only exacerbated their reputation for making lower quality cars, further adding to its woes.

If the Big Three have a chance of survival for the long-run, these constraints and others need to be revised or eliminated.

It is remarkable that the Times' ideological commitment to an environmental agenda is so strong that, even with the Big Three teetering on bankruptcy, it believes that is the most important issue to push at this time. As to the Times' hubris, perhaps its controlling shareholder, the Sulzberger family, wants to make an investment in an auto company. Then they can put their money where their mouth is and run GM anyway they see fit.

Secretary of State

I have long believed the President's cabinet should reflect a greater number of the leading politicians from the President's party, particularly in the roles of Secretary of State and Defense. So in that context, I'm pleased to see that Hillary Clinton and Bill Richardson are being discussed as possible choices for Secretary of State in an Obama administration.

Beginning with George Washington's administration, the Secretary of State was a leading political figure, as evidenced by how many became President shortly after: Thomas Jefferson, James Madison, James Monroe, John Quincy Adams, Martin Van Buren, and James Buchanan. Of the first seven Presidents after Washington, five served as Secretary of State, usually in the next administration. And the exceptions included political heavyweights like Henry Clay who could have become President.

In recent years, the pattern has been replaced with a new one: the Secretary of State as a foreign policy specialist, as exemplified by figures such as Dean Rusk, Henry Kissinger, Madeleine Albright, and Condoleezza Rice. And concurrent with this change, the position of Vice President evolved into the best platform for becoming the next President.

No doubt the complexity of maintaining relations with nearly 200 countries, in the context of high international tension in the Cold War, contributed to the desire to have specialists for the State Department.

But I see this as a lost opportunity to vest more of the leading political figures in the country with executive responsibility. It is easy to be a critic, where one can often get away with opposition or ducking hard issues - executive responsibility, and the prospect of holding it, may temper the criticism with a healthy respect for the need to make a decision amongst difficult choices.

Moreover, I like the additional experience that implementing the nation's foreign policy provides the leading politicians if and when they run for President. It also adds to the competitive landscape, rather than simply leaving the Vice President as best positioned to be the standard bearer for the party. And for those who worry about the loss of specialist knowledge, the National Security Advisor can be staffed to provide that perspective.

If Hillary Clinton or Bill Richardson gets the nod, it will be interesting to see if it begins a new, old tradition.

To Lend or Not to Lend, That is the Question

A day doesn't pass without a politician or pundit bemoaning the banking industry for not "doing more" to lend the money the government recently invested in leading banks.

What's stunning about this pressure is that it threatens to weaken the banks at the very time they need strengthening - as if the lessons of the financial crisis not only haven't been learned but are completely misunderstood.

Simply stated, the banks would lend the money if they thought it was profitable to do so. The only way you don't believe that is if you don't believe banks prefer to make as much money as they can.

If they aren't lending of their own volition but are pressured to do so, then they will be making loans that are at greater risk of losing money - and poor asset quality and underperforming loans are the proximate cause of the current financial crisis.

So we all have a profound interest in seeing the banks make good, sound loans. Anything less will drag out the crisis and delay the recovery.

What's happening is that the government's equity investment in the banks replenishes capital that was lost. Without the new capital, the banks would have to reduce the assets or loans they currently have outstanding.

So the government investment is increasing the amount of loans the banks can hold, as compared to not having the new investment.

And since the banks couldn't sell their current loans due to a lack of a market for them, the lack of new capital would likely lead to a run on banks and precipitate a true financial collapse.

And that's how a recession can become a depression.

So here's to hoping the banks become financially strong, soon.

Market Prices

On Fox New this morning, one of the hosts articulated what has become a common refrain regarding the financial crisis: criticism of the bonuses to be paid at the end of this year to bank employees. Paraphrasing Brian Kilmeade, he said, "It is crazy that Goldman Sachs and Morgan Stanley are going to pay $6 billion in bonuses at the end of this year."

If you watch the show, one gets the sense Kilmeade is a conservative, and this goes to show you that conservatives don't always (or for that matter don't often) understand free market principles.

It is very simple: if the banks pay below market compensation to its employees - many employees will leave, particularly the better ones. Yes, even in this market. If they are literally paid no bonuses, the firms would collapse. So does the departure of their best employees help these firms get out of their hole? Will this increase the chances of the government making money on its recent investments in these firms? Would you really prefer, and think we are all better off, if the people who ran these firms and filled their ranks were the employees who were attracted to below market compensation?

Of course not.

The flip side of this issue, paying above market compensation, can be seen at the auto companies - where the companies are teetering on the verge of bankruptcy in substantial part due to the above market compensation employees made in the past and today.

Market wages, like all prices, embed a great deal of information in them. Ignore them at your own peril.

Why this Blog

As the title of this blog suggests, its postings will be guided by the principles of the Declaration of Independence: the inalienable rights all of us equally hold, under a government established to secure these rights.

These words informed the basis of a revolution over two centuries ago, and have lost their importance as a guiding principle for public debate and policy today.

The scope of our governments' powers, and the existence of, and response to, the current economic crisis, sadly illustrate this all too well.