Spending as a Stimulus

It's very hard for conservatives to consider the possibility that government spending can stimulate the economy. Any Economics 101 text will illustrate that spending pushes the economy forward no matter who does the spending. The reason we debate tax cuts versus spending is not because one is inherently better than the other (if that were true, we should either stop taxing completely or let government do all spending), but instead because of the long-term impact of the spending versus the long-term impact of the tax cuts on a case-by-case basis.

If you gave each member of Congress $1B to go to their local casino and put it all on a single hand of blackjack, that would stimulate the economy. The problem with that approach is that we likely would not see much of an impact beyond the initial spend—it would be close to pure consumption. Similarly, we could give a 10% tax cut to every person in the country, but if all anyone is going to do is save that money, it will be completely wasted. 

All spending is not equal. When you spend money building a new transportation that enables workers from an area with excess capacity to an area requiring labor, you do a lot more for the economy than if you were to spend that money studying cow farts. When you drive tax cuts to small businesses who tend to re-invest excess cash as opposed to big companies who tend to pocket that cash, you do a lot more for the economy.

When comparing a tax cut versus a spending increase, you need to look at the big picture impact of the tax cut versus the spending increase. 

The best way to judge the impact of spending is on the macro-economic impact. Is the thing being spent on something that has limited or negative ROI for an individual business yet has a significant impact across society? Any program fitting this description is a good program for government to spend money on (and thus tax the populace OR borrow money).

The best way to judge the impact of a tax cut is to understand what the beneficiaries of a tax cut are likely to do with the money. If the tax cut is likely to go directly into investment vehicles, it's a good candidate for a targeted tax cut. To pay for a tax cut, you either need to cut spending OR borrow money.

The worst time to increase taxes or cut spending is during an economic downturn. During a recovery period, cutting taxes tends to be most effective in fueling a recovery because the recipients tend to be most interested in investing their windfalls. On the other hand, spending is much more effective in the middle of a pronounced downturn since individuals and businesses are shy about investing any excess cash during a downturn.

In fact, the current economic crisis is a perfect example of why tax cuts don't help as much during an economic downturn. There is plenty of capital to loan and invest in the market, but no one is doing it. There is too much fear and it is impacting investment. If we give a 10% tax cut right now to anyone, they will almost certainly pocket that savings. If, on the other hand, we spend $500M on a roads project, that will create a demand for capital from construction which will free up investment from banks and inject money into businesses serving the project and create jobs. That will in turn create confidence in the market and make it possible for capital to flow more freely.

For the long-term, hopefully the roads project is on a road we actually need and that will fuel long-term economic growth. Even if it is on a "Bridge to Nowhere", however, it will create a short-term stimulus that can hopefully create enough market confidence to free up capital and enable the free market to do its job.

The impact on the current debate on the stimulus plan is simply this: under the current circumstances, all else being equal, $1 in government spending will have a greater short-term economic impact than $1 in tax cuts. If spent on the right things, those spending increases should also have a greater long-term economic impact. Furthermore, the best place to cut taxes right now is on small and medium-sized businesses who are likely to re-invest whatever the economic circumstances. The closest thing we have to this mix is the Senate bill. It's not perfect. It has a lot of "sending Congressmen to the casino" crap in it, but it also has a lot of critical infrastructure spending in it. Under the current circumstances, almost anything is better than nothing.

Reign in the House Democrats

We all know that Republicans don't get the concept that you need to spend money on infrastructure and that spending facilitates economic growth.

What we have learned in the past two weeks is just how incompetent Democrats in the House are. I have always felt that Nancy Pelosi is the worst House speaker of my lifetime. Both in her failure to exercise the rights of Congress as an equal branch of government when she led the opposition party and now in her petty attempts to further liberal pet projects under the guise of a stimulus bill now that she is leading the majority party.

In the big picture, I think it's time for Democrats to kick her out of a leadership role. For today, however, it's time for the House Democrats to take their leadership from the Senate and pass the Senate bill as is. The objective right now is to kick into gear programs that will increase economic growth in the short term (now through 24 months), not to take care of all the problems we have in a single bill.

Let's look at the education component that has been removed from the Senate bill. House Democrats are all up in arms about this. If we were talking about an education bill, I would be upset. We're not. We're talking about a stimulus bill. Education is one of the most important things we can spend money on, and it's long-term ROI is unmatchable by any other spending or tax cut.

But it is very long-term. The only reason you try to force it into an economic stimulus plan is because the specific education spending you are proposing is questionable and cannot withstand scrutiny in an education bill. I fear that's what House Democrats are doing with many of these non-stimulus items.

The Rev. Warren Fiasco

For eight years, the United States has been ruled on ideological grounds by a President who promised to be "a uniter, not a divider". Instead of being a uniter, he consistently put ideologues in positions of power and actively sidelined anyone with divergent views. President Bush was not the President of the United States of America—he was the President of NeoConservative Americans and left the rest of us without any leadership at all.

President-elect Obama has chosen a man with views I cannot stand to perform the invocation at his inauguration. Many on the left are outraged at this selection. I think it's a great selection. President Obama is showing that he will be a Democratic President of America, not a President of Democratic Americans.

This inauguration does not belong to Obama or those who voted for Obama. It belongs to every single American, from progressives like myself to fundamentalist evangelicals like Rev. Warren. Everyone has a place at this inauguration.

Liberals who are outraged at the selection are no better than George Bush and Dick Cheney.

Proposal for GM

So I am against a bailout. What's the solution to the problem?

Those supporting a bailout are right about one thing: GM is too big to fail.

The bailout is wrong because it is not a mechanism for keeping GM from failing, only for putting off the failure and dragging out the pain of failure.

GM is a bad company run by incompetent management and burdened by absurd union contracts. It needs to shed its management, rip up its union contracts, and be broken into smaller pieces to succeed.

Bankruptcy won't make that happen. This situation is not the kind of situation in which a company enters bankruptcy, reorganizes, and comes out leaner. This situation is a liquidation event. Either way, good companies that have been serving GM will be put out of business because they won't see a dime of money that GM honestly owes them.

A bailout, however, has two equally bad paths:

1. It will perpetuate bad management practices and leave in place labor contracts that make no market sense. 
2. The government will put strings on the bailout. You know what's worse than bad businesses people managing a company? Government managing a company. 

There is an alternative. A bailout of the workers and vendors that have done nothing wrong while throwing out the management and bad corporate structure that made this situation possible. Here's how we do this:

1. Let GM enter Chapter 11 or Chapter 7. 
2. Any vendor or other creditor who is validly owed money at the time of bankruptcy will receive a government backed loan for all amounts owed by GM to them.
3. Any GM worker laid off will receive 6 months severance from the government.
4. Any GM worker without a college education or who has worked for GM more than 10 years will receive government paid education to re-skill themselves.

As a result, vendors and workers will receive reasonable protections against the bankruptcy, but the company itself will be broken up and its assets restructured in accordance with the market. The market-based restructuring will enable new companies to emerge than can make the US automative industry competitive again.

Let the Big Three Die

All of the consequences of GMs failure that proponents of a bailout use to argue support the bailout idea are true. If GM fails, people are out of jobs, good companies that have done nothing worse than offer services to GM will suddenly be saddled with bad receivables and the prospect of not making payrolls, and the state of Michigan will plummet in despair. 

But those arguments do not justify a bailout. Ford, GM, and Chrysler are poorly run companies with bad products. They have not continued to operate over the last 20 years by innovating and meeting consumer demand; they have remained in business by chaining the state of Michigan to their well-buying and spending money lobbying the US government for regulations that favor the folly of their product offerings.

Few industries have the luxury of seeing a trend coming for 30 years. The auto industry has had that luxury. We have all known that the price of gas would eventually go through the roof (and it will again). Japan, Germany, and the other auto-making countries recognized this and have a number of different products on the road today to match that need.

But not Detroit. 

In the past election, we had a number of silly discussions about "socialism" and "capitalism"—as if a 4% difference in tax rates on the highest 5% of income earners was somehow that dividing line. Bailing out the Big Three, however, is actual socialism. The worst of socialism. It says that employing people is more important than the value they add to our society. It also ignores what we know is a failure of socialism: if you save a job today that should not be saved, you will have to save it again tomorrow, and the next day, and the next day. And they will become less and less worthy of having a job as time goes on.

So, the bailout people have clearly illustrated a short-term impact. It's devastating and real.

Here's the long term outlook:

GM fails and sells off its assets, probably to a foreign car marker or a silicon valley company. Ford fails and sells off its assets. Chrysler sneaks by. Michigan goes into a severe depression and hordes of people leave Michigan for good. The auto-makers no longer control Michigan politicians and, amazingly enough, Michigan finally diversifies its economy. It learns how to survive without the auto-makers and eventually starts to see a prosperity that is actually earned prosperity. Detroit is no longer the cesspool of the nation.

On the other hand, if the Big Three are bailed out, we will save some jobs (there will still be a lot of layoffs), executives will get their golden parachutes, and we will be back in this position again in the future. You know why? Because these are bad companies. They must fail.

And if they truly are too big to fail, they must be broken up.

A Solution to the Financial Crisis

I am increasingly certain the proposed bailout is dangerous.

As long as it is the only solution on the table, however, you cannot throw rocks at it. A lot of people are throwing rocks at it without having the guts to propose an alternative.

Here's an alternative:

• Freeze all ARMs at their current interest rate level or 10%, whichever is lower.
• Pay off mortgages that exceed 80% of the current collateral value down to 80% of the current collateral value (if a home is worth $200K and you owe $210K, the government will pay your bank $50K and bring your balance down to $160K).
• Increase tax rate of 2% on anyone making more than $150K/year who benefitted from the mortgage payoff for 25 years. This extends to people who are not making $150K today but make it in 5 or 10 years; and it is dropped for people who have their income drop below $150K during that time frame.
• Refinance at current prime all mortgages under $250K for people making less than $100K/year and a 2-year history of being no more than 30 days behind on payments.
• Convert all interest-only real-estate loans less than $500K to 30-year, prime loans.
• Ban ARMs and interest-only loans.

The problem with the Bush administration solution is that it is very inflationary, it rewards bad decisions on Wall Street, and does nothing about the cancer causing this crisis—the plummeting home values.

My solution rewards no one. Everyone who took on a mortgage will still have their mortgage. Everyone who made a bad loan is still reliant on the people paying the loans to make their payments. However, everyone gets a free pass on the actual extraordinary event (the financial hurricane): the massive drop in home values.

As a result, many people who were in a bad position because they were underwater on their home values are all OK. The financial institutions at risk because of this situation will have an injection of cash and a reduction in risk profile. This injection of cash will create new capital that can go into the markets (the whole point of the Bush bailout).

Now, just buying out mortgages so they are not underwater does not address other nasty problem: risky loan instruments. If you could not pay your loan payments at 120% you home value, you probably still cannot afford them at 80%. The reason is because banks created goofy mortgage products that were once affordable for these people but have become completely unaffordable. So, the rest of my proposal addresses two key culprits: ARMs and interest-only loans. Turn them loans into loans people can afford. Reduce the risk profile of the institution and let people keep their homes.

The thing that kills home values is foreclosures. This proposal results in:

• A significant reduction in foreclosures (thus preserving home values)
• An injection of cash into financial institutions that can be used as future capital for investment
• Minimal regulation that prevents the greedy lending habits that created this crisis
• Everyone still be responsible for their own decisions—both Wall Street and Main Street
• It should be much less expensive for the government, meaning fewer new taxes and a lower risk of inflation (it is still an inflationary solution)

Analysis of the Economic Crisis

This economic crisis is every bit as serious as its being billed. The bottom line: if nothing gets done about this situation, no one will lend money. Period.

I know there is a minority of anti-fiat money people who think that is a good thing; but the reality is that it is a horrible thing.

You know in the good ole days the ads that said, "Bad credit? NO PROBLEM! You're approved." Today, those will read, "Good credit? DOESN'T MATTER! WE WON'T LOAN YOU A DIME!"

Why?

To put it simply, our lending institutions don't have the capacity to lend any more money. All of these "trash debts" on their balance sheet have diminished their reserves and put them at great risk. They just can't lend any more money unless the following things happen:

1. They increase their cash reserves
2. They decrease their risk profile

So what happens? Perhaps the most critical things are that:

• Big businesses don't have the cash to operate properly
• Small businesses can't get loans to make payroll or expand
• Individuals cannot buy houses or cars

Net result: an economic downward spiral

Individuals stop buying houses because they cannot get loans. Housing values decrease. Loan defaults increase as more and more people are upside down on their mortgages.

Small businesses simply go out of business because they cannot make payroll. New businesses cannot start (as an aside, one of the saving graces of a traditional recession is that people losing jobs start businesses that inject economic growth into the economy; that won't happen here because people losing their jobs won't find capital).

Big businesses that normally can borrow their way through economic downturns suddenly find they have no place to find capital. They cut jobs dramatically or go out of business.

HUGE job losses.

In short, we are honestly talking economic catastrophe. And I don't see where we recover. Eventually, I believe in America and believe we would recover. But this is Depression-style badness.

The Proposed Solution?

Any solution must create a health financial system capable of providing capital for economic growth. In other words, that has to be the end objective to deal with the short-term crisis.

Obviously, a long-term solution needs to include checks against lending the protect against over-exuberant lending to high risk customers as well so we don't end up in the same bucket the next time we have a real-estate bubble.

The proposed solution involves having the government buy off these "trash debts" at a fairly absurd price. For whatever reason, Paulson has proposed buying these things out at above the institution's carrying price (the carrying price is what the bank values the debt at on its balance sheet). The market price is well below that rate. For some reason, Paulson claims the market price undervalues these debts. I think that's bullshit. The market price is the right price.

At any rate, the government buys these debt instruments and then collects the payments. In an ideal world, everyone ends up paying back their loans and the government makes a profit. If the rate of return on the profits exceeds the interest the government is paying to borrow all these money, the US government ends up making a net profit.

In the mean time, the financial institutions are relieved of the burden of these risky debts AND they have money to loan into the economy.

Good news?

Well, three problems:

1. As mentioned above, Paulson is currently seriously overvaluing the debt. As a result, the government will overpay for these bad debts. That means more interest the government is paying on the money it is borrowing, and the harder it will be for the taxpayer not to get saddled with higher taxes to pay off this loss.
2. That's a lot of money being injected into the economy outside normal channels. I honestly fear two things:
   1. Inflation will kick in
   2. The Fed will have to hike interest rates a lot, thus making capital hard to get!
3. The proposal as I understand it now lacks important checks and balances. As a result, there is a lot of opportunity for corruption. If you are a Republican and don't care that Paulson has absolute authority over $700B, keep in mind it could be a Democratic appointee in the near future with that control. Either scenario is untenable. Beyond the risk for corruption is simply the risk of incompetence. Even with the best intentions, $700B in the hands of incompetents without any oversight is a bad thing. And finally, without tying any strings to this buyout, we risk these financial institutions turning around and making the same stupid mistakes.

Who is to blame?

Everyone is to blame. Not simply Republicans and Democrats. Managers and home owners, farmers and financial gurus.

It does start with the relaxation regulations governing financial institutions that began in the 1980s. These regulations were put in place in the 1930s in response to the excesses that caused the Great Depression.

Remember, in the 1920's we had a rapidly expanding economy with little regulatory oversight over financial markets. The result of the two things combined helped cause the Great Depression (among many, many, many other causes).

Fast forward to the 1980's. We relax many of the regulations meant to prevent another Depression. That relaxation continues through the end of the 1990's. In the mean time, we have an amazing period of economic growth.

So, what happens? Lots of capital is sitting in our financial markets as a result of rapid economic growth. Low inflation means that the cost of lending is low. And the lack of oversight combined with phenomenal growth in real-estate values makes financial institutions more and more willing to accept inappropriate loans (the real-estate values are key; they create the illusion that the loans are less risky than they really are).

So, now combine lack of regulatory framework with bad business decisions.

And add to that bad personal finance decisions. People are accepting way too much debt because they believe their home values will double in 5 years or something stupid.

So, we have:

• Lack of regulatory framework
• Rapid economic growth
• Rising real-estate values
• Low inflation
• Bad business decisions by financial institutions
• Bad personal finance decision by individuals

Remove 1 from the mix, and things are likely not so bad. Mix up the cocktail, and BOOM!