A New and Improved "Rescue the Economy" Plan

The US has managed to get itself in a no-win situation on many fronts. Try the usual trick of fiscal stimulus to combat a downturn, and our friendly foreign funding sources are likely to take a dimmer view of Treasuries. Higher interest rates (in a worst case scenario, a dollar crisis) could easily counter any boost provided by injecting more money into the economy.

Now we have written before that we think that the costs of preventing recessions are underestimated, but we may find ourselves in a considerably-worse-than-garden-variety recession, so Extreme Measures may be taken, like it or not. And if things deteriorate considerably, they could even turn out to be the least bad option.

Thus, if one is going to consider borrowing, investing in productive assets and projects not only provides income that will hopefully cover the cost of funds, but can also produce intangible benefits. For instance, it would behoove the US to take the lead in clean energy, not only because it is a growing market, but it would provide positive externalities (a better environment) and would help the US maintain its image as a technologically advanced, innovation-oriented economy.

Felix Rohatyn and Everett Ehrlich in today’s Financial Times suggest a program of fiscal remedies focused on what they consider to be the America’s big needs, with infrastructure front and center. It is more a discussion of priorities and a list of ideas that they consider promising than a definitive proposal. Consider it version 2.0 of the “rescue the economy” program.

From the Financial Times.

Ben Bernanke, Federal Reserve chairman, this week alluded to an economy facing “numerous difficulties”. In fact there are only two, but each alone is cause for genuine concern over the US economy’s prospects: first, an implosion of the financial system triggered by the teetering housing market; and, second, record prices for oil and other commodities that are largely driven by events abroad.

Policymaking in the past year has shuttled ineffectively between these two fronts. One day all eyes are focused on the prospective collapse of Fannie Mae and Freddie Mac and the next day we are pre occupied with the prospect of $200, or $500, oil. It is time to devise a programme to promote overall economic recovery by fighting for the economy’s future on both fronts simultaneously.

Six months or so ago, the Bush ad ministration and Congress approved a plan to provide about $200bn (€126bn, £100bn) of temporary economic stimulus aimed at the consumer. But this seems likely to fall short of bringing about a turnround. House Democrats are said to be weighing a package of tax rebates, spending and revenue-sharing along the lines suggested below. Well, they should – we must consider a broader government-financed programme with a greater focus on long-term investment.

If the government is going to stimulate the economy, it should start by expanding investment. Senators Christopher Dodd and Chuck Hagel have submitted a bill providing for the creation of a national infrastructure bank, which would provide assistance to state and local governments to inc rease investment in infrastructure. With an initial capital base of $60bn and the ability to insure the bonds of state and local governments, provide targeted and precise subsidies and issue its own 30-50-year bonds, the bank could easily provide $250bn of new capital to invest in local infrastructure over five years, which would also create several million new jobs, just as the domestic recession threatens to gain momentum.

At the same time, the federal government could initiate a revenue-sharing programme of as much as an additional $250bn to state and local governments to maintain service levels. Assistance to local schools should be a priority. Alternatively, some of this amount could be used to fund a partial Social Security tax holiday for employers, in order to maintain job creation.

On the financial front, the Treasury’s proposal to salvage Fannie Mae and Freddie Mac is a good start and may solve the problem. But we must be prepared to take further steps if needed. One option would be to design terms on which the Treasury would create “certificates” that would be swapped for conforming mortgage assets up to a predetermined percentage of banks’ capitalisation, together with a schedule for swapping these certificates back to the Treasury over the next three to five years. This would give banks breathing space to meet capital standards while the housing market stabilised. The prospect for government participation in any upside could parallel the Chrysler bailout that worked quite successfully almost 30 years ago.

A pervasive lack of confidence in our economy and our government is as serious a threat as a deterioration of the balance sheets of our financial sector. More over, a stable financial system is as important to renewed economic growth as is any fiscal stimulus, much as confidence in sustained aggregate demand is as important as balance sheet integrity to the financial system. But we should learn from our mistakes and act pragmatically to regulate markets as they exist in fact, not theory. The repeal of the Glass-Steagall Act, coupled with cheap money and tolerance for ever greater risk, led to this situation. Unbridled use of short-selling can be destructive of value and contrary to growth and investment. Speculation may play a role in the rise in commodities prices and, if so, risks more pain if the commodities bubble bursts.

A presidential election should not keep us from dealing with these problems. A powerful bipartisan programme of fiscal stimulus, financial restoration and regulatory vigilance should be considered. Such a programme could help us to avoid the worst recession in almost 30 years.

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8 comments

  1. Anonymous

    Higher interest rates (in a worst case scenario, a dollar crisis) could easily counter any boost provided by injecting more money into the economy.

    Not convinced.

    The core problem of the US economy is the orgy of bad debt indulged for the past 7 years and its broken, untrustworthy, “pass the buck” financial system. I’m not a fan of the late, unlamented Andrew Mellon but there certainly is purging of some sort or another that must be done at one point, meaning higher interest rates.

    Or we’ll stay stuck in zombie land.

  2. Gegner

    What are these clowns smokin’?

    Where is the money to carry out their proposals supposed to come from?

    Worse, who in their right mind thinks for one second that any such endeavor will not be ‘prototyped’ here but manufactured in the ‘cheaper there’?

    We’re already on the brink of a ‘dollar meltdown’…I’m sure ‘printing more’ will help this situation bring our civilization crashing down around our ears!

    These two are either very young, economists, or both!

  3. Independent Accountant

    Felix Rohatyn was an architect of the New York City “bailout” of the 1970s. He was a partner in Lazard Freres. I bet he must be about 70. His answer has been consistent for decades: spend more.

  4. Michael McKinlay

    There is only one way to save the economy.

    Restructuring entire systems … the tax system to reflect the current unfairness of rates and loopholes. The financial system around a Public Central Bank that arbitrates all credit with interest rate differentials , produces money and credit without debt and allows the interest rate to float. A total revamp of our trade system, based on reciprocal trade so that deficits don’t come about.

    Unfortunately corporate influence will never allow this to happen until the country is in dire shape when it may be too late to salvage what’s left of our current economy.

  5. Steve

    anon of 2:55AM:

    Manufacturing is only 11.7% of GDP (2007, source: NAM). The J curve won’t describe the effects of a lower dollar these days.

    Like a lot of other fixes being floated, Rohatyn’s proposal is what I call cargo cult economics — the repetition of past solutions without any recognition that we’re living in a different world.

    Government has been stimulating the economy uninterruptedly since the Depression, to the point that the US can’t pay the bill even when the debt-driven economy appears healthy. That continuous stimulation has bought a lot of votes over the years; now it’s part of a system that needs to be fixed, rather than being an exogenous force to jump-start things.

  6. Thomas

    “In fact there are only two[difficulties]?”

    Can I add a few more?

    Food inflation
    Healthcare spend being a totally ridiculous % of GDP in relation to its productivity.
    Military spending ditto.
    Widespread incompetence and corruption in the administration(s)…

    This isn’t supposed to be an exhaustive list.

  7. Richard Kline

    The concept of an ‘infrastructure bank’ which issues it’s own long term bonds is not a bad one. Something of the kind was on my mind as well when I suggested the return of the forced loan, i.e. capitalizing such an institution directly from the public rather than more expensively from the capital markets, and boosting actual saving by the public as well.

    I’m not so keen on these ‘Treasury certificates’ mooted by the Titanic Tandem. This is, to put it bluntly, a direct bailout of insolvent banks’ bondholders. The banks are bust; their bonds are toast; giving them Treasury money to play with, putatively at a profit which ‘re-capitalizes’ them, just means that the banks bondsmen get paid off—out of the Treasury. Rotten thought. Look, why don’t we take those Treasury $$$s and JUST CAPITALIZE ENTIRELY NEW AND UNENCUMBERED BANKS. As they turn profitable, they repay the Treasury, same concept but with out the bailout for busted investors. Yes, this would provoke runs on the likes of WaMu and HSBC: boo-hoo for them, they’ve played the game like duffers and they can get written off.

    Re: the dollar, I don’t think that we will see a dollar crisis as a result of foreign governments ‘dumping dollars.’ How? They ARE the market for Big Dollar Debt, so who would buy? Dumping the dollar would be perceived as a hostile act domestically, but also would draw the ire of all other major dollar holders for killing _their_ stakes as well. No sovereign holder of big dollar debt is going to dump; it’s not even clear that they can slow down their acquisitions. The threat to the dollar comes from private acquireres. The dollar tanks if at some point some large buyer says, “So sorry, but I can’t take dollars for this transaction. I can take currency X, currency Y, currency Z; I can take oil futures; I can take diamonds. I cannot take exposure to a fading dollar, though, unless a premium in the above forms is included. So sorry.” In the Spring, we heard whispers of this. Not coincidentally, in my view, that was the time the Fed and the Treasury started to get wild and crazy in their auctions and interventions. Will this happen? Couldn’t say, but when and as hemorraghing zombie banks start dissolving we’ll find out.

    I’m with Steve above as well that the US has been ‘stimulating away’ for two generations and recklessly so for over close on thirty years. More stimulus may buy us a few more years of baubles but we need to start generating some real value and real profit if we are going to keep from defaulting on our mountain of external debt. Not even live well or better, but avoid defaulting. And no proposal raised in the article leading off this post, with the possible exception of ‘leading the way in clean energy’ which is completely speculative and thus something of a chimera, involves any real profitmaking value added. And that is the real problem. If we don’t start making some real profit, we will all start living much smaller: Those are the only two real choices. And nobody employed in FIRE adds any real value.

  8. jstanley01

    For instance, it would behoove the US to take the lead in clean energy, not only because it is a growing market, but it would provide positive externalities (a better environment) and would help the US maintain its image as a technologically advanced, innovation-oriented economy.

    Eric Janszen in a Harpers article agrees. “Clean” energy? It’s The Next Bubble.

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