TCS Daily


An Economic Memorandum for the Next US President

By Desmond Lachman - September 18, 2008 12:00 AM

Over the next two months, Senators John McCain and Barak Obama will be engaged in the final stages of their electoral race for the White House. In the heat of the campaign, one must hope that the candidates do not lose sight of the fact that the next president will be inheriting the most difficult US economic situation in the past seventy years. With a view to underlining the enormity of the next president's economic challenge, I offer below the sort of economic memorandum that he is likely to receive from his economic advisers as he begins preparing for his inaugural address to the nation on January 20, 2009.

Mr. President, our in-depth assessment of the economy reveals a very much more disturbing picture than we had anticipated during the electoral campaign. Of particular concern are the abrupt weakening in the labor market, the acute stresses in the financial system (as underlined by the failure of several important regional and investment banks), the continued swoon in the equity market, and the plumbing of new all-time lows in consumer confidence.

This situation dictates that the economy must be at the front and center of your inaugural address. In this respect, you might wish to model your address on FDR's 1933 inaugural speech in the sense of aiming at bolstering confidence and affording a bold new vision to the American people as to how this difficult situation is to be turned around.

At the heart of today's economic crisis is the continued rapid decline in home prices at the national level. For not only do falling home prices erode the main source of the average American's wealth and financial security. They also compromise the solvency of our banking system. That in turn is now causing the banks to aggressively cut back on lending at the very time that the economy most needs such support.

For eighteen months now home prices have been falling at an annual rate in excess of 15 percent. Yet home prices show no sign of stabilizing. Unsold housing inventories are still at record levels and the foreclosure rate has now risen to an annualized rate of over 3 million homes. With more than one in three households now having negative equity in their homes, there is the very real danger that the foreclosure rate will continue to increase.

Simply allowing the housing bust to play out is not a viable policy option since it runs the real risk of creating adverse feedback loops that could be highly damaging to the economy. This is not meant to imply that there are easy policy options to putting a floor to the housing market bust. However, it would seem urgent that bipartisan support be found for building on last year's Chris Dodd-Barney Frank initiative to reduce housing foreclosures, while serious thought should be given for a temporary revision to bankruptcy procedures as far as they affect homeowners. You might wish to model your initiatives in this area on the Home Owners Loan Corporation of the 1930s.

A second major economic policy area in need of immediate attention is fixing the broken US financial system. Not to put a fine point on the matter, the US banks' egregiously bad past lending practices have resulted in a wide swathe of the US banking system being either insolvent or grossly undercapitalized. Japan's sad experience during the 1990s would suggest that simply allowing the banks' bad debt problem to fester is a sure recipe for losing an economic decade.

If bank lending is to be normalized, there would seem to be little alternative but for government intervention in the banks along the lines of the Resolution Trust in the 1980s Savings and Loan crisis.  One should not minimize the likely considerable cost to the US taxpayer of such intervention. However, the alternative is to have sub-par economic performance for many years. In the interests of both equity and minimizing moral hazard, it is imperative that any government intervention in the banks be conditioned upon the wholesale replacement of the banks' management and the total wiping out of the banks' equity holders.

A further issue in need of immediate attention is trade policy, where a slowing global economy has spawned a disturbing resurgence of trade protection both at home and abroad, as underlined by the recent failure of the Doha Round. If we have learnt anything from the 1930s, it is that the world can ill afford a turning back of globalization at a time of global economic weakness. The United States remains the only country in the world that can provide leadership for the maintenance of open world markets and your inaugural address provides the perfect opportunity for you to set the tone on this issue for the next four years.

I fully recognize that during the campaign we focused on the need for longer run reform of our tax system, energy policy, our entitlement programs and our health care system. Important as these issues are they should not be allowed to detract from the immediate task at hand of forestalling any deepening in our present economic crisis.

May I conclude by sincerely apologizing for not having broken the bad economic news to you earlier last year? However, I fear that had I done so you, might very well have lost your appetite for the job you have so single mindedly sought.
Desmond Lachman is a Resident Fellow at the American Enterprise Institute.

This article originally appeared in Handelsblatt.

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27 Comments

Open the borders
Let everyone in, not just the poor, but the wealthy and entrepreneurs from all over the world.

They will bring money and they will need a place to live.

and go belly-up for sure
Marjon, the wealthy don't tend to move, they just buy seasonal homes if anything. the entrepreneurs will come, especially when the bottom falls out, great opportunity there. No, 99% of those who will come will be poor. They can't afford a home, will put even more pressure on sagging labor markets, even more pressure on services and infrastructure.

The next president will already be too late! Even so, he needs a whole host of finacial wizzards to sort through the dos and don'ts (mostly don'ts) to try and fend off a major implosion without extending a resession or depression.

The real question is why? It is not all sub-prime mortgages, though that was the kicker that began the spiral. I see several instruments at work here.

First and foremost is the government. Since FDR and the Great Depression the government has used deficit spending to prop up the economy and "help the poor". This was not an open ended and sustainable strategy and economists have worned us of this for decades. Government regulation has become intrusive and not regulatory, creating another burden for business to overcome and taxation has often been a serious burden creating more pressure on business.

Then there is corporate greed and, yes, monopolistic mergers. Now there are enitrely too many companies "too big to allow to fail" who are paying the CEOs and top management obscene wage and benefit packages in spite of negative business practices. The chickens are coming home to roost and the taxpayers are being force to foot the bill through an already bankrupt federal government.

Finally come the unions who have for years been driving the manufacturing bus off a cliff. Now they are going to find a whole lot of their people out of a job as the companies downsize or go under. If they would have negotiate pay cuts and plant technology improvements a decade ago they could have actually provide more and better paying jobs in the long run.

I expect to see unemploymentclimb to near 10% by the time this is over; perhaps even higher. The Stock Market will lose 30%-40% of it's high level value. Finally, taxes are going to go up, welfare services are going to have to go down and the budget will have to be balanced. The government must pull back to basic oversight and foster a new sense of competition to get the entrepreneurial engine reved up.

The good news - rural America will be the least hard hit and may actually see gains through all this. The opportunities will be limitless as we begin to see an upswing and we may, in the end, actually see comparative deflation as all the markets, and government budgets, come into true balance.

All of this will come to pass, in some combination, no matter what anyone does. The big question is how long will it take? The answer is a long time if the government keeps propping up failed businesses and trying th fix this.

The actual value of the Dow is about 70% or less of it's current declining value; we still have around 20 million at-risk mortgages outstanding that must either fail or be reconfigured; there is still no oversight and too much government interference; unions are still hanging on to their old way of doing business. All of these conditions must be reversed before there will be a real recovery.

better advice
How is this advice any different from the advice that he would be getting from all the other economic advisors out there?
How about this advice: Dear Mr President: your job description, as laid down by our founding fathers, has absolutely nothing to do with trying to “steer”, “control”, “manage”, or “stimulate” the economy. In fact, the reason we have this so-called “economic crisis” right now is because government has been trying to do just that – control the economy. The economy is just a big word we use for describing the fact that people buy and sell products and services. Who they buy from, and sell to, how often, and at what price, should not be a concern of the United States government. There is a reason our founding fathers did not create an economic branch of government.
The fact that prices of goods and services (and the price of borrowing money) fluctuate is NOT a problem. This is precisely what prices are supposed to do. By fluctuating, they send signals about supply and demand, risk and reward, and allow people to make wise decisions about what is efficient and what is not efficient, without ever knowing the specifics. When I buy the cheapest pencil on the shelf, I reward the most efficient pencil manufacturer without even knowing his name. When government interferes with this process, in order to purchase the political favor of constituent groups, or to stimulate artificial growth or investment, it is interjecting faulty signals into the data stream.
The reason we are in this “crisis” is because we continue to interject noise into the signal. Then, when the signal gets corrupted, we try to correct it, by adding a counter-signal. Of course, all we are doing is adding more noise, so that the natural signals (the price of borrowing money, as set by the free market exchange between lenders and borrowers - uncorrupted by Fannie May, FHA, Federal Reserve, etc.) become increasingly drowned out. If we let the market correct itself, we may see some wild swings, as the market adjusts to recent changes, but we will have a chance at re-establishing a proper free market, and eventually reach equilibrium. (Not STABILITY, which seems to be everybody’s stated goal, but EQUILIBRIUM, which is a system in temporary balance, but ready and able to respond to proper stimuli.)

Zyndryl's Advice
Forget all that hokum. All we need to do is:

Abolish the corporate income tax
Give notice that the next hurricane or flood that comes along and wipes out your house that the government ultimately insures will mean that you've sold said house (and land) to the government if you want to be bailed out again (and for the last time).
For the FED: Peg the monetary supply so that the dollar price of gold remains nearly-constant. Give up targeting 'interest rates' and let those be set by the market.
For the FED, Part II: Require the Fed to transition from backing the currency with government debt to backing it with loans collateralized with hard, PRODUCTIVE assets (farms, factories, utilities, mines, etc) instead.
Get out of the mortgage business as well as the business of subsidizing mortgages.
Send out a letter to all citizens in all languages necessary that simply says, "We are the government, not your mother. Start voting like you know that."



Of the above, #1 is the most important thing we need to do if we truly want to increase the capital-labor ratio enough to lower unemployment and raise real wages, much like the Irish did. #3 and #5 are second on my lists of requirements.

#2,#4 and #6 fall into the category of 'real good to have but a pipe dream to ever expect'.

The wealthy move to where they can keep their money.
When Switzerland charges a maximum tax to live there,say $100k, the rich do move to Switzerland.
Before Hong Kong was turned over to China, many of the wealthy moved to Vancouver, BC.
Wealthy entrepreneurs want to live where they can entrepreneur and have their wealth protected from confiscation by the government.

Hokum Shmokum
Upon cursory glance your comments seem reasonable to me -- however, since I'm still somewhat dazed by the flurry of TCS articles posted of late, my judgement could very well be impared . . .

Am I waving the Red flag in front of the Bob Joneses and Roys of the world by posting this?
http://www.investors.com/editorial/editorialcontent.asp?secid=1501&status=article&id=306370789279709&secure=12

No, they move their money there
They may buy a house there (if there is a residency requirement of some sort), but they live where they want. They move their money into investment houses in locations where it is not confiscated.

Investor's Business Daily . . .
. . . continues to be a reliable fount of sanity and reason in this kneejerk socio-political climate.

Read this as well...
http://www.realclearmarkets.com/printpage/?url=http://www.realclearmarkets.com/articles/2008/09/congress_must_stabilize_the_do.html

He blows it on describing the limitations of the old gold standard, in my view. But he gets it correct on how we should do it TODAY.

Notice how his proposed bill is exactly how I've been describing on TCS this past year or more how it should work? (ahem!)

McCain is finally hitting Obama straight on regarding this mess ,too!
http://blog1.thejtandbearshow.com/2008/09/18/video--new-mccain-ad-advice-hits-obama-for-ties-to-fannie-mae.aspx

Of course, Roy & Rob will either claim it is all untrue or say it is a silly 'lipstick on a pig' distraction, I bet.

"locations where it is not confiscated. "
Hint, hint to politicians.

That's why I said that he didn't correcty describe the old gold standard
As for 'stimulus', he's just using the correct buzzwords to get his bill passed. However, having truly sound money for the first time in 35 years would stimulate GDP growth, that is for certain.

"In order to increase the amount of money in circulation, you would have to increase your reserve of gold. Maybe Poe's saying the same thing;"

No, he's not saying the same thing and we don't need reserves of gold. The 'standard' is really a price rule for the dollar to be maintained at. If the dollar price of gold rises above the target price (say $500/oz) then the Fed has to remove enough dollars from circulation to get it back down. If the dollar price of gold drops against the target price, then the Fed has to add more money into circulation to align the price back again.
Of course, after establishing a reputation for a willingness to do this and after a couple of currency manipulators like Soros burn themselves in futile attempts to try to counteract it -- the market will not stray from the target price much anyway. The Fed won't have to do much at that point. Poe alludes to this but doesn't do well in adequately describing it, I think.

As I said, no gold reserves are needed. If someone WANTS to actually convert dollars for gold, they can the buy it on the open market. The Fed's only job is to guarantee dollar-gold price stability over time so the gold you bought is worth the same amount in dollars 5, 10, 50, or 100 years later and vice versa. It is that assurance that will make the dollar 'strong'. That's where the old phrase 'as good as gold' comes from...and why that phrase isn't uttered much today.

The "AHEM" is a reference to how I've been writing about this exact issue for about two years now on TCS. NeaRNoaD & Marjon are familiar as well as with it.

Roy likes to trash it either because (a) he still doesn't get the process no matter how many times I explain it to him and incorrectly believes how it will work/not work or (b) gets it but doesn't want to ideologically accept it and/or (c) just likes to purposely push my buttons by switching from (a) to (b) and back again.

Regarding (b), Roy of course thinks the economy should be manipulated and 'pump-primed' by Wise Men and so is against the dollar being 'straight-jacketed' by a hard price rule against just about anything -- especially William Jenning Bryan’s 'cross of gold'.

Pointing out empirical evidence to him that clearly shows that price stability was far superior with the gold standard is blatantly ignored. Roy's 'inner economist' is Paul Krugman, apparently.

So..."AHEM!"

I like it
"What matters about money is not its quantity but its value. In this, dollars are no different than foot rulers. No one cares how many foot rulers there are in the world. What matters is that each one is the length prescribed by the U.S. Bureau of Standards."

That is exactly right. What is money, anyway? It is a way of keeping track of debts, or "favors".

A car costs more than a motorcycle because the cumulative amount of work that goes into creating a car is much greater, so making a car for you is a very BIG favor. By paying for the car, you show that you have earned this big favor, having already done many other favors for other people, and you cash in all those favors by giving all those I.O.U.s (dollars) to the car salesman.

Our government has declared itself the monopoly printer of I.O.Us (legal tender). This is a nice position to be in, because whenever an IOU gets lost or destroyed, they get to print a new one. And instead of just giving it out, they can trade it for favors. Thus, every dollar you lose/destroy is a dollar you give to the US government.

Of course, they don't really HAVE to wait for you to lose your old IOU before they print a new one, do they? They could just print new ones now, and cash them in before they are required. Thus inflation.
So, how many dollars should they print each year? The answer is "enough to cover the lost/destroyed dollars, and enough to meet the annual increase in demand due to population growth. If you print less than that, the dollar becomes scarce, and the value of the dollar goes up. If you print more than that, the dollar becomes abundant, and the value of the dollar goes down.

OK. I'm sorry. I'll stop. I sound like I'm giving an economics lecture to a 5th grader. To the point - the government could easily control the value of the dollar by controlling the amount of dollars released for circulation (printed and/or lent). Thus, it would be quite simple to create an equality between 500 dollars and one ounce of gold. The US gov need not hoard gold, and promise to trade dollars for gold on demand, like they did when the dollar was backed by gold. All they have to do is resist the urge to print money to pay their own debts.

Need to also resist the urge to control our lives.
"Yet much of the current chaos is the result of attempts to steer or control markets rather than let them be. Much of the chaos is the result of political failure.

In the wake of Hurricane Ike, customers wait in line for hours to buy gasoline, the inevitable result of anti-gouging ordinances that discourage retailers from raising prices and letting markets clear.

Ethanol mandates and subsidies try to create less carbon in the atmosphere than the market would create on its own. The result has been a worldwide increase in the price of corn that has hurt poor people around the world. The environmental benefits are negligible.

The turmoil in the housing market and the resulting financial crisis is just the latest example of political failure. Politicians wanted more home ownership than the market produces on its own, especially among low-income families. To encourage this politically popular goal, Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ) were allowed to privatize their profits and socialize their losses. At the same time, Housing and Urban Development (HUD) required them to expand their commitment to affordable housing. Freddie and Fannie achieved this goal by buying bundles of subprime mortgages."

http://www.forbes.com/opinions/2008/09/18/market-organic-regulation-oped-cx_rr_0918roberts.html


Since the government has screwed so many things, what gives you any confidence the government can 'control' the dollar?

Which is why Roy hates the Gold Standard
"Thus, it would be quite simple to create an equality between 500 dollars and one ounce of gold. The US gov need not hoard gold, and promise to trade dollars for gold on demand, like they did when the dollar was backed by gold. All they have to do is resist the urge to print money to pay their own debts."

No more 'pump-priming'. No more Great Societies. No more Fannie Mae and Freddie Mac in the first place, either.

If the government went on that standard, they would HAVE to resist the urge. For one thing, it would be law and one that would be actually effective at that (which is why they resist it). For another, it would be far, far more difficult to hide any monetary chicanery like they do presently. They would get caught and the market would punish the dollar with extreme prejudice. That, in turn would punish the politicians' Main Piggy Bank with extreme prejudice. (forget about you, me and the dog taking a wee on Main Street -- the politicians most certainly are forgetting about all that and have been for some time).

I don't like the gold 'standard'.
I do like the idea that the government can't control the value of money.

The government can do what you suggest now by controlling the money supply to keep its value at $500/oz Au.

Why not just use gold as money? Eliminate the middle man.







"manage supply to maintain a currency's value at its bullion parity"
This could be done for any commodity or basket of commodities.

But the issue still comes down to 'the manager'.

Is the government going to do it?

I have no problem with the concept of e-gold, but whoever issues the money has to own the gold upon which the money is backed.

Extend the concept to any asset and private banks can issue the money.

Yes, free banking works too
But it won't happen. Not in this country or most others.

It's going to be way easier just to peg the dollar to a price target than it ever will be to convert to free banking and/or real specie money.

Another way of regulating currency is the use of 'free bills'. Currency issued that is directly backed by productive assets. Colonial Pennsylvania pioneered it as did Weimar Germany. Inflation was not a problem, productive investment and subsequent GDP growth soared and neither were backed by gold even though they were effectively pegged with gold and could be exchanged for gold or gold-backed instruments if someone really wanted to do so.

"The Rentenmark replaced the Papiermark. Due to the economic crises in Germany after the Great War there was no gold available to back the currency. Therefore the Rentenbank, which issued the Rentenmark, mortgaged land and industrial goods worth 3.2 billion Rentenmark to back the new currency. The Rentenmark was introduced at a rate 1 Rentenmark = 1:1012 Papiermark, establishing an exchange rate of 1 United States dollar = 4.2 RM.

The Rentenmark was only an intermediate currency and was not legal tender. It was, however, accepted by the population and effectively stopped the inflation. The Reichsmark became the new legal tender on 30 August 1924, equal in value to the Rentenmark.

The monetary policy spearheaded by Hjalmar Schacht—the Central Banker—together with the fiscal policy of German Chancellor Gustav Stresemann and Finance Minister Hans Luther brought the inflation in Germany to an end.

The Rentenbank continued to exist after 1924 and the notes and coins continued to circulate. The last Rentenmark notes were valid until 1948."

from http://en.wikipedia.org/wiki/German_rentenmark#History

Ironically, the $700 billion bailout will qualify as 'free bills' since we taxpayers are getting assets. Not the most productive and certainly distressed assets, but way more real assets than what backs the remainder of our currency right now. That is the one bright hope in this mess, I suppose.

controlling the dollar
"Since the government has screwed so many things, what gives you any confidence the government can 'control' the dollar?"

As I understood the legislation under discussion (see Zandryl) the whole point of the new proposed law was to legally force the government to expand the money supply (print dollars) when the price of gold is below $500/oz, and not print dollars when the price of gold is above $500/oz. This would force the dollar to always be worth 1/500 of an ounce of gold.

If this law were enacted, the government would have no choice but to control the dollar - with one simple objective in mind - forcing it to have the same value as 1/500 of an ounce of gold. The reason they don't want this is because that stops them from controlling the dollar with other objectives in mind, like paying off the public debt through inflation, "stimulating" the economy, or any other politically motivated objectives.

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