A solution to our financial crisis

I received quite a few critiques of my “provide analysis but no solutions” policy.  So here are my recommendations, based on guesses about the course of events.  Being neither an economist nor financial guru, this describes the broad policy actions I suspect are needed — but not the details.  These measures are consistent with the posts I have written over the past year about the end of the post-WWII geopolitical regime and will allow us to adapt to that inevitable evolution.

This is the first in a series describing what needs to be done to avert a disastrous crash in the US economy.

Preamble

The policy response of our leaders has been inadequate, up to and including the Paulson Plan.  Their actions have been incremental and reactive in nature.  While each step has been larger than its predecessor, all have been reactions to the past dimension of the crisis — not the future.  That is, our leaders have been “behind the curve.”

Paulson and Bernanke have taken actions that would have been effective if applied 2 or 3 quarters earlier.  Borrowing a metaphor from emergency medicine, they have squandered the “golden hour“, since the crisis started with the collapse of the mortgage brokers in December 2006.

Correcting this flawed procedure is the first step.  Doing so at this late date will require immediate and drastic actions.   The severe effects of the recession — now affecting the developed nations, perhaps soon the entire world — will soon be felt, further destabilizing the economy and the financial system.

To determine the scale of the necessary measures, try a thought experiment (Gedankenexperiment).  Assume the scenario I describe.  If we implement the Paulson Plan, what measures will be necessary by Q2 of 2009?

Recommendations

1. Stabilize the financial system.
2. Stabilize the economy.
3. Arrange long-term financing for steps #1 and #2 with our foreign creditors.

Click on the above links for details.  A conclusion follows below, explaining why we will not implement such measures and the the possible consequences.  The above links go to posts explaining each recommendation in greater detail.

I.  Stabilize the financial system

No modern economy can survive the meltdown of its financial system.  There are many ways to avoid this, illustrated by the following.

(a)  Recapitalize the financial sector by a transfer of wealth from the taxpayers to banks and brokers — This is probably the key element of the Paulson Plan, done by the government buying assets at above market prices.

(b) Close defunct or weakening financial institutions under new bankruptcy legislation, under which the courts could act with extraordinary speed and authority.  This should involve replace managements.  New managements could be selected by a bi-partisan committee of business leaders that should have only a minority of members from the financial industry.

(c)  Outright nationalization — As done the defunct Savings and Loans during the early 1990’s, and today with the GSE’s and AIG.  Large scale nationalizations might be required.  If so, our political regime’s survival might depend on how this is done.  Not just their acquisition, but their operation and eventual privatization (if any).

Creation of an agency like the Depression era Home Owners Loan Corporation, as recommended by Nouriel Roubini, can play a role in any of these policy choices.

II.  Stabilize the economy

(a)  Why wait?  Set up the job training and education programs now, rather than throw them together in haste when they are needed yesterday.  There will be many unemployed, and this is an opportunity to upgrade their skills for the next cycle.

(b)  Many local governments will go bankrupt, as so many are vulnerable (e.g., NYC).  Work with the States now to prepare the necessary legal and financial apparatus to handle these.

(c)  Implement a massive monetary stimulus, such as taken by Japan at the start of their dark decade after the 1989 crash.  That means near-zero interest rates (far below the level of inflation) and a rapid increase in the balance sheet of the Federal Reserve.  The government has not taken these steps because they might lead to currency flight from the US Dollar, and the government does not want to take the necessary measures to prevent this (see III).

III.  Arrange long-term financing for steps #1 and #2 with our foreign creditors

This means a negotiated agreement with the foreign central banks who are our primary creditors, with the appropriate support from Congress.

We will need to reschedule our debt and obtain new financing.  Our government will have to rollover roughly $500 billion/year, plus the trillion or so in additional borrowing (as tax revenue declines and expenses skyrocket) for the next two years (perhaps longer).  Plus measures will be needed to stabilize the value of the US dollar, allowing a orderly decline.

These extraordinary negotiations will be inherently destabilizing, putting in question both the US Dollar’s role as reserve currency and America’s role as global hegemon.  This is the price paid by our past folly, getting us into this crisis.

Obtaining and executing this agreement must be concluded successfully.  It is a jump across a chasm to a new world.  But the chasm lies ahead of us, and must be crossed eventually.  Let’s strike a deal while we can negotiate from a position of strength.  Rather than waiting until we are desperate.

The cost will be high.  An agreement will be in the best interest of all, but that does not mean that we will not have to make concessions.  To give just one example, China might ask that the US break our relations (esp military) with Taiwan.

Conclusion

I believe that the downturn can be mitigated by immediate and decisive action.  Building public support for these measures and avoiding panic will require the highest level of statesmanship by our leaders — and responsible citizenship by us.

Of course we will not take such actions in a timely fashion.  Our leaders’ happy talk was intended to maintain spending and investment during a brief slowdown.  The unintended consequence is that the American people are psychologically unprepared for this crisis.

Worse, our Observation-Orientation-Decision-Action loop is broken.  Despite years of warnings (see this list) we have not seen the danger ahead.  Now that it is upon us, our fixed optimism prevents us from orienting ourselves to changed conditions.  I doubt that our leaders can either formulate adequate plans or execute them.

As so often in American history, we must fall back on the resourcefulness of the American people.  Our ability to act together, to force our leaders onto the right path, to have the resilience to weather difficult times.

If you are new to this site, please glance at the archives below.  You may find answers to your questions in these.

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

Key Treasury Department documents

We cannot plead the “we didn’t know the details in the fine print” excuse. The important details about this massive nationalization have been clearly spelled out for us.  See this page for a current list of Treasury Department documents.

Some posts about the current crisis

1. Treasury Secretary Paulson leads us across the Rubicon, 9 September 2008
2. High priority report: a geopolitical sitrep on the financial crisis, 15 September 2008
3. Say good-bye to the old America. Welcome to our new socialist paradise!, 17 September 2008
4. Another voice warning about the nationalization of AIG, 18 September 2008
5. A vital but widely misunderstood aspect of our financial crisis, 18 September 2008
6. A new sitrep, as we move into phase 3 of the financial crisis, 19 September 2008
7. Another step away from our Constitutional system, with applause, 19 September 2008
8. What do we know about the financial crisis? What are the key questions?, 20 September 2008
9. Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
10. America appoints a Magister Populi to deal with the financial crisis, 21 September 2008
11. Legal experts discuss if the Paulson Plan is legal, 21 September 2008
12. Essential steps to surviving the current crisis, 23 September 2008
13. A picture of the post-WWII debt supercycle, 26 September 2008
14. A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
15. The most important news of the month. Perhaps the year., 29 September 2008
16. German Finance Minister Peer Steinbrück explains how the world is changing, 30 September 2008

For a full listing see the FM reference page about the Financial crisis – what’s happening? how will this end?.

A few of the most important posts warning about this crisis

This crisis has long been forecast by many, including in articles on this site.  Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results.  To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime.  Here are some of those posts.

1. A brief note on the US Dollar. Is this like August 1914?, 8 November 2007 — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
2. The post-WWII geopolitical regime is dying. Chapter One, 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
3. We have been warned. Death of the post-WWII geopolitical regime, Chapter II, 28 November 2007 — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
4. Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
5. Geopolitical implications of the current economic downturn, 24 January 2008, – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
6. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
7. What will America look like after this recession?, 18 March 208  — The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
8. The most important story in this week’s newspapers , 22 May 2008 — How solvent is the US government? They report the facts to us every year.
9. Prof Nouriel Roubini describes “The Decline of the American Empire” ,18 August 2008
10. The World’s biggest mess, 22 August 2008 — A brillant ex pat looks at America from across the ocean.
11. “The changing balance of global financial power”, by Brad Setser, 22 August 2008
12. “The Coming US Consumption Bust”, by Nouriel Roubini, 6 September 2008