January 27, 2008
I think we can safely call the current situation an economic crisis. How do you deal with an economic crisis? The solution is to:
Identify the Problem
Solve the Damn Problem
How could it be any other way?
In any economic crisis, there is some entity, typically the government, upon which falls the responsibility of resolving the crisis to the best of its ability. Typically they fail miserably. One of the most common modes of failure in this regard is the failure to identify the problem. This was very much the case during the Asian Crisis of 1997-1998 for example, which was very obviously a currency crisis. Nevertheless, a myriad of “solutions” were applied as if the problem arose from some other source, such as excessive government spending, “crony capitalism,” or some other imagined beast. (In Indonesia in 1998, the IMF crisis-resolution program included revising subsidies on fishmeal.) Very little was done in resolving the currency issues, because very few people identified the currency issue as the problem. This was also the case in Japan in 1990-2002, which was also a currency issue. It seems the vast majority of commentators still haven’t figured that out, although it was as obvious as getting hit in the head with a stick. Their economic understanding didn’t include getting hit in the head with a stick, so when they were duly hit, confusion resulted.
So what else is new.
Remember the magic formula? It said that Low Taxes and Stable Money were the keys to economic success. With that in mind, we can put crisis-generating problems into three categories:
High or Rising Taxes
You’ll notice I’m making this very simple so that even a government bureaucrat can understand it. Maybe I need a purple dinosaur?
The solution to these problems is:
High or Rising Taxes: Lower Taxes
Unstable Money: Stable Money
Other Problems: Other Solutions
Yes, it really is that simple.
A corollary of this is that if you try to solve a tax problem with a monetary solution, or an other problem with a tax solution, the results will tend to be disappointing.
Let’s look at what forms these problems typically take today:
High or Rising Taxes: This was a biggie in the Great Depression, especially in the US, Britain and Germany. After signing the Smoot-Hawley Tariff, which imposed a 60% tariff on just about anything of importance, Herbert Hoover raised the top income tax rate in the US from 24% to 65%. Britain and Germany did pretty much the same. This was so disastrous that practically nobody would do something like this today. In recent times, gradualism has been the rule regarding tax hikes. Taxes are raised bit by bit over several years. Japan has been up to this recently, especially regarding payroll-type taxes. This gradualism produces a stagnant or deteriorating economy, but it usually avoids a sudden “crisis” like the Great Depression. Another thing that sometimes happens is that governments may impose a tax hike in response to a crisis caused by some other factor. The Asian governments raised taxes during 1997-1998 due to the bizarre notion that the crisis was caused by government deficits, although the governments had all been running surpluses for years and had low debt/GDP. Today, the US has a trend toward higher taxes, namely the Democratic opposition to making the Bush 2003 tax cuts “permanent.” Japan has a rising tax trend. Developed Europe and most of the EMs have a trend toward lower taxes. This is not the cause of the current crisis.
The solution to a problem of High or Rising Taxes is to undo the tax hikes. I mean — duh. If the Great Depression was instigated by the Smoot-Hawley Tariff or the Hoover tax hikes (and similar policies among governments worldwide), then a proper solution would have been to immediately abolish the tariff and the tax hike. You just say: ” Whoops, that was a mistake, let’s fix it right away.” This never happens. Apparently, the ego of the national leader takes precedence over all economic considerations, even though that leader will soon face mandatory retirement in any case. Even the incoming governments, who came to power by criticizing the policies of the previous tax-hiking leader, seem incapable of simply reversing the obviously wrong policies. Well, people are stupid, and people in government are even stupider than average. If I could elect a box of rocks, I would. At least they wouldn’t hike taxes. The Asian governments in 1998-1999 actually reversed some of the tax hikes that the IMF pressured them to impose in 1997-1998. That’s one reason the Asian economies are rock-’em-sock-’em today. For the kind of chronic underperformance caused by high (but not dramatically rising) tax rates, the flat-tax policies of Eastern Europe have been proven to be a wonderful solution. There are other solutions as well.
Unstable Money: This is certainly the case today, as we see currencies all around the world lose value. The dollar is at the head of this parade, as the kamikaze Ben Bernanke (can you be a kamikaze helicopter pilot?) cuts rates further as the dollar sinks to unprecedented lows vs. gold. Pressure is on other central banks to follow suit, both to counter an economic slowdown and prevent currencies from rising too much against the dolllar, introducting competetive currency issues. The Bank of Canada just cut rates, the BoE has been doing so as well, the BoJ is still maintaining super-low rates, and the ECB is under pressure to get with the program. Policy is inflationary worldwide. I continue to maintain that this inflation will have the greatest long-term consequences. However, thus far, the inflationary effect has been mostly perceived as beneficial. The inflation has translated into higher food and energy costs, which are affecting consumer budgets. and spending patterns. However, inflation also helps counter financial issues, as debts are easier to repay in a cheaper currency. Inflation also tends to introduce more consumption, as prices are effectively lower. Inflation really starts to hurt when prices rise by huge amounts and interest rates rise alongside. We’re talking CPI and T-bond rates over 10%. Nasty. We aren’t there yet. So far, the inflation has mostly been perceived as a good thing, as is typically the case in the early stages, and which is why central banks are still inflation-friendly at this time.
The solution to unstable money is stable money. This means a gold standard or, particularly for smaller countries, perhaps a currency board linked to a more-stable major currency. It may involve a correction of past monetary error, namely “reflation” (correction of deflation) or “disinflation” (correction of inflation).
Other Problems: If the present situation is not a High or Rising Taxes Problem or an Unstable Money Problem, then what is it? Well, if you’re 11 years old and have been reading the New York Times, you probably know that the present crisis is one primarily of crappy debt, and debt-linked derivatives. It is secondarily one of declining “consumer spending” perhaps, plus declining market prices for houses and the like.
OK, let’s think about this. The biggest problem for the collapse in fixed-income values is capitalization of banks. It is really not so good to have your financial system implode, even though certain hair-shirt libertarians might think so. Banks have been scrounging around for capital infusions, mostly from “sovereign wealth funds,” which is to say, foreign governments. At the same time, the Bushies have proposed a $150 billion “economic stimulus plan.” What if that $150 billion was used to recapitalize the banking system, including the bustaroonie monoline insurers? (Actually, the monolines should go under, with the government backing up guarantees of the straight-bond components, mostly munis. The CDO universe should head for the bottom of the ocean.) Now, I know that this kind of partial government ownership of the financial system is not kosher according to many people. It is definitely not an ideal solution. But this is not an ideal situation. Many other governments have stepped in to recapitalize/partially nationalize banking industries in crisis. It is common in the EM world, and Japan did so recently. Britain is in the process of doing so today with Northern Rock. For the most part, the governments are pretty well behaved about it, and are eager to hand the financials back to the private sector at the first opportunity. The process has gone pretty well. In the scale of things, this is no big deal. Why is it OK for foreign governments to recapitalize banks, but not the domestic government? In any case, this would seem a much more effective course of action than just mailing checks to taxpayers.
As for the “consumer spending” element (and the associated excessive “consumer spending” on houses), it should be apparent by now that much spending was fueled by the crappy lending which resulted in the crappy debt that is now going kerblooey. Since this was an unsustainable situation, nobody should attempt to sustain it. I have argued that it is common for an economy to have ups and downs within the context of overall positive progress, with the regular recessions of the 1950s and 1960s one example. This has been one of the most extreme credit bubbles in US history, which would be logically followed by one of the biggest credit busts in all of US history. Nevertheless, after a half-dozen or so bad years, which is not such a big deal compared to the multi-decade disasters of the Great Depression or the 1970s Inflation, things would probably get back on track pretty well if a) systemic collapse like mass banking failure were averted, b) taxes were kept low, and c) money was kept stable. Most of the economy outside the financial and housing-construction sphere is in pretty good shape. Many EMs and also developed Europe is benefitting from lower taxes and greater monetary stability. Things would muddle along, and turn up eventually. A few tax cuts would help, over the longer term. However, tax cuts won’t help much (especially in the short term, which is a priority in a crisis, practically by definition) if the problem is an Other Problem. Other Problems demand Other Solutions.
So, that’s my solution. As you can see, if you get the Identify the Problem part right, the solution part is usually rather straightforward.
Now, what is really going to happen?
A) The pace of financial deterioration will be too rapid for the government to react to effectively.
B) The present “lies, spin, and market manipulation” approach will take precedence over effective, fundamental solutions.
C) The government will attempt to solve an Other Problems problem with a Monetary solution, namely currecy devaluation (via low policy rates). This is like putting water on an electrical fire. Not so good. (This policy approach is a result of the fantasy that the Tax Problem of the Great Depression could have been solved by a Monetary Solution of currency devaluation, which should be obviously wrong wrong wrong, as our dear Ben Bernanke will presently demonstrate.)
D) The Other Problem (financial system insolvency, among other things) will remain unsolved, while an additional problem (monetary inflation, i.e., Monetary Instability) is added.
E) Depressed tax revenues due to recession, plus the prevalence of Stupid Spending (“tax rebates,” Iraq War) will put the kibosh on any tax cut proposals.
F) The ultimate result will be disaster.
Surprised? This is just business as usual, on this planet of economc ignorance.