The Economic Crisis: Square Pegs and Round Holes in Federal Policy

Some of the fundamental premises of federal economic policies are flawed, and the government's efforts to bail out the financial system and stimulate the economy may push futilely on a string instead of instigating a recovery. Let's look at the specifics.

Consumers. There is much discussion of the need to get consumers spending again. But the foundations of personal finance have been shattered. Houses, stocks, bonds and other assets have plummeted in value. Credit lines and access to loans have evaporated. Most importantly, the pace of layoffs has been rising rapidly. You won't spend if you don't have a job; and you won't spend much if you're afraid of losing your job. No end is in sight for any of these trends. The American consumer has rationally become the American saver. When the chips are down, there's nothing as comforting as a nice pile of cash. People always seek whatever makes them feel good, and right now that's cash in the bank and less debt. The government can't persuade them to spend if they don't want to spend--you can't lead people where they don't want to go. Instead, the government may be better off helping individuals to save. Once personal balance sheets are stronger, people will feel better and spend more. How about a tax break for savers?

Bank Lending. The love of cash doesn't stop with consumers. Bankers love cash even more. Many hold toxic assets and almost all hold other assets that are sinking as the economy fades. They need the cash to offset investment and loan losses. That's why they haven't loaned out much of their federal bailout money. With the fervor of the recently converted, bankers now practice prudence as preached in Puritan New England. The sinking economy and rising tide of layoffs make almost every borrower suspect in their eyes. Bankers, as capitalists par excellence, elevate their self-interest above all, and right now making more loans looks to them like a quick march into quick sand. A number of banks are turning down federal bailout money because they don't want the pressure to make loans they don't want to make. Bailout money shouldn't simply be given to banks--especially healthy banks--in the hope of fostering lending. It should be given only to a limited number of major banks that are on the verge of collapse, for the purpose of preventing systemic financial collapse.

Fed Efforts to Lower Mortgage Rate. The Federal Reserve has been buying up mortgage-backed securities in an effort to lower mortgage rates. Does it make sense to lower mortgage rates at the same time that the Fed is trying to persuade banks to make more mortgage loans? The interest rate is where the banks' and other lenders' profits come from. If you lower their profits, why would they lend more? Since the government wants banks to lend more, it would more logically let interest rates rise to compensate lenders for the now increased risks of lending. (Remember that the real estate market continues to fall, so a mortgage loan made today could be in trouble in a few months.) When the government prescribes prices, as it now is trying to do with interest rates (including both short term and long term interest rates), it shouldn't be surprised if the market doesn't function well. Markets rarely function well when the government prescribes prices. Lower interest rates do bring more borrowers into the market, but many are not customers that banks want to lend to. That's why the recent drop in mortgage rates has yielded relatively few refis and even fewer home buyers.

China's Currency. Secretary of the Treasury Timothy Geithner has accused China of "manipulating" its currency to give itself trade advantages. This is a loaded term that could affect U.S. trade relations with China. Today, China is America's largest creditor. If you need a loan, would it make sense to poke your lender in the . . . well, let's say eye . . . with a sharp stick? America, even today, is a rich and powerful nation that doesn't have to do what China would like it to do. China is a rising power that doesn't need to do what America would like it to do. But going their separate ways would be very costly to both nations. Both are much better off working together. Let's hope that officials at the Cabinet level understand this.

Reviving Real Estate. It seems likely that the new Congress and the Obama administration will do much more than their predecessors to revive real estate. Authorizing bankruptcy courts to rewrite mortgages, slowing down or suspending foreclosures, federal buydowns of mortgage rates, and more favorable tax credits for buyers are all possible. Abstractly speaking, these proposals would help the real estate market. But they would have been far more effective if taken by Bush administration in the summer and fall of 2007. The real estate crisis then was far less severe then than it is today. Stated otherwise, it would have cost much less in late 2007 than it will now to stabilize the real estate market. Federal measures today would cost a mint, but could only slow the decline. They won't bring back rising real estate prices. So we can't count on real estate to finance a renewal of consumption. The mortgage refis and home equity loans that paid for so much of America's boom from 2002 to 2007 will be scarcer than hens teeth for years to come. Real estate won't pull America out of the recession.

So what should be done? First, keep people going. Extend unemployment benefits liberally. Make Medicaid available to those who are unemployed, running out of money and have no health insurance. If the dispossessed are cared for, everyone else will maintain a modicum of confidence. But if the unemployed end up living in their cars and dying uninsured in hospital emergency rooms, we'll have a consumer retrenchment comparable to the 1930s, when every nickel and penny was hoarded against hard times.

Second, focus on reviving the real economy. That especially means manufacturing. The true wealth of nations comes from using raw materials to produce valuable goods. That's why, despite having a raft of problems, Japan, Germany and China are economic powerhouses today. Wealth doesn't come from speculating in the value of real estate or stocks, or playing other financial games. We can't refi our way to prosperity, just as the cave dwellers of the Neolithic couldn't refi their caves and live in baronial splendor. They had to produce flint tools and learn to till the land. We, too, need to work and produce. Government policies aimed at promoting production have the best chance of leading to a lasting recovery.