I have been part of the financial world and worked as a Vice President at two of the largest banks in the country; so I have had an opportunity to observe the functioning of the financial markets both from within and lately from the outside.
The United States economy stands on the brink of disaster. You wouldn't know it if you met the confused and feeble-minded John McCain. The Treasury Secretary and the Federal Reserve stand with a begging bowl to be filled by taxpayers whom they otherwise don't tire of telling that government intervention in markets is bad. There is an immediate need to address the lack of liquidity in the credit markets; if unaddressed there is a risk that financially sound businesses and creditworthy individuals will not be able to operate normally. It is this fear that the Bush White House through the Treasury Secretary is using as a weapon to scare the Democrats into doling out a trillion dollars for the bankers (I would call them bandits in blue suits). The Democrats should outright reject the Treasury proposal. The Democrats have a historic opportunity to consider a bold and effective plan of their own which is discussed in the following paragraphs.
The panacea proposed by the Treasury is neither good for the economy nor would it help struggling homeowners; in fact there are less expensive, easy-to-implement market based solutions (with minimum short term help from the government which won't even require funding by the government) than those proposed by the Bush White House. The solutions being proposed here would not only discuss the immediate liquidity crisis but will also put the financial markets on a sound footing. These are discussed below.
During the last three years, economic disaster hit working class and middle income families. Surely as day would follow night, the pain has travelled from Main Street to Wall Street. The considerable use of taxpayer funds in the last few months (billions spent for Bear Stearns, AIG etc.) has not done anything to stem the tide of bank failures.
Additional funding will have a similar effect as the fundamentals. The bankruptcy of Lehman Brothers, on the heals of the collapse of the Bear Sterns and Fannie Mae, is just the tip of the iceberg. We have already seen massive use of taxpayer funds to save or shore up these poorly managed entities. While the financial rewards of taking undue risks were reaped by the likes of Sandy Weil, the risk is and will continue to be borne by the taxpayer. Those who ridicule the thought of 'socialized medicine' have no qualms socializing risk faced by the financial sector which reaped significant rewards for taking high risk investments but expect the taxpayer to absorb the losses (and they do this every decade or so). The socializing of this risk must not be allowed and is not necessary.
In fact, structurally the U.S. economy is on the brink of collapse; housing prices would have to fall to pre-1999 levels before one would see any stability; one does not have to be a financial wizard to know that. Most people's salaries do not support the houses they have acquired; more on that later. For now I will address the immediate needs as presented by The Bush Administration and the reasons to reject it on financial rather than ideological grounds. The Democrats, as we have come to expect of them, are once again flat-footed on a strategic issue; their knee jerk response to curb CEO salaries and to help homeowners are both impractical and still will not address the fundamental issues and needs. I will also propose the course of action that Democrats should take. Such an opportunity to seize initiative away from the Republicans will never again exist. This is the time for the Democrats to seize initiative and not be reactive.
I propose that the Democrats advance two proposals simultaneously, one which addresses the immediate crisis of illiquid markets and the other as a starting point for addressing the structural imbalance of wealth and income distribution which plagues our society and which actually is a hindrance to economic policy.
The Immediate Issue:
1. For starters, the Treasury plan should be totally rejected. The bankers have shown tremendous propensity to self-destruct almost on a decade long cycle; in the 1970's we had the REIT crisis, in the 1980's they had to be bailed out from the Latin American debt crisis, the late 1980s saw the debacle of Savings and Loans and again the bankers were bailed out. The risk to the economy is not that these bankrupt institutions will collapse; these should be allowed to collapse. Were it not for repetitive government bailouts these banks have been bankrupt many times. Enough is enough.
2. The major risk to the financial system is that credit will dry up for viable businesses. This must be prevented. Surprisingly, this can be achieved rather easily. What follows below is a simpler and cleaner solution which has three components:
a. BackStop Commercial Paper: The first order of business is to provide a backstop to the commercial paper market. This is only a stop-gap measure and will stabilize the markets. The Federal Reserve should be allowed to fund A1/P1 commercial paper and, with careful analysis, some A2/P2 commercial paper. Additionally, credit lines to viable businesses can be backstopped for a short period of time.
b. Establish New Banks: Instead of spending a trillion dollars to help the bad banks and the defunct and highly leveraged hedge funds (that would be throwing good money after bad), it makes sense to establish new banks. For starters, five regional banks should be able to take care of most business/consumer needs. The government need not put up much in the way of funds but can build into their charters closer supervision. These banks will make credit available to good businesses and creditworthy individuals. Needless to say strict supervision of the new banks' portfolios is necessary so funds do not flow from these banks to the defunct banks. This will ensure that the credit flow to healthy firms continues unabated and these new banks will not be encumbered by lack of capital or bad debt portfolios like the existing banks and investment banks. This will also allow consumers and businesses to shift their assets from the bad institutions to the newer and healthier financial institutions.
c. Capital for New Banks: These banks may not need any government funding. There is no dearth of funds availability worldwide including the rich people in the United States. I am confident that individuals like Michael Bloomberg, Warren Buffet , T. Boone Pickens, George Soros etc. will be able to raise the funds and manage new institutions better than we have witnessed in the past. If necessary, the government can provide some capital though that may not be necessary. A rather significant injection of capital by Warren Buffet into Goldman Sachs is evidence of availability of capital in the private sector. This approach ensures that we redirect capital to the future needs, thus providing an impetus to the otherwise moribund economy. The added advantage to this approach being that the taxpayer funds will not stuck into bad investments.
d. The Treasury should continue to back the deposits at banks through FDIC until such time the new banks come to the fore. This should not be for a period greater than 6-9 months.
e. The existing financial institutions should be left to work out their problems. After all, they earn millions of dollars in compensation on the premise that they are smart and financial wizards. They are smart enough to work out their problems and those that don't will collapse. In the meantime, the new banks will provide a healthy dose of credit availability to the market and an even healthier dose of proper risk analysis which the new banks must be made to observe.
f. It should also be borne in mind that banks like Citibank, JP Morgan and Bank of America have already written down the bad assets and have raised capital where necessary. Goldman Sachs has done the same. So, there is no need to reward them with taxpayer money. The Treasury, most likely, was planning to help the hedge fund wizards who are leveraged 10-1 and those funds serve no useful purpose in the economy nor do they provide any liquidity to the financial markets, so any use of taxpayer funds to bail them out will be banditry.
Long Term Issue of Housing
While it may be politically expedient to try and help some homeowners against foreclosure, this would, in fact, perpetuate the problems of the middle and working classes as home prices would be kept artificially high. The housing crisis exists because real estate prices have gone up way beyond the earning power of most Americans. The incomes in the last decade have fallen while housing has skyrocketed. So, a long term solution is that housing prices should fall so ordinary people can afford a home which is supported by their income. Since there is no near-term prospect for incomes to rise, it's best to let market forces bring the prices down and only then can working people afford to buy and live in those homes.
Long Term Issue of Taxes
While the above would address the immediate response required to ensure that creditworthy businesses and consumers continue to have credit availability, we also have the opportunity to address the long-term structural imbalance that has accrued since the advent of the so-called Reagan revolution. This has been a trend of wealth accumulation (and income distribution) at the top 10% while the remaining 90% actually faced declining incomes. It is not an accident that despite the greatest economic expansion in history, the U.S. is left with 47 million uninsured, not including those on Medicare and Medicaid who, too, cannot afford market-based healthcare. It is no accident that 38% of white children and 50% of black children are born in poverty, while the GNP increased by historically high amount. It is the natural impulse of capitalism (which our psyche believes in) to accumulate wealth and income unless a mechanism for redistribution of income and wealth is found. If done wisely, redistribution of wealth and income invigorates and expands the middle class, which in turn is healthy for the economy. In a separate article I will show that the only time the working class and middle class expansion took place was when the income redistribution was in effect due to various policies/programs. However, the previous method of redistribution by taxing and spending will meet resistance with the populace.
So how do we address this structural imbalance where the U.S. is increasingly beginning to look like a third world country with a larger chunk of the populace gets poorer by the passage of time? The traditional way is to tax the people in the higher income brackets and spend the money on those at the lower rung of the financial ladder through government programs. This approach with today's government structure is not viable and just provides the Republicans with a stick to label the Democrats as "tax and spend liberals;" a view also taken on by the unsuspecting working class.
There is a bolder and more progressive approach one can take toward taxation: have no taxes for those earning less than $50,000 and a slightly higher tax rate for those earning above $500,000. This will effectively help build and sustain a middle class and a viable working class. The Republicans have been able to dupe the population into thinking there can be a free ride and this would actually turn their argument onto its head.
The $1,000 tax cut proposed by Mr. Obama (whom I support) is peanuts in terms of what is actually required. A bold move such as the one outlined above is what is required strategically. Too long Democrats have depended on the band-aid incremental approach and have never really studied the tax issue in a strategic way. Let us start with the premise that the working class contributes significantly to the national well being with its labor and deserve a respite from paying half their already meager taxes to the Federal Government, which channels them toward "bridges to nowhere" or to unnecessary wars.
As a next step we need to move from income taxes to dedicated taxes, like the payroll and Highway Tax. Dedicated taxes are the only ones which get spent for the purpose they are collected for, and, as experience shows, have worked very well. There is less risk of these being hijacked for "bridges to nowhere." Likewise, if the nation wants, it can then pay a war tax or sallow the government to borrow for wars, with the borrowing then to be paid with a war tax. This would ensure that the populace doesn't blindly follow the war-mongers like President Bush and John McCain into financial disasters.
In conclusion, I would suggest adopting a simple 5-point plan which is forward-looking rather than backward-looking.
1. Say No to the Treasury Secretary's bailout plan for the "bandits in blue suits."
2. Immediately establish new institutions for continued availability of credit to good firms.
3. Immediately create a backstop facility for commercial paper and lines of credit for healthy businesses.
4. Provide an immediate tax relief bill for those earning under $50,000, which will help distribute income and may help many homeowners. For now, let's assume no taxes are good taxes as otherwise the treasury will take these to help out Wall Street.
5. Let sleeping dogs lie; i.e. let real estate prices come down on their own to affordable levels. No need to throw good money after bad.
For too long the Democrats have surrendered the ground on taxes and free markets to the Republicans. Now is their chance to seize the initiative in these two areas.