THE BLOG
11/14/2008 05:12 am ET Updated May 25, 2011

Economic Recovery Will Require More Than Just Confidence And Cash

You have heard the terms, securitized mortgage instruments, they started the problem, and credit default swaps which magnified it five fold. Bailing is the right thing to do, otherwise some portion of 2.5 trillion dollars, the borrowing in the U.S., public and private, 18% of our 14 trillion dollar economy is at risk.

But bailing only deals with part of the problem. It replaces the money lost in the panic on debt securities. Printing the money for it is not even inflationary as it just replaces money that evaporated in this market. Not replacing it would actually cause peoples home values, dependent on availability of credit, to decline further, and drive up the cost of credit across the board, a deflationary influence on the economy. Reducing the money supply by increasing the cost of credit is what the Fed does to fight inflation. And in a fortnight we seem to have gone from inflation to deflation as the major risk. Oil has dropped by half since July, which is now both good news and bad news.

Even if and when the bailout starts to replace money supply, there is still a credit confidence crisis to deal with. The issue is that banks are intertwined in operations like a thousand octopuses in an arm wrestling contest. Banks loan to each other as well as to business and consumers. The stronger octopuses are cannibalizing the weaker octopuses in order to avoid their own demise.

Now in this environment, banks are leery of loaning to other banks because they do not know what is on the books of the borrowing banks and their debtor banks might end up defaulting. So it is a race to solidify ones own assets by eliminating exposure to bad debt on your books or on other bank's books. This is not a classic bank run, but is still classifiable as a bank run.

The reluctance to make loans to banks is mirrored in the business and consumer credit market. No one wants to make a bad loan for fear of not being able to sell it if there is a run on themselves. Add banking de-regulation to this and you can see that they will be leery of loaning to other banks, buying mortgages and other debt from other banks, and will be reluctant to make loans no matter how much money they have on hand.

The confidence in the securitized mortgage instrument is gone, the market has spoken. The credit default swap is now just a painful joke. A former tobacco executive tells me that banks are taking matters into their own hands. Inter bank executive meetings are taking place to resolve uncertainty about asset quality, solvency and loan practices so that one bank then can tell if at least one other bank can be trusted. The industry is now in the process of self regulating. Too bad it took a disaster to sober them up.

Confidence is not enough.

Banks self regulating, and probably correctly anticipating a new wave of re-regulation, combined with titanic infusions of public and private funds, will create a floor for the credit crisis. But those self same regulations will reduce the easy credit inspired economic growth of the last eight years, in which easy credit was substituted for wage growth. We had run to the end of that political gambit anyway. In fact, the current market and credit crisis reflects exactly that, as many economists have predicted for years now.

So the economy will rebound off of its lowest point in this recession/depression, but the rebound can't reach the levels of the period prior to the crisis because the buying power, driven by easy credit, will not be there. This will reveal the real sustainable economy that has been masked by easy credit and investment bubbles. What that new GDP will be is anybody's guess, but it will be lower, and if our economy is to grow in the future we are going to have to do it the old fashioned way, with general prosperity, rising wages and productivity.

So how do you grow from here?

The old fashioned way would be for the Federal Government to raise the minimum wage. Clearly "trickle down" has been proven not to work at all, twice, "trickle up" has been shown to work by Henry Ford himself, FDR, Bill Clinton. An across the board wage increase troubles many Republicans though, well actually it panics them. Many believe that increasing wages cause inflation and damage the economy. It might be useful for someone to point out the fallacy of that fear.

If labor at one business gets a raise it raises costs for that business and would then cut profits. What makes a cost of living raise or a minimum wage law work in effect is that if all labor in all businesses get a raise then the increased costs are offset by an increase in customers, those customers being the laborers of other business which can now afford your product. Efficiencies of volume and stability may then partially or completely offset increased costs. As margins may shrink total revenues will grow. Law is required because not exactly all businessmen are willing to go first. This is how economies are built. When efficiencies in operation or innovations create profit and if that profit is shared with labor, across the board, the economy benefits in proportion to the benefits of those innovations being shared. More people can live at a higher standard, including the providers of capital, because as markets grow then profits grow. That IS economics 101, something that has not been happening in this country for, what is it, eight years or more.

One thing though, if other businesses are not operating in labor cost parity with your business, then it does put you at a disadvantage. So any raise in minimum wage must be coupled with adjustments to trade policy, tax law, regional conditions, and a host of other factors affecting competition. And, if wages are increased beyond what is garnered in profit created from innovations, then wage increases are not only inflationary but are destructive.

Across the board wage increases are by noo means the only or may not even be the best solution to stimulating growth in the short term. Public works projects, national goals like carbon reductions and even perhaps a national specialization, like India has focused on computer technology, are possibilities. At this point it is quite certain that finance is not a specialty about which we can claim preeminence.

It will take smart and honest trade and domestic economic policy to make America grow again. The consideration of time tested Democratic policies is worthwhile. But for this century they are blunt instruments. It will not be possible to use them, wholesale, in this new environment of open borders and free trade without many casualties. We have paid for what benefits we get from free trade by increasing the complexity of our own domestic economic policy. What was a no brainer to implement will not be a no brainer to manage.

For the sake of our children who will be inheriting the Republican National Debt, we will need to grow the economy, produce, and achieve a positive trade balance. Republican ideology is inconsistent with these goals as it has amounted to deficit spending, free trade instead of fair trade, and unrealistic wage and credit policies. For a new century we need to be the smartest kids on the block...and carry a big stick.