Washington and the Fiscal Crisis of the States

The strings on federal stimulus money are making it harder for states to cut spending and balance their budgets. 

By RICHARD RAVITCH

As one whose interest in public service stems largely from the conviction that government can make a positive difference in people's lives, I have found the past year a paradox. From the financial crisis to health-care reform, the federal government has taken on challenges that urgently need to be addressed. Yet despite these actions—and sometimes because of them—the states, which provide most of the services that touch citizens' lives, are in their deepest crisis since the Great Depression. The state crisis has become acute enough to belong on the federal agenda.
New York State faces a budget deficit that could climb to $8 billion or $9 billion in fiscal year 2010-11 and the state could face another deficit in 2011-12 of about $14 billion to $15 billion. The causes of the larger deficits down the road include a drop off in federal stimulus funds, an increase in Medicaid costs, and the planned expiration of a state income tax surcharge, as well as the state's underlying structural deficit.
New York is in a tough spot, but few other states are immune from large and growing deficits. According to the Center on Budget and Policy Priorities, the states have faced and will face combined budget shortfalls estimated at $350 billion in fiscal years 2010 and 2011. Past experience suggests that these deficits will continue even if a national economic recovery takes hold. Moreover, we do not know how robust the recovery will be or what shape it will take. We know only that it will not spare the states the necessity of making acutely painful fiscal choices. New York and other states face draconian cuts in public services, higher taxes, or, more likely, a combination of both.

OpinionJournal Related Stories:

•Review & Outlook: States and the Stimulus
•Review & Outlook: The Deficit Commission Trap

The federal stimulus has provided significant budget relief to the states, but this relief is temporary and makes it harder for states to cut expenditures. In major areas such as transportation, education, and health care, stimulus funds come with strings attached. These strings prevent states from substituting federal money for state funds, require states to spend minimum amounts of their own funds, and prevent states from tightening eligibility standards for benefits.
Because of these requirements, states, instead of cutting spending in transportation, education, and health care, have been forced to keep most of their expenditures at previous levels and use federal funds only as supplements. The net result is this: The federal stimulus has led states to increase overall spending in these core areas, which in effect has only raised the height of the cliff from which state spending will fall if stimulus funds evaporate.
Until recently, some people predicted that the stimulus funds would not evaporate—that instead the federal government would rescue the states once more with another stimulus bill. But the prospect of this kind of help looks doubtful as an increasing number of lawmakers in Washington worry about the federal deficit and seem intent on taking serious steps to rein it in.
If those steps include neglecting the fiscal situation facing the states, the country could be headed for fiscal problems that are larger than the ones we face now. We are in a time of extraordinary economic change and Washington is struggling with the sometimes-conflicting demands of the federal deficit and the unemployment rate. But the states' growing deficits present their own urgent national problem that the federal government must place in the balance.
Federal policy makers do not have the option of assuming that the state fiscal crisis is temporary or will cure itself without further involvement by Washington. This crisis reflects the growing long-term pressures on the states from the health-care needs of an aging population and the maintenance needs of an aging infrastructure. Moreover, the $3 trillion municipal bond markets have begun to notice the states' deficits: Moody's recently downgraded the bond ratings of Arizona and Illinois because of the deficits those states face. The rating agency says it is waiting to see whether New York will reduce its budget gaps and has warned the state against trying to do so solely through one-time actions.
It seems almost inevitable now that the states' fiscal problems will have further effects on capital markets, possibly as soon as next spring and summer. If more cracks appear in the capital markets that handle municipal bonds, the U.S. Treasury and the Federal Reserve will be faced with an unattractive set of options: They can allow those markets to deteriorate or use federal tax dollars to shore them up and thereby increase the federal deficit.
It is safe to say that one way or another events will force federal policy makers to spend money in response to state deficits. Federal officials shouldn't wait for an emergency to begin to address two questions: Which services should the federal government provide and which should the states provide? And how should the costs of these services be split among federal, state, and local tax bases?
For example, Medicare, not Medicaid, is the primary payor of health-care costs for the elderly and disabled. About 17% of Medicare beneficiaries are low-income and, thus, also receive varying levels of state Medicaid benefits. These "dual eligible" beneficiaries account for some 40% of state Medicaid spending.
For these beneficiaries, the current system is a nightmare: They disproportionately suffer from chronic diseases but must navigate two separate bureaucracies and sets of rules in order to receive care. For the states, this system is a costly burden. From the perspective of a rational health policy, the system is an anachronism. It developed when Medicare did not provide income-based aid and did not have income-based information about those it served. Medicare now provides such aid and has the information and capacity to provide these benefits more effectively, with more potential for cost containment, than the current system.
A federal takeover of services to dual eligibles would cost about $70 billion per year. For many states, a share of this amount would be the difference between chronic fiscal crisis and a chance at structural budget balance. After the Troubled Asset Relief Program and health-care reform—with the cost of the latter estimated by the Congressional Budget Office at almost $900 billion from now through 2019 and $1.8 trillion in the 10 years from 2014 through 2023—the bill for such a takeover does not seem huge or disproportionate to the relief it would provide to state budgets.
Those of us responsible for the states' budgets have the unpleasant duty of imposing greater burdens on our citizens before we can reach legitimate balance between revenues and expenditures. It is not unreasonable for us to hope that federal policy makers will treat our state deficit problems with the same seriousness with which they are now preparing to address the national deficit.
Mr. Ravitch, a Democrat, is the lieutenant governor of New York.

 

Big Business Creates Jobs Too

Many small businesses fail. And innovating can be easier with corporate backing.

By ETHAN PENNER

A major focus of both political parties is job creation. Underlying the discussion is a glorification of the merits of the "small business" at the expense of "big business." The commonly quoted statistic from the Small Business Administration (SBA) is that 65% of all new jobs are created by small businesses, defined as any business employing 500 people or fewer. Armed with that bias, and appealing to populist sentiment, there is growing support in Washington for tax reforms aimed at helping small businesses by cutting the taxes they pay or by offering them tax breaks for new hires.
But here is what many people do not realize: 99.7% of all companies in America meet the SBA's definition of small business. This implies that the remaining 0.3% of American companies—big business—create 35% of all new jobs in this country. While cutting taxes in general is always a good idea for kindling economic vitality, ignoring the important role that big business plays in job creation is a short-sighted mistake.
Given the aforementioned statistic, combined with the fact that most low-paying companies fit into the small business definition, it is not a stretch to conclude that large companies are disproportionately responsible for creating both higher paying and stable jobs. Small companies clearly create jobs, and occasionally these companies provide stable, long-term employment. But the large majority of jobs created by this group are both very low-paying and highly unlikely to be around for the long term. According to the SBA, 56% of all startups fail within their first four years of operation.
It is actually within large companies that an entrepreneur can find, already in existence, much of what it takes to insure a venture's success. This includes the capital required to fund startup costs, the marketing presence to create a near-instant reach to customers, and the standing required to gain trust of both vendors and customers. The two largest bond fund managers in the world, Pimco and Blackrock, were born inside of existing large companies—Pacific Mutual Life and Blackstone, respectively—and flourished under entrepreneurial leadership. Blackrock then went on grow immensely after it was sold to Mellon Bank.

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Associated Press 

 

Apple Computer, a great example of a small company success, at one point was solely focused on computers. Yet in the past several years Apple's success has been driven by many new business lines including the iPod and iPhone. These product-line successes illustrate how a big company can entrepreneurially exploit its brand name, related technological expertise in the industry, access to capital, and sales and marketing reach. There is no doubt that if someone tried to launch either the iPhone or the iPod from his garage the results would not be what they have been for Apple.

In my own career I've had a number of opportunities to build new businesses within existing big companies. In 1993, with financial backing from Nomura Securities, my partners and I built a commercial real estate finance business in which we applied securitization techniques to the market in a comprehensive way for the first time.
At our peak we directly employed approximately 500 people around the country and indirectly many more. At Nomura we were credited with having inspired the creation of the Commercial Mortgage-Backed Securities (CMBS) market, which peaked in 2007 at $230 billion in new issue volume that year. As a consequence, we directly created thousands of high-paying jobs and helped to create many more jobs indirectly through the related services required to serve the new market (including legal, accounting, and rating agency and more).
Recently I joined CB Richard Ellis Investors, another large company, to build a new business line addressing the financing needs of the commercial real estate industry. My partners and I have been seeded with some capital from our parent company along with many other extraordinary benefits that have allowed us to jumpstart our operation in a challenging business environment. We've hired about a dozen people thus far and our plan calls for significant growth which, if we are successful, will lead to the creation of many new jobs. Perhaps, as was the case with Nomura, our success will inspire other companies to follow in our footsteps and many more jobs will be created.
In sum, if the government wants to spur the creation of stable and high-paying jobs it would do well not to neglect big business when establishing policy.
Mr. Penner is executive managing director of CBRE Investors and the founder and president of CBRE Capital Partners.

 

Why Taxing Stock Trades Is a Really Bad Idea

Everyday investors shouldn't be punished for a subprime fiasco fueled by Fannie Mae and Freddie Mac.

 

 

By DONALD L. LUSKIN AND CHRIS HYNES

The Democrat-dominated Congress has come up with a new way for President Obama to violate his campaign pledge to not raise taxes on families earning less than $250,000 per year. It's a tax on securities transactions—trading in stocks, options, futures and so on.
And why not single out trading for special taxation? We levy special taxes on tobacco, alcohol and other vices. Except that trading isn't a vice. The exchange and hedging of business interests is a virtuous—and utterly essential—activity in a free economy.
But you'd never know it from the angry anticapitalist rhetoric of the tax's proponents. Rep. Peter DeFazio (D., Ore.), who introduced the House bill establishing the tax—positions it as retribution for "the Bush administration's cowboy capitalism, markets know best, deregulation at all cost policies." Sen. Tom Harkin (D., Iowa), who introduced a similar Senate bill, says, "We need a shift in priorities in this country to ask not what America can do for Wall Street, but ask what Wall Street can do for America."
Are you just an ordinary American who trades stocks? You probably don't think of yourself as having much to do with "Wall Street," or of your trading as a vice that ought to be singled out for a special tax. And you surely don't think of yourself as someone who caused the recent financial crisis, which was, as Rep. DeFazio says, "brought on by reckless speculation in the financial markets."
If anything, you probably think of yourself as a casualty of the crisis, not its cause. Why should a stock market investor like you—or for that matter, even an investor literally on Wall Street—pay a tax as punishment for a crime of which you were the victim, not the perpetrator? The crisis was caused by excesses in the mortgage industry, led by government-sponsored entities such as Fannie Mae and Freddie Mac. How did stock transactions—or transactions in options or futures—have anything to do with this crisis?
The proposed tax would apply to commodity transactions as well. So here we find another class of victims being punished. When excesses in the mortgage market blew up the world economy in 2008, commodity investors were hammered as prices plunged in everything from crude oil to gold to corn. Many of them were ordinary businesses—far from Wall Street—trying to hedge themselves against the rising cost of energy.
To be fair, the tax would apply to credit default swaps, which were closely associated with the excesses in mortgage speculation. But if it's going to apply to stocks—which had nothing to do with the crisis except to be its victim—then why does the tax, as proposed by Rep. DeFazio, not apply to bonds? It was the bond market, not the stock market, that was the conduit for hundreds of billions of dollars of dodgy subprime mortgages. Could this possibly be related to the need for the federal government to issue Treasury bonds from here to eternity to finance the looming deficits from the cornucopia of programs being cooked up in Congress?
Setting aside the critical issue of why certain types of securities are singled out for tax, and others are not, the tax as currently proposed does not even succeed in fairly targeting speculators as opposed to investors. In fact, like most tax schemes, it is riddled with arbitrariness and capriciousness.
Suppose you buy a stock, and you hold the position for 20 years. You're an investor. Suppose the person who sold it to you was a day trader—who might end up buying the stock again 10 minutes later from someone else and then selling it after an hour. You both pay the same tax.
As proposed, you wouldn't have to pay a tax to buy or sell mutual funds. Yet mutual funds themselves would have to pay the tax on any trades they make in stocks. So as the owner of the mutual fund, you still end up paying the tax. According to the Investment Company Institute, the average turnover for stock-market mutual funds in 2008 was 60%, which would add up to a lot of taxes.
Transactions in retirement accounts would be exempted. So a corporation that invests to provide pensions to retired workers won't face higher costs. But a retired individual who has just sold his business and is living off the invested proceeds will pay the tax.
And don't believe the proponents of the tax when the say it's so small you'll never notice it. At one quarter of 1%, that would be a cost of $0.33 on a share of IBM. If you were to buy or sell $100,000 worth of IBM (or any stock), the tax would be $250. Single taxpayers would get an annual exemption of that amount. But trade again, and you're taxed $250. Again, another $250. Over and over. Each time, that's about 20 times the commission that a typical online broker would charge you to make that trade—yes, the greedy broker, the one on Wall Street.
More fundamentally, the proponents of the tax seem not to have thought through what effects it might have on America's global competitive position as the world's pre-eminent stock market. They simply wave away any concern with a flourish of moral indignation. Last summer, when Britain's Financial Services Authority Chairman Adair Turner proposed a trading tax for the United Kingdom, and set in motion a global movement toward such a tax, he called trading "socially useless."
We shouldn't have to "socially" justify any lawful activity. But surely it is "socially useful" to let free people transact freely, without regulators and legislators micromanaging them. If anything, given the spectacular failure of every regulatory authority and legislator to detect and deter the abuses in mortgage markets that led to a near-meltdown of the global economy, it is their activities that would appear to be "socially useless" and deserving of a special tax.
It's Economics 101 that the free actions of market participants cause supply and demand to reach equilibrium. And isn't that what investors—indeed, even speculators—do? Don't they try to buy things they think are cheap and sell things they think are expensive? Can they do it as well when facing the dead-weight costs of a transaction tax?
If not, then trading volume in our stock markets will fall. Beyond the tax, everyone—investor and speculator, great and small—who buys or sells stocks will pay more to transact in markets that are less liquid. And they will transact at prices that are not set as efficiently. In such a world, markets would necessarily be more risky, and the cost of capital for business would necessarily rise. The consequence of that is that innovation, growth and jobs would necessarily fall. That would be the full and true cost of the trading tax being proposed.
Mr. Luskin is chief investment officer at Trend Macrolytics LLC. Mr. Hynes is chief executive officer of Hynes Capital.

 

The Biggest Losers

Behind the Christmas Eve taxpayer massacre at Fannie and Freddie.

Happy New Year, readers, but before we get on with the debates of 2010, there's still some ugly 2009 business to report: To wit, the Treasury's Christmas Eve taxpayer massacre lifting the $400 billion cap on potential losses for Fannie Mae and Freddie Mac as well as the limits on what the failed companies can borrow.
The Treasury is hoping no one notices, and no wonder. Taxpayers are continuing to buy senior preferred stock in the two firms to cover their growing losses—a combined $111 billion so far. When Treasury first bailed them out in September 2008, Congress put a $200 billion limit ($100 billion each) on federal assistance. Last year, the Treasury raised the potential commitment to $400 billion. Now the limit on taxpayer exposure is, well, who knows?

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Associated Press 

 

The firms have made clear that they may only be able to pay the preferred dividends they owe taxpayers by borrowing still more money . . . from taxpayers. Said Fannie Mae in its most recent quarterly report: "We expect that, for the foreseeable future, the earnings of the company, if any, will not be sufficient to pay the dividends on the senior preferred stock. As a result, future dividend payments will be effectively funded from equity drawn from the Treasury."

The loss cap is being lifted because the government has directed both companies to pursue money-losing strategies by modifying mortgages to prevent foreclosures. Most of their losses are still coming from subprime and Alt-A mortgage bets made during the boom, but Fannie reported last quarter that loan modifications resulted in $7.7 billion in losses, up from $2.2 billion the previous quarter.
The government wants taxpayers to think that these are profit-seeking companies being nursed back to health, like AIG. But at least AIG is trying to make money. Fan and Fred are now designed to lose money, transferring wealth from renters and homeowners to overextended borrowers.
Even better for the political class, much of this is being done off the government books. The White House budget office still doesn't fully account for Fannie and Freddie's spending as federal outlays, though Washington controls the companies. Nor does it include as part of the national debt the $5 trillion in mortgages—half the market—that the companies either own or guarantee. The companies have become Washington's ultimate off-balance-sheet vehicles, the political equivalent of Citigroup's SIVs, that are being used to subsidize and nationalize mortgage finance.
This subterfuge also explains the Christmas Eve timing. After December 31, Team Obama would have needed the consent of Congress to raise the taxpayer exposure beyond $400 billion. By law, negative net worth at the companies forces them into "receivership," which means they have to be wound down.
Unlimited bailouts will now allow the Treasury to keep them in conservatorship, which means they can help to conserve the Democratic majority in Congress by increasing their role in housing finance. With the Federal Reserve planning to step back as early as March from buying $1.25 trillion in mortgage-backed securities, Team Obama is counting on Fan and Fred to help reflate the housing bubble.
That's why on Christmas Eve Treasury also rolled back a key requirement of the 2008 bailout—that Fan and Fred begin shrinking the portfolios of mortgages they own on their own account, which total a combined $1.5 trillion. Risk-taking will now increase, so that the government can once again follow Barney Frank's infamous advice that the companies "roll the dice" on subsidies for affordable housing.
All of which would seem to make the CEOs of Fannie and Freddie the world's most overpaid bureaucrats. A release from the Federal Housing Finance Agency that also fell in the Christmas Eve forest reports that, after presiding over a combined $24 billion in losses last quarter, Fannie CEO Michael Williams and Freddie boss Ed Haldeman are getting substantial raises. Each is now eligible for up to $6 million annually.
Freddie also has one of the world's highest-paid human resources executives. Paul George's total compensation can run up to $2.7 million. It must require a rare set of skills to spot executives capable of losing billions of dollars.
Where is Treasury's pay czar when we actually need him? You guessed it, Fannie and Freddie are exempt from the rules applied to the TARP banks. The government gave away the game that these firms are no longer in the business of making profits when it announced that the CEOs will be paid entirely in cash, though it is discouraging that practice at other big banks. Who would want stock in the Department of Housing and Urban Development?
Meanwhile, these biggest of Beltway losers continue to be missing from the debate over financial reform. The Treasury still hasn't offered its long-promised proposals even as it presses reform on banks that played a far smaller role in the financial mania and panic. Senate Banking Chairman Chris Dodd (D., Conn.) and ranking Republican Richard Shelby recently issued a joint statement on their "progress" toward financial regulatory reform, but their list of goals also doesn't mention Fannie or Freddie.
Since Mr. Shelby has long argued for reform of these government-sponsored enterprises, their absence suggests that Mr. Dodd's longtime effort to protect Fan and Fred is once again succeeding. It would be worse than a shame if, having warned about the iceberg for years, Mr. Shelby now joins Mr. Dodd in pretending that these ships aren't sinking.
In today's Washington, we suppose, it only makes sense that the companies that did the most to cause the meltdown are being kept alive to lose even more money. The politicians have used the panic as an excuse to reform everything but themselves.

 

Mandatory Usury in One Lesson

How Congress dictated a 79.9% interest rate.

'You might have less-than-perfect credit and we're OK with that," read an October credit-card solicitation from South Dakota-based First Premier Bank. The interest rate, however, will strike some as usurious: 79.9%. That's a more than eightfold increase from the 9.9% the bank previously collected for a similar card.
Wait, wasn't Congress supposed to have passed legislation against predatory lending? As a matter of fact, yes. The whopping rate increase is First Premier's way of complying with the Credit Card Accountability, Responsibility and Disclosure Act of 2009. Among other provisions, that law prohibits fees of more than 25% above a card's credit limit. First Premier has been offering an account with a $250 limit and annual fees of $256. By law the latter figure must come down to $75. To compensate for the lost $181 in fees, the bank is raising the rate by 70% of $250, or $175, a year.
If it sounds like a rotten deal either way, it is—if you have good credit. But if you don't, the cost may be worth it to re-establish your rating. Banks that lend money to customers with poor credit histories have to charge more to cover the extra risk. If Congress makes this impossible, banks will respond by refusing to lend to such customers, so that it will be harder for them to re-establish their creditworthiness.
Banks can't be expected to give money away, even if Congress is in the habit of doing just that. Unlike lawmakers, banks and other businesses can collect revenues only by offering something of value in return.

 

Markets fail. That’s why we need markets.

It may sound odd, but only free and open markets, not government regulation, can quickly and effectively clean up the mess that markets sometimes make.

By Arnold Kling and Nick Schulz / December 28, 2009

Arlington, Va.; and Washington Two camps have fought the political and philosophical battle for influence over the economy in the United States for the past 100 years. They differ in their views over the nature of markets and government. And both are wrong.
One camp makes it sound as if markets can do no wrong. Their views were ascendant in the 1920s and again in the 1980s.
The other camp argues, “Markets fail, and that’s why we need government.” The idea is that markets are prone to excesses and imbalances and need the thoughtful, steadying hand of government to protect consumers and investors from flaws and uncertainties of the market. This camp believes that wise technocrats can and will bring order to the markets.
In the wake of the financial crisis that gave way to the broader economic downturn, the advocates of government involvement in the economy are once again on the march and traditional defenders of markets are in retreat. And so we have seen government advance its role with partial ownership of many big banks, with a take-over of automotive firms, with a large “stimulus” program, with proposals for cap-and-trade for carbon emissions, and with a major initiative on healthcare.
The traditional defenders of free markets have had a rough time getting a hearing lately. After all, it certainly appears as if markets don’t work in any meaningful sense. The Dow rises and plummets in harrowing fashion, the housing market balloons and then craters, financial services firms teeter on the edge of extinction one minute and swing to record profitability the next.
Surely, government can do better.
Or can it? Over the past two generations, a different view of markets and government has begun to emerge, one whose moment may have arrived. It is a view that believes both traditional camps have overlooked some important aspects of markets.
What’s more, it is a view that, if embraced, helps reinterpret market gyrations and government interventions in a way that better reflects reality. The view is subtle, but it has a profound influence on how the public and policymakers should think of markets and, ultimately, the role of government in the economy.
This view can be summarized as “Markets fail. That’s why we need markets.”
This seemingly paradoxical view is based on several overlapping strands of research in economics as it pertains to development, history, technology, business expansion, and new-firm formation. According to this view, entrepreneurs at work in the economy – in finance, high tech, manufacturing, services, and beyond – are constantly experimenting, creating new business models, techniques, and technologies that upend the established order of things.
Some new technologies and innovations are genuine improvements and are long-lasting welfare enhancers. But others are the basketball equivalent of pump fakes – they look like the real deal and prompt market actors to leap hastily into action, only to realize later that their bets were wrong.
Given this dynamic, markets are unpredictable, prone to booms and busts, characterized by bouts of exuberance that are rational or irrational only in hindsight.
But markets are also the only reliable mechanism for sorting out this messy process quickly. In spite of the booms and busts, markets drive genuine long-run innovation and wealth creation.
When governments attempt to impose order on this chaotic and inherently risky process, they immediately run up against two serious dangers.
The first is that they strangle new innovations before they can emerge. Thus proposals for a Consumer Financial Protection Agency, a systemic risk regulator, a public health insurance plan, a green jobs policy, or any attempt at top-down planning may do more harm than good.
The second danger has to do with the nature of political economy. Politics creates its own kind of innovators who can be as destabilizing to markets as market actors themselves – but in far more pernicious ways.
Economists call these political entrepreneurs “rent-seekers.” Rent-seekers gain wealth, not by creating it, but by channeling it through political favors. Examples include government-sponsored monopolies, “targeted” tax breaks for special industries, and legislative loopholes inserted by lobbyists.
The boom in housing and mortgage securities that ended so badly was fueled by government policies that were encouraged by rent-seekers in the real estate, home building, and mortgage finance industries.
Rent-seekers aren’t partisan. They used President Bush’s push for an ownership society to promote sketchy mortgage products. Before that, they used President Clinton’s push for a fairer economy to compel banks to make loans to poorer neighborhoods. In both cases, rent-seekers turned political slogans into profit, but at a steep cost to society when the boom ended.
The response to the current economic crisis has perpetuated and even intensified this process, as hundreds of billions of dollars of taxpayer funds have been used to prop up the very firms that took such reckless risks. The bigger the bad bet, the bigger the bailout.
This gets to the key difference between markets and governments. When innovation-driven excesses and imbalances are recognized in the marketplace, the system can correct itself quickly. This is less the case when government policy failure occurs.
Because political failure is less publicly tolerable than market failure, the temptation becomes for policymakers to avoid acknowledging their role in creating or perpetuating problems. Or they double down on bad bets. So rather than recognize the government’s central role in the housing boom and bust and quickly changing its ways, we see the federal policy apparatus continuing to throw good money after bad in the mortgage market and on Wall Street.
Markets fail; but they learn from their failures. That’s why we need markets. Government can promise to guarantee our prosperity; but only markets can really deliver.
Arnold Kling is an economist with the Mercatus Center’s Financial Markets Working Group at George Mason University. Nick Schulz is DeWitt Wallace Fellow at the American Enterprise Institute for Public Policy Research. They are coauthors of “From Poverty to Prosperity: Intangible Assets, Hidden Liabilities and the Lasting Triumph Over Scarcity.”

 

Prepare for a Keynesian Hangover

Our government's spending orgy will haunt us in 2010.

By BENN STEIL

In 2008, as the U.S. economy teetered under the weight of years of reckless credit expansion, the Bush administration decided against proposals to sweep out the bad debts from the banking system and then fix the regulatory structure—an approach based on tried and tested models from the S&L crisis and other financial crises.
We will pay the price for this decision in 2010. That's because the Obama administration and the Federal Reserve are plowing forward with Plan B: Nationalize credit creation and "stimulate" the private sector by spending in its stead.
Richard Nixon's famous line, "We're all Keynesians now" never seemed more apropos. With the budget deficit at an eye-popping $1.4 trillion, and on track to stay above $1 trillion indefinitely, Berkeley economist Brad DeLong writes breezily in his Nov. 30 blog that "anything that boosts the government's deficit over the next two years passes the benefit-cost test—anything at all."
On the monetary side, the fireworks have been even more spectacular. Since the financial crisis of late 2008, the Fed has flooded the globe with newly conjured dollars in an unprecedented no-holds-barred effort to prod private credit expansion. Watching the booms in the markets for distressed debt, junk-rated corporate bonds and poor-country sovereign bonds since the summer, one might be forgiven for concluding that the Fed had succeeded well beyond its expectations, and that the market's flight to safety had given way to a flight to Vegas. Yet "the truth is that policy should be piling on," Princeton economist and New York Times columnist Paul Krugman writes in his Nov. 25 blog, "not looking for the exit."
Fed Chairman Ben Bernanke wants it both ways. On the one hand, he regularly reminds the market that he's already found the exit: continuously lending out its securities short term in order to soak up cash. The so-called reverse repo market through which this would be done is probably too small for the task of controlling inflation. But such a softly-softly approach is much more attractive politically than actually collapsing the Fed's bloated balance sheet, which would require dumping hundreds of billions of dollars of stockpiled mortgages.
On the other hand, Mr. Bernanke continues to berate the banks for failing to lend while the government continues to do so with heroic abandon.
Former Salvadoran finance minister Manuel Hinds points out in the latest issue of International Finance that banks have indeed been shirking on their day job of transforming increased deposits into increased private-sector credit. But they haven't quit entirely. In fact, they've funneled significant new funds into nonbank financial institutions—which have not lent them on. What's happening is that U.S. banks have been behaving exactly like developing country banks during earlier crises, such as Indonesian banks in the late 1990s—raising lending to their worst borrowers to keep them alive, lest the banks themselves collapse from their borrowers' defaults.
For U.S. banks, these zombie borrowers are their affiliated financial entities set up to manage so-called off-balance-sheet activities—such as the famous SIVs (structured investment vehicles) created by Citigroup and others during the boom. Thus, the massive fiscal and monetary bailouts of the banks have served to worsen the credit misallocation that led to the general economic collapse in 2008.
What is the right solution? The same one that most observers, including the U.S. government, backed until late 2008: Get the bad assets off of the banks' balance sheets. Banks will continue to use accounting gimmicks for window dressing, but as long as they know the truth—that their assets remain seriously impaired—they will continue to starve far too many sound commercial ventures.
Those who insist that the government buying up soured private assets amounts to an unacceptable bailout should be reminded that the market-driven alternative is called bankruptcy. Unfortunately, this option is now considered too politically toxic.
So what we're left with is the type of government-sponsored orgy of spending and money creation that Washington used to condemn with all-knowing righteousness when undertaken south of the border. But the effect of our doing it is far more consequential, since America possesses the exorbitant privilege of minting not only its own but the world's money.
As we move into 2010, no doubt the horns will be blowing for the long-awaited U-shaped recovery. I suspect it won't be long before we realize we've drunk too much, and that the second dip of a W-shaped recession awaits us.
Mr. Steil is director of international economics at the Council on Foreign Relations and co-author of "Money, Markets, and Sovereignty" (Yale University Press, 2009).