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JUST WHAT THE DOCTOR ORDERED

A Recession Can Clear The Air

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By Charles Morris
Sunday, November 16, 2008

Virtually all of America's financial and political artillery has been dragooned into the great task of heading off a recession. This is exactly the wrong way to go. As painful as it will be in the short run, a recession is just what we need.

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Our economic model is broken, and trying to restart it will just dig us deeper into a hole. The massive changes that are required can be made only through the violent rejiggering that takes place during recessions. That may sound coldhearted, but there's a precedent.

From 1979 to 1981, then-Federal Reserve Chairman Paul Volcker masterminded a nasty slowdown that broke stagflation -- the noxious combination of rising prices and no growth. Among other moves, Volcker pushed the yield on three-month Treasury bills up to an unheard-of 20 percent, stopping the economy in its tracks. Millions lost their jobs; Volcker was burned in effigy on the Capitol steps.

But when Volcker finally broke inflation's back in 1983, healthy growth resumed almost immediately, and Ronald Reagan rode the result to a landslide victory in 1984 -- a little fact that people worried about a one-term presidency for Barack Obama should note.

The arithmetic of our current problem is pretty simple: From 2000 through 2007, U.S. households borrowed $6.2 trillion, nearly doubling their debt. Most of it was borrowed against houses, and about two-thirds was spent on things other than another house or paying down mortgage debt -- including SUVs, flat-screen TVs and all the other consumer baubles of an American lifestyle. But when house prices collapsed, the home-equity cash spigot shut tight. U.S. consumer spending has fallen off the cliff, devastating car companies and shuttering factories throughout China.

The Treasury Department and the Federal Reserve have responded with pyrotechnics. The Treasury has infused hundreds of billions in cash into banks and other financial players. Even more remarkably, the Fed has distributed more than $1 trillion in new loans and credits to a broad range of financial and non-financial companies. The automobile manufacturers have now joined the queue, and President-elect Obama has signaled that he'd like them to be included in the bailout.

So far, none of this has worked very well. Banks continue to tighten credit and lending standards. Even interbank lending came close to freezing up last month -- a level of disruption not seen since the 1970s.

All these frenzied attempts at staving off recession seem to be aimed merely at jump-starting the consumer borrowing-spending binge that underpinned the ersatz growth of the 2000s. But the real need is to shift to a more balanced system that's less addicted to high-leverage finance.

Pouring money from the Fed into the banks just delays the day when banks -- and now we taxpayers -- will have to tally up our losses. The Fed is exchanging Treasury bonds for bundles of subprime mortgages at 98 cents on the dollar. But in the real world, those bundles could barely fetch 30 to 50 cents on the dollar. Does the Fed seriously believe that subprime mortgages are going to recover their value? The Japanese tried papering over bad assets during their 1990s credit crunch, and their economy has barely budged in 20 years.

At the same time, Congress and Treasury Secretary Henry M. Paulson Jr. are insisting that banks increase lending. To whom? House prices are still falling at double-digit rates. Credit-card defaults are spiraling upward. Companies are weak. Banks know how fast their loans books are deteriorating, and they desperately need cash to build up their reserves against all the bad loans they've made. Forcing them to ratchet up lending now is just pushing them back into the quicksand they're struggling to climb out of. It's financial folly. It would also be political folly for the new Obama administration.

For years now, even Democrats have been drinking the free-market Kool-Aid that the best economy is whatever markets decree it should be. So for most of the past two decades, the U.S. economy has been driven by whatever Wall Street is best at financing -- mostly bigger houses, fancier cars and more electronic toys from Asia. We have become a nation where people struggle to make payments on four-bedroom houses with faux-marble bathrooms and two SUVs in the driveway even as they worry about their lousy health insurance, evaporating pensions, shaky Social Security benefits and tapped-out 401(k)s.

Wall Street, meanwhile, prospered mightily. Financial-sector profits, which typically average about 10 to 15 percent of corporate profits, had leapt to 40 percent by 2007. Total corporate profits also soared, nearly doubling as a share of national income. But instead of triggering an investment boom, the gains were mostly distributed to shareholders. Exxon brags that it has invested $90 billion in exploration and new plants since 2003, but it has distributed even more -- nearly $120 billion -- to shareholders. The cash incomes of the top 1 percent hit an all-time high in 2006, just a tad higher than the previous record in 1929. That's the cash that fed the hedge funds, private-equity funds and the other yield-chasers that inflated the decade's asset bubble.

The scale of that bubble is reminiscent of the price-inflation bubble that bedeviled President Jimmy Carter. So are the policies being used to deal with it. Carter and his hapless Fed chairman, G. William Miller, flooded the economy with dollars even as consumer price inflation spiraled out of control. Volcker took over the Fed in 1979 and, by previous standards, moved aggressively his first year in office. But he made little headway. Finally, in late 1980, he cracked down hard and significantly raised interest rates.

Unemployment soared from 5.8 percent to 9.7 percent. Inflation stubbornly held on but finally broke in 1983. For the next several years, Volcker continued to crack down at the slightest hint of price buoyancy, until the markets took for granted that the United States was a low-inflation economy.

The 2008 analogue to the Volcker strategy would be to force a harsh, fast marking-down of all bank assets to real values. A one- to two-year bloodbath is far preferable to a decade of death by a thousand cuts. Many banks will fail and will have to be re-equitized by the government -- the terms should be neither punitive nor excessively generous -- but the weakest and the most irresponsible should simply be let go.

The banking system that emerges should be dull -- one where credit analysis trumps financial engineering and where everything is on the balance sheet. The big Canadian banks, RBC and TD Bank, have been determinedly dull in the 2000s and have turned in superb profits, far outperforming their supposedly brilliant American cousins.

Shrinking the banking sector will curtail bubble-style lending and force the share of GDP represented by consumer spending back down from its current 70 percent to a more sustainable 65-66 percent. It will be very painful, putting many companies in jeopardy, but it is the only way to engineer a transition to a world in which we spend less on houses and TVs and more on infrastructure and health care. Interest rates will be higher to encourage savings and taxes will go up, but debt should go down and the bottom half of the population should be more secure. It will also be very important to shore up our tattered social safety net to cushion the recession's impact on that lower half.

Democrats should seriously study the 1979-84 period. The political lesson is that Reagan backed Volcker all the way, even when the Republican Party was calling for Volcker's head. The deep recession cost the Republicans seats in the 1982 midterm elections. But when inflation suddenly cleared and growth resumed, Reagan won the 1984 election in a landslide. The dollar was once more the world's strongest currency, and the Reagan era had been launched.

If Democrats insist on piling on the palliatives, as the party's congressional leaders seem to be advocating, and the country hobbles along at 0 to 1 percent annual growth, they may get through the midterms, but they may also ensure that President Obama gets an early release from the burdens of office.

crmorris@crmorris.com

Charles Morris, a lawyer and former banker, is the author of "The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash."


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