Paging FDR

On September 19, U.S. Treasury Secretary Henry Paulson sent members of Congress an extortion note telling taxpayers to hand over $700 billion or their savings, jobs and homes would be forfeit. In spending that money to buy trash securities from financial firms, his actions would not be overseen, reviewed, reversed or subject to contract law.

The bailout bill being fought over in Congress as of press time isn’t quite as bad as Paulson’s initial request. The upfront amount was reduced to $250 billion, and the Treasury’s actions will be subject to oversight and review. That lends hope that some restraint may be exercised on the prices paid for the low-grade securities the public is forced to buy. And the lower the prices paid, the better the chance that we can recoup our expenditure.

A provision that would, under certain circumstances, give government an equity participation in the firms that benefit from the plan means that taxpayers could profit if the companies’ shares rise once they have dumped their toxic assets in the public coffers. There are limits (though in our view insufficient) on executive compensation in participating firms, and even a little help for homeowners. Re-regulation of the financial industry, vital to avoiding a repeat, is not included, but is too important to rush, and will hopefully be the first priority of the next administration.

But even with the above improvements, we think this bill is bound to fail as anything but, at best, a Band-Aid, because it fails to address our most fundamental problem.

Relieving the financial industry of its lousiest loans will get the economy growing again, the reasoning goes, because fear and uncertainty about those loans have frozen the flow of money and dried up the supply of credit. Take away the loans and the credit spigot will flow again.

That may prove true as far as it goes (provided the quantity of toxic sludge isn’t a lot bigger than expected). But there’s still a big problem on the demand side: no matter how much credit is available, U.S. households in aggregate are already too much in debt to take on any more safely. That’s why lenders had to make up crazy, unsound financial structures to begin with: it was the only way to make loans look affordable.

The problem is not just sub-prime mortgages, but regular mortgages, credit card debt, student loans and medical debt—the whole shebang. Over the past few years, debt in proportion to income has soared to record levels and saving rates have gone negative. American households in aggregate are grossly overextended. When people are drowning in debt, you don’t solve the problem by making it easier for them to borrow more.

We can see only three scenarios unfolding here. The first is the worst: this latest attempt to reflate economic growth with hot air succeeds for a while, allowing households to accumulate yet more debt that they can’t repay, and the Treasury comes back again in a few years with a demand that reads in trillions rather than billions. Or, despite the bailout, consumers balk at taking on more debt and lenders at advancing credit to the uncreditworthy, consumption declines, jobs are lost, defaults increase on existing debt—and it’s bailout time again, a lot sooner than in the first case but at least with a smaller tab.

But there’s another approach to lightening debt loads: increase income. Debt is not bad in and of itself, only in proportion, and part of what underlies today’s crisis is the fact that middle-class incomes have been stagnant for years. If incomes rise enough, households should be able to afford old debt payments, save some money and even take on new debt.

Will the businesses that can now access credit (if the bailout works) invest it in ways that boost worker income? That’s not what they did over the last eight years, even though productivity soared and corporate profits rose to a record percent of GDP. They bought back stock, engaged in mergers, invested overseas and overcompensated executives—did everything but boost middle-class wages and salaries.

Instead of heaving billions at Wall Street and hoping for the best, maybe we need a program structured to funnel money directly to middle-class jobs and wages, a New New Deal. How about a Green Deal, focused on creating alternative energy infrastructure and green technologies—something for which our own area, incidentally, has positioned itself well? If we could boost household income by building productive infrastructure, the economy could grow on the basis of real productive capacity, not the illusory prosperity of cheap money and asset inflation that has left us bankrupt.

Saints Reagan and Greenspan notwithstanding, as we teeter on the brink of a second Great Depression, it may be time to wonder whether that FDR guy wasn’t on to something after all.

Dr. Punnybone

Generation Rx