What's he endgame for stimulus spending? Killing capitalism?

[Susan Kuhn Frost]

Every investor knows: never invest without an exit strategy -- an endgame. The Obama Administration pushes huge increases in the size of government and is permanently increasing in the money supply far above the US's production of goods and services. Without "balance sheet reform," actual losses in personal, corporate, and government accounts -- we won't remain a capitalist country.

For all talk of stimulus spending, I would like to see equal talk about tax policy. I would like to tax policy changes to encourage business creation and expansion -- a 'thousand points of light" seeking opportunities. I'd like to see tax incentives for home purchases, and forgiveness of income tax when a short sale is made. These policies will allow the housing market to right itself, a major step in avoiding Japanese-style stagnation.

Asset values are inflated; if the heavy hand of government keeps pumping them up, the basic engine of capitalism will be weakened or destroyed. Or maybe that is the end game....euro-fying the go-go American entrepreneurial spirit.

The Bush Administration and Democratic Congress got so much wrong, for not heeding warnings about credit default swaps, for being too cozy with Fannie and Freddie, for missing the Maddoff fraud . I shudder to think of all our economic resource allocations being made, not by entrepreneurs heeding consumer demand, but a one-party government heeding its donor base.

So what do YOU think the end game is -- or should be?

[Stephen Baker]

I don't understand the point about asset values being inflated. Explain?

[Susan Kuhn Frost]

Thank you for giving me the opportunity to think more about this.

Housing is still pretty inflated...there just aren't the buyers out there who can qualify at these high prices. There is a demographic factor (fewer buyers in the prime homebuying age) apart from the problems in the credit markets. So the free market should be sending home prices down. 2005 was the best year ever for residential real estate appreciation -- the bubble year of all time.

If government stimulates market activity through tax credits for home purchases or other subsidies, then it keeps air the bubble (rather than letting it all out) because its actions will keep prices higher, just postponing the inevitable market adjustment.

On the other hand, if government encourages short sales, for example by easing the process by which they are completed, and by relieving the seller of paying income tax on the foregone mortgage amount, then housing prices will come down to a level at which they are sustainable in the free market.

So it is a question of emphasis -- let asset values fall and soften the impact now as best we can, or prop them up now because government will continue to prop them up far into the future through playing a more active role in the market.

That is why the question of the end-game is an important one.

If the idea is that government will grow to take over more than half of the economy then who cares, it should prop up the real estate market any way it can.

BUT if the idea is that all of this activity is short-term stimulus, then policies should be designed to EASE PAIN WHILE THE MARKET FINDS ITS OWN LEVEL.

I support the latter policy direction; this recession is a wake-up call for the US to live within its means, and stop counting on China, Brazil, etc. to buy our T-bills and our stocks and bonds which is what finances easy credit here.

It is just a matter of time -- and that time will be sooner rather than later because of this recession -- that alternatives to the dollar-denominated investments emerge. We were supposed to be the bastion of safety for the world, and instead, our mismanagement has made us the trigger for a severe recession. There is some speculation that the Chinese yuan and the Euro will emerge as regional alternatives to the dollar ... not ready to happen this year, or next, but alternatives to the dollar are within sight. When that happens....watch credit tighten if we are not ready.....

So if we continue to live beyond our means.....paying credit card bills, mortgages, etc. for assets that are in decline, consumers will be unable to spend on other things....this is a recipe for long-term slow growth ala Japan after its real estate bubble burst. Our loss of economic power will translate into a loss of military power...and what happens then may not be at all in our national interest......

So there are lots of reasons to get our economic house in order sooner rather than later. I think the best way is to take the hit now, eased as much as possible, without forcing government to become the long-term growth engine of the economy. Our national interest is much better served by careful repair where our regulatory system is broken, short-term stimulus that addresses long-neglected problems, and a long-term commitment to a vigorous private sector.

I would also commend to everyone the blog written by Mike Shedlock of Sitka Pacific, Global Economic Trend Analysis (http://globaleconomicanalysis.blogspot.com). Mike writes about this question of, as he puts it, "Balance Sheet Reform" passionately and in depth.

[Susan Kuhn Frost]

Here is a more cogent explanation than I can write of the dangers of keeping a credit bubble alive...focusing on the bank side of the picture. From the NYT this weekend (login required):

BEGIN QUOTE
...propping up failed banks and extending them huge amounts of credit has made business more difficult for the people and companies that had nothing to do with creating the mess. Perfectly solvent companies are being squeezed out of business by their creditors precisely because they are not in the Treasury’s fold. With so much lending effectively federally guaranteed, lenders are fleeing anything that is not. [This is what I mean about the end of capitalism....federal intervention disrupting the market mechanism].

Rather than tackle the source of the problem, the people running the bailout desperately want to reinflate the credit bubble, prop up the stock market and head off a recession. Their efforts are clearly failing: 2008 was a historically bad year for the stock market, and we’ll be in recession for some time to come. Our leaders have framed the problem as a “crisis of confidence” but what they actually seem to mean is “please pay no attention to the problems we are failing to address.”
END QUOTE

[Susan Kuhn Frost]

Ah....here is more good sense from the same NYT article. Bold and [] are mine.

BEGIN QUOTE
If we are going to spend trillions of dollars of taxpayer money, it makes more sense to focus less on the failed institutions at the top of the financial system and more on the individuals at the bottom. Instead of buying dodgy assets and guaranteeing deals that should never have been made in the first place, [e.g., keeping the bubble inflated] we should use our money to A) repair the social safety net, now badly rent in ways that cause perfectly rational people to be terrified; and B) transform the bailout of the banks into a rescue of homeowners.

We should begin by breaking the cycle of deteriorating housing values and resulting foreclosures. Many homeowners realize that it doesn’t make sense to make payments on a mortgage that exceeds the value of their house. As many as 20 million families face the decision of whether to make the payments or turn in the keys. Congress seems to have understood this problem, which is why last year it created a program under the Federal Housing Authority to issue homeowners new government loans based on the current appraised value of their homes. [the rest of the article shows how banks have undermined the HOPE program...again, keeping inflated assets on lenders books, good for them bad for the rest of us.]
END QUOTE

Susan Kuhn Frost said:

Here is a more cogent explanation than I can write of the dangers of keeping a credit bubble alive...focusing on the bank side of the picture. From the NYT this weekend (login required):

BEGIN QUOTE
...propping up failed banks and extending them huge amounts of credit has made business more difficult for the people and companies that had nothing to do with creating the mess. Perfectly solvent companies are being squeezed out of business by their creditors precisely because they are not in the Treasury’s fold. With so much lending effectively federally guaranteed, lenders are fleeing anything that is not. [This is what I mean about the end of capitalism....federal intervention disrupting the market mechanism].

Rather than tackle the source of the problem, the people running the bailout desperately want to reinflate the credit bubble, prop up the stock market and head off a recession. Their efforts are clearly failing: 2008 was a historically bad year for the stock market, and we’ll be in recession for some time to come. Our leaders have framed the problem as a “crisis of confidence” but what they actually seem to mean is “please pay no attention to the problems we are failing to address.”
END QUOTE

[Stephen Baker]

Yes, I agree with much of that, Susan. The question, then, is: What kind of stimulus spending should the govt be doing in the next year or two? Which investments benefit us all while leaving the bulk of the economy private?