What to do about the economy.

In a comment to my FB post about the video on QE2 Sean DeButts asked what my solution would be for the economy. It’s an important question that deserves a detailed response.

Jobs are the number one thing we need to get the economy moving and jobs require capital and the willingness to put that money to work. Now …there is plenty of money around, billions and billions sitting on the balance sheets of banks and companies but it is not being put to work. Why not? Let’s look at companies first.

Companies will only invest if they think they can get a return on that investment and are confident that the rules won’t change before they can earn that return. Right now everyone knows that the deficits the US is running will lead to collapse if something doesn’t change but until what those changes will be is decided companies (and individuals) are worried that they might be singled out to pay for those deficits. That’s why I believe the National Commission on Fiscal Responsibility and Reform’s deficit reduction plan must be put into law by Congress and signed by the President. See: http://bit.ly/h1tILt for the Charley Rose interview with the co-chairs of the Commission.

Now I don’t agree with everything in the plan, nobody does and it will surely change as it works its way through the legislative process but it is a very good starting point and one that was developed by a bipartisan group of business leaders, leading economists and elected officials. In addition to getting control of and then reducing the deficit the plan would simplify the tax code and reduce special interest loopholes, two things that will build confidence.

Will it work? I believe it will, similar plans worked in Canada, Sweden and Britain. Interestingly those plans were put in place by ‘liberal’ governments too. See a review of ‘The Canadian Century’ starting on page 3 of: http://bit.ly/h1tILt for how our northern neighbors did it.

Now the banks, especially the Too Big To Fail (TBTF) banks also have billions sitting on their balance sheets but aren’t lending much either. There are three main reasons for this; First the Fed has been lending them billions at essentially 0% interest and those billions have been left on deposit at the Fed invested in risk free Treasury securities. If they can make good risk free returns at little or no cost why should they make higher risk loans to businesses, especially since underwriting loans costs money up front and some loans might not be repaid?

The second reason the banks, especially the TBTF aren’t lending is because they potentially face billions in losses from having to take back the bad mortgages they packed into Mortgage Backed Securities (MBS) while claiming they were all AAA rated. They are also facing huge potential losses from the ‘Foreclosure Mess’ which in reality is a mess they created by breaking the chain of title of ownership of every mortgage they packed them into the aforementioned MBS. The potential losses from having to take back the mortgages has been estimated to bee up to $120 Billion or higher with who knows how many billions on top of that to sort out who actually owns the mortgages and therefore who can foreclose on the ones not being repaid.

The third reason banks aren’t lending is because they have billions of commercial loans on their books at prices they know don’t reflect the actual worth of those loans. ‘Mark to make believe’ it is called and regulators allowed the banks (once again especially the TBTF) to do this to prevent them all from failing all at once during the financial crisis. They hope the values recover and as long as interest rates stay low borrowers will continue to make payments when they can but if interest rates rise the tide will go out and everyone will know who was swimming naked, to quote Warren Buffett. For more on how banks and lenders knowingly went astray see: http://bit.ly/dzcQyE

Long term TBTF is too big to exist and banks must be separated into low risk depository institutions offering guaranteed accounts and higher risk investment banks that can go broke without causing the whole financial system to collapse. See my ’08 blog post for more: http://ashworthpartners.com/the-bank-bailout-trap/

In the short term the best solution would to have new banks with clean balance sheets who are ready to lend. One idea I like that was proposed by President Obama is the creation of an ‘Infrastructure Bank’ that is set up to fund the repair, renewal and development of our national infrastructure. This would put money to work creating the means for a better future while creating jobs in the present. See: http://huff.to/e56oSB for more on the Infrastructure Bank proposal.

Another critical undertaking that will help prevent us falling back into another financial mess is serious regulatory reform for our financial markets. At their very root, debt and equity markets exist to channel money to productive investments, growing the economy and creating jobs. Unchecked however these markets always go astray, witness the CDO-cubed which is really a fake of a knockoff of an imitation investment. These ‘investment products’ along with most all of the derivative trading vehicles do nothing to promote the growth of the economy or the creation of jobs outside of Wall Street investment houses and need to be controlled and regulated or abolished. See my blog post for more: http://ashworthpartners.com/those-who-fail-to-learn-from-history/

Finally there is one more critical thing that we have failed to invest in; our future. We must improve our education system so that our children (and us too) can learn to be productive and competitive in the global economy. We must also reform our immigration system so that we don’t throw out foreign students as soon as they get a world class education, often at our expense. For more re-read Thomas Friedman’s ‘The World Is Flat’ now that his predictions have become history. Also see Fareed Zakaria’s excellent article on ‘How to Restore the American Dream’: http://bit.ly/cT0Glb

Well that’s my long (and partial) answer to a question that we should all be thinking hard about and communicating to our elected officials about. I welcome your thoughts and comments!

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