Comfortably Numb

Let’s start by asking what this crisis is really about. It is not fundamentally about greed on Wall St. This is a crisis of Main St. – the fundamentals of the US economy are not good. For years now, Americans have been living beyond our means, consuming more than we save, letting our infrastructure and public institutions deteriorate and allowing the productive parts of our economy – the factories and labs that actually make things – to shrivel and die.

As Steve Randy Waldman of Interfluidity notes, the role of Wall St over the past decade or so has been to administer a series of shots of methamphetamine to hide the pain of our deteriorating real economy – injecting capital provided by foreign central banks into the veins of a series of asset bubbles.

That said, Wall St. has fundamentally failed to intermediate the world’s capital into productive investments in the US. Instead of investing in enterprises that could have improved the productivity and competitiveness of the US economy, it blew a series of asset bubbles that are now bursting – blowing up the US housing and financial sectors and setting the stage for the mother of all hangovers.

But Wall St’s role as the Dr Feelgood for the fundamentally sick US economy was aided and abetted by a number of public “servants.”

Public enemy number one was Alan Greenspan, who kept interest rates too low for too long after 9/11 and failed to provide adequate oversight of the financial sector by the Fed. Instead of taking away the punchbowl when the party got good, as he was supposed to do, Greenspan merely winked as the punch was spiked with grain alcohol.

Second were a series of ideologues and incompetents (pace Phil Gramm) who enacted a number of deregulatory measures that kept Main St addicted to Wall St’s financial alchemy. Legislative measures like the Gramm-Leachey bill, the near total lack of oversight by the Fed and the SEC, and the failure to address structural weaknesses in the real economy all combined to make Wall St the only game in town. It’s no coincidence that smart, ambitious young people all want to be Masters of the Universe on Wall St instead of becoming engineers or public bureaucrats.

Third, the ‘global savings glut,’ which saw the oil exporters and the economies of East Asia rack up huge dollar-denominated foreign exchange reserves that were then recycled back through the US financial system in a sort of vendor financing scheme resulted in a credit boom that caused a fundamental mispricing of risk. To some extent, the breakdown of global credit markets can be traced to the fact that we still don’t really know what the various mortgage backed securities and other assets on the books of financial institutions are really worth.

But given all this, the question remains, what now?

The real risks of the massive public bailout being proposed by Messrs Paulson and Bernanke aren’t so much the moral hazards of intervention or even the massive hit to taxpayers bottom lines that a $500 billion (and counting) public bailout implies – although those are nothing to sneeze at.

Rather, the real risk is that these bailouts will be enacted in an environment of fear and desperation and will fail to address the structural problems on Main St.

We have got to stop smoking the crack pipe of capital account inflows from foreign central banks and shore up the productive parts of the real economy. We must save more, consume less, rebuild our infrastructure, make American producers more competitive, and encourage our financial sector to direct capital to these areas.

While there are very few specifics available as to the direction and scope of the bailout making the rounds on Capital (sic) Hill, the devil will prove to be in the details. Make no mistake, serious government intervention is necessary at this point to stave off a total collapse of the global financial system. But the risks of a poorly thought out and hastily put together rescue package are huge – yesterday’s ban on short-selling being a case in point.

On the financial side, some sort of Resolution Trust version 2.0 is probably necessary – but the haircuts must not be confined (as they pretty much have so far) to equity holders. Creditors must take a loss as well, and even regular Joes who got in over their heads with a mortgage they couldn’t afford must be made to feel some pain too. Taxpayers cannot and should not make all the people and institutions that made bad bets be made whole. That includes the People’s Bank of China and the various sovereign wealth funds that have been pressuring Paulson for a bailout.

Over the longer term, serious thought must be given to how to prevent financial institutions from blowing up and taking everyone else with them. Thus far, one of the lessons Wall St has taken away is that if you screw up, you better screw up royally if you expect to get any help. Some way must be found to restrict the massive use of leverage by financial institutions, and capital adequacy ratios need to be tightened and enforced. Much wider oversight of the financial sector – from broker-dealers to insurance companies to hedge funds – must be put in place and staffed with competent experts. And there should be some way of tying the compensation of financial executives with their long term performance.

But structural reforms to the real side of the economy are much more important in terms of the long term wealth and prosperity of our economy. In a year or two, we will have cleaned up the balance sheets of our financial institutions and the markets should be (more or less) back to normal. But if we don’t address the domestic and international structural imbalances that have gotten us here, we will have merely delayed the day of reckoning. I’m going to throw out a few ideas, but this is by no means an exhaustive list:

Congress could write legislation authorizing the creation of a domestic development bank in the United States to help fund infrastructure projects. Such projects would need to be financed in conjunction with the private capital in some form of public-private partnerships. A development bank could fund the long end of project bonds and bring in both private capital to fund the short end of the bonds and private companies to build, operate and perhaps eventually own, new toll roads, ports, rail lines and the like.

Wholesale tax reform, including the introduction of a VAT and carbon taxes, could induce Americans to save more, consume less, and import less foreign energy.

Increased public funding for education, science, and research and development would help ensure that we have the skills and human capital in the future to innovate and create productive new businesses. A particular focus on green technologies could be particularly useful.

Some form of universal health care would improve the competitiveness of US businesses by relieving them of some of their skyrocketing health care costs.

There are surely other good ideas out there. The point is to stop throwing good money after bad with these ad-hoc bailouts and put in place a systematic plan to invest in the productive parts of the US economy.

Finally, a global economy requires global rules and institutions to run properly.  Global trade and financial imbalances cannot be sustained indefinitely, and an orchestrated unwinding of these imbalances is vastly preferable to the short, sharp shock of a dollar crisis. We also risk destroying the ‘second wave’ of globalization that so far has succeeded in lifting literally hundreds of millions of people out of poverty around the world if we can’t create international institutions that safeguard our social and environmental well being.

It is not just factory workers whose jobs are at risk in this brave new global economy - as we have seen, investment bankers and insurance executives can lose their jobs too when regulations and public institutions fail to keep pace with financial innovation and the torrid pace of creative destruction in 21^st century capitalism.

This is all, of course, a lot to ask. Given the way our Presidential campaign has been going and the generally moronic level of our political discourse, I really fear for our country – and by extension – the world.

If there’s one thing for sure, don’t believe any politician who tells you he’s going to cut your taxes. We’ll be paying for this mess for a long time to come. Let’s just hope the money isn’t entirely wasted.