A Better Plan

The American economy is going through a profound restructuring. Less money will be spent on home construction in the future. American car companies will be smaller in the near term. The financial sector will employ fewer people. Such restructurings are painful because they are associated with layoffs and bankruptcies. But there are many ways for the government to mitigate the effects of this economic correction without risking trillions of dollars on bailouts. Below I outline a 5 part approach to coping with the current economic crisis and the financial sector's problems. Compared to the Obama administration's approach, this plan devotes less money to the financial sector and more money to the social safety net and job creation.

1) Restore Confidence: The most efficient way to restore confidence is to greatly expand unemployment benefits and the affordability of health care. Compared to many other developed countries, the United States has a weak social safety net. Parents who are worried that their children may lose access to medical treatments have every reason to drastically cut spending, causing an especially severe economic contraction. If Americans were more confident that they could maintain a decent standard of living, economic activity would be higher. This policy does not mean that we have to adopt a European style economy. The U.S.A. can skip the restrictive labor rules found across the pond because they hamper economic growth. We should just borrow the good stuff (the safety net) and we should do it as soon as possible.

2) Fight Unemployment: There are millions of unemployed Americans out there right now who want to work. Many businesses are shrinking. Eventually, other businesses will expand to fill the gap. But that can be a slow process. In the meantime, the government should use this excess supply of labor to modernize American infrastructure so that the country enters the next global economic expansion on a competitive footing. We need more stimulus money.

3) Maintain Price Stability: The Federal Reserve has done a good job fighting deflation so far. Under Bernanke's direction, the Fed has expanded the monetary base to help prevent a dangerous drop in prices. However, the Fed should be more cognizant of inflation risk. Bernanke ought to be more conservative in the assets he acquires during this monetary expansion because he may need to sell the assets quickly - thereby reducing the monetary base - to fight inflation. The Federal Reserve should conduct monetary policy. It has no business assuming massive credit and interest rate risks.

4) Ensure That There Is A Viable Financial Sector: This does not mean that huge banks need to be bailed out. The economy will benefit if a competitive group of healthy financial institutions exist to provide credit to people and businesses. The government can intervene if such a group does not exist. But that intervention should not take the form of pumping cash into failing banks. Rather, the money should be used to better capitalize the healthiest banks. Such a policy has a higher chance of ending in full repayment to the government and in an expansion of credit.

5) Impose Harsher Terms On Bailout Recipients: Many commentators argue that some banks are too big to fail. One argument for saving failing financial institutions is that their failure would be catastrophic to other institutions, setting off a dangerous chain reaction. I would like to see more evidence on this point. But even if one does assume that a firm's failure would be intolerably harmful to the economy, it does not follow that the government needs to spend billions of dollars to save investors in the firm. The government can guarantee the failing firm's obligations to customers and counterparties, but allow bondholders and equity investors to suffer losses. While discussing such an approach, market commentator and fund manager John Hussman wrote:

"Ultimately, if a financial institution is not capable of surviving without large and constant infusions of public capital, the stockholders and bondholders of that company – not the public – should be responsible for the losses incurred. . . . [T]his can be achieved without customer losses or a disorganized Lehman-style unwinding." (Here's the link.)

In conclusion, the Obama administration needs to rethink its approach to the current economic crisis. More money should be spent on the social safety net and building infrastructure. Less money should be spent on saving investors in financial institutions. Both can be accomplished without stifling the free market and without financial market chaos.