A New Federal Role in Economic Recovery

My post on fundamental assumptions generated some good discussion which began waxing economic in flavor. As part of that discussion I had a new idea about a more reasonable approach the federal government could take to soften economic hard times without outright manipulating our expectations of reality as they do now.

I should start by clarifying my perspective on what the federal government does and what is economically realistic. Economic realism insists that we recognize the inevitability of economic downturns. They are going to happen. Unfortunately the assumption at the federal level seems to be that we must strive for perpetual economic growth – we might tolerate one or two quarters of a mild contraction but anything beyond that is unacceptable. As proven by our significant and now two year old recession sometimes the economy needs to undergo a much harsher adjustment – especially after the government has been pumping the supposedly healthy market with perpetual stimulus for years. (I know, they have not called anything they did stimulus until the stimulus bill in early 2008.)

Personally I think a better approach to the federal government smoothing the rough spots out would be to establish a baseline – let’s say 5% unemployment – where any state meeting that baseline would not receive any federal economic assistance to combat unemployment. Then they would look a the spread between the unemployment rate of various states and be allowed to give economic aid to any state with at least 5% higher unemployment than the state with the lowest unemployment. The upper limit of that aid would be equal to 1/3 of the difference in unemployment between the higher of 5% and the unemployment rate of the state with the lowest unemployment with the limitation that government aid cannot help one state leapfrog another. Let’s show what that would mean with current (October 2009) numbers.

The state with the lowest unemployment is North Dakota at 4.2% so any state with more than 9.2% unemployment could get aid from the federal government to help lower their unemployment. For the October 2009 numbers that would mean that only 21 states could get any federal assistance rather than having the federal government trying to jump start the economies of all 50 states. Of those 21 states Arizona, Missouri, and Washington (at 9.3% unemployment) could receive aid equal to 0.3% of their respective economies (they would not be allowed to leapfrog Idaho and new York which have 9% unemployment and cannot receive this federal aid because they are within 5% unemployment of North Dakota’s unemployment rate). In fact, 12 of the 21 states would receive enough aid to bring them equal to the 9% unemployment rate of Idaho and New York because that would be less than 1/3 of the difference between their actual unemployment rates and the magical 5% unemployment. At the other end of the scale Michigan, with the highest unemployment would have their rate cut below 12% from their current 15.1%.

If every state had unemployment rates over 5% the new benchmark would be the lowest unemployment rate of any state. If we imagine that lowest unemployment rate was 6.5% (adjusting all states up to 6.5% and leaving states with higher unemployment where they are) only states with unemployment over 11.5% would receive aid, six states in all, and only Michigan would get the full 1/3 of the difference between their rate and the base rate of 6.5% (leaving them with 12.2% unemployment).

If all states were below 5% unemployment or if they were all clustered between 3.5% and 8.5% unemployment then the federal government would not give unemployment assistance to any of the states. If anyone is curious to see them, I have all my numbers in a spreadsheet that you can download.

The fact is that of the economy of the entire nation is slumping then no government program can provide a solid foundation to real economic growth – all it can do is produce the illusion of economic stability. Real economic growth can only be build on fundamental economic change, not on the illusion of stability provided by printing money and manipulating interest rates. While committed free marketers would likely hate my proposal just like they hate the current government intrusions in the economy and while those who don’t object to socialism will find my suggestions very harsh on downtrodden regions of the nation, I think that my idea is much better at providing a cushion for the hardest hit areas while allowing the economy to shrink or grow towards whatever the realities of our national economy are which the government tries so hard to mask right now as if our perceptions were the only economic reality worth considering.

15 comments for “A New Federal Role in Economic Recovery

  1. Charles D
    December 4, 2009 at 1:54 pm

    Interesting idea certainly. My first reaction is probably an iconoclastic one – allocating funds based on state unemployment levels is really rather arbitrary. State governments have little control over the macro-economy at this point and in fact, they are barely relevant since the competition for jobs between them has been reduced to a competition to buy employers with no guarantees of continued employment. Additionally, a state may have a very bad unemployment problem in one or two counties while the rest of the state is in better shape and thus would not qualify for help. In addition, state governments vary greatly in their efficiency and integrity so there is little guarantee that funds would be used well.

    Second, I question the value of unemployment assistance as anything but a stop-gap measure. Jobs need to be created, preferably well-paying jobs with a long-term future. This is not going to happen by cutting corporate taxes, providing unemployment insurance, or other limited financial incentives. What we have to do is make some decisions about how to invest for the future and if the private sector is unwilling or unable to make those investments, then in an economic crisis, government could step in. I support government spending for infrastructure improvements that will help future commerce, investments in industries that have a long-term growth potential such as alternative energy, and investment in education because we cannot hope to bring about long term economic recovery without a well-educated work force.

    • December 4, 2009 at 2:05 pm

      Thanks for taking the time to consider my ideal. You have made a few assumptions that are entirely flexible. For one thing, any money from the federal government does not have to go through the states – Congress allocates funds directly to projects and private companies all the time so how well the state would manage the funds is not necessarily an issue. Second, must the federal government be directly responsible to help each depressed county, city, or family? What level of granularity can appeal directly to the federal government? This idea could theoretically be implemented at any level but let’s stick with states and say that if a state is doing well overall but has two counties that are in trouble the state would be responsible, in theory, to do what they could to help the troubled areas.

      As to the value of unemployment assistance, I absolutely agree that it can be nothing more than a stopgap measure. Government is not generally capable of doing more than stopgap measures in areas where it is not primarily there task to make things happen, such as the economy. If the private sector is unwilling to invest in the future (which is almost never true unless someone is manipulating the system) the government may be able to help temporarily but such a situation would be indicative of a far more dangerous systemic problem in society that the government is incapable of addressing. If the private sector is incapable of investing in the future then so is the government because the government has no resource available that they have not first taken from the private sector.

  2. Charles D
    December 4, 2009 at 7:28 pm

    Where we differ I think is that I don’t assume that there are areas where government SHOULD not do things. The private sector, for example, makes investments based on it’s own future and their outlook may be quite short-term. It does not necessarily follow that because the private sector is unwilling to make an investment, that investment is not in the national interest. Currently the private sector is unable to make investments because they are unable to obtain credit. The cannot obtain credit because the banks that normally would provide it have used their funds for speculative investments that failed. To an extent, one can blame the government because the large financial institutions pursued those risky strategies knowing that the government would bail them out in the end. Or you might view that they gained control of the government for that purpose.

    The lack of business credit is not really due to government taking from the banks, but rather the bank’s own irresponsible investment strategies. Bailing out the banks simply rewards them for taking poor risks and thus induces them to repeat the bad behavior. Bailing out the victims of their crimes might be not only more moral, but more prudent.

    • December 4, 2009 at 10:03 pm

      You are definitely right about where we differ, but I guess any regular reader knows that I believe there are areas where the government should not do things. I think it is interesting that you can recognize that the government can be at least partly to blame for fostering an environment that would encourage the irresponsible behavior that many banks engaged in and lost so much of their capital and yet not recognize that as a sign of inappropriate participation in the financial system on the part of the government.

      By the way, there is no such thing as speculative investments. Investment is a process of studying and making educated decisions. Sometimes it does not pay off, but it is not particularly risky. More often than not the only question is how much return, not whether there will be a return. Speculation, on the other hand is simply a form of gambling, but it rarely involves a deck of cards or a set of dice. The banks lost their money speculating and because many people in society do not recognize the difference between speculation and investing (they think investing is a form of speculation) they write the whole thing off as bad luck or lack of regulation rather than what it truly was – a system of perverse incentives.

      • Ronald D. Hunt
        December 4, 2009 at 10:54 pm

        Before the 1999 bank deregulation that removed deposit requirements banks where forced to optimize their lending portfolio. In order to maximize profit they had to sure insure the that lent assets had a good return. After the removal of deposit requirements their was no effective limit to the banks ability to lend money.

        This combined with the huge pile of deposits dropped into the investment banking system through deregulation allowing the merger of investment and consumer banks. This created a situation where to keep up with the competition the banks had to maximize the size of the loan portfolio’s. The banks that did not fall into this behavior where bought out or had their executive staff replaced with executives that would engage in this behavior.

        Now I am not saying that before 1999 bank regulation was where it should be, I am saying that cutting off your leg to keep from stubbing your toe is just plain stupid. Removing the regulation that stopped the merger of investment and consumer banking would probably have been fine if the deposit requirements where eased back slowly over time perhaps to a 15:1 or 20:1 ratio over 20 years rather then the 10:1 ratio that they where. I would also think eventually allowing banks to be exempt from the deposit requirement by opting out of FDIC protections would be fine as well assuming that banks customers where given time to move their assets else where if they so desired.

        At this point however it does not really matter it is unlikely that deposit requirements could be reintroduced as the economic fallout of banks going from 30:1-40:1 leveraged asset ratio’s to 15:1-20:1 leveraged asset ratio’s would likely completely shutdown the economy. It might be possible to move deposit requirements onto consumer’s though loan down payment requirements(Reach mentioned on his blog that Canada only allows home loans to cover 80% of a homes value), Even this would have damaging fallout however. Reach also pointed out that Canada has no deposit requirement on their banks, which seem to be doing fine through the American recession.

  3. Charles D
    December 5, 2009 at 7:31 am

    David, sometimes failure to regulate is an “inappropriate participation in the financial system on the part of government”. Properly run banks are essential to our economic system and permitting them to gamble with their/our funds like drunks in a casino is irresponsible, but only government has the power to prevent them from doing so.

    Ronald is correct about the 1999 deregulation. There’s a tendency among liberals to blame Bush for everything and, at least initially, to believe that electing Obama would solve some of these problems. As this video clip points out, one day after the election, Obama brought in an acolyte of Robert Rubin (architect of the 1999 deregulation) to choose his economic team, thus foreclosing any hope of fixing the problems.

    Bipartisanship is not dead. When the question concerns Wall Street, the military/industrial complex, or the pharmaceutical/health care industry, you can count on a large majority of both parties voting together to screw the American taxpayer.

  4. December 5, 2009 at 8:53 am

    It’s not simply the lack or removal of regulation that brought the banks to act so foolishly, it is our unspoken but ever-strengthening “capitalist” practice of socializing losses while keeping gains privatized. Banks felt safe and justified in taking on extra risks because in a worst case scenario they still would not be risking the actual deposits of their customers because those deposits were guaranteed by the federal government. If they lose on their risky bets “nobody” gets hurt (aren’t you happy to be part of “nobody”?) but if they win they look like geniuses and they have lots of extra profits. The best guard against institutional gambling is to leave each institution responsible to cover their own losses – for example we could require them to liquidate hard assets to cover the deposits of their customers if they do not have sufficient cash on hand. The government could promise to loan the necessary funds until the assets are sold but not promise to insure the actual deposits. (That idea is off the top of my head and might well need some refinement.)

    Ron, I suspect that the damaging fallout you predict from is a major downward adjustment in the level of borrowing and spending by consumers. Personally I recognize that would be painful but it would also force our economy to become grounded in reality once again rather than eternally encouraging everyone (individuals and businesses alike) to borrow against their future all the time.

    Charles, you may be surprised to hear that I also believe that failure to regulate is sometimes an inappropriate lack of participation on the part of government. The problem I have with calls for more regulation and laying blame at the feet of deregulation is that they often seem short-sighted as if all regulation were created rather than recognizing that there is regulation that is necessary and there is also regulation that is destructive or damaging. Calls for regulation are not unlike calls for bipartisanship. There is nothing wrong with people from different sides of an issue settling on the proper solution together, but when bipartisanship is a goal in itself we get the kind that you noted – a majority of each party coming together to the detriment of the nation.

  5. Charles D
    December 5, 2009 at 9:23 am

    I agree about the socialized losses. We have had a longstanding policy about how to deal with failed banks, but the largest ones (too big to fail) know they are exempt. I agree with Senator Sanders when he says that an bank that is too big to fail is too big to exist. We should guarantee deposits up to $200,000 as with every other bank, and then temporarily nationalize the bank, spin off all the non-banking subsidiaries, and then re-privatize the bank as one or more normal sized institutions. The shareholders who permitted the bank to go on a gambling spree should eat their losses.

    I also agree that not all regulation is necessary or desirable. One reason we end up with ineffective regulation is that we fail to come to an agreement on an objective and then test our solutions by their effectiveness in meeting the objective. We too often get involved in policy arguments based not on pragmatism but on ideology (both right and left).

  6. Ronald D. Hunt
    December 5, 2009 at 4:46 pm

    “it is our unspoken but ever-strengthening “capitalist” practice of socializing losses while keeping gains privatized.”

    Yes, this is definitely a true statement. I don’t buy for a minute however that we will ever have enough “quality” politicians to allow a massive economic collapse rather then bailing out. And to be completely truthful I don’t really have a problem with this so long as it is an issue that is recognized and the rules/regulations and designed with this in mind.

    Somewhat similar to Charles Suggestion, I have heard some talk about corporate death penalty, In that a failed institution rather then being allowed to go bankrupt would be seized by the government bailed while under government control and then sold off piece by piece until the government had satisfied all customer obligations and then the costs of the bailout itself. It’s unlikely this could ever pass congress however.

    I have heard about preemptive actions to break up “to-large-to-fail” banks, their are some mildly toothed regulations in an Amendment that passed from the only Socialist in congress Berni Sanders(my favorite congressman) but will likely never be used in the coming FCPA act. This will probably pick up enough republican votes to get passed without the democrats having to gut it to satisfy the blue dog’s. oddly Ron Paul will probably be one of those votes(in an odd twist of fate or something) because his audit the Fed bill is attached to it.

    “Ron, I suspect that the damaging fallout you predict from is a major downward adjustment in the level of borrowing and spending by consumers. Personally I recognize that would be painful but it would also force our economy to become grounded in reality once again rather than eternally encouraging everyone (individuals and businesses alike) to borrow against their future all the time.”

    Partly from consumer lending party from derivatives trades. The derivatives market is around 1.8 Quadrillion dollars this year. Cutting leveraged asset ratio’s down even by a few points would be hugely damaging.

    To pull it off you would have to create a government department for consumer lending to make up for the difference of lending when the banks can’t, and have a lot of addition bailout money on hand(we we know how well that will go over politically).

    • December 7, 2009 at 11:31 am

      I don’t think I understand what you are referring to when you say “I don’t really have a problem with this so long as it is an issue that is recognized and the rules/regulations and designed with this in mind” – could you clarify what you think we should have in mind when designing rules and regulations?

      As far as I understand the idea of a corporate death penalty (I’ve heard that idea before but I’m not yet convinced that I fully understand it) I have no problem with having a way to prepare large failing institutions for economic burial. I am not as comfortable with the idea of taking preemptive action against any bank deemed “too big to fail” although I understand the appeal of the idea and I believe that we we as individuals and as a nation start to make really poor decisions as soon as we accept that some of them really are too big to fail.

      The derivatives market is around 1.8 Quadrillion dollars this year.

      That number is very telling right there (I’d like to know the source of that figure). Does the nation even have real assets worth 1.8 Quadrillion dollars? When I hear that we have a derivative market that is arguably worth more than everything we have it serves as sound evidence of how pretentious and ungrounded our financial system is.

  7. Charles D
    December 7, 2009 at 1:03 pm

    That 1.8 Quadrillion figure tells you a lot about the derivatives market – mainly that it has no basis in reality. The way I see the corporate death penalty is simple. Corporations are legal entities chartered by the states. The states or, arguably, the feds have a right to revoke that charter at any point for just cause. I believe we need to tighten up the corporate charter process either at the state level (unwieldy certainly) or by federalizing it. Originally states granted charters to corporations to serve specific named economic purposes that, if successful, would benefit the people of the state. If the corporation failed to achieve those purposes or violated its initial agreement, it was common to simply withdraw the charter. See http://poclad.org/articles/grossman01.html and grossman02.html for some further ideas on holding corporations accountable.

    • December 7, 2009 at 1:21 pm

      Thank you for providing those links, they look very interesting so far. I recognize that corporations are legal entities created and defined by the government, but I wonder how many corporations really have done anything to merit having their carter revoked. I think we can see the danger that comes with treating a corporation as having all the rights of a person without the exact same responsibilities, but to some extent I think our hands are tied with regard to existing corporations. One thing we can do is change the legal rights for future corporations, but revoking rights already granted to existing corporations would be a breach of contract unless we have evidence (case by case) of those corporations exceeding their charter or engaging in some illegal activity.

  8. Ronald D. Hunt
    December 7, 2009 at 4:48 pm

    Information comes the Depository trust and clearing corporation

    The following line can be read from any of the about statements at them bottom of their press releases, “In 2007, DTCC settled more than US$1.86 quadrillion in securities transactions.”

    As to your comment,
    “Does the nation even have real assets worth 1.8 Quadrillion dollars?”

    Derivatives don’t represent real assets, for the most part they represent something resembling insurance(this is an over simplification) that is derived from real assets(hens the name derivative =p).

    Now I would guess that the 1.8 Quadrillion number is actually the full contract amount of that a derivative could represent rather then the actual amount that is exchanged.

    Banks for example will package a 1000 mortgages together and buy a security against the projected default rate. That is they pay for an insurance option upfront for a projected default rate of say 3% for this they pay the equal of 5% of the projected default rate and if the default rate goes higher then that the derivative of course covers that cost up to a contracted amount say 7%.

    Now the funny part about all of this is that those 1000 mortgages are generally considered a safe investment so they can be used as collateral for loans or purchases on the derivatives market. This perception was reinforced by the fact that the Collateralized mortgage obligation is in way “insured”.

    And remember that investment banks also run the consumer mortgage insurance market as well. You will be familiar with this charge if you have ever owed more then 80% of the value of a house.

    Now what happens is that in this alphabet soup of OTC’s, CMO’s, Options, Derivatives, etc is that the banks executives where giving their customers deposits and premiums to share holders in their pursuit of bigger bonus’s. This is one of the forces that pushed leveraged asset ratio’s into the stupid region.

    They effectively created a situation where a 3% decrease in the market or a 3% run on savings accounts could bankrupt the entire American banking system. This is a problem of to huge a sum of money being dropped on them suddenly via repeal of glass-steagall(deposit requirements,merger of consumer and investment banking), a total willful ignorance of regulation, and finely anti consumer bankruptcy laws that prevent loan modifications even if cases of outright lender fraud.

    Similar behavior lead to the great depression and is why deposit requirements and the separation of consumer and investment banking where passed in the form of glass-steagall. Mostly I put the blame on the removal of deposit requirements, From my understanding(given its limited) most of the other regulations could be removed and the market could eventually adjust.

    • December 7, 2009 at 9:53 pm

      $1.86 quadrillion – wow, that would round to 1.9 quadrillion in speculative imaginary assets – and we wonder why the nation is in financial trouble. We have moved a long way away from goods (or even goods and services) based economics.

  9. Lola
    January 5, 2010 at 3:48 pm

    Lowering interest rates have not prevented foreclosures. 25% of the mortgages are higher than the home value. Banks will not loan money, property values plumet, homes are foreclosed. Low interest loans were given to individuals with great jobs reducing % revenues. Individuals strugling to pay were denied loans, causing continued balance deficits.

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