Another Plan to Destroy the Economy

Before you can get in another word, it keeps getting worse. Former Treasury Secretary Larry Summers recently stated, "We are facing the most serious financial stress that the U.S. has seen in at least a generation." It's safe to say the credit crisis has reached unprecedented levels. Before a financial crisis proliferates into an economic collapse, something has to be done. But what?

We've already seen several government bailout proposals thrown around -- none of them too convincing. Back in November, fellow Fool Seth Jayson described how Ben Bernanke's homeowner bailout plan was full of hot air. Last month, I made my own cries that the current stimulus package might stimulate a bigger mess.

But it was Harvard economist and former Reagan advisor Martin Feldstein's plan that really got me going. Last week in The Wall Street Journal, Feldstein proposed that the government lend troubled homeowners 20% of their outstanding mortgage balance to ease pain. The money, he suggested, would come from selling Treasury bills (because those grow on trees) and have a 15-year payoff period. Of course, all interest owed on the government loans would be tax-deductible.

From the top
The plan doesn't bail homeowners out -- it simply shifts debt from the private market to the government and its taxpayers. From step one, the plan calls for an attempt at paying off loans that (a) never should have been made in the first place, and (b) were issued using real estate values straight out of Neverland.

That's most of the problem. Regardless of who holds these mortgages -- Bank of America (NYSE: BAC  ) , Goldman Sachs (NYSE: GS  ) , Countrywide (NYSE: CFC  ) , a CDO, or Uncle Sam -- you're left with one nagging point: The real estate backing these loans is worth much, much, less than it was before. Sure, as Feldstein points out, government loans could lower interest payments, but that, as you'll remember, is how we got into this mess in the first place.

Lower interest rates would help some keep their home for a period of time, but it may just forestall the inevitable. Loans were made under inflated real estate values that we may not see again for decades. While lower borrowing costs would be welcomed, playing musical chairs with interest rates will hardly form a solution.

Japan's folly is our lesson
For a historical view on how such a plan might turn out, look to Japan over the past 20 years. The '80s were a booming time for the Land of the Rising Sun. A massive personal savings rate and booming electronics industry fueled the economy, sparking rampant speculation. As some saw Japan as too big to fail, a real estate bubble formed that sent property values soaring. Sound familiar?

As we've seen before, speculative bubbles share one common trait: They end in calamity. Japan's property bubble was no exception. Japanese property values came crashing down as the speculation came to terms with reality. Japan's major stock index -- the Nikkei -- followed suit, falling for more than a decade before bottoming out in 2003.

Sure, the Japanese property boom was magnitudes greater than ours. One famous report claims the land under the Imperial Palace was worth more than all of California. But why on earth did it take more than a decade to recover?

Historians, take heed
Japanese banks, regardless of how loony the loans made during the bubble turned out, were very reluctant to write off bad debt. Nobody wanted to take writedowns because, the thought went, prices would eventually recover and property could be sold for the amount outstanding on the loans.

That, of course, never happened. As banks held on for dear life with a barrage of ugly loans on their books, a credit squeeze dripped into other sections of the economy, wreaking havoc on growth. From 1990 to 1999, Japanese real GDP growth averaged an anemic 1.5%, even with interest rates near zero. What finally got Japan off the gurney was, you guessed it, banks coming to terms and writing off bad loans.

As Japan learned, interest rates weren't the problem. Waiting for property values to rise doesn't work. But Feldstein's plan calls for just that: Pulling out all stops to keep doomed loans on banks' books for as long as possible.

We've been here before
In the dot-com bust eight years ago, it wasn't interest payments on margin accounts of investors holding eBay (Nasdaq: EBAY  ) and Yahoo! (Nasdaq: YHOO  ) that caused capitulation. It was the astronomical prices they paid in the first place. Real recovery couldn't start until those investments were completely purged -- not just bailed out by a government waiting for sky-high prices to return. The real estate bubble today isn't any different.

Anxious politicians and those looking for a quick fix will throw around ideas to get us out of this mess without having to face the consequences of our actions -- history speaks for itself.

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