Macro Economics
What the Government Really Should be Doing

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By RodgerRafter
November 26, 2008

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

Todd Harrison at Minyanville asked readers for their thoughts on:

"the best way for the government to navigate the current market malaise?"

So I gathered up my thoughts and emailed him the following:

1. Bailouts shouldn't at the level of preferred shares. Bond holders deserve to take losses before the government. The government should push through and facilitate a streamlined Chapter 11 process that wipes out common and preferred shareholders and recapitalizes firms by turning bondholders into equity holders to recapitalize the firms.

Customers, clients and counterparties (grudgingly) have to be protected with government guarantees to keep the system functioning.

Of course the politics of the bailouts are mostly about protecting the CDS writers from bond defaults, so we see the government hopping in at the preferred stock level and the even-more-blatantly-corrupt Citigroup asset backstopping.

2. Stimulus needs to focus on rebuilding a sustainable economy, rather than simply boosting consumer spending. Spending on renewable energy projects is a no-brainer. Stimulus checks and unemployment extensions are only helpful as wealth redistribution, but not good from a long term perspective. Health care spending and other "quality of life" improvements can be good, even if they don't have a measurable economic benefit.

States and municipalities need huge block grants fast. They can't just borrow more money into existence like the Feds, and they will be pro-cyclical with forced budget cuts if the don't get big bucks from the Feds. Every state, and every city should get a big grant based on population.

3. Housing is toast due to severe oversupply and overpricing. Policy has been based on selecting who will be the bag holders as imaginary wealth evaporates. Of course it should mainly have been the creditors, and investors in bad mortgage debt, but there's just too much money to be made by shifting the short and long term pain to others, so corruption rules the day.

Subprime lenders were wiped out first through the inverted yield curve, eliminating competition for the big banks in the current steep-curve environment. Since then, every measure has been designed to delay losses to creditors by propping up prices and shift losses to government and quasi-government agencies.

If housing prices were encouraged to crash, it would make housing more affordable and free up more money for discretionary spending. Instead prices are propped up to protect big banks from having to take losses. We should be looking at ways (strict accounting rules, forced bankruptcies, GSE actions) to force the rapid liquidation of surplus REO in order to bring down housing costs and utilize our housing stock to the benefit of the nation.

4. The Markets are rigged, and people have lost confidence. The SEC has long served corporate executives rather than shareholders, and that needs to change if confidence is to be restored and companies are to achieve better long term performance.

Pension plans are underfunded and they should be forced to bring up investment levels with more rigid and reasonable assumptions. In a climate where long term interest rates remain depressed, pension funds should have to assume returns in the neighborhood of 4 to 5%, rather than 8 to 10%. If that means big losses are realized now and some companies are forced into bankruptcy, then it's better to have that happen now for the guilty parties, rather than later when the PBGC will have to pick up the tab.