A Simpler Plan

I missed a chance to be on CNN again (gosh darn it!) in order to do an hour long show on NPR Oregon with economist Brad DeLong. The show got me thinking about a simpler way to fix the current problem than doing reverse auctions of toxic assets. Simpler economically and politically.

Here it is:

Any American with a mortgage can trade it in for a government one for the same principal amount, at a fixed 7 percent interest per annum, for any term up to 50 years. In return, the government will pay off the existing mortgage with a Treasury bond with the same market value and maturity as the mortgage it is replacing. The lender can then hold the bond on its balance sheet until maturity, sell it in the market, use it as collateral for a loan, strip and sell the coupons, etc.

Because the government can at present borrow at far less than 7 percent, and because it can easily garnish wages using existing (tax) infrastructure, this will not be a bailout but rather a source of revenue which can be applied to pay down the national debt. (See my blog entry below about the colonial loan offices, which prove that governments can and have profited by providing mortgages to citizens.) The two keys are extending the term of the mortgage to the point that homeowners can afford to make the payment and making sure that borrowers don't default simply because they are "in the bucket" (have negative equity) by using the coercive power of the state. Anyone who prefers to default rather than take the government loan may do so, at which point the lienholders (new owners) may, if they wish, mortgage the property to the government for the amount they are owed. (Or they can resell or rent it, as they prefer.)

The plan is also much more palatable politically than the current administration plan, for several reasons:

a) as noted above, it is not a bailout, but rather the entry of a new lending competitor that can win borrowers away from current mortgage lenders due to its long time horizon and low cost of funds. This is a major point because NOBODY wants a bailout if one can be avoided;
b) it does not require the creation of a new government bureaucracy (like the Homeowners Loan Corporation of the Great Depression) because existing agencies and workers can handle the minimal work involved, so fiscal responsibility types (who I admire) can support it without hypocrisy;
c) helping financial services firms by eliminating their root problem (defaulted mortgages) is much more popular than directly bailing out "Wall Street fat cats," which is especially important in an election year;
d) since any American with a mortgage automatically qualifies, this proposal does not directely discriminate against fiscally careful Americans nor does it unduly reward the fiscally profligate.

Of course most of those who will take the government mortgages will be subprime borrowers paying greater than 7%, those who got caught with teaser rates, ARMs, etc., and those about to be foreclosed upon.

This is a half hour's work, so I reserve the right to modify details if I have erred conceptually.

Finally, if done just right this is an example of a Pareto improving policy, a concept I urged politicians earlier this month to consider more carefully before going for the partisan jugular.

Your Humble and Obedient Servant ...

I received this email several times today ...

and I think it might be spam:

REQUEST FOR AN URGENT BUSINESS RELATIONSHIP

DEAR AMERICAN:

I NEED TO ASK YOU TO SUPPORT AN URGENT SECRET BUSINESS RELATIONSHIP WITH A TRANSFER OF FUNDS OF GREAT MAGNITUDE.

I AM MINISTRY OF THE TREASURY OF THE REPUBLIC OF AMERICA. MY COUNTRY HAS HAD CRISIS THAT HAS CAUSED THE NEED FOR LARGE TRANSFER OF FUNDS OF 800 BILLION DOLLARS US. IF YOU WOULD ASSIST ME IN THIS TRANSFER, IT WOULD BE MOST PROFITABLE TO YOU.

I AM WORKING WITH MR. PHIL GRAM, LOBBYIST FOR UBS, WHO WILL BE MY REPLACEMENT AS MINISTRY OF THE TREASURY IN JANUARY. AS A SENATOR, YOU MAY KNOW HIM AS THE LEADER OF THE AMERICAN BANKING DEREGULATION MOVEMENT IN THE 1990S. THIS TRANSACTIN IS 100% SAFE.

THIS IS A MATTER OF GREAT URGENCY. WE NEED A BLANK CHECK. WE NEED THE FUNDS AS QUICKLY AS POSSIBLE. WE CANNOT DIRECTLY TRANSFER THESE FUNDS IN THE NAMES OF OUR CLOSE FRIENDS BECAUSE WE ARE CONSTANTLY UNDER SURVEILLANCE. MY FAMILY LAWYER ADVISED ME THAT I SHOULD LOOK FOR A RELIABLE AND TRUSTWORTHY PERSON WHO WILL ACT AS A NEXT OF KIN SO THE FUNDS CAN BE TRANSFERRED.

PLEASE REPLY WITH ALL OF YOUR BANK ACCOUNT, IRA AND COLLEGE FUND ACCOUNT NUMBERS AND THOSE OF YOUR CHILDREN AND GRANDCHILDREN TO WALLSTREETBAILOUT@TREASURY.GOV SO THAT WE MAY TRANSFER YOUR COMMISSION FOR THIS TRANSACTION. AFTER I RECEIVE THAT INFORMATION, I WILL RESPOND WITH DETAILED INFORMATION ABOUT SAFEGUARDS THAT WILL BE USED TO PROTECT THE FUNDS.

YOURS FAITHFULLY MINISTER OF TREASURY PAULSON 

An Easy Analogy

I first used a version of this analogy in Richmond on CBS 6's "Virginia This Morning," on 4 September 2008. It seemed to work well and some people seem flummoxed by the recent market disturbances so I thought I'd share it here.

The national debt is like a guy sitting in a boat called The Economy. When the national debt is small, the guy is skinny and there is plenty of distance between the boat and the waterline. If a wave (a crisis or shock) comes along, the boat may rock but it will stay afloat.

When the national debt is big, by contrast, picture a big dude -- South Park's Eric Cartman in the Kathy Lee Gifford episode, Marlon Brando near the end, or Jared before he found Subway sandwiches. Barely afloat on calm seas, the first big wave that comes along may swamp the poor little boat.

Now, because the boat is an analogy for the economy, we have to allow it to change size. Until recently, the boat was growing, albeit more slowly than the guy (debt). That gave advocates of the debt (of which there are too many, imho) reason for hope. But consider this: the boat has stopped growing and may actually shrink and at precisely the same time the guy is scarfing greasy donuts and washing them down with beer, and not even the light stuff.

Add on top of this the fact that a big wave may come along, perhaps a manmade one at that, and you can see why everyone is spooked.

Political Risk

In addition to the potential random and kick-em-when-they're-down shocks I discussed in yesterday's post, we also face tremendous political risk. 2008 is starting to look eerily similar to 1932 -- an unpopular Republican president in office, a pending election, and a financial crisis that won't go away. The threat before the election is that both parties will try to use the crisis to score political points. The threat after it, especially if the Democratic candidate wins as in 1932, is that the Republicans will sit on their hands while the minds of market participants race wondering what the incoming administration will do.

The good news is that the new president will be inaugurated in late January instead of early March. The bad news is that the world moves much faster now so late January is still a very long way away indeed. In early 1933, the payments system actually broke down just before FDR took office. You can't imagine what chaos that would cause today ... credit cards would stop working, ATMs would run dry, and Americans would learn the dirty little secret that their bank deposits are not convertible into Federal Reserve Notes on demand. Banks will exchange deposits for cash when it's convenient but they don't have to do it and in fact holding nothing close to enough vault cash to meet even a modest run. Let's hope it doesn't come to this but it would behoove policymakers to consider the possibility. We don't need a financial Katrina.

The Next Great Crisis

We're entering a dangerous period indeed. The government is currently planting the seeds of the next crisis. As I argued in One Nation Under Debt, we should never have allowed the debt to grow so large (2/3rds of GDP) in what was essentially peacetime. If the bailout doesn't go well and if the economy remains soft (and hence government receipts low), we could be looking at a national debt to GDP ratio of 100%. We could probably survive that, if nothing else bad happens. But guess what? The mere fact that we are down greatly increases the likelihood of getting whacked by additional negative shocks.

The probability of a natural catastrophe has not increased but our ability to respond effectively to one is impaired due to the difficulties at AIG (a major insurer) and in the capital markets more generally. At least two major recessions were exacerbated by natural catastrophes. The explosion of Mount Tambora in 1815 led to the "year without a summer" in 1816, disrupting agricultural markets in North America and Eurpe that culminated in the Panic of 1818/19. The Great San Francisco earthquake (1906) has been implicated in the Panic of 1907 because it created a massive flow of gold from British insurers to the West Coast, which induced the Bank of England to raise interest rates, which, in turn, burst an asset bubble.

Of course we don't know when or where the next major hurricane, earthquake, or volcanic eruption will occur. Nobody (I hope!) can cause one, and nobody can stop one, so such a shock will be random, dumb luck. Maybe one will hit us, maybe one won't. Such is not the case for manmade catastrophes. Terrorists must be salivating at the thought of hitting us hard while we are down. Hackers are undoubtedly gearing up to make attacks on technical network infrastructure that might fall into disarray during bankruptcies, quick forced mergers, and the like. And nation state enemies like North Korea and Russia are already beginning to behave badly. Another big shock might be all she wrote for the U.S. dollar.

I'm not being alarmist here, or if I am so is the Wall Street Journal which ran a short article yesterday (Septembe 20, 2008, B16) called "Stocks Gain -- So Does the National Debt." The article notes that the dollar could go either way at this point because "currency markets might see the fiscal cost [of the bailout] as a good trade-off against the bigger risk of letting the U.S. slip into a deep recession." That's right. But, as noted above, if the bailout does not go well, the national debt swells further, and we get whacked with another shock, the dollar could plummet again, to the point where the U.S. government may have to borrow in euro, sterling, yen, etc. At that point, we have to suffer very high interest rates and borrow only domestically or revert to emerging market status and borrow in other currencies, with all the attendant default risks.

Alexander Hamilton Was Wright

Yes, the Wall Street Journal correctly reported yesterday (September 20, A3 "Government Bailouts: A U.S. Tradition Dating to Hamilton") that I named one of my sons Alexander Hamilton Was Wright. I just couldn't resist the play on my last name, which sounds like "right" (correct) but actually means "maker" (as in wheelwright, cartwright, etc.) . So, yes, Hamilton was both correct and one of America's makers. For details, see Financial Founding Fathers (with David J. Cowen), The First Wall Street, and, of course, One Nation Under Debt. (Hamilton Unbound, by contrast, is actually a Hamiltonian interpretation of early U.S. history rather than a biography. It's a pun too.)

Fannie, Freddie, the National Debt, and the Federal Loan Office (FLO)

In an article entitled "Fire the bazooka," The Economist, that unbelievably witty British weekly news mag, says it is "time to nationalise [i.e., nationalize] America's mortgage giants," namely Fannie Mae and Freddie Mac. The mag realizes that a government takeover would "technically add huge liabilities to the government's balance sheet" but quickly notes that "these would be offset by mortgage assets that are almost as large." What it doesn't say is that nobody wants those assets and that is why ole Freddie and Fannie are in such a pickle in the first place.

It IS possible for a government to run a mortgage office successfully. Before the American Revolution, several colonies, most notably Pennsylvania, sponsored "loan offices" or "land banks" that lent what were then large sums for long periods on the collateral of improved land and other hard assets. The loan offices were far from perfect. They usually lent for less than the going market rate so the quantity of mortgages demanded exceeded the quantity the government was willing to supply. In some places, like Massachusetts, some nasty political non-price rationing closed the gap. (Read corruption.) Also, if times were tough the government did not foreclose as vigorously as private lenders did. But maybe that was a virtue and that interest on the loans made other forms of taxation almost completely unnecessary in colonial Pennsylvania certainly was a good thing!

The Fed has always lent to member banks. Recently, in response to the subprime mess, it began lending to other types of financial institutions as well, in the name of financial system stability. The message it has sent is loud and clear and consistent with earlier pronouncements: get as big and risky as you want because we have your back. And so Fannie, Freddie, Indy, Bear, and many others did, and we and our kids are going to be asked to pay for it. Some people consider this arrangement unfair and it is difficult to argue with them.

Perhaps what we need is a Federal Loan Office (FLO) that will make mortgage loans to any bona fide American citizen for any 1 to 4 unit residential building that s/he can afford. (The IRS can help out with that one.)* The government's cost of funds is zero so it can set the interest rate where it pleases, higher to slow the economy down and lower to speed it up. The Fed would still control monetary policy, sterilizing mortgage flows with open market purchases or sales of Treasury bonds when necessary. All interest payments would be credited to the Treasury and the mortgage interest tax deduction would be eliminated. Like the Fed, the FLO would be a quasi-independent government "profit center" rather than an additional burden on the federal budget.

It could also be used to provide effective fiscal stimulus. Instead of sending out stimulus checks 6 times too small and 6 months too late, the government could use the mortgage loans to stimulate the economy quickly by telling borrowers, to wit most American families, that they need pay only half or some other fraction of their usual payments for the next x months. It could even pass a moratorium on all payments to combat particularly large shocks, postpone payments in disaster areas, and so forth. We'll have to think carefully, however, about how to spot and stop potential political abuses of these powers and there will be some tricky issues during the transition period.

*Mortgage loans should have two bases, the value of the mortgaged property and the borrower's income. The IRS knows Americans' income history better than anyone; perhaps people will think twice about cheating on their taxes if it affects their ability to obtain a mortgage. Assessments should be done by at least three randomly chosen local assessors.

Fixing healthcare with pay for performance

Even if our national government somehow gets its fiscal act together and pays the funded national debt down, or at least slows its rate of increase below that of real economic growth, the American people will still face two other daunting financial problems, Social Security and healthcare entitlements. I'll tackle S.S. in a future post and concentrate on healthcare in today's installment.

The debate over healthcare tends to revolve around insurance. I think that emphasis is misplaced. Insurance is an issue only because healthcare has become so expensive. In the 19th and early 20th centuries, people wanted reimbursement for lost wages due to illness, not for healthcare costs. That changed as the cost of doctor visits, surgery, hospitalization, and medication soared faster than inflation year after year in the last three quarters of the 20th century.

But the real problem is not simply the cost of healthcare, it is the value proposition. People would happily pay high prices for medical treatment if they actually worked to alleviate suffering, stop further damage, and so forth. Modern medicine does some things very well and the doctors, nurses, and other specialists who provide those services ought to be well compensated for them.

Unfortunately, however, modern medicine is far from flawless. Many diseases and disorders continue to flummox it. My parents, brother, and wife, as well as several colleagues, suffer from chronic medical problems that doctors can't, or won't, fix. Here is where the value proposition comes in. Why do we pay doctors (etc.) even when they don't make us better? Would we pay an auto mechanic who looked at our car, maybe changed out a part, but didn't fix the rattle? Would an accountant expect payment for just looking at your taxes? Why should we pay our doctors just for seeing us?

I recently suffered from a viral infection in my throat that led to acute pharyngitis. I couldn't even swallow my own spit. The ER staff got the swelling down but sent me home without trying to ascertain the cause. Unsurprisingly, I ended up going back to the ER two days later. This time the docs did not even alleviate my pain, sending me home with a concoction I suspect was a placebo. Whatever it was, it didn't work. A week later, I recovered thanks to my own immune system but the ENT insisted that I pay him an office visit anyway. He actually had the nerve to request that I come back 2 weeks later, even though he admitted he could do nothing to help me or to prevent another bout of this nasty ailment. All told, I shelled out almost $200 in co-pays for this "treatment." Lord knows how much my insurer will pay, and all for nothing.

If the government said patients only had to pay when doctors actually helped them our national healthcare bill would be slashed, perhaps by as much as half. That would go a long way toward alleviating the entitlement burden and decreasing health insurance premiums. Some smart egg would have to create a system that would minimize abuse (doctors claiming to do more than they did; patients claiming that they were not helped when in fact they were); entry into the healthcare professions would have to be opened to more people (which in and of itself would be ameliorative); our tort/medmal system would need to be revamped (it needs it anyway).

Imagine, though, how differently doctors would behave if they only got paid based on proven results. Unnecessary office visits and long waits would vanish, doctors would specialize around symptoms/diseases rather than body systems, and referrals to doctors better equipped to handle particular problems would come more rapidly. As long as the rewards matched the risks, doctors could be found who would take on any medical problem, including gunshot wounds and advanced cancer. Overall, doctors would have to work harder and smarter.

Healthcare professionals will therefore come up with all sorts of reasons why this proposal is dumb. As they mumble and bumble, just ask yourself if you would believe the same sort of story from any other professional services provider.

The Trouble with Balance Sheet Analysis

In my never ending quest to alert the American people to the avalanche of debt about to befall them (and sell a few books at the same time), I sometimes stumble across otherwise rational looking and sounding people who claim that the national debt is no big deal. Such folks sloughed off this week's increase in the debt ceiling (to over $10 TRILLION) and the announcement of a $.5 TRILLION annual federal deficit, the largest in nominal terms in U.S. history. Their main line of counterattack is that while we OWE a lot we also OWN a lot so the debt is no big deal. Our assets exceed our liabilities (at least they claim) so the country is basically sound.

That sounds a lot like Bear Stearns and Fannie Mae thinking. The trouble with balance sheet analysis of the national debt is that the value of assets can change, and usually much more quickly than the value of liabilities. If interest rates were to spike, due to some shock and/or high levels of inflation, the value of most assets would drop (yet more) but the government would still owe $9.5 TRILLION (and growing). And of course most government assets are not liquid.

Cash flow issues loom large as well. Say we borrowed another $10 TRILLION to fix our aging bridge and highway infrastructure. For the balance sheet types, there is no problem here because our nation's assets will increase by the same amount of the debt. (Implausibly assuming, of course, that the public gets $10 TRILLION worth of construction for its money. See http://search.barnesandnoble.com/booksearch/results.asp?WRD=busted+budgets for a counter view.) But the interest due on the debt would double. To pay that additional interest the government could always print more money, but that would further fuel inflation, which is already getting to scary levels. It could also increase tax revenues but that seems unlikely, at least this election cycle.

I'm increasingly convinced we need major changes to the way our government gets and spends our money. Unfortunately, we'll probably have to suffer through a major crisis to get reforms passed and then they will be rushed and grossly suboptimal.

Walking the Walk: Can McCain Do It?

I caught a bit of a John McCain speech today. He is certainly "talking the talk" regarding fiscal responsibility. But can he really walk the walk? A message I received today from a government budget bureaucrat in response to my op-ed in the Free Lance-Star suggests not.

My correspondent, who I shall call Shallow Throat, says that our budgeting system is broken because at the unit level it builds in automatic yearly increases and fails to create incentives to cut back spending. If McCain wants my vote, he should address this important issue in a concrete way.

I suggested to Shallow Throat that what we need to do is to build in the expectation of annual budget decreases, at least in real (inflation-adjusted) terms. That way, front line government managers will have incentives to cut fat because the money that pays for it will disappear soon, and automatically.