Tuesday, November 13, 2007

How to Heal the U.S. Economy

Today, November 13, 2007, the business news was dominated by the mortgage mess. Recently announced bank losses make clear that the Federal Reserve's interest rate cuts in September and October haven't made the boo boos go away. Instead, they've returned with a vengeance, bigger than ever, and are knocking chief executives out of corner suites. All predictions are for further losses this current quarter and next year. While the Federal Reserve expects an economic slowdown, but no recession, many private sector prognosticators are more pessimistic.

Clearly, the financial services sector is wagging the entire U.S. economy. The New York Times reported on Sunday, November 11, 2007, that the financial sector accounts for 31 percent of all corporate profits in America. That's too much. You can't build a thriving economy on financial services. Banks don't produce anything tangible--you can't eat a financial service, wear one or seek shelter under one. Financial services are simply an adjunct to the true heart of any economy--the production of goods. People survive by extracting resources from the environment around them. That's why the production of goods remains the foundation of true economic strength. (If you don't believe this, think about China.)

Financial services firms are unquestionably necessary in a modern economy. They facilitate the process of economic exchange on a large scale, across long distances and even over international borders. They pool excess savings and make it available to businesses that hope to make productive use of it. They provide investment services to those who hope to save for the future.

But, as any good economist will tell you, there is a limit to the value of anything. Too much of anything and it loses value. The first bite of Belgian chocolate is much better than the 20th bite. And so, too, with financial services. Financial services firms used to make their money by providing savings and investment vehicles for the thrifty, underwriting offerings of securities for companies that needed capital, and making loans to businesses and other borrowers that were creditworthy. Today, financial services firms are obsessed with booking fee income, even if it means creating and selling opaque, complex, risky and illiquid investments that ultimately are causing a lot of pain and doing little or no good. The recklessness of the bankers involved in this stuff has resulted in hundreds of billions of dollars of accrued or likely losses. That's still a lot of money, even today.

Financial losses such as these cannot be eliminated. The only question is where they will land. They've been landing on hedge fund investors, banks, mortgage lenders, mortgage brokers, and last, but certainly not least, homeowners. And if there is a government bailout, as some on Wall Street and in Washington are crying for, losses will land on the taxpayers.

The subprime mess is the product of taking financial services too far. We don't need this much financial engineering. We don't need this much investment in real estate. Trying to turn people with poor creditworthiness or no creditworthiness into homeowners is like trying to build a house in a rain forest with mud bricks. And the worst part of it is that this was national policy. Homeownership was encouraged, not only for its supposed civic benefits, but because a rising real estate market would provide home equity that consumers could tap into in order to continue their merry escapades at the mall.

But you can't build wealth by creating asset bubbles. Home prices and equity can't rise continuously forever. Why all the brilliant and highly educated people on Wall Street couldn't figure this out is a very good reason not to rely on financial services to be a future engine for the U.S. economy. These are not people who should receive government subsidies or bailouts. The financial services firms should be forced to take responsibility for their actions, and book their losses.

The wealth of the U.S. is shrinking, with the dollar dropping in value and foreign capital quietly exiting with scarcely a tip for the hat check girl. Given our zero percent savings rate, America's limited capital base shouldn't be funneled toward more financial engineering or further attempts to make home loans to the non-creditworthy. Instead, it should be guided toward production.

America is a creative nation. Its creativity has made it the science and technology center of the world. More Nobel Prize winners in the sciences live and work in the U.S. than anywhere else. The Silicon Valley is a magnet for geeks from all corners of the globe. Formal and informal venture capital is available for almost every manner of tinkerer and garage-based technology startup. With its advantages in science and technology, America is a natural for the production of high tech products. Biotech is another area of great potential. Entertainment, including movies and television programming, is a major export. Okay, 98% of it is dreck, but it's better dreck than the movies and TV programming other nations produce. With global warming and industrial pollution in the third world rising, pollution control and environmental protection technologies are another area where America could do well. America is perhaps the world's largest producer of commercial aircraft.

International trade agreements make direct government subsidies of particular industries problematic. But let's stop diverting undue amounts of capital into real estate. It's only encouraged a degree of financial engineering that was too clever by half--and then half again. And we should require adult behavior from Wall Street. The Fed should keep the overall financial system liquid enough to function. But it should require losses to be booked, and managements to be held accountable. We have a crisis today in the financial markets because of a severe misallocation of capital caused in part by government policy and in part by monumental misjudgments by financial services firms. Extending or perpetuating that misallocation will prevent the U.S. economy from healing. The pimply-faced kid in a garage attic working on a pocket-sized device that makes phone calls, brews coffee, browses the Internet, picks up the dry cleaning, takes photographs, writes a novel, cooks a meal, displays TV programs, and drives your car automatically using GPS, is the future of America. He shouldn't have to compete for capital with a bunch of real estate speculators who have access to government subsidies.

Animal News: cows flee McDonalds. http://www.wtop.com/?nid=456&sid=1291604. Who can blame them?

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