Thursday, November 6, 2008

Time for a New Approach to the Economic Crisis: End the Government Confidence Game

The stock market has dropped 10% over the last two trading days since Barack Obama was elected President. President-elect Obama shouldn't take it too hard. The market's drop has little to do with him. It's the result of the George W. Bush Administration's failed confidence game in dealing with the financial crisis.

All financial markets are based on confidence. This is true whether we're talking about stock, bonds, options, currencies, mortgage-backed securities, synthetic CDOs, or derivatives of derivatives. The Bush Administration's focus in responding to the mortgage crisis and credit crunch has focused on trying to restore confidence in order to get credit flowing. The Federal Reserve's ever-expanding programs of loans to an ever-widening circle of business enterprises, the bailouts of Bear Stearns and AIG, the nationalizations of Fannie Mae and Freddie Mac, and the still somewhat amorphous $700 billion bailout bill which will be used in some fashion that will eventually be defined are all meant to prop up the financial system by instilling confidence.

In the ten days preceding the recent election, the stock market gained about 18%, after central banks around the world announced a plan to make coordinated interest rate cuts in order to stimulate flagging economies. The surge in stock prices may also have been driven in part by the relief that the uncertainty of the presidential campaign was about to end (the financial markets hate uncertainty, because it's very hard to price).

However, after the election, the markets had to face the fact that the recession hadn't gone away, notwithstanding all the government bailouts, programs and policies. The Bush Administration's policies have lagged behind the economic tailspin, which is no longer driven only by falling real estate values and rising mortgage default rates, but also by a widespread slowdown in consumer spending driven by a number of disparate factors. Among other things, job losses are worse than expected, European banks turn out to have nastier problems than we thought, larger nations are quickly nationalizing their banking systems and smaller nations effectively admitted their insolvency by seeking IMF assistance. Retailers are almost all reporting bad financial results, with only Wal-Mart having something positive to say because it's focusing on serving the down market portion of the down market segment. Manufacturing is hurting and the U.S. export market will weaken as a result of the recent strengthening of the dollar.

It may be tempting to President-elect Obama to say something about our having nothing to fear except fear itself. That wouldn't set the right tone now. The Bush Administration's confidence game has failed, because confidence games don't work when assets are falling in value. Almost all asset classes, from stocks to bonds to commodities to real estate to the economy as a whole, are now falling in value. Everyone knows it, and everyone who has money to lend also has good reason to be cautious about lending. And a lot of people who have money invested in the stock markets are trying to get out.

Instead, President-elect Obama should use words that invoke Winston Churchill's promise of blood, toil, tears and sweat. Candor from the White House is essential. We're at the early stages of battling a difficult economic crisis. Few of us will escape wholly unscathed, and all of us will have to make sacrifices. While America's problems today do not begin to approach the depths of Britain's problems in the spring of 1940, we need to unify and find a sense of national purpose, step back from the partisan rancor of recent years, and work together to find lasting solutions. Further, we can't expect government to fix all problems. Those Americans who now reach for their bootstraps will end up much better off than those that wait with hands held out. The new President should be candid about what the government can't do and the importance of self-reliance and self-help. We Americans have always wanted a government of limited powers, and we'll have to work for it if we still want one.

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