DAILY ECONOMIC DATA

Uncle Sam: Too Fat to Fail?

• By DANIEL HENNINGER

Three weeks before the selection of a U.S. president, we are witnessing a generalized global collapse of confidence in financial and political institutions. Each hour, it seems, brings another reason to withhold faith.

On Tuesday, after another dramatic plummet in the Dow Jones Industrial Average of 508 points, the American people sat down at 9 p.m. to watch between the two men running for the U.S. presidency "debate." Forgoing Ambien the first time this week, they rose in the morning to learn that the Federal Reserve and four European central banks plus Canada's cut interest rates a half-point to boost confidence in their financial markets. Hours later, the Dow in the U.S. opened and fell 250 points.

The rarest coin in the realm now is confidence. Let us posit that John McCain and Barack Obama in their debate or at any given hour are doing next to nothing to raise confidence. They have company in their failure -- 535 Members of Congress and one President.

President George W. Bush's approval rating hangs at 25%, nearly an unprecedented low. Congress's approval is at historic lows. A Rasmussen poll last weekend said nearly 60% of the public would chuck the entire Congress.

The standard remedy for this in political systems everywhere is throw the bums out. In 2006's off-year congressional election, the American people threw out one set of Republican bums and, if current polls mean anything, replaced them with the Democrats' finest bums.

Maybe it's time for Plan B.

Mark down 2008 as the year that many large public and private institutions hit the wall. Suddenly, in different ways, they were manifestly failing. Why?

Tuesday's presidential debate offered a glimpse. Amid the din of crashing banks in the U.S. and Europe and stumbling government efforts to plug the dikes, Barack Obama and John McCain airily promised to wave into life one grandiose solution after another to health insurance, social security, energy supplies and incomes. Do serious voters believe any of this?

Some weeks ago Barack Obama got into trouble for saying a difficult question was "above my pay grade." That plastic droplet of modesty is the beginning of wisdom. Step back and most of what is before us now is above anyone's pay grade.

Consider the magnitude of these problems or the sheer, dumb size of the institutions. Another phrase of financial usage familiar everywhere now is "too big to fail." But if something is too big to fail, isn't it....too big?

Look in any direction and what you see are institutions that are Too Big. Too big to fully understand, and thus too big to manage efficiently. Faced with Godzilla-sized problems, logic flees: If they're too big to fail, the solution is....make them bigger!

The fat government we know about, with its $2.942 trillion annual outlays. The problem of unmanageable public bigness is also seen in state legislatures in a condition of permanent nonperformance, as in New York, California or Michigan. We become numb to these outsized and failing public institutions, which grind in circles while the pols purport concern about massive, forward-crawling public monoliths like Medicare, social security or public pension debt.

By contrast, the starkness and hourly reporting of the financial crisis has made the dilemma of size impossible to duck.

Citigroup, a financial-services colossus that can't manage what it's already got, is trying to chow down Wachovia, a slightly smaller colossus. J.P. Morgan absorbed first Bear Stearns and now WaMu bank. Bank of America acquired Countrywide Financial and then Merrill Lynch. The concern here is less that these entities are anticompetitive than that they are too big to succeed.

We've all been tutored in economies of scale -- that bigness permits cost saving. Check out its little-known fraternal twin -- diseconomies of scale, wherein size becomes a stagnant lake of inefficiency -- and risk. Ever try to fight your way through Merrill's voicemail tree? Wait til you phone customer service at BoACountrywideMerrill.

The biggest vice staring us in the face isn't greed. It's gluttony (now known as obesity) in both the public and private spheres. What has been laid on the table with the financial crisis and the loss of political faith is whether the U.S. system and its institutions are up to the future. Like Wall Street, Uncle Sam is not too fat to fail. Even before this crisis, intellectuals and pundits were writing off America as certain to be overtaken -- politically and economically -- by the likes of China and India.

Both Obama and McCain Tuesday night denounced Washington's "special interests." In fact, those interests are the hungry commercial pilot fish that swim alongside the massive federal Leviathan. If either man wanted to send a signal to the world that the U.S. whale was ready to move past the mortgage crisis to new strength, he would blow up the Department of Housing and Urban Development.

Fat chance. Fat's winning.

The GOP Peddles Economic Snake Oil

Suddenly Republicans are against market values?

THOMAS FRANK

OK, let me get this straight: The central axiom of conservative Republicanism is that government is inherently corrupt and can't do anything right.

Over many years of ascendancy, conservative Republicans have filled government agencies with conservative Republicans and proceeded to enact the conservative Republican policy wish list -- tax cuts, deregulation, privatization, outsourcing federal work, and so on.

AP

And as a consequence of these policies our conservative Republican government has bungled most of the big tasks that have fallen to it. The rescue and recovery of the Gulf Coast was a disaster. The reconstruction of Iraq was a disaster. The regulatory agencies became so dumb they didn't even see the disasters they were set up to prevent. And each disaster was attributable to the conservative philosophy of government.

Yet now we are supposed to vote for more conservative Republicans because we learned from the last bunch of conservative Republicans that government just doesn't work.

That is the advice of Sarah Palin, Republican vice-presidential nominee, in last week's debate with her Democratic counterpart, discussing the dread prospect of universal health care: "Unless you're pleased with the way the federal government has been running anything lately, I don't think that it's going to be real pleasing for Americans to consider health care being taken over by the feds."

Conservative misrule, prompted by conservative disdain for government, proves that government cannot be trusted -- and that the only answer is to elect another round of government-denouncing conservatives.

"Cynicism" seems too small a word for this circular kind of political fraud. One reaches instead for images of grosser malevolence. It's like suggesting that the best way to recover from pneumonia is to stand in the rain for three hours. It's like arguing that the way to solve nuclear proliferation is by handing out weapons-grade plutonium to everyone who asks for it.

Consider also the perverse incentives that such a logic would establish. If we validate Mrs. Palin's thoughts on federal bungling by electing her to the high office she seeks, we are encouraging her to bungle everything that comes her way. After all, by her thinking, such bungling will not discredit her doctrines but rather confirm them, demonstrate the need for more Sarah Palins down the road. We will be asking for it, and it's not much of a stretch to predict that we will get it.

In the three-ring circus of conservative blame-evasion, however, that's only one act. Over in the House of Representatives, a new breed of Republican idealists spent last week dazzling the faithful by taking a bold stand against the Wall Street bailout. The administration's plan was a "slippery slope to socialism," declared their leader, Jeb Hensarling of Texas.

One might have admired their pluck but for the breathtaking opportunism of their own counterproposal, the "Free Market Protection Act," which is described on the Web site of the Republican Study Committee. True, it is not a "slippery slope." It is a headlong stampede over a precipice, a running leap out a skyscraper window.

It starts by calling for "voluntary private capital" to solve the problem of bad mortgage-backed securities (MBS). Several sentences later it asks for a "mandatory" fee to be levied on all MBS, good or bad, and apparently without regard for whether it's held here or overseas, where American law doesn't apply. I asked William Black, the University of Missouri-Kansas City professor of economics and law whom I quoted last week, what he thought of this scheme. He replied, "This is significantly insane as a matter of finance -- and unconstitutional as a matter of law. This clause would cause a world-wide financial panic were it implemented."

Back at the study committee's Web site, I see conservatives call to "Suspend 'Mark to Market' Accounting." Suddenly our "free-market protection" gang has decided it's unfair to make companies value their MBSs at . . . the market price. Somehow the all-seeing market has gone irrational, and so companies must be allowed "to mark these assets to their true economic value," meaning, one might say, to mark them however they please, a practice that, to put it shortly, is what got us into this mess in the first place.

Space prevents me from discussing the plan's provisions to temporarily suspend capital gains taxes and repeal the Humphrey-Hawkins Full Employment Act. But I will note that, in discussing the derring-do of Mr. Hensarling and his hard-core colleagues, the New York Times chose to refer to them as "populists" -- friends of the common people. As an indicator of the confused state of our political discourse, the signals don't flash any brighter than this.

Years ago, conservatives realized that to destroy the legitimacy of your adversary's concepts is to destroy your adversary. Today we are surrounded by the wreckage. Much depends on our success in rebuilding.

How to Unfreeze Bank Lending

The government should guarantee interbank activity.

ROBERT C. POZEN

The most pressing problem for American companies and cities is the unwillingness of financial institutions to make short-term loans. Banks are reluctant to lend to other banks, as shown by the huge spread between the interest rate on interbank lending and the yield on three-month Treasury bills. At the same time, money-market funds are shying away from short-term commercial paper of money-center banks and large companies in favor of U.S. Treasury bonds.

As a result, many American companies are facing serious challenges in financing their inventories and payrolls. Even triple A credits like General Electric must pay very high rates to sell their three-month commercial paper. Similarly, many local governments must pay very high rates to obtain short-term tax-exempt financing. The yields of short-term paper from most municipalities are now running above 5% on a tax-free basis.

Unfortunately, federal purchases of troubled assets under the Economic Stabilization Act will take several months to generate more liquidity. The initial purchases are not likely to lead to more lending by the institutions willing to accept the conditions of the federal bailout. These conditions include giving stock to the federal government as well as limiting compensation and golden parachutes for top executives of an institution that sells more than $300 million in troubled assets to the Treasury. Accordingly, the sellers will be mainly weak institutions that will use the cash proceeds received from the Treasury first to cover their loan losses and rebuild their capital.

Yesterday, the Federal Reserve announced that it will buy at discount unsecured commercial paper from certain non-lending institutions. This is an important stop-gap measure. However, the ongoing needs of local companies and governments can be met only if they can borrow regularly from local banks.

To melt the freeze on short-term loans by banks, the federal government needs to reduce the risk of surprise from such loans. Healthy banks and money market funds are wary after the rapid demise of AIG, Lehman and Wachovia. Therefore, the Federal Reserve should guarantee most of the short-term borrowing of well-capitalized banks for a small fee.

Such a guarantee for interbank lending would be consistent with the widening government support of banks in Western Europe. This has been done already in Ireland, for example. At Saturday's meeting of the G-7 finance ministers in Washington, the Fed should launch a coordinated program with European central banks in guaranteeing loans to their banks.

Here's how the guarantee might be structured to dovetail with the federal bailout bill and constrain moral hazard. A bank could borrow up to a specified percentage of its tangible capital, with a Fed guarantee for a limited period such as three or six months. This limit should be designed to give enough time for new sources of lending to be generated by the federal purchases of troubled assets. The Fed guarantee would cover a large portion, say 90%, of the principal of these loans only in the event that the borrowing bank becomes insolvent. The non-guaranteed portion of these loans would give lenders the incentive to make intelligent choices and monitor the borrowers.

With this federal guarantee, banks will lend to other banks and the interbank lending rate will fall back to its normal level. Money-market funds will also buy the commercial paper of well-capitalized banks. In turn, these banks will have additional cash to make short-term loans. In this way, the current freeze on credit will melt into a new pool of liquidity.

Mr. Pozen is chairman of MFS Investment Management.

It's Time to Think Big on Tax Cuts

McCain should revive his support for an alternative flat-tax system.

JACK KEMP and PETER FERRARA

John McCain needs to show the nation that he has the economic recovery plan to restore long-term economic growth. To do that, he needs to refocus his campaign with a new tax plan. Mr. McCain should come out for an alternative, optional flatter tax system, which he has already supported.

Under this proposal, Americans could file their income taxes under the existing tax code or they could choose instead to pay taxes under a simpler code with fewer deductions but lower tax rates. Building on work already done by Steve Forbes and House Budget Committee member Paul Ryan, a Wisconsin Republican, Mr. McCain could propose an optional tax system with just two rates, 10% and 25%, compared to the six rates of the current code ranging from 10% to 35%.

What's more, such a proposal would include a cut in income taxes, and tax rates, for every American who pays taxes. The alternative system would impose no income taxes on the poor and what is often called "the working class" (the bottom 40% of income earners who don't pay federal income taxes now). This proposal would also eliminate federal income taxes on the middle class, the middle 20% of income earners who pay only 4.4% of all federal income taxes today.

The new tax system would allow most Americans to file their taxes on a single sheet of paper, saving them the hundreds of dollars they spend today to have their taxes professionally prepared.

And such a tax reform would be an antidote to the class warfare, neocollectivist tax policies of Barack Obama. If implemented, it would also jump-start the economy. Under this optional tax system, savings would increase and investment would soar as capital around the world is drawn to a suddenly more confident U.S. economy.

This new surge of capital would end the credit crunch, and allow old businesses to expand and new ones to start. Wages would grow, along with the overall economy. And as the world invested in America, the dollar would strengthen, as happened in response to the tax cuts that generated the 1980s Reagan boom. This would ease inflationary fears and pressures on the Fed.

With a strong dollar, the Fed would be under less pressure to try to revive the economy through monetary policy. That would give Mr. McCain the flexibility to push for a new "price rule," which would base monetary policy on prices of a basket of commodities, including gold.

Mr. McCain has already proposed a freeze on nondefense, discretionary spending, and to limit overall federal spending growth to 2.4%, about one-third the annual increases since 2000. Along with his trade policies, the pro-growth tax rate cuts in this alternative tax system would give Mr. McCain all the major components -- lower taxes, freer trade, a strong dollar -- of Ronald Reagan's 1980 recovery plan.

Mr. McCain already has proposed several promising pro-growth tax reform plans that would lower taxes on investment and the middle class. With American companies suffering the second-highest corporate tax rate in the industrialized world, Mr. McCain would cut the federal corporate rate to 25% from 35%.

This would create jobs and increase wages, while boosting the dollar and raising revenue. A 2007 Treasury Department study found that Ireland, with a 12.5% corporate rate, raises almost 50% more revenue as a percent of GDP than the U.S. does with a 35% rate.

Mr. McCain is also already proposing to cut taxes on savings and investment through expensing for capital equipment and technology investments -- allowing such expenses to be deducted in the year they are incurred, like all other expenses, rather than over several years under arbitrary depreciation schedules as today. This would do more for Detroit automakers than government loans.

He would prevent increases in individual income tax rates, capital gains tax rates, and dividend tax rates by making the Bush rate cuts permanent, and cut the death tax to below pre-Bush levels.

Mr. McCain wants to increase the dependent exemption to $7,000 from $3,500 per person today. This would reduce taxes for middle-class families in the 25% income tax bracket by $875 per dependent. It would probably eliminate most of the remaining federal income tax liability for the middle class by itself.

Mr. McCain also proposes to abolish the Alternative Minimum Tax (AMT), which is currently slated to grow to impose a trillion dollar tax increase on the American people in just a few years, burdening 25 million middle-class families. Abolishing the AMT would save middle-class families $2,700 on average per year, a cut of $60 billion each year from current law.

Mr. Obama, by contrast, offers tax increases on savers, investors, small business, employers, and other job creators, a trillion dollar plus spending increase, and new regulatory burdens. That has no prospect of restoring economic growth. It will only do the opposite.

Mr. Kemp, chairman of Kemp Partners, is a nationally syndicated columnist. Mr. Ferrara is director of entitlement and budget policy for the Institute for Policy Innovation and general counsel of the American Civil Rights Union.

DAILY ECONOMIC DATA

We Need a Game Changer, Now!

The Treasury’s $700 billion plan to purchase troubled assets has had no visible effect on financial markets. Since the bill’s passage, the Dow has fallen 1500 points.

Treasury will not make its first purchase of assets with its new fund for at least two weeks. In today’s world, this is a long time…too long. Every firm that fails increases the odds that another will fail. And every failure undermines confidence in the economy and causes a deeper distrust of the capital markets. We need a game changer, now.

The Treasury should use the broad latitude it has been granted with its $700 billion rescue fund to enter the market directly to help firms that face liquidity or capital issues. This could take the form of buying preferred shares, or directly helping with short-term funding needs.

We are hearing that the Treasury is thinking hard about these options and are hopeful that a move in this direction will be taken quickly.

We Won't Suffer a Japanese Deflation

The risk here and now is inflation.

DAVID GITLITZ

As U.S. credit markets continue to be roiled in chaos, some are bandying about the notion that America's problems resemble those of Japan in its deflationary "lost decade" of the 1990s. "Deflation looms. It certainly does loom," said one functionary for a major international bank. "The cycle in which debt destruction and asset price destruction reinforce each other clearly has a very, very, strong negative effect on the economy."

This analysis expresses a common fallacy that asset-price declines give rise to economic weakness, and the effect is therefore deflationary. But "deflation" is not a synonym for economic contraction. Deflation is rather a sustained decline in the overall price level, i.e., the opposite of inflation. Like inflation, deflation is a monetary phenomenon.

There is no evidence that deflationary influences are now at work in the U.S. economy. I was very familiar with the Japanese deflation, having been the first to recognize and name it in a 1995 op-ed on this page. I was exposed to considerable public criticism by the Bank of Japan at the time, but history has shown my diagnosis to be entirely correct.

Aside from some superficial similarities, the current U.S. financial market disturbance bears no resemblance to the economic misery that afflicted Japan for more than a decade, and in important ways continues to linger there. In fact, the comparison should provide some comfort to Americans. U.S. monetary conditions are nearly the exact opposite of the devastating deflation that characterized the Japanese experience.

The U.S. had its real-estate bubble through the first six years or so of the current decade, and on the surface, that might seem comparable to the real-estate bubble that preceded Japan's decade of deflation. Our bubble had its roots in the Fed's exceptionally accommodative monetary policy -- a situation not unlike Japan through the late 1980s, when the Bank of Japan was also too easy for too long. But unlike the Fed, the BoJ turned toward tightness with a vengeance, apparently with the objective -- at least initially -- of pricking the bubble.

Japanese land prices began their long fall in 1991 on the heels of a sharp currency appreciation in 1990, with the yen soaring nearly 20% against both the dollar and gold. That was just the beginning. By 1995, the yen/dollar would see a nearly 50% appreciation, and the BoJ's deflationary bias remained in place for a number of years. The relentless rise in the currency's purchasing power magnified the real burden of yen debt, crushing borrowers and crippling the Japanese banking system.

Contrast that with the U.S. experience, in which the decline in real-estate values would coincide not with a deflationary appreciation of the dollar, but an inflationary depreciation. From the time home prices peaked in mid-2006 through the currency's lows last spring, the trade-weighted value of the dollar fell by some 18%. Over the same period, the price of gold rose by about 75%. While the dollar has rebounded moderately in the last several months, by any objective measure it remains in a weak position. On a trade-weighted basis, it has returned to its levels of about a year ago. But before doing so, it had never been weaker. At around $830 in gold terms, the dollar has recovered a modicum of the purchasing power lost when gold soared above $1,000 last March in the midst of the Bear Stearns calamity. But at current levels the price of gold is double what it was four years ago.

The relative damage to real-estate values between the U.S. and Japan is instructive. Thus far, U.S. home prices have fallen about 12.5% from their peak. But they remain about 40% above their 2000 levels. In Japan, by 2001 the destruction of values brought land prices down to about half their levels of the late 1980s.

The U.S. housing downturn and associated financial-market turbulence is attributable not to tight monetary conditions, but to an unsustainable speculative bubble triggered by loose monetary conditions. The current market turmoil might well put the economy into at least a shallow and short-lived recession. But unlike Japan, the U.S. economy will not have to dig its way out of a debilitating, long-lasting monetary deflation.

On the contrary, the current economic climate is marked by a considerable upswing in inflation, with the headline consumer price index now running at about 5.4%, up from less than 2% a year ago. The decline in crude oil prices will keep down the reported rate for a few months. But once oil stops falling, the underlying inflationary influences will reassert themselves, and no sizeable long-lasting decline in reported inflation is likely in the foreseeable future.

The "lost decade" of stagnation and monetary deflation, and its remaining legacy today, were the product of a persistently too-tight Bank of Japan. The Fed was not tight even before the present crisis, and as the crisis has unfolded has gotten progressively easier. Today, America's real concern is inflation.

Mr. Gitlitz is chief economist at Trend Macrolytics, LLC.