Special Report

The Economic Recovery Plan

Without an understanding of government's and regulations' leading role in creating the current mess, there'll be no recovery and we'll be stuck with the Barack Obama plan.

By 9.24.08

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We can fix our economy right now if we would just sharply increase taxes on employers, savers, investors, big business, small business, anyone who would start a business, and workers who make too much money. We need more power and authority for the wise, selfless, government bureaucrats in Washington who really understand our economy and how to fix it. Then, acting only in the public interest for the good of all peoples, without any influence from special interests or politics, they can impose new regulatory burdens on the stupid, greedy, corrupt businesses that actually hire the workers and pay them their wages.

We also need more money and power for Washington to increase federal spending by an additional trillion plus dollars. Then, we can give $50 billion each year to the UN to fight a global war on poverty. As a nation of hopeful peoples, we could then also spend so much more here at home for child care, health care, welfare, education, state and local government spending, new green energy based on love rather than greed, and retooled cars designed for the social good, all run by the government and those same wise, all-knowing, non-political, government bureaucrats in Washington.

This is the Barack Obama economic recovery plan. He got it from the same people who developed the Hugo Chavez economic plan for Venezuela. Honest.

The Root of the Problem: Government
The financial panic gripping America right now, and threatening to throw the entire economy into a serious tailspin, was not caused by corruption on Wall Street, deregulation, free market economic philosophy, the 1999 repeal of the outdated, 1930s Glass-Steagall Act, or any of the other far left talking points advanced by the Obama campaign.

The root of the problem began with bad, mismanaged monetary policy by the Fed. Earlier this decade, the Fed overexpanded money and credit, reflected in historically low interest rates for far too long. This began a classic boom and bust business cycle, concentrated mostly in the housing bubble that crested with ridiculously high housing prices a couple of years ago. When that bubble burst, housing prices began to tumble.

This would have caused a mild downturn. But other bad government policies have greatly exacerbated the problem. These started with the Community Reinvestment Act (CRA), adopted during the Carter Administration, but greatly expanded during the Clinton years. CRA regulations demanded that financial institutions provide mortgages to lower income borrowers they thought were too risky, in unstable neighborhoods that they thought exposed their loans to too much risk. Barack Obama's friends at ACORN became major abusers of the CRA, using it to label financial organizations as racist and to block needed regulatory approvals, until ACORN was bought off with money and loans for its favored allies.

This was the beginning of government policies to expand mortgages on easier and easier terms to lower income borrowers, demanding less and less in terms of down payments, documented incomes, and positive credit histories. These practices eventually grew into the subprime mortgage market, where money started to flow even to dubious borrowers with questionable backgrounds.

But it was the federally established and backed Fannie Mae and Freddie Mac that spread the subprime mortgage risk throughout the financial world. Fannie and Freddie issued securities, which the market took as effectively government guaranteed, to raise money to buy mortgages from banks and other financial institutions. They then sold shares in pools of such mortgages to other financial institutions and investors, in America and around the world.

When Fannie and Freddie started selling shares in pools of subprime mortgages, they were spreading serious, unrecognized risk throughout the financial system. With their implicit government guarantee, they were able to borrow huge amounts to fuel an explosion in subprime mortgage lending, and to pump up the housing bubble overall to even greater extremes. They even began buying and stockpiling shares in subprime mortgage pools sold by others, which greatly encouraged even more subprime lending. As AEI economist Kevin Hassett noted on Monday at Bloomberg.com, "As of last June, Fannie alone owned or guaranteed more than $388 billion in high-risk mortgage investments." This was the tip of the iceberg of trillions in increasingly dubious mortgage related securities.

The growing problem was not unnoticed. Hassett quotes Alan Greenspan warning in 2005 that if Fannie and Freddie "continue to grow, continue to have the low capital they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest risk adversion, they potentially create ever-growing potential systemic risk down the road....We are placing the total financial system of the future at a substantial risk."

Senator John McCain was one of three co-sponsors of a 2005 bill to address this budding crisis by establishing strict new regulatory controls over the government-sponsored enterprises Fannie Mae and Freddie Mac. The bill squeaked through the Senate Banking Committee, but Democrats such as Chris Dodd, Hillary Clinton and Barack Obama in the Senate, and Barney Frank in the House, unified to kill the bill. Hassett writes, "If the bill had become law, then the world today would be different. In 2005, 2006, and 2007, a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of our oldest and most venerable financial institutions. Without [Fannie's and Freddie's] checkbooks keeping the market liquid and buying up excess supply, the market would likely have not existed."

It was government backed Fannie and Freddie that came to be plagued with outright corruption. Clinton turned it into a feeding trough for Democrat cronies, led by Fannie Chief Franklin Raines, Clinton's former budget director. Fannie Mae actually tampered with its own accounting books to show profits that would allow Raines to gain huge incentive bonuses under his contract. Raines amassed $90 million in personal compensation and bonuses from a government-sponsored enterprise.

Fannie and Freddie sought to protect their ongoing racket by hefty political contributions to key political angels. The top recipient of such contributions has been Senate Banking Committee chairman Chris Dodd. The second highest recipient has been Barack Obama.

Mark-to-Market Death Spirals
As housing prices began to fall after the bubble burst, additional government regulations became deadly killers. Accounting regulations adopted after the Enron fiasco required financial companies to mark the value of their assets to market. This means that companies must value their assets on their balance sheets based on the latest market indicators of what their assets could presently be sold for.

Under these rules, declining housing prices don't just reduce the value of defaulting mortgages. They reduce the value of all mortgages, because the housing collateral protecting them is now worth less. More foreclosures and home auctions depress housing prices further, further reducing the value of all mortgage related securities.

The credit agencies seeing declining capital margins then downgrade credit ratings. Declining capital and credit ratings cause stock prices to decline. Financial institutions find that they must raise more capital to meet regulatory requirements. But the reduced credit ratings make this more difficult. Companies trying to sell assets to raise capital, particularly mortgage related securities, find this drives down the value of their securities further.

Panic sets in and no one wants to buy mortgage related securities, driving their value under mark-to-market regulations down toward zero. Balance sheets under mark-to-market suddenly start to show insolvency. This downward spiral shuts down lending to these companies, so they lose all liquidity (cash on hand) needed to keep company operations going. Stockholders realizing that they will be wiped out if the companies go into bankruptcy or get taken over by the government start panic selling, even when they know the underlying business of the company is fine.

This is how with only about 5% of mortgages in default, major companies with still solid underlying business operations, like Merrill Lynch, Bear Stearns, AIG, and even Lehman Brothers, find themselves suddenly bankrupt overnight. The companies would all have survived under the accounting rules followed for decades. But under the brilliant new mark-to-market regulations, increasingly widespread panic threatens the entire economy.

A Real Economic Recovery Plan
Earlier this week, former House Speaker Newt Gingrich posted at AmericanSolutions.com, a real, comprehensive economic recovery plan that would, indeed, get America booming again. Candidates can spend the rest of the fall running on this platform:

First, Gingrich writes, "the Federal Reserve should return to protecting the dollar against inflation." Indeed, the Fed should closely follow the "price rule" for the conduct of monetary policy, which is what the Reagan supply-siders wanted in the 1980s, and got for a while. This means that the Fed would be guided in its monetary policy primarily by seeking to maintain stable prices for a basket of commodities including gold. This would eliminate inflation over time, and smooth out the roller coaster boom bust cycles we have suffered in recent years.

Second, Gingrich writes, "the Federal government should return to a fiscal policy of controlled spending." Indeed, the new President next year should call for a package of $150 billion in spending cuts for the first year, which would be the equivalent relative to the size of the budget of the Reagan 1981 budget cuts.

Gingrich also writes, "[W]e should adopt a tax code which encourages investment, savings and job and productivity growth within the world market." In fact, we should adopt an optional flat tax system which would sharply reduce marginal tax rates for all taxpayers, creating the foundation for an economic boom. We could have one flat 17% rate, or 2 rates of 10% and 25%.

Gingrich also supports personal accounts for Social Security, which could be expanded over time to replace the payroll tax for all workers with a personally owned, family wealth building accumulation of assets. This would be a revolution in the personal prosperity of working people.

Of course, we should immediately end the mark-to-market accounting regulations that are creating a systemic panic in our economy. We should just reestablish the previous market value estimate rules. That would solve the short-term panic without the Paulson, $700 billion bailout package. Gingrich writes, "[I]t is pretty destructive to have artificial accounting rules ruin companies that would have otherwise survived under previous rules."

Gingrich calls as well for an "all sources, all of the above" American energy policy that "combines drilling for oil and gas, oil shale, clean coal, biofuels, flexfuel cars, wind, solar, hydrogen, and nuclear power into a deliberate strategy of creating the most abundant energy economy in the world. Gingrich writes, "The liberals in Congress have responded to the American people's anger over energy prices by trying to pass fundamentally dishonest bills which raise taxes and at the same time limit energy production while pretending to increase it. These dishonest efforts would actually make it permanently illegal to drill for oil and gas in most of the areas offshore."

Indeed, the news media should stop asking Barack Obama if his chair is comfortable and if he would like a glass of water, and ask him what his policy is to reduce gas prices. They would find he doesn't have one because he thinks high gas prices are good for the environment.

Gingrich goes on to propose reforms for health care, education, immigration, litigation costs, financial regulation, infrastructure, and other areas, all of which would further contribute to economic growth and booming prosperity for all. The plan is reminiscent of the Reagan economic recovery program in 1980, which had four components: (1) reduced taxes (2) reduced government spending (3) anti-inflation monetary policy that would restore a sound dollar and (4) regulatory reform.

This is a winning platform for this year as well.

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About the Author
Peter Ferrara is Director of Entitlement and Budget Policy at the Heartland Institute, General Counsel of the American Civil Rights Union, Senior Fellow at the National Center for Policy Analysis, and Senior Policy Advisor on Entitlements and Budget Policy at the National Tax Limitation Foundation. He served in the White House Office of Policy Development under President Reagan, and as Associate Deputy Attorney General of the United States under President George H.W. Bush.