How to fix the world economy

The world financial system has plunged into what Alan Greenspan, former chairman of the Federal Reserve, is calling a “once-in-a-century” financial crisis, and international headlines have begun to read like an obituary for capitalist economics. Once-mighty institutions like AIG, Fannie Mae and Freddie Mac have been nationalized. Venerable investment banks Lehman Brothers, Washington Mutual and Bear Stearns have gone bankrupt or were sold for a song. Gold and oil, both of which are critical benchmark commodities, now regularly swing 10 per cent on any given day. After hitting a record 1,555.10 points on June 13, 2007, the S&P 500 Index has since fallen 24 per cent to 1185.87 points as of Sept. 24, 2008.
To avert disaster Hank Paulson, United States secretary of the treasury, is advocating an ill conceived $700 billion taxpayer funded bailout for Wall Street.
But a buyout now is the wrong strategy. First because it will do real harm to the economy, and second, because it will send the wrong message to American companies. At the very least, his scheme will balloon federal debt levels, ramp-up inflation and reward the half-witted inventors of the sub-prime mortgage. In a worst-case scenario, it could even debase the dollar and engender a permanent crisis in the American economy – akin to Japan’s lost decade after the 1997 East-Asian currency meltdown.
But the impulse to rescue imperilled Wall Street banks is not only a violation of the free-market; it’s also historically misguided. In 1979 the United States Government set a trend by bailing out a floundering Chrysler with $1.2 billion in loan guarantees. Flash forward three decades and the American auto-industry still doesn’t make cars that people actually want to buy. In 2001, the American airline industry received $15 billion in financial assistance. According to the Global Airline Trade Association, the industry is expected to post at least $5.2 billion in losses for the 2008 fiscal year alone. So, if the $700 billion bailout doesn’t work – what can be done to salvage the financial system?
Well, if the American economy were healthy, the banks would be allowed to fail and would be re-capitalized, or bought out, by accumulated US dollar savings. But since Americans save minus 0.4 per cent of their income, the only available reserves of US dollars are in the sovereign wealth funds of Saudi Arabia, Singapore, Russia and China. Naturally, I understand the reticence of politicians in turning over blue chip companies to foreign interlopers (thus the bailout). However, I would argue that the embarrassment of having Sheikh Al Nahyan, of Abu Dhabi, chairing Bank of America or Citigroup is worth avoiding another Great Depression.
Now, once the current financial debacle is over, several areas will be ripe for reforms to help avoid a redux of the sub-prime summer of ’08.
Regarding the United States federal debt, immediate budgetary action is needed. Over the 37 years since Nixon abolished the Gold Standard, the United States’ outstanding debt has skyrocketed a staggering 2,200 per cent to $9.7 trillion. A further $53 trillion in un-funded Medicare and Social Security commitments, through 2019, remains a non-issue in Congress. Like Glenn Beck’s metaphorical asteroid – debt levels of this magnitude will eventually crush the United States’ economy. Senators Obama and McCain often talk about a Manhattan Project for alternative energy; how about a Manhattan Project for retiring the federal debt?
On tax policy, Congressional policy makers should adopt the Fair Tax. When income and investment are saddled with burdensome taxes, and consumption is hardly taxed at all, is it any wonder Americans don’t save? The Fair Tax would shift those incentives by replacing income, corporate, capital gains, and estate taxes with a simple consumption tax (like our GST).
On Federal Reserve policy, chairman of the Federal Reserve Ben Bernanke must avoid the pitfalls of his more famous predecessor, Alan Greenspan. The spigot must be tightened, and loose credit must be mopped-up, in order to fight inflation and the steady de-valuation of the US dollar.
To quote Alan Meltzer, professor of political economy at Carnegie Mellon University, “capitalism without failure is like religion without sin – it just doesn’t work.” Hank Paulson’s sweetheart bailout might work in the short term, but it’s no substitute for intensive free-market reform of the United States economy.