By J. Morton Davis - 02/10/09 05:40 PM EST
At 37 percent, consumer confidence has just declined to the lowest level since we began tracking it in 1967. The nation’s reported two-month job loss is the highest in 50 years. Retail sales have just suffered their worst plunge in 35 years. The overwhelming majority of individuals’ 40l(k)s have sunk so far they’re not even 201(k)s. Housing prices continue their relentless freefall, and home foreclosures proliferate.
We are approaching the longest recession since the 1930s without any light at the end of this darkening tunnel. Alan Greenspan maintains we’ve already experienced the worst financial crisis in a hundred years. Having just lived in the best of times, we are now, arguably, living in the worst of times.
To be fair, it’s not for lack of purposeful effort that we are still enduring the harshest and longest economic plummet since the Great Depression. After all, those in charge from the president on down through Congress, the secretary of the Treasury, the chairman of the Federal Reserve and the chairwoman of the FDIC made a valiant attempt to halt the avalanche. We all watched as they zealously lurched from policy to policy with enormous taxpayer dollars and political pressure to salvage Bear Stearns, Freddie Mac, Fannie Mae, Merrill Lynch, AIG, and numerous failed or failing banks and their depositors. Assistance efforts even included non-bank enterprises and non-industrial entities like GM, Chrysler, American Express, GMAC and Countrywide.
As Martin Weiss writes in Depression, Deflation and Your Survival, however, “even as the government sweeps piles of bad debt under the carpet, mountains of new debts go bad — another flood of mortgages that can’t be paid. Even as the government commits new billions to be spent on financial rescues, trillions in wealth are wiped out in the continued sinking of housing values.”
Initially, a $700 billion bailout package, TARP, was quickly enacted, of which approximately half has already been expended. According to the Milken Institute, the government has already spent or pledged $7.5 trillion to help the economy. All to no avail. Bill Gross, head of the giant Pimco fund, insists it will take trillions more.
On top of this, the Fed made an extraordinary effort by reducing interest rates to all-time lows.
But that has proven almost useless since banks won’t extend credit to even the most worthy borrowers. Moreover, lack of demand means businesses already have excess capacity and therefore no interest in borrowing to expand or to improve productivity. As The New York Times asserts, “homeowners, consumers, are not only cash-short but house-poor and as a result they are unable or disinclined to spend.”
As almost every country’s central bank, in an effort to resuscitate its country’s economy, has recurrently cut interest rates (to almost zero), conditions seem only to have worsened. It is like pushing on a string, or death by a thousand cuts.
Still, banks are experiencing a deterioration of their assets and expect this calamity to continue. A recent Times editorial accurately describes the problem as owing to “house-price declines and foreclosures” which have become “the catalyst in a vicious downward spiral.”
Falling prices and rising defaults perpetuate the credit crunch and economic collapse. Banks’ fear is pervasive, so the credit sector is paralyzed and shut down. There is almost no hope this credit crunch will soon abate.
To remedy this appalling dilemma, the most recent scheme being proposed, even enthusiastically by some, is for the government to set up a “bad bank” to buy up all the “toxic” (possibly worthless) assets from banks so they might become “good banks” with strong balance sheets. The idea is that by eliminating the fear that impels banks to hoard cash infusions from the government (in case they are further besieged by more losses), they can then once again use “good assets” to extend credit.
This may sound reasonable, even constructive, but there is no way for the government to value these dubious assets, or estimate potential taxpayer losses. Moreover, according to Sen. Charles Schumer (D-N.Y.), vice chairman of the Joint Economic Committee, highly regarded officials estimate it would take $3 trillion to $4 trillion to buy the bad assets.
So that doesn’t appear to be an advisable strategy.
What’s been tried hasn’t worked and new approaches being considered are unlikely to work any better.
As Winston Churchill shrewdly observed, “Americans will always do the right thing … after they’ve exhausted all the alternatives.” As President Obama, our inspired new leader, kept urging us during his brilliant campaign, we need change — change that works.
For a stimulus strategy to work it must be targeted at the source of the problem. Just as Larry Summers, former Treasury secretary and now director of the National Economic Council, so wisely counsels, “it should be temporary, targeted and timely.”
The strategy must halt foreclosures that dump more unsold houses on the market, depressing prices still lower and in turn impelling more homeowners to default, making more mortgages worth less or worthless.
While many desirable, even laudable undertakings have been proposed to stimulate the economy — on healthcare, education, energy and infrastructure — it’s critical now that we prioritize. The stimulus bill should not become a special-interest Christmas tree.
Some projects in these categories should be part of any stimulus package, especially in the infrastructure area that can create a great many jobs, providing they can indeed have an immediate impact on the economy. A major problem with the stimulus program being considered is that less than half the stimulus money would be spent this fiscal year. Too much would wait until 2010 and 2011.
So let’s spend what it takes to turn this frightful economy around, but let’s also target the spending to solve the problem. The first priority must be housing. A strategy that would end the foreclosure crisis, raise housing prices, resuscitate banks’ toxic assets and resurrect housing and financial markets (and thence the entire American economy) is the 3 percent solution.
Supply in the housing market outstrips demand today by 1.5 million homes. Foreclosures are driving up that total; 2.3 million homes face foreclosure, and Credit Suisse estimates that another 8 million mortgages could go into foreclosure in coming years.
A stimulus that would forestall this dire prospect would be government-provided 30-year mortgages at 3 percent interest for anyone who buys any already built but unsold new home or any foreclosed home for $300,000 or less with a minimum down payment of 10 percent.
Inventory would fall quickly, prices would stabilize and then rise. Until housing prices started to fall in 2007, when only 774,000 new homes were sold, about 1 million homes or more were sold each year since 2001. So the current inventory of fewer than 400,000 new homes would sell quickly if buyers were offered a 3 percent mortgage.
If the 1.5 million “excess” homes mentioned above cost an average of $250,000 — the median price for an existing home in December 2008 was $175,400 and the mean price was $216,000 — their total cost would be $375 billion. If the Treasury raised this amount in 30-year Treasury bonds at 4 percent (only recently they were trading at a yield of 3 percent or less and are still being bought at yields below 4 percent) and the government were to absorb the 1 percent difference between the 4 percent yield on the bonds and the 3 percent mortgages, the total cost would be only $3.75 billion a year to clear up this inventory.
In fact, with the 10 percent down payment it would cost only $3.4 billion and if the house were sold within 10 years the mortgage would not be transferable to the new buyer, thus eliminating this attractive subsidy and reducing the cost to the Treasury. Even if there were 4 million homes in foreclosure and eligible for the 3 percent mortgage, the cost to the government would be only $10 billion per year.
By providing this subsidy, or a substantially larger commitment if the program were expanded to include pending foreclosures where mortgage indebtedness exceeded the value of the homes, it would still be a relatively modest total cost compared to the several trillion it would take to aggregate and buy banks’ bad assets.
Even better, instead of issuing Treasury bonds at 4 percent, which would compete for dollars needed by private industry and consumers, the Treasury could just monetize the capital required — print the dollars — and provide them to the borrowers through the federal housing authority and thereby incur zero cost to provide these mortgages. In that case the government would be earning the 3 percent on these dollars for the benefit of taxpayers instead of incurring the cost of borrowing via bonds. To be sure the Treasury did not compete with the private financial sector, it should be involved in the mortgage business only until the housing and mortgage markets stabilized and revived.
Over time the profit on these government loans would be significant. If all 4 million homes mentioned earlier were funded through a government mortgage, the government would initially earn approximately $30 billion a year. As these mortgages amortized over 30 years, the Treasury would get all its principal back plus more than $500 billion in profit!
This is a better, cheaper way out of our financial dilemma, much more effective than trying to save failing entities directly. It would raise the price of foreclosed and unsold homes by increasing demand and the ability of buyers to pay for them. It would stop the falling dominos that keep pushing prices lower.
During the Depression, when farmers could sell their produce only at prices that wiped them out, the government saved them with subsidies. These fostered growth to the point where the farm sector became one of the most vigorous and envied components of the U.S. economy. Sagacious political leaders did not bail out farmers by buying their farms or by doling out dollars to prop up their balance sheets. Instead, they leveraged the impact of federal money by using subsidies to revive a devastated economic sector.
A 3 percent mortgage is a “subsidy” that could do the same. This would not only help save the financial system, but also create many jobs in the housing and construction industries. It would be a tremendous, instant and effective jolt for our malfunctioning economy.
Many will argue, perhaps correctly, that if the Treasury prints more money, inflation will result.
But at this critical juncture we need a little inflation, or reflation. As Ben Stein, writing in Times, rightly asserts, “the inflation threat is small in an economy in full credit-collapse mode. There is virtually no dose of stimulus that is too much in an economy as shell-shocked as today’s.”
Inflation is the least of our worries, and even if it did reemerge, the Fed has learned to combat it effectively by raising interest rates and tightening the money supply.
Deflation, which is what we have now, prompts people to wait for lower prices before buying, thus depressing demand, costing more jobs, lowering wages and profits, making it even more difficult to repay debt, triggering more defaults and more business and bank insolvencies.
Inflation generates higher wages and profits, and prompts consumer buying to beat rising prices, thus encouraging demand. This means more hiring and job growth, better nominal wages, and the easier repayment of loans with “cheaper” dollars. Those presently underrated toxic loans become solvent and repaid.
Inflation is amazingly beneficial in helping debtors repay creditors and apparently worthless loans become sound. The balance sheets of lenders, the troubled banks, are resurrected.
Mr. President, Congress, let’s enact the 3 percent mortgage stimulus solution! It will save the banks, help homeowners, revive the housing industry and financial markets, generate new jobs, renew economic growth and lift the American and entire global economy.
Davis, a shareholder in The Hill’s parent company, is an economist, an MBA graduate (with distinction) from Harvard Business School and author of From Hard Knocks to Hot Stocks (William Morrow and Co.) and Making America Work Again (Crown). His
e-mail address is firstname.lastname@example.org.