We are witnessing a furious battle in the economy. On one side is the frightened consumer. She has more buying power via the Pigou Effect. But she is fighting the fear of new job losses. Even in a very serious recession, about 90% of households will likely keep their jobs. Here’s the question, though: Will those 90% have the confidence to deploy their new spending power when the threat of layoffs glares from across the playing field?
The Pigou route is powerful but does not fit on bumper stickers. The government must force down longer-term real interest rates. High long-term interest rates tell us: “Give up on the future. Today’s dollar won’t be worth much in the future.” The Federal Reserve Board, European Central Bank (ECB) and BoE must inject liquidity into every part of the yield curve. Traditionally, the Fed has preferred to create a steeper yield curve in recessions to widen bank spreads on lending, but we are now facing a corporate lending crunch that requires a flattening structure between 10-year commercial paper and the Fed Funds rate. Then Congress should cut the Social Security payroll tax, and for Pete’s sake, don’t jack up taxes on capital, as the Obama campaign promised last year.
Won’t this ignite inflation? Nope. Inflation is a yellowed newspaper headline ready for the shredder. The Fed may be running the printing presses overtime, but that is merely offsetting the destruction of money as banks, insurance companies, and hedge funds dump and de-lever.
The inflation scare last spring looked like the Y2K hoax. Yes, commodities skyrocketed, but they were bubbles. As the bubble was popping, I was asking Ben Bernanke to shout En guard!, slap ECB chief Jean-Claude Trichet across the face with a white glove, and challenge him to a duel on the future path of inflation. Trichet was constipated. In November, when the BoE had pushed rates down to the lowest since 1955, Trichet and the ECB still had not pushed rates even below their 2006 level. Today’s economy is starting to looks less like 2006 and more like 6 A.D.
We must also have a legal strategy to reduce the incentive to bet against the future. That’s where US$65 trillion in credit default swaps come in. My proposal will test President Obama’s Harvard law school education. President Obama should march the Attorney General into the Supreme Court to declare CDSs void, unless the buyer has a stake in the underlying company. There is precedent. For example, I cannot take out a life insurance on you, because I would then have a strong incentive to nudge you onto the subway tracks. For a hundred years courts have nullified impersonal life insurance contracts as “void as against the public interest.” Because CDSs are called “swaps,” they have escaped this insurance rule. 90% of CDSs have been bought, not to hedge, but to profit on the death of companies. When you combine these with short-sellers, there’s simply too much incentive to light a match to the entire world economy.
No path looks attractive, of course. A hedge fund friend told me that John McCain should’ve bragged more about Sarah Palin’s hunting skills. At the rate we’re going, the only industry left will be hunting and gathering. It’s not that bad. But it is that urgent.
Earlier in my career I worked at the White House with Treasury Secretary designate Tim Geithner, and taught with Larry Summers at Harvard. Summers and Bernanke are masters of Pigou and Keynes. Now, they must use the collective wisdom of the last hundred years, not to settle a decrepit academic dispute, but to save our standard of living.
It’s not just Pigou’s last chance.