Recipes for Recovery

On Monday, November 10th, the New
America Foundation’s (NAF) Next Social Contract Initiative
and the Committee for a Responsible Federal Budget hosted “Recipes for
Recovery,” a half-day event on the current state of the U.S. economy and potential
government responses.

Frank Micciche, Deputy Director of NAF’s Next Social
Contract Initiative, kicked off the event, observing that it was a precarious
time for both the U.S.
and global economies. Given the turmoil, he explained, both Congress and
President-Elect Obama have called for the government to pass stimulus
legislation designed to temper the economic downturn. Micciche then introduced
the day’s panels and keynote speakers, and turned things over to Richard Medley
of Medley Capital.

First Keynote Address: Richard Medley

Medley opened his remarks by suggesting that “free money
makes people stupid.” He argued that the root cause of the financial crisis was
that “adults lost control of the situation;” the result would be a financial
system changed for a generation or longer. This new financial system, Medley argued,
would be far more traditional than the current system. Firms would no longer
“lend to deadbeats,” but they would also have less leveraging ability. This will
mean slower-growing banks, a shrinking and consolidation of the hedge fund
industry, and the return of small banks.

Medley argued that new regulations would be necessary to
ensure we don’t repeat our mistakes, but advised that politicians “take a
breath” – for a year or more – before making any major decisions. He contended that
trying to regulate during a crisis would lead to overreaction and over-regulation.
He also suggested that it makes sense to wait and see how the markets sort out
and then regulate them, rather than influencing the direction of markets themselves.
Ultimately, Medley argued that government should limit the amount of leveraging
allowed. Although this would mean slower growth, he explained, it would mean
sounder growth – and could prevent another crisis.

After Medley’s speech, Mort Kondracke of Roll Call asked
what would constitute over-regulation.
Medley argued that requiring too much transparency (along the lines of
Nicolas Sarkozy’s proposals) or too stringent a view of the appropriate
structure of the financial market would be a bridge too far. He said that regulators should not force
firms to publicly disclose all their positions, nor should they mandate new
savings and loans. Rather, governments
should pause for a breather and let the system naturally gravitate toward the
proper regulation.

Dana Chasin of OMB Watch next asked what forms of restricted
leverage Medley imagined, and questioned whether encouraging restructuring and
Mergers and Acquisitions is sound policy. Medley replied that lending has
frozen up because balance sheets had big holes to fill, and no one knows just
how deep the holes are. Until markets
discover the real value of assets and securities, he suggested, government must
step in and establish a floor on prices.

A third questioner noted that the United States has lots of regulators,
but the rest of the world is quickly moving to the “twin peaks” of a prudential
regulator and a consumer regulator. He
asked if this consolidation was a good move.
Medley answered that, although the various U.S. agencies lacked comprehensive understanding
of what was happening in the financial markets, one czar is not necessarily the
answer. He stressed that it will take a
long time for the new regulatory framework to sort itself out.

First Panel: Jumpstarting the Recovery: Proposals for an Economic
Stimulus

Medley’s speech was followed by a panel discussion,
moderated by former U.S. Representative and CRFB Co-Chair Bill Frenzel. The
first panelist was Albert Dwoskin of A.J. Dwoskin & Associates. Dwoskin
opened by explaining that we are in an economic tsunami. The housing sector is
suffering particularly badly, he explained, even in geographic areas which have
traditionally been resilient. He suggested that massive cuts in public
expenditures, particularly infrastructure investments, are exacerbating the situation.
Because so many projects are on hold, Dwoskin argued, infrastructure investment
would be an effective stimulus that would both create manufacturing demand and
put people to work.

Michael Lind of the New America
Foundation spoke next, suggesting first that there is now a
consensus in favor of infrastructure stimulus – it is timely, targeted, and
results in the creation of tangible assets with economic value. Lind provided
an overview of current public investments, explaining that they cost $300
billion a year, with more than 70% coming from state and local governments.
Lind argued that this level of spending was woefully inadequate, both by
historical standards and in terms of what is necessary. He suggested that
infrastructure stimulus could be linked to the creation of a long-term
infrastructure strategy which leveraged public money to crowd in private
investment. Specifically, Lind called for the creation of a National
Infrastructure Bank which could serve the dual purpose of providing the country
with its infrastructure needs and offering an easy vehicle to provide stimulus
when it is needed.

Ethan Zindler of North American Research spoke next,
discussing how clean energy could play a role in the economic recovery. Zindler
first argued that the government’s role should be to foster private sector
investment more than make direct investment. He then illustrated the clear
upward growth trend of clean energy investment, as well as the stifling effects
of the current economic downturn. Part of the problem, he suggested, is with
the Production Tax Credit which is an ineffective impetus for clean energy
investment when banks are unwilling to make loans. At the same time, he
suggested that there are a number of sound clean energy infrastructure projects
out there, and the prospects of the White House and Congress investing in them
is good.

Next on the panel was Brian Riedl of the Heritage
Foundation, who suggested that there should not be a stimulus package at all.
Riedl explained that the only way to create economic growth is by increasing
productivity – and productivity can only be increased through more labor or
capital, or technological advancement. Because stimulus does nothing to change
these fundamentals, he suggested, it cannot create any real economic growth.
Riedl explained that stimulus is based on the theory that government can
stimulate demand; however, he argued, government cannot create money – only
redistribute it. And because this redistribution often involves distortionary
tax increases or borrowing money which would otherwise go into private
investment, it could actually make things worse. Some government spending can
promote growth, Riedl suggested, to the extent it is targeted towards
investments (in infrastructure and education, for example). But even here, economic
growth stems not from the spending itself, but from the final product. And even these investments, Riedl claimed,
are often handled better by the private market.

The final panelist was Maya MacGuineas, President of the
Committee for a Responsible Federal Budget and head of the Fiscal Policy
Program at the New America Foundation.
MacGuineas opened by expressing her shared skepticism, with Riedl, about the
effectiveness of a stimulus package, but asserted that the economy is in enough
danger that politicians should err on the side of passing one anyway. She
argued that demand could be boosted somewhat, and that there would be a
psychological benefit to stimulus. MacGuineas also suggested that stimulus was
a political inevitability. However, she outlined a number of risks attached to
any package. First, stimulus might be overly expansionary, loosening credit
beyond where it should be. Second, stimulus might “rebalance the economy” incorrectly,
propping up industries and sectors which should either fail or be restructured.
Third, stimulus might be executed poorly, and include too many pork barrel
projects and unrelated expenditures. Finally, stimulus could involve too much
borrowing, which might lead to a federal debt bubble. To avoid these pitfalls,
MacGuineas explained, the Committee for a Responsible Federal Budget has put
forth three principles: 1) all stimulus provisions must have an economic rather
than political justification; 2) borrowing can only be used for temporary
measures; and 3) stimulus should include a mechanism to begin a process for
addressing the nation’s long-term
fiscal imbalances.

In the subsequent question and answer session, the first
questioner noted that candidate Obama tended to punt on the question of tax
increase for upper-income Americans – and asked the panelists to comment. Dwoskin predicted that taxes will revert to
pre-2001 rates for Americans with incomes over $250,000, and that Obama will
implement new policies “sooner rather than later.” Lind said that, if he were President-Elect,
he would not raise taxes during a recession, and that he would cut corporate
tax rates. Riedl claimed that raising
taxes during a recession is “the worst thing you can do,” and worried that
Obama might repeat Herbert Hoover’s policies in the early years of the Great
Depression. MacGuineas argued that Obama
will not raise taxes now—his plan is to simply let the Bush tax cuts expire in
2010. However, she also noted that it is
a fallacy to assume that tax increases on the rich will resolve America’s
ballooning fiscal imbalances. It is more
important to fundamentally reform the tax code, resolving the AMT issue and
outdated corporate tax schemes.

A second questioner asked whether we were witnessing the
start of a new federal debt bubble similar to the subprime crisis, and wondered
how the country can service that debt.
MacGuineas agreed that the nation is over-leveraged, and its finances
are non-transparent–mirroring problems in the financial sector. Interest payments already constitute 9% of
the federal deficit. By contrast, Riedl
said that debt levels are not currently out of control, and in fact are lower
than during the 1990s as a percent of GDP.
But he was worried about the trajectory of debt, suggesting that in 15
to 20 years debt might be 100% of GDP.
Zindler noted that how the government spends money is as important as
the amount of debt, and pondered whether the U.S. was “just too big to fail” in
some sense. Lind concurred that it is
crucial to allocate debt correctly. He
supports debt-financed increases in infrastructure investments, but is wary of
abusing good ideas (e.g. Boston’s Big Dig).
To avoid potential pitfalls, he suggested that America needs an
institutional system removed from congressional horse-trading.

Another questioner asked about entitlements, sparking a
discussion over whether America could afford its Social Security, Medicare, and
Medicaid obligations. MacGuineas and Riedl agreed that the long-term fiscal
challenges were extremely daunting, and Riedl pointed to the country’s $44
trillion in long-term unfunded liabilities as its biggest challenge. Lind
disagreed somewhat with the idea of “unfunded liabilities,” arguing that it was
unfair to project the future costs of Social Security and Medicare as
liabilities, but not other areas of the budget such as defense. Lind also
suggested that the real fiscal challenges was health care cost growth, which
can and will be brought under control, leaving only a roughly four to five
percent of GDP increase in government spending – which could be paid for with
higher taxes. Riedl responded that Social Security and Medicare are mandatory
entitlements which make promises up front, and so they should be treated
differently than defense spending, which is allocated every year through the
annual budget process. Skepticism was also expressed over whether health care
costs could be controlled to the extent Lind suggested.

The last questioner of the first panel lamented the lack of
transparency in the budgeting process, and asked whether the panelists believe
the new administration would change this. MacGuineas said that the lack of
budget transparency is a major problem, and stems in party from antiquated
budget processes and concepts first implemented in the 1970s, as well as a
large portion of spending being on auto-pilot. She suggested that the federal
government lacks the ability to budget for the long-term, reinforcing political
myopia. Zindler added that budgeting is
as much an art as a science.

Second Keynote Address: John Engler

Engler began by declaring that he would “make the case” for the
manufacturing sector and its importance to the U.S. economy. He introduced his topic by citing several
unfavorable statistics about the economy, including record lows in manufacturing
sector indexes and an overall GDP drop of 0.3% in the third quarter of
2008. He noted that 90,000 manufacturing
jobs were lost in the last month, and predicted that unemployment could peak at
10.5 percent. According to Engler, the
highest manufacturing job losses came from industries like fabricated metals,
plastics, and the auto industry. Engler
said the average number of hours worked at manufacturing jobs was also down
“dramatically.”

Engler eventually focused on recent bad news about Ford and
GM, saying that they had lost, respectively, $3 and $2.5 billion in the last
quarter alone, and recently had the worst sales month for automobiles since the
Second World War.

Engler expressed confidence that an Obama administration
would be sensitive to the auto industry’s plight, and pointed to Obama’s
advocacy for a second government loan to automakers, as well as his urging of
Congress to pursue a second stimulus before his presidency begins, as evidence
for this claim. Engler argued in favor
of a stimulus because of the extent to which the automobile industry is intertwined
with other parts of the economy.
Thousands of supplier and retail companies, Engler said, are also
connected to the automobile industry, and to allow automakers to fail would be
to cripple the entire industry, causing unprecedented unemployment and damage
to the economy.

Engler moved on to express support for a stimulus bill that
would work through infrastructure improvement, saying that this was an area in
which the U.S. had majorly underinvested for some time. Engler noted that while in the 1950s and 1960s,
the US spent 3% of GDP on infrastructure, spending is far lower today. “We have been,” he said, “living off of
grandpa’s investment in infrastructure for a while,” and we now face an
“infrastructure deficit.” Furthermore,
he argued that even if our aging infrastructure has so far mostly remained
functional, we are still “paying” for our underinvestment—for example, time
lost through traffic congestion on too-crowded highways. Because many commodities, which are heavily
used in infrastructure construction, are currently relatively low in price,
Engler believed that the U.S. could improve its infrastructure at “bargain”
prices. He sketched out a wide landscape
for potential infrastructure projects, going beyond well-known highway and
bridge construction projects to waterways and airports. Engler also suggested that some money could
be used to help airports transition to a satellite-based air traffic control
system, and tied the quality of our infrastructure to national competitiveness. Finally, Engler advocated cutting corporate
taxes and reducing corporate loopholes.

The first questioner, an international investor, noted that
he had watched Engler and the auto industry rebuff calls for increased
emissions standards for 30 years. He
said that automakers could make a case for a bailout, but wondered whether they
could continue to conduct business as usual.
He questions whether the government should force changes to how Detroit
works. Engler said that stronger
government intervention in the auto industry sounds great, but you still have
to get consumers to buy the more efficient cars. He noted that the carmakers’ problems had
been building for a long time, and that, during his time as governor, the Big
Three pushed much of their work out to suppliers. This magnifies the potential knock-on effects
of bankruptcy.

The second question, Jed Shilling of Chrysler Financial,
said that taxpayers must save the auto industry, and asked what the industry
owed us in return. Engler argued that
there can be no unlimited assistance for automakers, but went on to note the
“rhetorical disconnect” between advocacy for change and consumer behavior. The auto industry will of course owe money
back to the taxpayer, and also a change in how they operate. But it is a two-way street: we owe them too,
in the form of a preemptive single national emissions regulator to replace the
current state-by-state patchwork.

The third questioner asked how we can ensure that our
infrastructure investments are smart and forward-looking. Engler answered that the auto industry’s
energy efficiency has increased dramatically in the past generation, and that diesel
trucks set to come out in 2010 will actually clean the air. He expressed great confidence in American
industry’s potential to adapt to the times and make consistent environmental
gains.

Second Panel: The Long Road Back: Markets, Regulation and
Fiscal Policy After the Bubble

Bill Hoagland of CIGNA opened the second panel by sketching
out what he called the transition to a “post-bubble situation.” Hoagland expressed skepticism about a second
stimulus package, and suggested that the biggest problem with a second stimulus
was “where the dollars will come from, not where they will go,” citing
predictions of a 2009 deficit in excess of $1 trillion dollars.

He noted that, since 1981, 82% of U.S. debt has been
purchased by foreign entities, and contended that this trend could not continue
for much longer. Hoagland pointed out that
voters in the most recent election “opposed almost every bond initiative on the
ballot,” heightening the fiscal dilemmas at all levels of government. “If we don’t get the deficit down,” Hoagland
said, “either foreigners will have to continue funding us or the country will
have no choice but to start printing money.”

In the next Congress, Hoagland foresaw a showdown between Democratic
“Neo-Keynesians,” who argue for continued deficit spending, and Democratic
“Blue Dogs,” known for advocating controls on spending and deficits. He wondered whether the next Congress would
suspend PAYGO rules to fund emergency spending or some of the Obama
administration’s campaign promises.

Hoagland closed by arguing that it is impossible to advocate
for entitlement or healthcare reform without tax reform because the problems in
either area are connected to the configuration of the tax system.

Ellen Seidman of the New America Foundation spoke next,
focusing on certain lessons from the financial crisis and the proper solutions
moving forward. Seidman said the crisis had provided further evidence that
“people are not rational economic beings,” and that “the availability of data
does not lead to being informed.”

Seidman noted that competition and shareholder pressure had
encouraged executives to seek out short-term rewards at the expense of what
amounted to irresponsible behavior in the long run. For financial institutions, Seidman hoped
that high levels of leverage would no longer be taken as a sign of a “healthy
bank.”

Reflecting on the regulation of banking institutions,
Seidman called the current system “backward”–thanks to the relative ease of monitoring
smaller entities, small banks are actually more closely regulated than large
banks. She said that greater
transparency within institutions was a top future priority, and called for the
effective enforcement of existing banking rules. Finally, regulators must ensure that all
parties have a stake in financial transactions to avoid perilous situations
like those from the recent past, in which sub-prime lenders had little
incentive to worry whether those to which they were loaning were truly
creditworthy.

The third speaker, Joshua Rosner of Graham Fisher & Co,
opened by saying that the recent financial crisis was caused in part by “both
parties [in financial transactions] not having equal access to
information.” He cited two sources of
costly misinformation: over-reliance on rating agencies and outdated or
irrelevant financial modeling tools.
Rosner also discussed how the “sub-prime” borrower as it existed during
the financial boom was a new entity: sub-prime lending formerly consisted of
offering the same financial products as would be offered to a borrower with a
good credit rating to borrowers with lower financial ratings–not the creation
of newer, riskier lending schemes.
Investors’ unfamiliarity with this new type of lending might have
contributed to the financial bubble.

He predicted that the U.S. was only at the “front end” of
the crisis, and that next year would bring a mass of credit card defaults. Other sectors of the economy would also show
new signs of weakness.

Rosner claimed that the money from the $700 billion dollar
bailout package was not being efficiently allocated, because banks were taking
the equity they were given and “sitting on it” to fulfill regulatory
requirements, rather than feeding it back into the economy.

He pointed out how mortgage securities, which were
“internally leveraged” because of the inherent risk that they would not be
repaid by the borrower, were sold as “financial products,” masking the real
risk they entailed. Rosner hoped that
the practice of securitization itself would not be blamed for the financial
crisis, calling securities a vital instrument in modern financial markets. He also called for industry-wide standardization
of terms like “subprime” and “default,” because the complexity of modern
markets had caused their exact meanings to become less clear.

Rosner finally called attention to the “moral hazard” of
allowing so many institutions (e.g., Fannie Mae and Freddie Mac) to become
“appendages of government,” and wondered how the government would ever manage
to disentangle itself from the associations it had created.

The last panelist, former SEC Commissioner Bevis Longstreth,
addressed several general points about what caused the crisis and how the
system could be reformed in the future.
Longstreth criticized the powerful influence of financial firms over
their regulators, the pressure on politicians to eschew certain types of
prudent regulation, the competition of regulatory agencies vying for turf, and
the actions of regulators like former Federal Reserve Chairman Alan Greenspan,
whose legacy of deregulation has been diminished in light of the current crisis.

Longstreth offered several suggestions to “fix the
system.” First, he recommended that the
SEC be made into a self-financed institution like the Fed, so that it is less
susceptible to outside influence.
Second, citing the decline in professional standards among “gatekeepers”
for public corporations, Longstreth thought that bolstering these standards
could restore integrity to the system.
Third, he claimed that an audit of public corporations by federal
regulators might restore transparency and root out abuses. Fourth, Longstreth contended that government should
create a new entity or empower a existing entity to explicitly advocate for the
interests of investors. Finally, Longstreth
asserted that the US should “appoint highly qualified people to head regulatory
agencies.”

In the Q&A period, the first questioner stressed the
importance of industry standards, and asked whether regulators should force
more transactions onto transparent markets.
Rosner answered affirmatively, criticizing the Treasury Department’s
reverse auction approach for the TARP legislation. He argued instead for a forward auction
process, in which ten thousand qualified buyers can bid on troubled assets, as
a means of moving price discovery forward.

The second questioner, Jim Vitarello of the Government
Accountability Office, inquired how one might design a regulatory system that
encourages the realignment of long-term incentives. Rosner noted that credit-rating agencies were
never meant to drive securitization, and were only good at assessing corporate
debt. In the secondary market,
regulators should require agencies to rate at original assumptions. Furthermore, conflict of interest needs to be
more effectively managed. Seidman
agreed, adding that regulators must also pay more attention to the compensation
system. Firms need not pay
mortgage-sellers entirely up-front.

Jed Shilling of Chrysler Financial, posed the question of
how to avoid government bailouts that simply monetize financial assets which represent
no real value. Seidman answered that,
unfortunately, “the water is over the dam”–both financial assets and real
assets will be part of the bailout.
Treasury should have required financial institutions to write-down their
assets before they got the money. Rosner
added that the value of competing regulators was that what one drops, the other
might catch. We cannot ensure against
financial assets’ monetization, but we can think about breaking up large
institutions instead of bailing them out.

Finally, Frank Micciche of the New America Foundation asked Hoagland for insight into how the TARP bill made its way through Congress. Hoagland replied that the process was very messy, and motivated by a strong sense of urgency. The legislation was not as well thought-through as it should have been, and we are now witnessing the repercussions of such a convoluted process.

—Event Summary by Philip Sugg, Program Associate, Fiscal Policy Program, New America Foundation

Video of Medley’s opening keynote is available at right; the additional discussions will be added shortly.

Participants