Sometimes making up a fictional story can clarify a point better than laying down the facts, so let me tell this story. Once upon a time a king was elected to sit on the throne and wave a magic wand to make things happen for his people, the human race that inhabits planet Earth. In the winter season of the year 2008-2009 the king was unexpectedly called upon to wave the wand and do his magic.
The problem crying out for solutions was that in a place called the United States of America, there lived approximately 100 million families who were badly served by a system they thought was good but turned out to be wanting. This was the case because the financial leaders of that nation were a bunch of snake oil peddlers who pushed toxic mortgages and mortgage backed securities on the public in America and everywhere else in the world.
When the bubble that those leaders created to inflate their holdings finally burst, the system began to collapse and to drag everything down with it. To save the situation, those who were in government brought in a few hundred billion dollars to serve as crutches and they used them to keep the system from totally collapsing before the king had the time to do his abracadabra.
When the time came, the king did what he had to do and thus restored the situation almost exactly to where it was in the summer of 2007, a time when the majority of the people did not know what was going on and were having a party. But there was a small difference between the two situations in that the king did not give back to the investors the 10 trillion dollars or so that they lost on the stock markets and other industries.
Instead, the king allocated 10 trillion dollars to solve the problem in a different way. He dedicated 2 trillion dollars to shore up the capital of the banks, a move that restored the latter to where they were before the collapse. And he deposited on the kitchen table of every family a bag containing 80,000 dollars.
The result was that all the prices that were deflating during the collapse started to inflate again, and they got back to their previous levels. Confidence was restored among the banks and the people alike, and they all went back to doing business the same way they did before this whole thing started. What happened after that is of no importance because the point of the story is not the plot but the lesson that we can draw from it.
And so I begin with this question: Can the newly elected government in America do what the fictional king did and solve the financial crisis facing the world today both for the short term and the long term? And the answer is that he can but not exactly in the same manner as did the king because the President elect does not have a magic wand. He can, however, do something close to that.
You see, years of running a balance of trade deficit with the rest of the world has flooded the markets with American dollars. A great deal of that money found itself in the hands of foreigners and the hands of Americans abroad. And much of that money, as well as money in the hands of Americans at home have now been destroyed by the near meltdown of the financial system. This happened because the money was not made of actual bills but was of paper that resembled cheques written with no sufficient funds behind them.
With this in mind, the American government can now restore the situation at home to where it was by doing two things. First, set aside 2 trillion dollars to re-capitalize the banks. Second, set aside 8 trillion dollars to help the American families. The rationale behind this is the following:
The reason why the banks need to be re-capitalized is that such an act will restore confidence among them. This will get them to lend to each other again and lend to the public. However, those in charge must consider the 2 trillion dollars a line of credit and draw on it only when necessary. In return for cash, the banks will have to do business close to the level they did before the meltdown. The banks that refuse to co-operate should be nationalized. Their refusal will be called a strike and the government will respond in the same way that president Reagan responded to the strike of the air traffic controllers. That is, the heads of those banks will be fired and replaced with people who will run the show as it must be run.
As for the 80,000 dollars to each household, you don’t really need to do that unless you want to devalue the dollar to the pre-meltdown level. What happened over the decades is that the dollar lost value due to the accumulated trade deficits run by Americans. Now, however, much of this money has been destroyed and the dollar has started to rise again. But if you "print" money and flood the markets as much as before, the dollar will devalue again.
To understand this part we must realize that when American toxic securities were sold to foreign banks, these securities were used as collateral to borrow money from the central banks over there. But when the securities proved to be worthless, the foreign banks lost their capital upon which their central banks re-capitalize them with local currencies. The effect was that the supply of foreign money on the world markets increased at the same time as the supply of American dollars was decreasing.
Thus, to issue new money in America at this time will not disadvantage the dollar by much in relation to the other currencies. But what this whole saga will do is paint an image of Uncle Sam as being the con artist who swindled the world of trillions of dollars. And you can imagine what this will do to the confidence that foreigners will have for the American business model and for the idea of doing business with America at all.
The point of all this is that an American stimulus package worth a few trillion dollars at this time will not be catastrophic for America because this much money existed at some point in the past and has since been destroyed. The worst that can happen is that the dollar will go back to being worth 70 Euro cents. But the smart thing to do now is to spend the trillions wisely and spend them only if and when needed.
This prescription will contribute to the short term solution of the problem. But the meltdown can also be an opportunity to fix the long term problem. And the need for this is exemplified by the global nature of the current crisis which made everyone realize that while the arteries for trade have been opened to global commerce, they have also been opened for global mischief which is detrimental to the stability of the newly erected worldwide system.
Consequently a few cherished ideas will have to be re-examined, among them the notion that a jurisdiction which has a comparative advantage in one sector of the economy or a handful of them should concentrate on that advantage. It was thought that due to the opening of a worldwide market for every conceivable product and every service, the jurisdiction that fully exploits its advantages will do very well.
But it is now dawning on people that the idea of resting an economy on a single industry or a handful of them will subject the jurisdiction to a danger over which those in charge will have no control. In other words, it is realized that a jurisdiction without a diversified economy is a jurisdiction that is at the mercy of outside forces that may not have its interest at heart.
Here the historical record will be the guide for the decision makers. These people will see that ever since the beginning of industrialization, single industry towns and similar localities have experienced an anxiety about being at the mercy of forces they could not control, and have responded to the challenge by diversifying their economic activities. They did so by subsidizing the outside industries which came to take advantage of a rent-free land they granted to a new commerce, by offering to those industries tax credits or tax holidays, and by tailor-making a package of other incentives to suit the needs of every newcomer.
And when the underdeveloped nations of the world began to develop in earnest, they too adopted a similar approach except that in addition to granting the familiar incentives, they offered to the incoming industries such things as cheap labor, lax environmental regulations, low cost utilities, simplified business procedures and so on.
But now that globalization is destined to come under scrutiny and control, there will have to be a new worldwide agreement under which all jurisdictions will be granted the right to protect the industries they deem vital to their national security and for which they will negotiate an acceptable level of subsidization and other similar protectionist measures.
An agreement of this kind will encourage all jurisdictions to strive towards the achievement of a balanced economy as much as possible. The essential features of a balanced economy being the approximate match between the production capacity and the consumptive needs of the population in every industrial sector, the measures will cover one or more of the following sectors: agriculture and food processing, textile and related industries, machinery and transport equipment, chemicals and pharmaceuticals, communication and home entertainment electronics.
But given that a jurisdiction which used to channel its resources and efforts towards the one sector where it did well must now diversify and spread itself thin, the question becomes: What will that do to the high productivity that the jurisdiction used to enjoy, to the comparative advantage it had and most importantly, to the potential for growing the economy at the fast pace that it did previously?
The answer to that question is this. There was a tradeoff to be made between less volatility with diversification on the one hand, and more volatility with a higher growth on the other hand; and the choice was made to go with the more balanced approach. But this is not the end of the story because the average of the economic growth over a long period of time will prove to be the same in both cases.
And there is no mystery as to why this is so. For the same reason that you save on gas when you drive a car at a steady and lower speed, you spend a minimum of effort and capital when you go for a steady and lower growth in the economy. By contrast what happens in a situation of fits and starts is that you burn a great deal of cash to accelerate to a high level of growth then find yourself depleted of energy by the time you get up there. You glide downward while you rebuild your reserves and when you reach the trough, you wonder if it is worth going through the cycle again.
Moreover, when all the jurisdictions of the world will drop the beggar-thy-neighbor approach and adopt the steady and balanced approach to their economies, the whole world will consistently score a steady rate of growth which will be beneficial to all if only because of its predictability. This situation will be much more preferable than the periods of boom and bust that the world has experienced up to now.
So how do we get there from here? The answer is that with diversification in mind, America should negotiate with the rest of the world a treaty that will allow every jurisdiction to take all necessary steps to protect its industries up to an acceptable percentage. Then spend 8 trillion dollars or so to rebuild the low tech, labor intensive civilian industrial base over say, the next 10 years. Concurrent with this must come the related infrastructures which will span the range from a network for technical education to the modernization of the electric grid. And always bear in mind that it is a fallacy to believe you can have a viable economy of only high tech industries and of services in a country the size of America.
America is a massive and diverse country that has massive and diverse needs. Unlike Dubai or Singapore it cannot continue to import its everyday mundane supplies from abroad and hope to pay for them with innovation and services. This reality has become glaringly obvious these days by the fact that the only innovations America has offered to the world lately are of the toxic financial type mixed once in a while with a new way to brew a cup of coffee, a stylized way to cook French fries or an innovative way to flip a hamburger.