Attention: Deficit Disorder

The new Democratic Administration has been marked by a flurry of policymaking and legislation, crisis-management and confidence building, international diplomacy and domestic firefights.  If successful, it will mark a radical reorganization of America’s domestic and foreign priorities.  If successful, the financial crisis will be dealt with in a systematic way, and the foundations for a new era of American growth will be laid down through a series of investments in energy, health care, and education.  It will affirm the positive goal of government, the managerial chops of technocrats, and the transformative power of the American Presidency.

The danger, as always, is that in their hubris to do everything at once, nothing will be done well while racking up an enormous bill.  

The biggest casuality of the hummingbird approach to the economy is the financial system.  Geithner neither has the money or people to do a serious job at solving the banking crisis.  At the same time, there is enormous political pressure to prevent the failure of a single institution.  Given these constraints, the government’s actions resemble the failed investment banking practices–guarantee massive quantities of flawed debt, slice and dice risk into tranches (the Treasury gets the equity bit, the Fed the rest), conceal risk and liability through structured finance, and rely on the same private actors who caused the crisis to oversee it all.  Arbitrary and inconsistent government actions, as well as constant fear-mongering and denouncement of bankers, have led to a flight of private capital from this area, and prevent bankers themselves from improving the situation.  The United States is now running the world’s largest hedge fund, and the failure of these initiatives will bring catastrophic failure to the economy.

Coming to grips with the largest financial upheaval since the Great Depression ought to be the primary responsibility of the government.  Bizzarely, the administration is risking the chance that the problems will largely go away on their own, and have largely focused their energies towards capitalizing on the crisis to pass sweeping reforms on the domestic front.   These reforms are predicated on the notion that the American economy is fundamentally healthy, but the gains are a little too concentrated on the top end.  In that, they fundamentally ignore the huge changes we’ve seen over the past year.

So you see an energy policy focused on reducing oil dependence and raising renewable resources.  Aside from the other problems with this approach, it also does not make a lot of sense given the massive fall in energy prices.  While Obama has offered great rhetoric on the need for education reform, his education plan essentially assumes that you can fix a leaky pipe by increasing the water pressure by throwing more money at the same failing schools.  Massive sums are on the line for health care reform, but even these understate the true cost, while the experience of Massachussets suggests that offering health reform by increasing coverage will continue unsustainable cost acceleration.  Mind you, these changes are going on under a backdrop of unsustainable entittlement spending in Social Security and Medicare.

These problems can be linked to the speed requirements under the stimulus plan.  When Congress is given a few days to spend a trillion dollars, they will do so in ways that further long-held Democratic aims, not in ways that fundamentally improve the economy.

Will this work?  Ask the Europeans–they have largely refrained from costly stimulus, perhaps because they realize that deficit-fueled spending binges are not the road to growth.  In the urge to fix everything bad about the economy, we are going to take up unprecedented amounts of debt.  To be sure, the current crisis calls for the government to pick up some slack.  But even if you think that the economy will recover quickly, you’re looking a gap between spending and revenues that will not be closed.  With more normal predictions, the CBO estimates a trillion dollar deficit every year,out for the next ten years.  

This is flat-out unsustainable.  There are plenty of buyers for government debt now, in a flight to safety, but how long will this continue?   At some time in the future, the Fed will have to sell Treasuries to mop up money supply and prevent hyper-inflation.  This will happen at the same time that private investors will ditch low-yielding Treasury bonds for higher-yielding investments like corporate bonds.  And China will look to diversify its foreign currency holdings away from the dollar as well.  An unsustainable domestic public financing problem, combined with weak foreign demand for bonds, can only go horribly badly.  The only answer for our debt problem will be massive inflation and taxation.  Compounding the inflation problem is problem of how the Fed will wind down their enormous money operations without hyper-inflating the economy or pushing us into another recession.  

The hubris of this Administration in tacking every problem under the sun will be answered in the form of a financial tsunami which will make us wish longingly for the present situation.

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