Ok, smarty, what would YOU do?

The country is in a tough economic spot. All indications are that there is no recovery from this two year old recession. More people are losing their jobs. More businesses are going bankrupt. A general gloom has decended over the marketplace.

The federal government has tried the standard remedies: lower interest rates, deficit spending, make-work programs, and bailouts. Nothing has worked. The critics of the current, and former, government have been crying that the powers-that-be are impoverishing us all. The supporters of the government are responding that the critics have no better ideas and that they are just playing politics with a national tragedy.

Fair enough. I have been a critic by claiming, from early on, the government's programs won't work and will probably make the problems worse. So far I have been right. But do I have any positive contribution to make beyond sniping at our Dear Leader? As a card-carrying amateur pundit and economic seer, let me try my hand.

My Take On The Situation:

First, I believe the cause of this recession is the same as all the other recessions and depressions of the past. Credit booms lead to credit busts, as day leads to night. The Austrian economists von Mises and Hayek constructed an understanding of the boom and bust cycle almost a hundred years ago that explains in clear cause-and-effect terms how new credit money causes malinvestment and cannot be sustained, therefore there is credit contraction, deflation, and correction (recession, bankruptcies, etc.). So, if you want to stop a recession, don't have a credit boom. Once the credit expansion has happened, the rest is inevitable.

Where are we in this cycle today? We have just endured 40 years of credit expansion exacerbated by the disconnection of our money supply from the only anchor it had: gold. With the collapse of the Bretton Woods agreement in 1971, and our reniging on agreements to redeem our dollars with gold, the door was left wide open for monetary expansion without limit. All things being equal, a currency that is inflated far beyond the economy's increases in goods and services will lose value. Prices would go up. People would demand more pay. The spiral of "cost-push inflation" and continuing loose money policies would result in ever accelerating price increases until the money lost all value in a hyper-inflation. That did not happen in the U.S. because the dollar became the "reserve currency of the world," thereby soaking up the newly minted dollars to be used in other international exchanges. We were able to create the money instead of products, and send it overseas to trade for goods. The effect was to make it economically silly to produce products here when we could buy all we wanted with paper and electronic dollars created from nothing.

That new money, however, came into our hands via debt. The loans we, and our government, took out fueled the boom in the stock market, the dot-coms, housing, and now bonds. But at the core, they were still loans that needed to be serviced. When the debt load became excessive, we, as individuals, stopped funding our purchases with new debt and the recession began. When banks stopped lending, credit cards cancelled customers, and consumers started paying down their debts, the money supply reversed.

Deflation became the name of the game, and according to the Federal Reserve, the enemy. Ben Bernanke earned the name "Helicopter Ben" when he pledged to prevent deflation (sometimes referred to as 'liquidity crisis') by dropping money from the air if need be. So far, despite doubling the M1 money supply in a recent 12 month period, the total M3 money supply has been shrinking by over 9% on an annualized basis. Thus the growing unemployment, downward pressure on prices, and bankruptcies. You can see why he would consider deflation to be the enemy.

What Can Be Done?

The danger in trying to reinflate the money supply is that the result could easily be a newer and bigger bubble, total loss of confidence in the dollar, and hyperinflation, or, just as bad, the economy may refuse to reinflate with new lending and instead painfully deflate over a long period of time instead of all at once. Decades of precious life could be squandered.

The first thing that must be acknowledged is that the correction is inevitable. Stop trying to fight it, because all you will do is expend resources you will need later. As Churchill was supposed to have said: when you're going through hell, keep going. We need to get through this, and as quickly as possible.

So, no bailouts, no stimulus, no subsidies, no zero interest rates. These are the things that caused our injury, so we need to stop doing them. The immediate result will be a sudden deflation.

The Federal budget will have to be slashed, and not by a little, but by a lot. Forget our overseas empire...it will have to go. The military will have to refocus on defending the U.S., not nationbuilding Afghanistan and Iraq. I'm guessing an 80% reduction would be about right.

Subsidies for all our Federally funded pet projects will have to end, from arts projects, to cash for clunkers, to the space program. Done. Over. If we don't, there will be no way to stop Federal borrowing that's putting us on the path to becoming a banana republic.

Social programs are in a different league. Programs that help those who reasonably cannot help themselves should be kept intact. I'm talking about Food Stamps, Unemployment Insurance, Social Security, Medicare, and Medicaid. Because each of these programs is essentially broke today, they may require even more funding in the future as the economy tanks and the demographics of the baby-boom retirement looms. I believe that each of these programs is doomed to fail, so I advocate, long term, planning their reduction and elimination. But that's for another day. Today, if they were eliminated, helpless people would starve to death.

Next, take some positive steps. Allow people to escape from the crashing dollar system by giving them the option to make deals or settle their debts in any currency or commodity they please. This could be done by repealing the legal tender laws that require settlement of debts in dollars. The dollar would quickly seek its' own value amongst all the options out there. For the average person, however, they would have an escape from the inflate/deflate rollercoaster, and this one move alone could give the economy the ability to quickly correct and rebound.

During a deflation, it is critical that expenses be reduced to match the reduced money supply. The biggest single expense in most people's lives is the burden of government: taxes. The burden must not be allowed to grow, and ideally will shrink, as a percent of income. Less money for the government means more money for the people to service their debts, accumulate savings, invest in their future, and enjoy their lives. But make no mistake: if tax cuts mean more government borrowing, nothing is gained! Government spending at all levels must be cut AND taxes must be cut in order to lighten the burdens on the economy and allow it to rebuild.

I would make it illegal for the Federal Reserve to create money out of thin air. That is where the inflationary boom and deflationary bust cycle has its' beginning. Fractional reserve banking is the mechanism by which a small amount of currency becomes are large amount of credit, and it is also the point of failure in our monetary system. Banks create debt in the society by lending the same money out multiple times at once, thereby falsely increasing the apparent money in the economy. When the people are overburdened with debt, they cease new borrowing and begin to pay back their loans, which causes the apparent money supply to contract (deflation). The banks are now at risk of runs on their deposits, as there is not enough money in reserve to satisfy all of the claimants, so they build their reserves by not lending, and the economy goes into a tailspin. It all started with the Federal Reserve and the practice of fractional reserve banking. Both must be stopped, or the boom and bust cycle can never be brought under control.

I don't think we can outlaw fractional reserve banking overnight, though that might be the moral thing to do, because the deflationary shock to the economy would shake our society down to its' bones. I also would not change the reserve requirements to make the banks more resistant to runs, because that would provide the people with a false sense that the banks are "safe" when infact they are still insolvent. 100% reserves would be 100% safe, but the deflation that would be required to get there might do serious social and political harm to our society. Instead, I would eliminate the Federal Deposit Insurance Corporation, and make it clear that nothing is completely safe. Suddenly companies and the people will want to know that their bank is treating their money with care, and banks will become more careful with their loan porfolio. If the Federal Reserve is prevented from printing money to 'loan' to banks to save them from their mistakes, then there would be a real chance that banks could go out of business if they are reckless with their depositors' money. The market would discipline banks in a way no regulator ever could.

Finally, to allow full employment at lower money supply levels, wage rates must be allowed to fluctuate. While it may seem cruel to eliminate the minimum wage, it is far far more cruel to condemn an entire class of people (the people who have the least education, are aged or inexperienced, disabled, or otherwise less productive) to institutional unemployment. They must be allowed to work for an agreed upon wage, even if they wage is very low. Full employment would ensue, and because the costs of overhead would plummet, prices would drop also. This is not so radical an idea as most people would assume. One of the tenants of Keynesian economics is that inflation of the money supply is needed to achieve full employment because people are resistant to accepting lower wages. An increase in the money supply means devalued purchasing power, which means REAL wages are lowered without the worker's knowledge. As all economists know, Keynesians included, real wages must go down if large masses of unemployed are to find jobs again. I believe inflating the money supply to acheive full employment introduces us to the boom and bust cycle detailed above. Let's be up front with the unemployed and tell them they will need to work for less instead of stealing their purchasing power and creating the boom and bust cycle to achieve the same end.

Those are my thoughts today. I'll get back to you when they are on the verge of being adopted.