• What we are doing right now is far worse than nationalisation.

TO BE NOTED: From the FT:

"Insight: World of Bizarro Keynesianism

By Jack Schwager

Published: March 18 2009 14:50 | Last updated: March 18 2009 14:50

Welcome to the world of hyper-real money. The budget numbers for 2009 are frightening: a $1,750bn deficit, equal to a staggering 12 per cent of GDP, double the prior record post-World War II level. Even worse, giant deficits loom ahead for 2010 and beyond. The Republicans have recently assumed the mantle of fiscal responsibility, warning of the very real dangers associated with cumulative huge deficits and expressing quite valid concerns that the permanent expansion of the government’s share of the economy would have a long-term detrimental impact on economic growth.

Forgive me, though, if I choke on the hypocrisy. This is the same party that had control of the presidency during the past eight years as well as both houses of Congress from 2003 to 2006. This is the same party that inherited a budget surplus and transformed it into a string of unbroken deficits, doubling the entire national debt in the process, and leaving behind a $1,000bn deficit and an economy in shambles by the time President Obama was sworn in.

This is the same party that embraced an economic philosophy of, ”deficits don’t matter” – Vice President Cheney’s response to Treasury Secretary O’Neill who had the temerity to question Administration policy because it would lead to burgeoning deficits, a sin for which he was soon after shown the door. Now when they have just lost control of power and the economy is in freefall, Republicans are championing fiscal responsibility. Taken as a whole, Republicans seem to be following a new economic doctrine of deficit spending during bubble economies and deficit restraint in collapsing economies. This could be termed as “Bizarro Keynesianism” – in the Bizarro World, a creation of the Superman comic book series, everything is the opposite of what it is in our world.

Still, aren’t Republicans at least correct in expressing outrage regarding the 2009 spending bill, which in flagrant disregard of the ongoing financial crises was loaded up with earmarks and recently signed by President Obama? Of course, they are, but their indignation would be more convincing if the average total earmark spending per Republican senator weren’t higher than the corresponding average for Democrats.

Hypocrisy, however, does not alter the validity of Republican concerns over the exploding deficit. We are in dangerous territory. The ballooning of the US debt burden in the years ahead could have many potential adverse consequences – a debasing of the currency, which could ultimately lead to inflation and rising interest rate costs. Higher interest rates would increase borrowing costs, placing further upside pressure on the deficit, while at the same time depressing economic activity. We could end up facing an economic dilemma even worse than the current one. Add to this list the long-term demographics and the associated implied expansion in entitlement expenditures and it is difficult to see how we can avoid an economic endgame that ends very badly, unless we radically change a spending process that is driven by political expediency rather than economic efficiency or cost/benefit considerations.

The core of the problem is that in the name of democracy we have evolved a political system wherein special interests can legally spend millions in political contributions to garner billions in beneficial legislation that wastes taxpayer money, circumvents government oversight, impedes free market competition, and has an adverse impact on the general public interest. If we are to avert economic disaster, we must act decisively to make necessary changes. A few recommendations:

1. Do what needs to be done to fix the banking system. The argument against so-called ”nationalisation” of the banks is a sham in at least four ways:

• No reasonable economist, including those to the left of Paul Krugman, are recommending nationalisation in the socialist sense of the word. No one wants government permanently running banks. What is in fact being recommended is a Federal Deposit Insurance Corporation (FDIC) restructuring of problem banks followed by re-privatisation.

• The FDIC is already restructuring problem small banks. So if we are to use the loaded language of opponents of government intervention to take over and clean up banks, we already have nationalisation of banks. We are fixing small problem banks, while procrastinating in fully dealing with large problem banks. If battlefield medics used the same logic, they would diligently dispense throat lozenges to soldiers with sore throats while ignoring the wounded in the hopes they would get better on their own.

• What we are doing right now is far worse than nationalisation. Essentially, we are privatising profits and socialising losses. There is only one word that can adequately describe opposition to a government supervised restructuring of problem banks in the name of capitalism: chutzpah.

• We are supposed to be worried about the poor job the government would do in cleaning up the banking system. How much worse could they do than the managements that got us into this mess in the first place? Moreover, we are extremely fortunate that the agency that would spearhead a bank cleanup, the FDIC, is expert at the task, and headed by widely respected Chairman Sheila Bair.

A plan that would restructure all problem banks, large and small, would address the heart of the problem, eliminate the uncertainty that is having such a lethal effect on the markets, minimize the waste of throwing good dollars after bad in a futile attempt to avoid the inevitable, and allow taxpayers to benefit from the sale of the cleaned-up banks to private hands. The one proviso is that any implemented plan avoid making bondholders whole (via implicit guarantees) at the expense of the taxpayer (a cautionary note cited by former IMF Chief Economist Raghuram Rajun). A comprehensive bank restructuring plan (instead of the current piecemeal process) with taxpayers benefitting from the upside in proportion to their risk assumption is not only the best solution, but also the one that would have the least detrimental impact on deficits.

2. Scrap the tax code and replace it with a graduated flat tax. The Obama Administration has it wrong here: The problem is not that tax rates are too low for higher income earners, but that the tax system is unfair. The Byzantine US tax code, which has grown to an astounding 67,000 pages, is a testament to inefficiency and inequity fostered by generations of special interest influence. Even Rube Goldberg would be repulsed. The system is beyond repair. The most logical conclusion is to junk the current code in its entirety and start all over. A graduated flat income tax would allow the government to collect the same revenues at considerably lower tax rates, which would provide economic stimulus, eliminate in one swoop a multitude of anti-competitive special interest tax breaks, and dramatically reduce lost revenues due to tax cheating. Simplification would also provide savings to taxpayers in tax preparation and the government in reducing the bureaucracy of tax collection. Using a graduated (or multi-level) flat tax would address the argument that a single level flat tax is regressive. The truth is that a graduated flat tax would leave the overwhelming majority of taxpayers better off, hurting only tax evaders and the beneficiaries of targeted tax breaks.

3. Eliminate wasteful spending, especially big ticket items. As one example to illustrate the point, consider the F-22. Here is a hugely expensive fighter jet (approximately $1 billion for three planes), which with two ongoing wars has not even been used once in combat. So much for it being a practical or needed weapon. The Pentagon already has 183 and wants to double the fleet. Meanwhile, drones, which have proved to be immensely effective at a small fraction of the cost are in short supply. Logic and the goal of a strong military both argue for scrapping the purchase of additional F-22s, using part of the savings to expand the supply of needed drones, and contributing to some deficit reduction in the process. Defense Secretary Gates to his credit favors exactly such a policy. So where is the opposition coming from? Both sides of the aisle because defense contractors wisely make sure that the production of weapon systems is spread to as many Congressional districts as possible.

4. Address the Entitlements Time Bomb. Given the demographics of an aging population, the current trajectory of implied spending for the three major entitlements programs – Social Security, Medicare and Medicaid – is untenable. Left unchanged, either tax rates or deficits would have to climb to impossibly high levels. The implied long-term outlook was potentially disastrous even before the current economic crisis. Now with deficits soaring, it has become all the more critical to deal with the issue. As one example of the nature of the problem and the availability of reasonable solutions, consider Social Security. Everyone understands the main source of the problem: people live a lot longer now than they did when Social Security was enacted. Social Security was never intended to fund long retirements. The solution is straightforward: Raise the retirement age more quickly and more substantially than currently planned.

5. Eliminate counterproductive, politically motivated subsidies. Generally speaking, most subsidies interfere with efficient market pricing and cause more harm than good. Sometimes, however, subsidies could be justified if they provide potential longer-term benefits that are not reflected by current market prices. For example, subsidies to encourage development of alternative energy technology could have long-term investment benefits by reducing future energy costs and reducing dependence on foreign oil. Most government subsidies, however, distort the market and provide no benefit or are even detrimental. For example, subsidies to promote ethanol, whose production requires about as much energy as it produces, contributes to rainforest destruction, and misdirects the efficient use of assets is a prime example of politically inspired spending that gives us less than zero for the dollar.

6. Increase spending to eliminate waste and fraud. Targeted spending to increase funding for government departments and agencies with a specific role to curtail fraud (e.g., Medicare fraud) and waste (e.g., contract overpayments) would be a way to increase government employment and reduce taxpayer costs at the same time.

7. End earmarks. In a world of trillion dollar deficits, earmarks may not be a major item, but they are emblematic of government waste. If Congress and the President can’t even eliminate this widely unpopular source of waste, then the situation is truly hopeless.

Despite the extraordinary severity of the crisis we face, special interests rather than sound principles continue to drive the political spending process. Unless we change course, we are on a road to disaster. The changes that need to be made will upset both sides of the political spectrum. Conservatives who have never seen a weapon system they didn’t like, regardless of the cost or efficiency, will hate the idea of any defense spending cuts. Liberals will cry foul at touching Social Security. But the point is that someone has to pay. Either we place enormous burdens on taxpayers in coming years, which will further aggravate economic contraction, or we debase our currency, which could have even worse consequences. The current collapsing economy and exploding deficits remove the luxury of continuing with the politically driven, wasteful spending ways of the past. If we don’t make logical and necessary spending cuts now, we may face a dismal choice between depression and hyperinflation in the future. The time has come for Congress to put the economic survival of the country ahead of parochial interests and re-election concerns.

The author is investment director at the Fortune Group, a London-based alternative asset management firm, and author of the Market Wizard and Schwager on Futures book series"