President Obama has called for sacrifice and sharing. I wholeheartedly agree.

However, before sharing the pain, and before working towards a solution, we must understand the problem. To date, many mistakes have been made because Congress, the Fed, and the previous administration did not attempt to understand the problem and the role everyone played in it.

Fed’s Role

The Greenspan Fed slashed interest rates to 1% in 2002 fueling the biggest housing bubble in history.

Furthermore, Greenspan was the biggest cheerleader of derivatives and subprime lending on the planet. Fed Governor Ben Bernanke went along with Greenspan every step of the way. The serial bubble blowing tactics of the Fed must be eliminated at all costs.

It should be clear now that the Fed does not know, and is guessing every step of the way what interest rates should be, and is also guessing what the solution to this mess is.

Congressional Role

Congress refused to rein in the GSEs and ignored repeated warnings by many to cut off their lending. Fannie Mae and Freddie Mac were accidents waiting to happen.

It simply is not Government’s job to promote housing in the first place. Promotion of housing caused prices to go up (until they crashed) and this is why Congress was always chasing its tail perpetually looking for affordable housing solutions. The very sponsorship of affordable housing programs guarantees that affordable housing will not exist.

In addition, Congress threw money at every problem, built bridges to nowhere, and wasting a trillion dollars on a war in Iraq fought on trumped up charges of weapons of mass destruction. All of those things cheapened the US dollar and kicked off a commodities bubble that has also crashed.

State Legislatures Role

State legislatures are also to blame. 44 states now have large budget deficits. California in particular is a basket case. States believed the housing party would last forever and failed to fund pension plans while squandering money on all kinds of irresponsible pet projects. Property taxes rose to and remain at unsustainable heights. States are now running out of money to fund all the projects and benefits they have promised.

My biggest fear right now is Congress will throw money at the states, without requiring them to make the sacrifices that need to be made. Spending must be cut, programs must be cut, benefits must be slashed, and pensions must be capped.

I ask that not one cent of Federal (taxpayer) money go to any state that does not make the necessary sacrifices. Part of that sacrifice must be a reduction in pay by the Governor and legislature of every state.

I commend Ohio Governor Ted Strickland for having the courage to ask for across the board union pay cuts. That is a start, but it is only a start.

Pension Plans

Pension plans are a particularly sore point for many citizens. Promises have been made to unions that cannot be kept. Such promises caused the bankruptcy of the city of Vallejo, California. Other cities are sure to follow.

Wages and pension benefits of all government employees needs to be brought inline with wages and benefits in the private sector. There is no other way out. Pension benefits must be capped for all new state and federal hires. Taxpayers should not have to bear the pain for funding massive benefits for government employees when they have no such opportunities for themselves.

Fractional Reserve Lending

Unquestionably bank greed came into play. Massive leverage and off the book SIVs by Citigroup and others certainly played a role. However, it is important to understand the Fed’s role as an enabler.

The culprit in this case is fractional reserve lending. This fraudulent policy, sponsored by the Fed, allows more credit to be extended than there is base money supply. This was the enabler that allowed banks to lend and securitize over and over and over again, recording fake profits every step of the way.

Over time, asset bubble form such as the bubble in housing. To keep the bubble going, the Fed printed more and more money, and banks extend more and more credit. As with every credit bubble, there eventually there comes a day reckoning when what has been lent out, cannot possibly be paid back. That day of reckoning is now.

In simple terms the Fed is a sponsor of the world’s biggest Ponzi scheme. The scheme has now blown sky high, as money to keep the bubble growing simply ran out. That is why 10 new Fed programs have failed to produce any results.

Unless and until fractional reserve lending is eliminated, these kinds of problems will reappear. I ask Congress to disallow fractional reserve lending. It cannot be done at once, but it can be phased in over time. It will be a painful process but banks must share in the pain for their role in the mess.

Role of the SEC

Many blame the rating agencies for the ridiculous AAA ratings on mortgage backed securities. The rating agencies deserve criticism, but one must take the problem back to the root source. It was SEC sponsorship of the rating agencies that actually created the problem.

The origin of the rating game mess dates back to 1975 with the establishment of the Nationally Recognized Statistical Rating Organization (NRSRO) by the SEC.

NRSRO turned upside down the model of who had to pay. Previously debt buyers would go to the ratings companies to know what they were buying. In the revised model, the issuers of debt had to pay to get it rated or they couldn’t sell it. Not only that, but they have to be rated by one of the rating agencies approved by the SEC.

This led to shopping around to see who would give the debt the highest rating. In the new model, the rating agencies got paid by the quantity of the work they did rather than the quality of the work they did.

Now there are calls for regulation and oversight of the ratings agencies. However, the simple and correct solution to this problem is to eliminate government sponsorship of the rating agencies returning to the model where the rating agencies get paid by the quality of their work rather than the quantity of it. I guarantee this solution will work.

Why Banks Aren’t Lending

Money was given to banks and many members of Congress are asking for banks to increase lending. I suggest that instead of attempting to force banks to lend, that Congress seek reasons why banks are not lending. Here is the answer.

1. Banks are still insolvent after all those capital injections. There is simply no capital to lend. Book values of banks, if credit were to realistically be marked to market is negative.

2. There is no reason to lend. What do we need more of? Cars? Pizza Huts? Houses? Nail Salons? Malls? Furniture? What? Nothing is what.

3. There is no consumer demand because there are no jobs. Since there are no jobs (or significantly fewer jobs) banks are unwilling to extend credit to consumers with less of an ability to pay it back.

It is a serious, serious mistake to force banks to lend at this point. All it will do is increase bank writeoffs.

A Word About Jobs

In spite of what Krugman and other economists say, Government cannot really “create” any jobs per se. It can raise taxes and shift private sector jobs creation to government jobs (typically a malinvestment), and it can bring production and consumption forward for those jobs that are genuinely needed (filling potholes and repairing bridges), but once the potholes are filled and the bridges repaired, one has to ask the question, “What will we do for an encore?”

There is no free lunch. It is impossible to spend one’s way out of a hole. It cannot be done and should not be tried. Japan proved it. So did FDR. Ultimately it was World War II and the destruction of much of the world’s productive capacity that ended the great depression. The US was relatively untouched by the war, and could lead a worldwide recovery.

That said, there is a genuine need to repair infrastructure and that need must be done at the cheapest possible price.

I Urge Congress To Scrap Davis Bacon

When it comes to jobs creation, we need to get the most work done for the cheapest amount. The way to do that is to scrap the Davis-Bacon act. Economist Greg Mankiw writes:

“More public projects would pass a cost-benefit test if we repealed the Davis-Bacon Act. This law requires contractors on these public projects to pay “prevailing wages,” which are typically union wages well in excess of what would occur in a free market. If the government paid market-determined wages for infrastructure projects, we could have both more infrastructure and less government debt. Without doubt, that legacy would benefit future generations.”

Where’s The Apology?

Now that the bubble has burst there has not been one peep from Bernanke for his role in the mess. Nor has there been an apology from Barney Frank or anyone in Congress for their role in this mess.

What about an apology from governors and state legislatures for their role in the mess. How about an apology from the SEC?

Instead we are told we must share the pain. Here is a synopsis of the plan to date.

Sharing The Pain Plan

Ordinary Taxpayers 100%
Banks 0%
Congress 0%
State Legislatures 0%
Bernanke 0%
Fed Governors 0%
Fannie Mae Bondholders 0%
Freddie Mac Bondholders 0%
FDIC executives 0%
SEC 0%

Is it any wonder the average person is up in arms over the bailouts. When does Congress share the pain? When do bank executives share the pain? When does Shelia Bair share the pain? When does Paulson share the Pain? When does Bernanke share the pain?

Bernanke, Barney Frank, and anyone else in Congress who supported Fannie and Freddie owe US taxpayers a huge apology. They should share in the pain.

Healing cannot begin until those responsible for the mess own up to their part in it. Instead, Congress is turning to Bernanke for answers when he failed to see the problem. If Bernanke could not see the problem, how can he possibly see the solution?

Bernanke failed to see this coming, denied it every step of the way, then threw 10 new programs at the credit crunch, all of which failed.

  • I call for Congress to share the pain by cutting their own salaries.
  • I call for Congress to not give one cent to the states unless they do the same.
  • I call for a reduction in salaries at the FDIC, the SEC, and every Federal department.
  • I call for a reduction in salaries at the Fed.
  • I call for a reduction in salaries in state and local governments.
  • I call for capping of pension plans everywhere in government.
  • I call for Congress to revoke Davis-Bacon.
  • I call for the end of SEC sponsorship of the rating agencies.
  • I call for union concessions from the auto makers.
  • I call for executives and all employees of banks and brokerages receiving money to share the pain.
  • I call for an apology from all who contributed to this mess, including Bank and Brokerage executives.

Most of all, I call for the resignation of Fed Chairman Ben Bernanke, the abolishment of fractional reserve lending, and the end of the Fed itself, the latter to be phased out over an appropriate period of time.

Mike “Mish” Shedlock
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Timothy Geithner (timothy.geithner@ny.frb.org)who is due to replace Henry Paulson as the head of the Treasury Department.

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