Recipes for Recovery

From Washington to Wall Street

On Monday, November 10th, the New America Foundation’s (NAF) Next Social Contract Initiative and the Committee for a Responsible Federal Budget hosted “Recipes for Recovery,” a half-day event on the current state of the U.S. economy and potential government responses.
Frank Micciche, Deputy Director of NAF’s Next Social Contract Initiative, kicked off the event, observing that it was a precarious time for both the U.S. and global economies. Given the turmoil, he explained, both Congress and President-Elect Obama have called for the government to pass stimulus legislation designed to temper the economic downturn. Micciche then introduced the day’s panels and keynote speakers, and turned things over to Richard Medley of Medley Capital.
First Keynote Address: Richard Medley
Medley opened his remarks by suggesting that “free money makes people stupid.” He argued that the root cause of the financial crisis was that “adults lost control of the situation;” the result would be a financial system changed for a generation or longer. This new financial system, Medley argued, would be far more traditional than the current system. Firms would no longer “lend to deadbeats,” but they would also have less leveraging ability. This will mean slower-growing banks, a shrinking and consolidation of the hedge fund industry, and the return of small banks.
Medley argued that new regulations would be necessary to ensure we don’t repeat our mistakes, but advised that politicians “take a breath” – for a year or more – before making any major decisions. He contended that trying to regulate during a crisis would lead to overreaction and over-regulation. He also suggested that it makes sense to wait and see how the markets sort out and then regulate them, rather than influencing the direction of markets themselves. Ultimately, Medley argued that government should limit the amount of leveraging allowed. Although this would mean slower growth, he explained, it would mean sounder growth – and could prevent another crisis.
After Medley’s speech, Mort Kondracke of Roll Call asked what would constitute over-regulation. Medley argued that requiring too much transparency (along the lines of Nicolas Sarkozy’s proposals) or too stringent a view of the appropriate structure of the financial market would be a bridge too far. He said that regulators should not force firms to publicly disclose all their positions, nor should they mandate new savings and loans. Rather, governments should pause for a breather and let the system naturally gravitate toward the proper regulation.
Dana Chasin of OMB Watch next asked what forms of restricted leverage Medley imagined, and questioned whether encouraging restructuring and Mergers and Acquisitions is sound policy. Medley replied that lending has frozen up because balance sheets had big holes to fill, and no one knows just how deep the holes are. Until markets discover the real value of assets and securities, he suggested, government must step in and establish a floor on prices.
A third questioner noted that the United States has lots of regulators, but the rest of the world is quickly moving to the “twin peaks” of a prudential regulator and a consumer regulator. He asked if this consolidation was a good move. Medley answered that, although the various U.S. agencies lacked comprehensive understanding of what was happening in the financial markets, one czar is not necessarily the answer. He stressed that it will take a long time for the new regulatory framework to sort itself out.
First Panel: Jumpstarting the Recovery: Proposals for an Economic Stimulus
Medley’s speech was followed by a panel discussion, moderated by former U.S. Representative and CRFB Co-Chair Bill Frenzel. The first panelist was Albert Dwoskin of A.J. Dwoskin & Associates. Dwoskin opened by explaining that we are in an economic tsunami. The housing sector is suffering particularly badly, he explained, even in geographic areas which have traditionally been resilient. He suggested that massive cuts in public expenditures, particularly infrastructure investments, are exacerbating the situation. Because so many projects are on hold, Dwoskin argued, infrastructure investment would be an effective stimulus that would both create manufacturing demand and put people to work.
Michael Lind of the New America Foundation spoke next, suggesting first that there is now a consensus in favor of infrastructure stimulus – it is timely, targeted, and results in the creation of tangible assets with economic value. Lind provided an overview of current public investments, explaining that they cost $300 billion a year, with more than 70% coming from state and local governments. Lind argued that this level of spending was woefully inadequate, both by historical standards and in terms of what is necessary. He suggested that infrastructure stimulus could be linked to the creation of a long-term infrastructure strategy which leveraged public money to crowd in private investment. Specifically, Lind called for the creation of a National Infrastructure Bank which could serve the dual purpose of providing the country with its infrastructure needs and offering an easy vehicle to provide stimulus when it is needed.
Ethan Zindler of North American Research spoke next, discussing how clean energy could play a role in the economic recovery. Zindler first argued that the government’s role should be to foster private sector investment more than make direct investment. He then illustrated the clear upward growth trend of clean energy investment, as well as the stifling effects of the current economic downturn. Part of the problem, he suggested, is with the Production Tax Credit which is an ineffective impetus for clean energy investment when banks are unwilling to make loans. At the same time, he suggested that there are a number of sound clean energy infrastructure projects out there, and the prospects of the White House and Congress investing in them is good.
Next on the panel was Brian Riedl of the Heritage Foundation, who suggested that there should not be a stimulus package at all. Riedl explained that the only way to create economic growth is by increasing productivity – and productivity can only be increased through more labor or capital, or technological advancement. Because stimulus does nothing to change these fundamentals, he suggested, it cannot create any real economic growth. Riedl explained that stimulus is based on the theory that government can stimulate demand; however, he argued, government cannot create money – only redistribute it. And because this redistribution often involves distortionary tax increases or borrowing money which would otherwise go into private investment, it could actually make things worse. Some government spending can promote growth, Riedl suggested, to the extent it is targeted towards investments (in infrastructure and education, for example). But even here, economic growth stems not from the spending itself, but from the final product. And even these investments, Riedl claimed, are often handled better by the private market.
The final panelist was Maya MacGuineas, President of the Committee for a Responsible Federal Budget and head of the Fiscal Policy Program at the New America Foundation. MacGuineas opened by expressing her shared skepticism, with Riedl, about the effectiveness of a stimulus package, but asserted that the economy is in enough danger that politicians should err on the side of passing one anyway. She argued that demand could be boosted somewhat, and that there would be a psychological benefit to stimulus. MacGuineas also suggested that stimulus was a political inevitability. However, she outlined a number of risks attached to any package. First, stimulus might be overly expansionary, loosening credit beyond where it should be. Second, stimulus might “rebalance the economy” incorrectly, propping up industries and sectors which should either fail or be restructured. Third, stimulus might be executed poorly, and include too many pork barrel projects and unrelated expenditures. Finally, stimulus could involve too much borrowing, which might lead to a federal debt bubble. To avoid these pitfalls, MacGuineas explained, the Committee for a Responsible Federal Budget has put forth three principles: 1) all stimulus provisions must have an economic rather than political justification; 2) borrowing can only be used for temporary measures; and 3) stimulus should include a mechanism to begin a process for addressing the nation's long-term fiscal imbalances.
In the subsequent question and answer session, the first questioner noted that candidate Obama tended to punt on the question of tax increase for upper-income Americans – and asked the panelists to comment. Dwoskin predicted that taxes will revert to pre-2001 rates for Americans with incomes over $250,000, and that Obama will implement new policies “sooner rather than later.” Lind said that, if he were President-Elect, he would not raise taxes during a recession, and that he would cut corporate tax rates. Riedl claimed that raising taxes during a recession is “the worst thing you can do,” and worried that Obama might repeat Herbert Hoover’s policies in the early years of the Great Depression. MacGuineas argued that Obama will not raise taxes now—his plan is to simply let the Bush tax cuts expire in 2010. However, she also noted that it is a fallacy to assume that tax increases on the rich will resolve America’s ballooning fiscal imbalances. It is more important to fundamentally reform the tax code, resolving the AMT issue and outdated corporate tax schemes.
A second questioner asked whether we were witnessing the start of a new federal debt bubble similar to the subprime crisis, and wondered how the country can service that debt. MacGuineas agreed that the nation is over-leveraged, and its finances are non-transparent--mirroring problems in the financial sector. Interest payments already constitute 9% of the federal deficit. By contrast, Riedl said that debt levels are not currently out of control, and in fact are lower than during the 1990s as a percent of GDP. But he was worried about the trajectory of debt, suggesting that in 15 to 20 years debt might be 100% of GDP. Zindler noted that how the government spends money is as important as the amount of debt, and pondered whether the U.S. was “just too big to fail” in some sense. Lind concurred that it is crucial to allocate debt correctly. He supports debt-financed increases in infrastructure investments, but is wary of abusing good ideas (e.g. Boston’s Big Dig). To avoid potential pitfalls, he suggested that America needs an institutional system removed from congressional horse-trading.
Another questioner asked about entitlements, sparking a discussion over whether America could afford its Social Security, Medicare, and Medicaid obligations. MacGuineas and Riedl agreed that the long-term fiscal challenges were extremely daunting, and Riedl pointed to the country’s $44 trillion in long-term unfunded liabilities as its biggest challenge. Lind disagreed somewhat with the idea of “unfunded liabilities,” arguing that it was unfair to project the future costs of Social Security and Medicare as liabilities, but not other areas of the budget such as defense. Lind also suggested that the real fiscal challenges was health care cost growth, which can and will be brought under control, leaving only a roughly four to five percent of GDP increase in government spending – which could be paid for with higher taxes. Riedl responded that Social Security and Medicare are mandatory entitlements which make promises up front, and so they should be treated differently than defense spending, which is allocated every year through the annual budget process. Skepticism was also expressed over whether health care costs could be controlled to the extent Lind suggested.
The last questioner of the first panel lamented the lack of transparency in the budgeting process, and asked whether the panelists believe the new administration would change this. MacGuineas said that the lack of budget transparency is a major problem, and stems in party from antiquated budget processes and concepts first implemented in the 1970s, as well as a large portion of spending being on auto-pilot. She suggested that the federal government lacks the ability to budget for the long-term, reinforcing political myopia. Zindler added that budgeting is as much an art as a science.

Second Keynote Address: John Engler
Engler began by declaring that he would “make the case” for the manufacturing sector and its importance to the U.S. economy. He introduced his topic by citing several unfavorable statistics about the economy, including record lows in manufacturing sector indexes and an overall GDP drop of 0.3% in the third quarter of 2008. He noted that 90,000 manufacturing jobs were lost in the last month, and predicted that unemployment could peak at 10.5 percent. According to Engler, the highest manufacturing job losses came from industries like fabricated metals, plastics, and the auto industry. Engler said the average number of hours worked at manufacturing jobs was also down “dramatically.”
Engler eventually focused on recent bad news about Ford and GM, saying that they had lost, respectively, $3 and $2.5 billion in the last quarter alone, and recently had the worst sales month for automobiles since the Second World War.
Engler expressed confidence that an Obama administration would be sensitive to the auto industry’s plight, and pointed to Obama’s advocacy for a second government loan to automakers, as well as his urging of Congress to pursue a second stimulus before his presidency begins, as evidence for this claim. Engler argued in favor of a stimulus because of the extent to which the automobile industry is intertwined with other parts of the economy. Thousands of supplier and retail companies, Engler said, are also connected to the automobile industry, and to allow automakers to fail would be to cripple the entire industry, causing unprecedented unemployment and damage to the economy.
Engler moved on to express support for a stimulus bill that would work through infrastructure improvement, saying that this was an area in which the U.S. had majorly underinvested for some time. Engler noted that while in the 1950s and 1960s, the US spent 3% of GDP on infrastructure, spending is far lower today. “We have been,” he said, “living off of grandpa’s investment in infrastructure for a while,” and we now face an “infrastructure deficit.” Furthermore, he argued that even if our aging infrastructure has so far mostly remained functional, we are still “paying” for our underinvestment—for example, time lost through traffic congestion on too-crowded highways. Because many commodities, which are heavily used in infrastructure construction, are currently relatively low in price, Engler believed that the U.S. could improve its infrastructure at “bargain” prices. He sketched out a wide landscape for potential infrastructure projects, going beyond well-known highway and bridge construction projects to waterways and airports. Engler also suggested that some money could be used to help airports transition to a satellite-based air traffic control system, and tied the quality of our infrastructure to national competitiveness. Finally, Engler advocated cutting corporate taxes and reducing corporate loopholes.
The first questioner, an international investor, noted that he had watched Engler and the auto industry rebuff calls for increased emissions standards for 30 years. He said that automakers could make a case for a bailout, but wondered whether they could continue to conduct business as usual. He questions whether the government should force changes to how Detroit works. Engler said that stronger government intervention in the auto industry sounds great, but you still have to get consumers to buy the more efficient cars. He noted that the carmakers’ problems had been building for a long time, and that, during his time as governor, the Big Three pushed much of their work out to suppliers. This magnifies the potential knock-on effects of bankruptcy.
The second question, from Jed Shilling of Chrysler Financial, said that taxpayers must save the auto industry, and asked what the industry owed us in return. Engler argued that there can be no unlimited assistance for automakers, but went on to note the “rhetorical disconnect” between advocacy for change and consumer behavior. The auto industry will of course owe money back to the taxpayer, and also a change in how they operate. But it is a two-way street: we owe them too, in the form of a preemptive single national emissions regulator to replace the current state-by-state patchwork.
The third questioner asked how we can ensure that our infrastructure investments are smart and forward-looking. Engler answered that the auto industry’s energy efficiency has increased dramatically in the past generation, and that diesel trucks set to come out in 2010 will actually clean the air. He expressed great confidence in American industry’s potential to adapt to the times and make consistent environmental gains.
Second Panel: The Long Road Back: Markets, Regulation and Fiscal Policy After the Bubble
Bill Hoagland of CIGNA opened the second panel by sketching out what he called the transition to a “post-bubble situation.” Hoagland expressed skepticism about a second stimulus package, and suggested that the biggest problem with a second stimulus was “where the dollars will come from, not where they will go,” citing predictions of a 2009 deficit in excess of $1 trillion dollars.
He noted that, since 1981, 82% of U.S. debt has been purchased by foreign entities, and contended that this trend could not continue for much longer. Hoagland pointed out that voters in the most recent election “opposed almost every bond initiative on the ballot,” heightening the fiscal dilemmas at all levels of government. “If we don’t get the deficit down,” Hoagland said, “either foreigners will have to continue funding us or the country will have no choice but to start printing money.”
In the next Congress, Hoagland foresaw a showdown between Democratic “Neo-Keynesians,” who argue for continued deficit spending, and Democratic “Blue Dogs,” known for advocating controls on spending and deficits. He wondered whether the next Congress would suspend PAYGO rules to fund emergency spending or some of the Obama administration’s campaign promises.
Hoagland closed by arguing that it is impossible to advocate for entitlement or healthcare reform without tax reform because the problems in either area are connected to the configuration of the tax system.
Ellen Seidman of the New America Foundation spoke next, focusing on certain lessons from the financial crisis and the proper solutions moving forward. Seidman said the crisis had provided further evidence that “people are not rational economic beings,” and that “the availability of data does not lead to being informed.”
Seidman noted that competition and shareholder pressure had encouraged executives to seek out short-term rewards at the expense of what amounted to irresponsible behavior in the long run. For financial institutions, Seidman hoped that high levels of leverage would no longer be taken as a sign of a “healthy bank.”
Reflecting on the regulation of banking institutions, Seidman called the current system “backward”--thanks to the relative ease of monitoring smaller entities, small banks are actually more closely regulated than large banks. She said that greater transparency within institutions was a top future priority, and called for the effective enforcement of existing banking rules. Finally, regulators must ensure that all parties have a stake in financial transactions to avoid perilous situations like those from the recent past, in which sub-prime lenders had little incentive to worry whether those to which they were loaning were truly creditworthy.
The third speaker, Joshua Rosner of Graham Fisher & Co, opened by saying that the recent financial crisis was caused in part by “both parties [in financial transactions] not having equal access to information.” He cited two sources of costly misinformation: over-reliance on rating agencies and outdated or irrelevant financial modeling tools. Rosner also discussed how the “sub-prime” borrower as it existed during the financial boom was a new entity: sub-prime lending formerly consisted of offering the same financial products as would be offered to a borrower with a good credit rating to borrowers with lower financial ratings--not the creation of newer, riskier lending schemes. Investors’ unfamiliarity with this new type of lending might have contributed to the financial bubble.
He predicted that the U.S. was only at the “front end” of the crisis, and that next year would bring a mass of credit card defaults. Other sectors of the economy would also show new signs of weakness.
Rosner claimed that the money from the $700 billion dollar bailout package was not being efficiently allocated, because banks were taking the equity they were given and “sitting on it” to fulfill regulatory requirements, rather than feeding it back into the economy.
He pointed out how mortgage securities, which were “internally leveraged” because of the inherent risk that they would not be repaid by the borrower, were sold as “financial products,” masking the real risk they entailed. Rosner hoped that the practice of securitization itself would not be blamed for the financial crisis, calling securities a vital instrument in modern financial markets. He also called for industry-wide standardization of terms like “subprime” and “default,” because the complexity of modern markets had caused their exact meanings to become less clear.
Rosner finally called attention to the “moral hazard” of allowing so many institutions (e.g., Fannie Mae and Freddie Mac) to become “appendages of government,” and wondered how the government would ever manage to disentangle itself from the associations it had created.
The last panelist, former SEC Commissioner Bevis Longstreth, addressed several general points about what caused the crisis and how the system could be reformed in the future. Longstreth criticized the powerful influence of financial firms over their regulators, the pressure on politicians to eschew certain types of prudent regulation, the competition of regulatory agencies vying for turf, and the actions of regulators like former Federal Reserve Chairman Alan Greenspan, whose legacy of deregulation has been diminished in light of the current crisis.
Longstreth offered several suggestions to “fix the system.” First, he recommended that the SEC be made into a self-financed institution like the Fed, so that it is less susceptible to outside influence. Second, citing the decline in professional standards among “gatekeepers” for public corporations, Longstreth thought that bolstering these standards could restore integrity to the system. Third, he claimed that an audit of public corporations by federal regulators might restore transparency and root out abuses. Fourth, Longstreth contended that government should create a new entity or empower a existing entity to explicitly advocate for the interests of investors. Finally, Longstreth asserted that the US should “appoint highly qualified people to head regulatory agencies.”
In the Q&A period, the first questioner stressed the importance of industry standards, and asked whether regulators should force more transactions onto transparent markets. Rosner answered affirmatively, criticizing the Treasury Department’s reverse auction approach for the TARP legislation. He argued instead for a forward auction process, in which ten thousand qualified buyers can bid on troubled assets, as a means of moving price discovery forward.
The second questioner, Jim Vitarello of the Government Accountability Office, inquired how one might design a regulatory system that encourages the realignment of long-term incentives. Rosner noted that credit-rating agencies were never meant to drive securitization, and were only good at assessing corporate debt. In the secondary market, regulators should require agencies to rate at original assumptions. Furthermore, conflict of interest needs to be more effectively managed. Seidman agreed, adding that regulators must also pay more attention to the compensation system. Firms need not pay mortgage-sellers entirely up-front.
Jed Shilling of Chrysler Financial, posed the question of how to avoid government bailouts that simply monetize financial assets which represent no real value. Seidman answered that, unfortunately, “the water is over the dam”--both financial assets and real assets will be part of the bailout. Treasury should have required financial institutions to write-down their assets before they got the money. Rosner added that the value of competing regulators was that what one drops, the other might catch. We cannot ensure against financial assets’ monetization, but we can think about breaking up large institutions instead of bailing them out.
Finally, Frank Micciche of the New America Foundation asked Hoagland for insight into how the TARP bill made its way through Congress. Hoagland replied that the process was very messy, and motivated by a strong sense of urgency. The legislation was not as well thought-through as it should have been, and we are now witnessing the repercussions of such a convoluted process.
Hyatt Regency Washington
Washington, DC, 20001
Morning Keynote Address and Q&A
Richard Medley
CEO, Medley Capital
Panel I: Jumpstarting the Recovery: Proposals for an Economic Stimulus

Albert Dwoskin
President and CEO, A.J. Dwoskin & Associates

Michael Lind
Director, American Infrastructure Initiative, New America Foundation
Maya MacGuineas
Director, Fiscal Policy Program, the New America Foundation
President, Committee for a Responsible Federal Budget
Brian Riedl
Senior Policy Analyst and Hermann Fellow in Federal Budgetary Affairs, Heritage Foundation
Ethan Zindler
Head of North American Research
New Energy Finance, LTD
The Honorable William Frenzel
Former Representative from Minnesota
Co-Chair, Committee for a Responsible Federal Budget
Lunch Keynote Address and Q&A
The Honorable John Engler
President & CEO, National Association of Manufacturers
Former Governor of Michigan (1991-2003)
Panel II: The Long Road Back: Markets, Regulation and Fiscal Policy After the Bubble
Bill Hoagland
Vice President for Public Policy, CIGNA
Former Senior Economic Advisor to Senate Majority Leader Bill Frist and Staff Director for the US Senate Budget Committee
Bevis Longstreth
Former SEC Commissioner (1981-1984)
Joshua Rosner
Managing Director
Graham Fisher & Co

Ellen Seidman

Director, Financial Services Policy, Asset Building Program, New America Foundation
Former Director, U.S Treasury Department's Office of Thrift Supervision