Mass Confusion in Washington

Perhaps Washington's policy confusion will take a brief 2-day holiday next week, but then it's back to the hair of the dog that bit us. The confusion seems to be about what to do about the economy. All the talk is about which "stimulus" plan will give the most bang for the buck. Should we spend big on infrastructure? Pump up the private credit markets? Save homeowners? Increase social insurance payments? Increase tax cuts to business? Subsidize "green" energy? Bail out failing industries? Drop dollars from helicopters? All of the above? (If you're expecting our new president to magically come up with the right answers, you're living on a whim and a prayer.)

These folks seem to be missing the lesson the market has taken great pains to teach us. Almost all these options focus on pumping up collapsed demand - yet the demand collapsed because it was running on hot air. The real problem is that quibbling over whether a dollar of infrastructure spending or unemployment insurance yields more than a dollar of tax cuts is like rearranging the deck chairs on the Titanic. Now the Fed is even considering targeting a positive rate of inflation, so people can be assured that their balance sheets will gradually strengthen as their real wealth slowly vanishes.

Instead we should be focusing on how to get people back to acting on their risk-taking animal spirits. (People, mind you, private individuals--not government or its servants.)

We need to reexamine some simple economic truths:
1. Governments don't create jobs, private entrepreneurs and businesses do.
2. Governments don't create industries either, risk-taking investors and businesses do.
3. Inflating demand that is not built upon increased productivity and production is a form of illusion. Giving people money they can never pay back to buy stuff they don't need isn't going to fill anyone's coffers with profits, only losses.
4. National economies grow when people work more, produce more, save, consume and invest. Government can't accelerate this train by pumping up one or another of these activities.
5. The best any government can do is set up the rules of the game and the playing field so private citizens can produce wealth. Then get out of the way.

We can see that very few of the policy proposals square with these fundamental economic truths. The problem we face now is that we've allowed behavioral incentives to become distorted to favor some actors over others. We bred excess and then fed it. Now government is leaving its big paw prints over everything. This only counteracts any positive incentives that may arise from this financial correction.

Asset prices, especially housing, have been totally distorted by the vicissitudes of policy. Public pronouncements of what prices "should" be can only add to the uncertainty. Some corporate and private balance sheets are flush with cash, but as long as the distortion and uncertainty goes on, the longer they will stand on the sidelines and wait. The bigger danger of the housing market is that it will take years to reach economically rational prices, not that it will get oversold.

We should be providing clear positive incentives to all economic actors that directly bear upon their risk-return calculations and reduce their perceptions of uncertainty. Naturally, I favor tax cuts targeted to productive effort. No subsidies, bail outs or guarantees on outcomes. And it would be reassuring to know a dollar will still be worth a dollar next year.

As our policy-makers dither over different proposals to put Humpty back together again I hope they will focus on answering one question: will this policy encourage actors to take prudent risks without engendering moral hazard?

If the answer is not a resounding yes, let's skip it and leave well enough alone.