Image courtesy of Wikimedia Commons

President-elect Obama wants to avoid the Herbert Hoover scenario. In this scenario, many economic initiatives are tried but fail to bring the U.S. out of recession. The high expectations are not met. The result: a single term.

Of course, there are differences. Herbert Hoover was inaugurated in March 1929. The stock market crashed in the last week of October 1929 and the economy fell into recession and depression shortly thereafter.

 It is clear that the initial economic damage precedes President-elect Obama. Even though he inherits this mess, the American public fully expects a recovery during his administration. If the recovery does not happen, the Obama administration will be viewed in the same way as Hoover’s – a failure.

Mistakes to be avoided

1. The government and other banks let the New York commercial bank called the Bank of the United States fail on December 11, 1930. Wall Street financiers like J.P. Morgan refused to step into help this bank. The failure of this bank caused a massive run on banks and is widely viewed as the trigger point for the Great Depression.

Perhaps the failure of the government to step in to deal with Lehman Brothers is somewhat analogous. This failure caused a massive disruption in credit markets and was the single most disruptive event in the current crisis.

The new administration wants to avoid any disruptive situation with any large financial institution. We cannot afford to shatter confidence.

2.  Protectionism 1. It would be a colossal blunder to go the way of the Smoot-Hawley Act (signed into law in June of 1930). This law erected tariff barriers to protect U.S. manufacturers from foreign competition. When the U.S. raised tariffs, other countries retaliated. U.S. exporters found their overseas markets vanish. While I don’t expect tariffs will be the policy tool, given the size of the U.S. trade deficit there are many other ways to erect non-tariff barriers that might have a similar effect to the Smoot-Hawley. Surely, we have learned this singular lesson from the Great Depression.

3. Protectionism 2. In 1929, President Hoover authorized the Mexican Repatriation program. This amounted to deportation of both legal and illegal immigrants to Mexico. It had a similar effect to the Smoot-Hawley. It raised the cost of production and U.S. exporters suffered

 4. Tax increases. In 1932, the income tax was sharply increased. The rate on the highest incomes went from 25% to 63%. Higher taxes deepened the depression. By 1933, the unemployment rate was almost 25%.

 5. Deflation. The administration contracted the money supply leading to a sharp deflation. Deflation causes people not to spend (why spend today when it will be cheaper tomorrow?) and defeated recovery.

 What Can Be Done

 1. Adjust the focus of the Troubled Asset Relief Program to inject equity capital into a range of “good”  small and medium sized banks. When capital hits good banks, it is multiplied in the credit system. When capital hits “bad” banks (or at least banks looking to reduce their risk), the fresh capital goes into a black hole. – it is not lent out and has no impact on credit creation.

2. Incent banks to cram-down selected mortgages (for example, single family homes where at least 10% equity was put down for the initial purchase).

3.  Avoid inefficient policies like blanket moratoriums on foreclosures. Many borrowers were irresponsible and deserve to be foreclosed. Sometimes the foreclosure is on a second property that was purchased purely for speculation. It is inefficient to protect people that took reckless risk. This goes for financial institutions too.

 4.  Move swiftly to close down banks that are troubled. Do not throw good taxpayer money at banks that are beyond the margin of failure. Create a new Resolution Trust Corporation to dispose of these banks assets. This should happen quickly. Let’s get all of the bad news out to the public now. Right now, no one knows the real situation in terms of the health of our banking system. The uncertainty this induces prolongs the credit crisis.

5.  Ban reverse amortization mortgages unless you can prove you are financially qualified. The average citizen cannot pick up the telephone and trade options on a Chicago exchange. You need to be qualified to do that. The same should go for a mortgage contract that contains a complicated option. Many consumers were misled by banks and did not understand the risk. We cannot allow that to happen again.

6.  Do not allow deflation. This means monetizing today (and paying later with inflation). To me, the cost of a depression is a lot greater than some future inflation. There are many innovative proposals floating around. For instance, the Treasury could issue real estate bonds directly to qualified owners of real estate. The size of the bond would depend on the specific characteristics of the real estate. The special bond could be used to: pay mortgage payments, reset (points) the mortgage rate, reset the principal, or be used as currency to purchase a new house. These real estate certificates would, at minimum, stop the free fall in housing prices. Assuming they would not be sterilized, they would be inflationary.

7.  Related to 6 – make it clear that Federal Reserve Chairman Bernanke will be renewed. Speculation that he will be replaced in two years just causes uncertainty. The chairman has shown a willingness to make bold, innovative monetary policies to address the crisis. His actions were often ahead of the game. In contrast, the Treasury secretary seemed to be playing catch-up. Bernanke is a great depression scholar. He knows the mistakes that were made. It is unlikely that he will repeat them.

7.  Focus on jobs now. Unemployment always lags the business cycle. We have not seen the worse. Many see a 10% unemployment rate. The most effective government sponsored program would be large scale infrastructure. Our infrastructure has been over depreciated and is in dire need to renewal. It is  a long term investment for our economy. In addition, it uses U.S. labor and U.S. goods and services. In contrast, some tax rebate could simply be spent on foreign goods. Infrastructure projects take time to get going – and we need to set them in place sooner rather than later.

 8.  Focus on small and medium sized enterprises (SME).  The SMEs provide growth in the economy. SMEs are the drivers of employment – not the large firms. Expand the scope of the Small Business Administration allowing SBA guarantees on certain loans. Minimize the bureaucracy so that these can be applied for on-line in conjunction with the bank lender and approved the same day.