Virtually all economists agree that a massive economic stimulus package is necessary to prevent one of the most severe recessions (and potentially depressions) since the Great Depression of the 1930s.  However, the $800 billion stimulus bill working its way through congress is fatally flawed.

This battle must be won on two fronts.  First, we must fix the root of the problem, which is the housing crisis .  And second, we must stimulate spending which accounts for 2/3 of the US economic output.

The challenge with the current bill is that it spreads out the money over too many areas without addressing these two core investments.  There is but a small amount pledged to help homeowners (which does help address the root but insufficiently).  At the same time, there is a massive amount of spending to bail out the states, but that money isn’t going to into incremental programs that would stimulate the economy.  It’ll just help plug the massive state deficits without any incremental spending there.

Additionally, there are massive tax breaks spread across broad income brackets.  That’s frankly just a massive waste of money.  Do you really think someone is going to go out and have the confidence to start spending again because they have an extra $20 in their paycheck every 2 weeks?  That’s just absurd.

Rather, the stimulus spending should be solely on getting unemployment down or extending benefits for unemployed:

·         People without jobs aren’t going to spend (obviously). 

·         People collecting unemployment will spend since they have no choice.  That helps the economy, but it’s not sustainable long term.

·         People who get a new job created through government spending will not only create value for society through product work, but they will then have the confidence to spend their earnings and even finance some of their spending (an American pastime).

·         People who already have jobs will feel more confident to spend more when the labor market tightens.  That’s because (1) they will feel it is less likely they will lose their current job, and (2) they will feel even if they do lose their  current job there are others out there.

It’s all about confidence and pragmatism.  Fix the underlying cause, and get people working over the next 2 years.

Tax cuts are great and can stimulate long term growth.  But in the short term, it’s all about targeted programs to get people back to work.

The biggest enemy to the end of the financial crisis and the beginning of an economic recovery is Treasury Secretary Henry Paulson himself.  Let's forget for a minute that the decision by Paulson and Bernanke to let Lehman Brothers fail was the precipitating event leading to credit markets freezing up and the first round of financial panic.  Since then, the two have been working diligently to correct this collosal mistake.  But separating actions from words, we see that words are in fact much more potent.   

Since the end of September, every time Henry Paulson has opened his month, the Dow has dropped on average 196 points.  On days when he was silent, the Dow has dropped on average 28 points. 

So what's going on here? When the crisis started spiraling out of control after the Lehman failure, Henry Paulson and Ben Bernanke swiftly stepped in with bold action, taking over AIG, preventing further failures, and proposing an unprecedented bailout fund of $700 billion.  That was all somewhat re-assuring.  But when congress waivered, Henry Paulson's second monumental mistake was appealing directly to the public, telling them if he didn't get the package the US would face the next great depression.  

And the world responded.  "Great depression?" they gasped. Consumer confidence plummeted, as did consumer spending (which accounts for a stunning 2/3 of US GDP).  Corporations, in a mass panic, swiftly switched into a mode of panicked layoffs and cost cutting.  The banks, already spooked, continued to tighten their lending not just to consumers but to corporations and other banks as well. And ditto for the rest of the world.

 Economics is as much or more about confidence and psychology than it is about fancy macro or micro-economic theories.   So here we are.  Every time Henry Paulson opens his mouth, he spouts some more doom and gloom.  The US and world economies are in ful fledge panic.  Everyone, from gas station attendants to corporate CEOs are talking authoritatively about great depressions, cutting costs and spending, and general doom and gloom.

And it's a self fulfilling prophesy.  If people think there will be a depression, and change their behaviors accordingly, there will be.

 What we need now is for Henry Paulson to shut up and go about the business of stabilizing the economy quietly.  Silence is golden, and will pay of (literally) in gold. It's time for confidence to heal and markets to stabilize so that the next Treasury Secretary and the next administration can implement their own set of policies. 

Check here for recommendations for Mr Obama's economic bailout plan .   

Shhh....  If you listen carefully, you can hear Milton Friedman - the father of neo-conservative economic theory  -  turning over  in his grave. Milton, who believed markets to be rational, perfectly transparent, and generally smart enough to look after their own interests argued vigorously against government regulation or government intervention in economic policy. In Milton's world, corporations would be smart enough to avoid an economic crisis, and if one should occur, they would be able to pull themselves out of it.  Alas, the 2008 economic crisis seems to have successfully unsettled his basic premises and derailed a half century neo-conservative economic policy and dogma.  

Friedman's onetime idol and conceptual opposite was John Maynard Keynes .  Keynes was the most influential economist of the 30s and argued that in cases of catastrophic economic crises, corporations and markets may not be capable of pulling themselves out of the "death spiral", resulting in a recession or even depression much deeper with more severe societal dislocation than would otherwise be necessary.  In the most dire cases, strong government intervention was the only solution to ending economic collapse.   In fact, massive government spending and employment did successfully end the great depression.

So who is ultimately right?  They both were in a sense.  The challenge with Keynes was that he argued for consistent and regular government meddling in short-term economic swings, which ultimately led to the stagflation of the 70s.  Ultimately, Friedman was correct in the respect that short term meddling in unemployment rates and economic growth lead to unintended consequences.  But he - like Allan Greenspan - was wrong to think that corporations can operate at optimal efficiency without government regulation.  This being proven by the failure of:

• AIG: One of the largest insurers of the world
• Fannie Mae and Freddie Mac :  The largest mortgage originators of the world
• Lehman Brothers:  One of the largest investment banks
• Merrill Lynch (near failure):  The largest investment bank in the world
• Citigroup (near failure): One the the largest banks in the world  

So in a big picture sense the US government should:

• Recognize the situations where market and corporate irrational behaviors have the potential for massive negative consequences and put in effective regulation, so we can avoid the situations that create an economic crisis
• Generally stay out of the way of the economy where possible
• Keep an eye out for developing bubbles and "pop" them if necessary to avoid a massive economic crisis 
• And when all else fails, in the case of massive impending economic crisis and collapse, step in and vigorously manage the economy.

According to this plan, now that we're stuck in the worst case scenario - the most severe economic crisis and collapse since the great depression - what is called for is aggressive government action.

First Things First, "Why are we in an economic crisis?"

There are a couple underlying causes in the current collapse.  First, people were buying houses they couldn't afford and banks were irrationally lending those buyers money.  When this housing bubble collapsed, home prices started depreciating.  People couldn't afford their mortgages and stopped paying banks.  The banks were then left with a ton of bad debt on their books and started going bankrupt or teetering on the verge.  These same banks stopped lending money, and businesses started feeling the squeeze.  These businesses then started laying off workers.

All this was bad enough, but then Paulson famously and stupidly, and maybe famously stupidly, came out and started screaming about the next great depression.  At this point, consumers panicked and consumer spending - accounting for over 2/3 of the US economy - ceased.  This caused businesses who saw evaporating demand to start laying off.  Then more people who sensed their jobs were at risk started spending even less.  And so it continues today.

How do we fix the economic crisis?

It's quite simple, honestly.  First, the US government needs to do everything possible to stabilize the financial sector.  It's already working aggressively to stabilize the banking sector, which is a step in the right direction. 

Second, it needs to focus on jobs. The economy, especially the US economy, cannot recover until people feel secure in their income and start to spend again.  Period. Economic crisis is as much about emotion and psychology as reality, and that's the case here.  Historically speaking, that has meant massive public works projects that are in the national interest.  It's a short-term win-win.  The government makes investment in the long term competitiveness of the country.  At the same time, workers get job security and income and start spending again.  The good news is that we have no shortage of strategic projects that need investment:

• Massive mobilization to secure our energy independence and simultaneously save the planet from global warming .  We should make immediate and massive investments in nuclear power, solar, wind and other power generation plants.  At the same time, we should invest massively in more energy efficient technologies like hybrid cars, better insulation, etc.
• Tactical investments in our crumbling roads, bridges, etc, to the extent that it improves commercial transportation or improves the free flow of labor.
• Medical modernization .  The United States spends more per-capita on healthcare than anywhere else in the world but our life expectancy lags dozens of countries. We need to find ways to improve efficiency. 

Finally, and most controversially, the economic crisis could be dramatically worsened if a major employer like GM, Ford or Chrysler failed.  Yes, these companies deserve to fail.  Just not right now.  

So Mr. Obama, you have inherited the worst economic crisis since the great depression.  But your path is clear.  Go forth and save the United States! 

As much as GM, Ford and Chrysler claim the recent crisis is the result of nothing more than the short term credit crunch, that claim is pure spin.  The truth is much colder and harder than that. 

• Fact: GM market share peaked 40 years ago when they controlled over half of all vehicles sold in the US.  They have lost market share nearly every single year since then, to the low 20s today .  
• Fact: Despite near unanimous agreement that fossil fuels are causing global warming, and the fact that the US was sending hundreds of billions of dollars a year to repressive middle eastern governments, some of which covertly funneled funds to terrorists, the “big three” automakers steadfastly opposed tighter fuel efficiency standards.
• Fact: If GM, Ford and Chrysler had adopted stricter fuel efficiency standards, they would have a fleet of more competitive cars instead of huge gass-guzzling cars that nobody wants to drive, and they wouldn’t need this bailout.
• Fact: Executives from the big three showed up to congressional hearings on their own private jets .  When asked to raise their hands if they would give up their private for the benefit of their company, not a one of them raised their hands.  This is more symbolic than anything, but it shows how out of touch with public opinion they are.

So while the automakers like to blame unions, the credit crunch, or basically anything except their own mismanagement for the current crisis, the blame lies firmly and directly at the executive management's feet.  After decades of building cars that nobody wanted, the chickens have come home to roost.

Should GM be allowed to go bankrupt?

Yes.  GM, Ford and Chrysler all deserve the situation they are in.  In fact, in normal economic conditions, they should be allowed to fail completely.  But these are not ordinary times, and a complete collapse of the US auto industry would be catastrophic to the US economy.  It is reasonably estimated that 3 million jobs would be lost in such a case.  The drag on the already imploding US economy may even be enough to push us from recession to depression.

The Age of Pragmatism

This is not the time for idealism.  It is the time for pragmatism.  Americans are thankful every day that we don’t live in a socialist economy.  So any assistance should conform to the following criteria:

• It significantly and substantially benefits the US economy.
• It holds executive management of the auto makers accountable for the failure of their businesses.
  
• The existing investors (shareholders and bond holders) should not receive any benefit from government intervention.  They took the risk in exchange for return, and this is an extreme example of what risk really means. 

Pragmatically speaking, this means a financial rescue package along the following lines

• Each company that receives assistance will first declare bankruptcy
• Shareholders' equity would be wiped out by issuing a very large number of new shares to the US government (along the lines of what happened at AIG, Fannie and Freddie).  Existing debt holders should be wiped out. 
  
• The top 2-3 layers of management and the board should be fired without severance.  A new reform minded CEO would be appointed to head the new company, and would report directly to the treasury secretary.
• Over the next 2-3 years, valuable parts of the business would be sold off, union contracts would be re-negotiated to ensure long term competitive cost structure, pension benefits would continue but at a reduced level.  The remaining core business would be structured to be profitable as a much smaller entity, producing roughly half the vehicles as today.
• At its core, the auto business is a fashion business .  And these companies need to make cars the public demands, which will be the focus of a 5 year turnaround plan.
• The US auto industry would adopt aggressive and tough fuel efficiency standards, re-tooling their plants to a higher reliance on hybrid, fuel cell and electric technologies.  Time lines would be aggressively shortened so that by 2015 we see major, quantum leap improvements in US fuel efficiency.
  
• All US government owned equity in GM, Ford and Chrysler would be sold back to the public by 2015, and the companies would be fully independent by that point.

This plan punishes those who deserve it, protects the US economy and some level of employment, accomplishes strategic goal of energy independence and reduction in global warming , and offers the potential windfall to tax-payers after successful completion.