To Save the Economy, Don't Shed Market Principles

It's been dismaying to see so many who normally support free markets give up their principles in supporting Henry Paulson’s bailout plan. These folks know all too well the litany of government encroachments on the free market that have contributed to the current crisis.

Fannie, Freddie, the Community Reinvestment Act and other government policies subsidized and encouraged the growth of lending far beyond that which was financially sensible. Yet how is it that when the crisis deepens the solution is for more government even among those who should know better?

The reasoning goes that a strong negative feedback loop is in place causing markets to seize, and now the only solution is to use Public capital to stem the panic. I believe this view to be seriously mistaken. The only capital that the government can deploy is that which it takes from the private sector.

Unless we swap Amtrak or a National Park for these distressed assets, the government will be borrowing the necessary money from the private sector. Put simply, the government will be borrowing from the same pool of capital that currently does not want to buy these distressed assets.

It's argued that because of the panic, prices for these securities have disappeared, but maybe that's just because holders are reluctant to accept much lower prices. After all, Merrill Lynch had no problem dumping its mortgage portfolio a few months ago once its executives were willing to bite the bullet and sell at a very low price (I wonder if the buyers are still happy with their purchase).

While it's quite possible that the bailout will help stabilize markets in the near term (particularly since so many on Wall Street and Capital Hill have created their own panic by assuring everyone that there is no alternative, and failure to move forward on the plan would lead to a repeat of the Great Depression), there will be some significant long-term costs. The lessons of past financial inflection points are that we must let the markets reallocate capital from less efficient to more efficient uses. The sad fact is that we need to go through the brutal process of downsizing our financial and real estate industries. Actions taken to recapitalize doomed financial companies will only postpone the day of reckoning, which will make matters worse as the Japanese learned in the '90s.

Alternatively, why not just propose a massive tax cut as a way of driving private capital back into the markets? Let's return $700 billion to the private sector absent government allocation, and let the dispersed knowledge of millions of citizens make the decision on how best to deploy this sum.

To make it simple and quick, how about cutting all tax rates in half for at least the next 2 years? A sizeable tax cut like this would offer a tremendous boost to the economy, and it would make the transition to an economy with a smaller financial industry quicker and easier.

Income-tax reductions might put enough extra money in people's pockets such that they’ll be less likely to lose their jobs, not to mention default on mortgage payments whose underlying securities presently ail the financial system. While there's no doubt there would be additional pain in the near-term no matter the solution, a lower penalty on work would put us on surer footing sooner.

Importantly, the timing for tax cuts couldn’t be better. With economic conditions deteriorating, Keynesians should be just as supportive as free-market types. The fact that there's only a month until elections doesn’t hurt either. Are there any Democrats campaigning on how bad the economy is who will want to face their constituents after having voted against a tax cut like this?

Lower tax rates will help the economy begin the healing process immediately by increasing the expected after tax returns on capital, and by boosting expected GDP.

From a monetary perspective, there are other actions that would also help in the very short run. The Fed could continue to exercise its role as lender of last resort to protect the solvency of the financial system. And with a tax cut in place, the Fed would have more leeway to monetize debt without it causing inflation. That is because the tax cut would increase the productive capacity of the economy and effectively soak up or sterilize the growth in money supply. Without a massive tax cut the Fed will be caught on a razor's edge of not monetizing enough and feeding deflation, or monetizing and creating inflation.

But right now, to support the heavy hand of government is to countenance a continuation of the hubris which has brought us to where we are today. Rightly or wrongly it will lend credence to the arguments of those who say the solution is more spending and regulation; actions that will weigh on our economic health for generations to come.