The Meltdown Lowdown (No. 13)

Inflation: The Latest Import

Inflation is likely to inch up over the course of the year, with higher import prices being a major cause. The problem is higher-than-high oil prices -- all imports cost more because of the drop in the dollar. Non-oil import prices are up 7.3 percent from June 2007 to June 2008. Over the last three months, they have been rising at a 12.1 percent annual rate.

Most of this has not shown up yet in the consumer price index (CPI). While the June CPI jumped by 1.1 percent, bringing its annual rate of increase over the quarter to 7.9 percent, this was mostly an oil and food story. The core CPI (which excludes food and energy) rose 0.3 percent in June and has risen at an annual rate of just 2.5 percent for the quarter. But, higher import prices eventually will show up in the core measure also.

But the bad news on import prices is actually good news for the economy. Higher import prices will lead people to buy more domestically produced goods, thereby reducing the trade deficit. It ain't pretty, but that is the only way to get the trade deficit down to a sustainable level. The lower dollar also makes our exports cheaper for people in other countries, thereby causing them to buy more U.S. exports.

However, the big question is how will the Fed respond to the news that rising import prices are pushing inflation higher? The correct response is to grin and bear it. We set ourselves up for this hit when the Clinton administration consciously pursued a high-dollar policy in the late 1990s. This policy produced short-term gains in the form of cheap imports but was clearly unsustainable over the long term. The Clinton crew rightly bet that it would be gone when it was time to pay the bill.

The Fed can try to temporarily prop up the dollar with high interest rates and squeeze inflation out of the system by using high unemployment to keep wages down, but that will only delay the inevitable adjustment process. The inflation hawks should have been yelling about the overvaluation of the dollar back in 1997. If the dollar had never been allowed to reach the unsustainable levels that caused the trade deficit to explode, it would not be falling now.

Bailing Out Fannie and Freddie: What Will We Get?

Congress and the Fed are chasing after Fannie Mae and Freddie Mac with buckets full of money to ensure that the mortgage giants stay in business. Given the huge political fights that we must have to get a few billion for child care or children's health care, it might be worth asking a few questions before we give hundreds of billions of dollars of loan guarantees to these institutions. While everyone agrees that it would be a disaster to allow Fannie and Freddie to go under, "saving" them can mean very different things.

First, one point should be very clear: The wreckage facing Fannie and Freddie was entirely preventable. It also is real. It is not a psychological phenomenon as some are now claiming. These institutions face bankruptcy because they are looking at tens of billions of dollars of bad loans, an amount that far exceeds their capital.

Both Fannie and Freddie insured millions of mortgages that were issued on homes purchased at bubble-inflated prices. In many cases, these mortgages are now deep underwater, with people owing 20 percent to 30 percent more than the value of their homes.

This situation invites defaults and leads to large losses when defaults take place. Furthermore, with the housing crash wiping out mortgage insurers, Fannie and Freddie will, with increasing frequency, be taking the full hit from these loans, rather than sharing the losses with a mortgage insurer. Many of the mortgages that Fannie and Freddie bought required that the homeowner take out mortgage insurance as a condition of the loan (homebuyers are often required to buy mortgage insurance if they do not make a down payment of 10 percent to 20 percent). If the mortgage insurer is bankrupt, Fannie and Freddie are liable for the full loss on mortgages they hold or guarantee.

This collapse was entirely foreseeable. (I first warned that the housing bubble could bring down Fannie and Freddie in 2002.) The folks at Fannie and Freddie insisted on ignoring the evidence of a housing bubble and made loans that helped to fuel it. The fact that Fannie and Freddie face bankruptcy due to their own mismanagement should affect the terms of their bailout.

No. 1 on my list is a real cap on executive compensation. How about a limit of $2 million total annual compensation (that counts salary, bonus, stock options, everything)? That should certainly be plenty for people who arguably should be unemployed.

Cutting executive compensation is not just vengeance. The country has seen a massive upward redistribution of income over the last three decades. As a result, most workers have seen little benefit from the economy's growth over this period. While market forces were not generally responsible for this upward redistribution (the main cause was government policies), in this case the hand (or handout) of government is very clear.

Left to the market, Fannie and Freddie would be out of business, and their executives would be unemployed. If the government decides to intervene to prevent their collapse then it certainly has a right to set pay caps for the folks who wrecked the companies.

This should be a standard practice in all of the bank bailouts. For example, when Fed Chairman Ben Bernanke arranged the takeover of Bear Stearns and promised to protect the other investment banks, he should have imposed serious pay caps as a quid pro quo for the Fed's generosity. As it was, he just handed more money (in the form of extremely valuable credit guarantees) to some of the richest people in the country.

The condition of keeping Fannie and Freddie in business should also be that the stockholders get wiped out. That is supposed to be what happens to the shareholders in a bankrupt company, at least in a free-market economy. The country has absolutely zero interest in propping up the share prices of Fannie and Freddie. Unfortunately that seems to be a central part of the current bailout plan.

Instead, Fannie and Freddie should be taken over and run in receivership until their books are in order and the crisis is over. At that point, we can have a serious debate about whether it would be helpful for them to again be partially private institutions, or whether they should remain fully public.

In some cases -- for example, guaranteed student loans -- the private sector doesn't add any obvious value, just expense. If it is clear that there would be value added from having Fannie and Freddie return to their prior status, then we can go this route. But we should not privatize them just for ideological reasons. If the secondary mortgage market can be most efficiently supported through public institutions, then the reformulated Fannie and Freddie can remain public institutions for the indefinite future.

Obama's Capital Gains Tax Break for Small Businesses and Tax Accountants

In an effort to show that he supports small businesses, Sen. Obama came out with a proposal last week for a zero capital gains tax rate for small businesses and start-ups. Tens of millions of voters will be reassured by his commitment to help those struggling to start a business on their own.

By contrast, policy-wonk types will be inclined to ask questions like, "What capital gains does someone who starts a restaurant or shoe store have?" The answer is, ordinarily, "none." However, if you give them a zero tax rate, all sorts of income will suddenly appear as capital gains. Any good accountant should be able to make much of the profit, or even the salary of the owner, appear as a capital gain for tax purposes. For example, the business owner can leave money in a subsidiary that is then sold as a separate enterprise, when the subsidiary really is just a portion of the owner's salary that exists as a corporation only on paper. Such creative bookkeeping doesn't do anything to help the economy and probably won't do much to help small businesses, but it is certainly good news for tax accountants.

"Mental Recession," What Is In Their Heads?

After Federal Reserve Board Chairman Ben Bernanke warned of bad economic times ahead, President Bush held a news conference in which he urged Americans to calm down and "take a deep breath." Many will no doubt be trying to hold that breath until he leaves office.

In the same vein, former Sen. Phil Gramm, who is taking time off from his job as a lobbyist to help Sen. McCain's presidential bid, told The Washington Times last week that the country is suffering from a "mental recession." Gramm then complained that we "sort of have become a nation of whiners." After some initial hesitance, the McCain campaign disavowed Gramm's comments.

This one raised all sorts of fascinating questions. Since McCain is running for president, and if we are a nation of whiners, then does McCain intend to court the whiner vote? Can we expect to see the formation of a "Whiners for McCain" group? And, most important, will mental recessions be covered under Sen. McCain's health-care plan?

I'm not quite sure that Sen. Gramm's comment will help McCain get elected, but it is probably better than traveling the country calling Social Security's financing mechanism a disgrace.

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