Friday, October 3, 2008

Big-Digging Ourselves Out

Senator McCain says he'll lead us out of this crisis by freezing federal spending on everything but "defense" and entitlements. He will (and this now seems just a corollary) end earmarks as we know them: no new spending on schools and colleges, health insurance, hospitals and claims processing, bridges (to somewhere), bullet-trains, dikes, and green power--in short, on none of Senator Obama's promised investments in next generation infrastructure and intellectual capital.

On the surface, this seems a responsible, if unfortunate, plan. Jim Lehrer's relentless, smug debate question--"What are you prepared to give up?"--implicitly pointed to McCain's answer. But the question was simple-minded. And McCain's response shows that he understands how we got here about as well as he understands how Iraqis get to democracy.

MCCAIN, LIKE BUSH, thinks a surge of "shopping" will follow the bail-out--and it might. Obama's middle class tax cuts may, indeed, make sense if we want to mitigate an immediate recession. The problem is that, like Anbar warlords, American consumers will continue to be subsidized by more of the money we borrow from overseas lenders. We consume about two billion more a day than we produce. What can we do about that?

Put this another way. What would a competent bond-rating agency say about U.S. debt denominated in a steadily devalued currency? Would an auditor endorse a corporate strategy that shows no way of getting past a pattern of spending more than it earns? Worse, will sane venture capitalists invest in college graduates like, well, Sarah Palin?

Palin told Katie Couric--she was talking about climate change--that it doesn't matter how we got here, it matters that we act. But, no, if we don't know how we got here, we won't know how to act. So let's assume, with the House acting today, that our current crisis of short-term credit can be overcome. What will happen to long-term investment when it becomes clear how the worsening structural imbalances producing the current crisis persist. How did we get here?

One. Chinese companies, banks and funds have accumulated about one and a half trillion dollars in recent years, largely by manufacturing (though not mostly designing) our stuff, and they've invested much of this back in Western capital markets. The sovereign wealth funds of the petroGulf, with as much a three trillion in accumulated capital, have also pumped about sixty percent of their assets back into Western capital markets.

Here's the deal: by linking their currencies to the falling U.S. dollar they have deliberately kept their currencies undervalued (in effect, a subsidy by their emerging entrepreneurs of our consumption) in the forlorn hope of keeping our growing number of stagnant-wage-workers--people who cannot move from closing factories to knowledge businesses--buying at Walmart and putting gas in Chevy (or increasingly, Toyota) trucks.

Two. Since money was so plentiful, what financial services company would not try to cash in by collecting fees lending it in all kinds of new-fangled ways? With easy credit, easy mortgages, etc., housing prices rose--and looked like they'd never come down. Families took on more and more debt, that is, to buy what they needed and make up for the money they were not earning in wages.

Three. The debtors' bubble predictably burst.

Four. This also became the creditors' bubble.

THERE IS ONE way out: invest now, and heavily, in people and infrastructure.

"Wall Street's success in generating wealth beyond their expectations led to an overconfidence in their abilities to properly judge the riskiness of their own investments," says Steve Cucchiaro, the President and Chief Investment Officer of Boston's Windward Investment Management, "so they finally over-leveraged themselves, not just the struggling people they sold debt to.

"Bailing-out financial services companies is for now; we have to do it. But the long term problem remains. Who works, who earns what, what do we make, and what do we buy?" The picture, he suggests, has not been pretty: too few of our people making the things the world needs, too many of people borrowing to buy oil and junk. But there is another way to think about this:

"Boston has just seen the Big Dig," Steve continues, "nearly $15 billion invested in opening up Boston's harbor to ten times that sum in new investment. The Big Dig was ridiculed for marginal cost over-runs. But it created more efficient roads and tunnels, taught engineers, inspired architects, and created great jobs for a generation of logistics experts, builders and contractors, whose children had more stable homes.

"Would it have been better if the $15 billion had come into the economy as a stimulus program ultimately financed by borrowing from foreign sources, money that sent the very rich to buy yet more luxury goods and the middle class to the malls to buy things, and often frivolous things, made in China?"

NONE OF THIS is new, perhaps. But I'm flogging it because we have to keep the big picture in mind and not get distracted with purely psychological game theories. Labor productivity (that is, the ratio of smart machines to people) is rising in American companies that are surviving global markets. But if as Warren Buffet says, we get to 11% unemployment, that is a different crisis than 6%. And if the 89% that is working is earning (in real terms) 20% less than workers did a generation ago, what eventually becomes of demand at the malls?

There is obviously a crisis of confidence. But flocking behavior does not explain everything. If lenders are going to have confidence in our future, they will not be counting on old ways of getting us into stores: borrowed tax cuts, borrowed government give-backs, borrowed equity loans, etc. They want to see not just Main Street with the confidence to consume. They need to have confidence that Main Street has the education and infrastructure to produce.