To Obama's Transition Team

American Solutions For American Problems
And why the “conventional wisdom” won’t work
by Karl Denninger

President-Elect Obama has called upon Americans to provide him with ideas – and solutions – to the problems our nation faces.  One of these calls has been issued related to the health-care industry, but I have chosen to pen this missive not only in that vein but also in the interest of resolving the economic crisis we find ourselves in as Americans, since the entirety of this mess is in fact inter-related.

We must start with “how we got here”; in this regard the following graph should prove instructive:

Let us also note that GDP over the last eight years has grown by approximately 30%, or $4.5 trillion dollars, from 2000 to 2007.

When one compares the GDP and total US Debt, you find a striking fact – there has been no actual GDP growth at all in the last eight years.  In fact, you can go back through President Clinton’s second term in office and you will find the same thing – the entirety of so-called “growth” since 1996 was in fact growth in debt, not GDP.

Once we understand the foundation of what has happened, we can then look at the basic facts surrounding our economy.  These facts include:

• There has been no actual GDP growth for more than ten years; claiming “growth” from increased debt is exactly identical to my going out and borrowing $200,000 on my credit cards, then claiming to be $200,000 richer.  I am in fact poorer than when I started since I must not only repay the $200,000 but must also pay interest on it!
• We have replaced productive output (building cars, computers, TV sets, washing machines, etc) with non-productive output (shuffling paper, creating “financial innovation”, etc)
• “Financial innovation” is in fact equity-stripping; if there is 300 basis points of profit available in a bundle of mortgages over the reference rate (e.g. 10 year swaps), that’s all there is.  You can allocate who gets the 300 basis points but you cannot increase the amount of actual profit available.  Financial “innovation” is in fact a fraud as the only means by which you can obtain more than originally existed is through lying; this is typically accomplished through obfuscation and opacity (e.g. CDOs with 100,000 pages of underlying documentation which are flatly impossible to read due to volume before the purchase decision is made.)
• The fiscal and monetary policies of the previous ten years and more have been insanely inflationist, causing the prices of necessary goods and services, such as homes, education and health care, to skyrocket, while global wage arbitrage has caused real standards of living to decline for 90% of Americans.  We must stop this now if we are to have a working middle class in this nation going forward.

Once the above are accepted as indisputable facts (and they are; if you doubt them please do the research to back up your opinion with other than a 30-second sound-bite off TV) a few immediate conclusions become apparent:

• Keysian economics is an abject failure.  The premise of the Keysian economic thought is that during “flush” times in the economy the public treasury will be refilled; this surplus will be used to provide stimulus through the “down” periods in the economy, thus smoothing out both the booms and busts.  Unfortunately human greed and political reality makes this goal impossible; the surplus is never actually accumulated (as we have seen since WWII) and instead it is not only both spent but spent many times over, leading to an ever-increasing call for more and more stimulus.  This inevitably leads to exponentially more debt and ultimately the failure of the currency and political system.
• We cannot tax and spend our way to prosperity.  We tried both taxing and spending and just spending without taxing.  Both led to radical increases in public and private debt but zero real GDP growth.  The experiment has been run and failed; we must stop doing that which has not (and cannot) work.
• We are in the mess we find ourselves in not due to ordinary business cycles but due to intentional acts on the fiscal, trade and monetary policy fronts that encouraged excessive reliance on credit while allowing wage arbitrage to prevent classical wage-price inflation to take hold.  These intentional acts have led us to where we are today.  More of the same will not solve the problem just as giving a drunk a bottle of whiskey does not cure what ails the alcoholic.
• We cannot exit from the economic malaise we find ourselves in until and unless the excessive debt is either paid down or defaulted.  Simply put, an ever-expanding debt load creates an ever-expanding requirement for debt service.  This is a Ponzi scheme that mathematically must fail.

From this we find the foundation for solutions that are driven first by mathematical necessity, and then by maintenance and improvement of the public weal, both directly and indirectly.  These are:

• Debt that cannot be paid off (not just rolled over) must be defaulted.  The era of false  GDP growth via additional debt is over and this falsehood can no longer be extended or tolerated.  This should have taken place after the 2000 Tech Wreck, but was intentionally prevented by both monetary and fiscal policy.  We are no longer able to continue that charade and risk an all-on fiscal and political collapse if we fail to recognize and deal with the mathematical reality of our situation head-on.
• The public treasury must be rebuilt.  The most-obvious means to do this is via tax increases and spending cuts.  However, that is not the most efficient method, never mind the fact that such attempts in the past have always failed due to hubris, conceit and outright fraud in the Congressional Budget Process.  There is another path which I shall explore presently.
• The mistakes that caused this disaster must be recognized, admitted, and prevented from occurring in the future so that generations to come do not have to go through what we are going through (and must go through) today.  This means significant regulatory changes are necessary and they must be “wiggle-proof."

Tax Policy

Without a tax policy all other policy measures are a waste of time.  The Federal Government cannot spend without the ability to tax, although you wouldn’t know that walking around the Halls of Congress.

Our currency and national sovereignty in fact are inextricably tied to the ability of the government to back its debt with the future productivity of Americans.  After all, that’s what a dollar is – a “call option” on the future ability of the government to raise tax revenues from the citizens as a consequence of their productive pursuits. 

Without that ability there is no dollar – and no government.

There are many who argue that “the rich must pay their fair share” and other similar platitudes that devolve down into taking more from the most productive members of society.

Yet in my entire life I have never obtained a job from a poor man. 

Neither have you.

It is clearly, and obviously, counter-productive to tax wealth or earnings.  Taxing these things penalizes progress in society as a whole, and that which you penalize you will get less of. 

In the 1990s we were told that “welfare reform” would result in hundreds of thousands of children losing their milk (literally) and starving to death.  In fact, after Welfare Reform passed, what we got instead was a dramatic lowering of the out-of-wedlock birth rate, fewer babies born into abject poverty and welfare-receiving homes, and a record number of persons thought to be “permanently” in need of welfare in fact went out and found jobs.  A never-before-seen migration from the poor to the working middle class occurred, and not one child starved.

Why?

Because we removed some of the incentives to sit at home and drink beer.

There are many competing proposals to “reform” the tax system but only one truly changes the base of taxation – The Fair Tax as ensconced in HR.25 in the previous Congress, and as set forth in John Linder’s book (along with Neal Boortz.)

The Fair Tax deserves a full review and consideration for a number of important reasons:

• It immediately removes nearly an entire government department from the “spending” side of the balance sheet (the IRS), shrinking that department to 1/10^th or less of its present size.
• It completely removes the tax burden from the working poor (defined as anyone living at or under the poverty line), including the payroll tax, which is currently the poor’s highest tax burden.  Of the various competing tax proposals The Fair Tax is the only one that accomplishes this goal.
• It is entirely voluntary in that it is a tax only on consumption.
• It creates an instantaneous tax haven in the United States for corporations, which would lead to an immediate and massive migration of firms from around the world to our shores.  Along with their headquarters, of course, would come hundreds of thousands of jobs of both white and blue-collar variety, something we desperately need.
• It is revenue neutral today, and ties government funding to GDP output tomorrow, aligning for the first time the interests of government funding with those of private financial profit.

The Fair Tax has a number of detractors, most of whom have been tremendous beneficiaries of tax policies that have helped the firm or individual involved while punishing a competitor in some fashion.  It comes as no surprise that someone who currently pays 15% in taxes while their competitors pay 30% would decry losing their advantage but the fact of the matter is that if both firms would then pay 0% the general public would benefit tremendously from the gain in employment in both firms and both firms would then have to compete on their merits, not on their lobbying payments.

In short it is time to scrap the IRS and bring The Fair Tax into America.

Economic Policy

We cannot bail people out from their bad decisions.  It is, in fact, that simple.  The bad debt of the previous 20 years must instead be forced to default through withdrawal of all of the ridiculous “support systems” that have been put in place over the previous year.

We have committed more than $8 trillion dollars (and spent upwards of $2 trillion) that we do not have in attempting to prevent the deflationary credit collapse that must come. 

There has been no meaningful salutary effect on lending and won’t because the problem isn’t lack of capital to lend – it’s a (very justified) fear of inability to pay by those who are seeking funds.  The prudent are not going to borrow in economic circumstances such as this and the imprudent can’t pay back the loans – it is therefore impossible to “spur lending” when the only people willing to take on more debt are those who are doing so with full knowledge they won’t be able to cover it!

Deflation is thought of with horror by bankers and “intellectual elite” alike, yet we must have a public policy debate on this matter.  Is it really all that bad to experience deflation?

Let’s take just one example – home prices.  Public policy is concentrated on “keeping home prices from falling.” 

Can I ask why?

If you are a first time homebuyer, do you want a high or low price for that house, all other things being equal?  Is it not in your best interest if the price of the home is lower rather than higher, in that you will spend less of your income to purchase it?

Of course it is.

If you’re a car buyer – do you want a higher or lower price for the car you wish to purchase?

If you’re in the grocery store – do you want to pay more or less for food?

Electricity?

Water?

Sewer services?

Can you find someone who wants to pay more for their goods and services?  Yet a persistent decline in the prices of those things is the definition of deflation.

Who benefits from deflation?

Those who save, are prudent in their spending, and not in debt.  Consumption is limited to things you actually need to buy - prudent spending as opposed to frivolous spending - as prices may fall in the future.  Exactly why is this bad, unless you intend to saddle people with more debt than they can discharge and more consumption than they reasonably require?

Who wants to avoid deflation?

Those who are over-levered, in debt, and are trying to avoid declaring bankruptcy by foisting off bad economic policy on the rest of the nation!

But exactly why is bankruptcy evil and to be avoided?  Is it not the just reward that comes from too much debt – that is, taking on too much leverage in one’s personal or business life?

Of course it is. 

And yet we allow the bankers and politicians to wax onward about how we must avoid punishing the imprudent and rewarding those who are prudent, who have done the right things with their financial lives.

Why is this allowed to continue?

Let’s be blunt – bankruptcy is not an evil thing.  It is a cleansing act, both for the declarer (who has their debt discharged) and for the imprudent lender (who may be forced underwater themselves.)  It is the market-clearing mechanism that enforces discipline upon both lenders and borrowers.

For the borrower, their business or personal credit is destroyed and the trappings of wealth they have displayed (but not been able to pay for) disappear. 

For the lender who extended credit imprudently they are punished decisively as well, perhaps forcing them into bankruptcy.

The argument against withdrawing all these “alphabet soup” mechanisms is that “the financial system will collapse and lead to a deep depression.” 

This, however, is a lie on both fronts; first, the “depression”, that is, a contraction of GDP to sustainable levels (rather than the fraud of claiming GDP growth when in fact all that has grown is debt) is going to happen anyway, and second, the financial system is not necessarily comprised of its present firms; it is the system that must be maintained, not today’s players who have siphoned off trillions of personal wealth while robbing both the taxpayer and the private economy.

It is indeed important to maintain the means by which transactions in the economy can clear and prudent lending can take place.  Nobody would seriously argue that a farmer, for example, should not be able to borrow to purchase the seed for his field, to be paid upon the harvest.  The rate of interest charged represents both the time value of the money borrowed and a premium against the risk of crop failure (and thus bankruptcy of the farmer who cannot repay the loan.)

But this system of finance does not require the current participants; only that there are participants.

Thus, The Federal Government should take approximately $500 billion and charter ten (10) new federal banks with $50 billion of “Tier Capital” each.  These banks would then be immediately IPO’d to the public.  The Tier Capital “lent” to the banks would come with a fairly onerous coupon attached (e.g. 9%?) that would encourage immediate replacement of the government capital with private capital.  

All existing institutions would be barred from participation.

As these new banks would have completely clean balance sheets they would be able to lend (at the usual 8% reserve ratio) approximately 12 times the amount of capital placed into the system.  This would result in a net aggregate $6 trillion in lending capacity in the economy, more than enough to replace the existing lending functions performed by the FHLB, Fannie, Freddie and the commercial banks.

Without the government “teat” to sustain them those firms that had made imprudent bets would be forced into bankruptcy.  The government has already extended FDIC insurance to $250,000 per depositor, and should for a period of one to two years make that guarantee unlimited to protect depositors.

The insolvent banks currently in the system would rapidly fail but the system would remain intact and able to provide its liquidity and lending functions in the economy.  No depositor would lose a nickel; in fact, deposits would gain in value against hard assets such as houses and cars, as the prices for both would collapse rapidly to sustainable levels.

Imprudent firms and their creditors would take severe losses and/or go bankrupt themselves, as would their debtors.  From this path of action we would garner an immediate and dramatic reduction in the total outstanding debt as shown in the above chart, while retaining the security of our financial system and the essential transaction and credit-clearing elements.

In addition, those who have been prudent and saved, along with those new to the workforce and adulthood, would be able to form households well within their standard of living and earnings capacity.

At the same time we must re-enact Glass-Steagall, enforce at least an 8% reserve requirement on deposits to be held in cash (with no wiggle room via “sweeps” and other game-playing), rescind all “23A exemptions”, and demand that all assets be marked to market and consolidated on balance sheets. 

No more Enron-esque games, no more lying about valuations via “models” that are best described as a work of fiction, and no more evasion of Tier Capital and reserve requirements!

In short we must stop rewarding failure, lies and fraud and instead start rewarding success and prudence – something that public policy has not done, with rare exception, for the last twenty years.

President-Elect Obama has proposed a massive public-works project system amounting to perhaps $500-700 billion in his first few months as President. 

One must ask – is President-Elect Obama hell-bent on repeating the mistakes of FDR?

A better suggestion is to instead provide subsistence-level food, shelter and clothing for the displaced and pass The Fair Tax (as outlined above in “Tax Policy”.)  That is, provide bunk-room style places of shelter and sleep, along with nutritious food.  These do not (and in fact should not) be luxurious or even “basic hotel” type accommodations – a bunkroom with showers and a cafeteria is sufficient, as the point here is to guarantee that all Americans have a roof, a shower, a set of clothes and food – guarantees that will be sorely needed in the months and years ahead.  Set these up in major cities across the nation along with at least one in the central part of each state for those who are unable to find work yet require the basic necessities of life, and offer them to all US citizens and legal residents.  Our first and foremost calling as a civilized society is to provide the basic necessities of life – food, shelter, sanitation and clothing – to those who are displaced by bad economic times. 

We do have infrastructure needs in this nation but “make work” programs do not solve economic problems.  Nor does spending money we don’t have.  We must first get our fiscal house in order and that means promoting a “positive carry” in tax collection and GDP; once that has been achieved we then can spend on infrastructure and employment will follow.

Simply put, we need to dig things out of the ground (mine), grow stuff (farm) and make things (manufacture) and then and only then does infrastructure to move all that “stuff” have a purpose.

True economic prosperity comes from converting the positive carry of the earth (and sun) into goods and services, not from building bridges and/or pushing paper.

Today oil has become inexpensive because it is priced on the “last barrel” you wish to burn, and we are burning less of it.  This is a temporary phenomenon born out of our economic malaise, but it will turn around.  We must have an energy infrastructure in place, and “pie in the sky” green plans will not work. 

Simply put if it depends on a tax subsidy be worth doing it we must not engage in it.

The simple fact is that GDP cannot expand at a sustainable rate without energy production expanding as well. Replacing transport fuels with either biofuel or electrical (e.g. plug-power cars) requires a massive upgrade of our electrical generation and distribution system.

So does our future economic prosperity, unless we wish to shackle it to the vagaries of foreign nations that control the majority of the oil we now consume!

Wind and especially solar sound good, but do not pass the economic fitness test except in certain very limited areas.  We cannot provide more than 5-10% of our energy needs from these sources and neither is a particularly good base load generation scheme as both are subject to the whims of weather.

One form of energy, however, is both excellent from a base load perspective and is not subject to the vagaries of nature – nuclear power.  If we are serious about energy and infrastructure you should commit to building 100 new nuclear plants in the next 10 years, and 100 more 10 hence, or a total of 200 new facilities.  Fuel supply is an issue, which mandates that we have a mixture of advanced designs such as pebble bed units and fast breeders that can produce more fuel than they consume, making the installed base of plants fuel-cycle positive. 

The technology to produce fast breeders exists and has since the 1960s; Fermi I was an operational, power-producing plant in Monroe MI that was decommissioned after an incident caused by a design change that had unintended consequences. 

There is no such thing as 100% “safe” energy and never will be.  Life is about trade-offs and it is time for the Office of The President to be honest with the American people about what they are, and why we must choose wisely.  While nuclear power comes with a risk of accidents coal kills tens of thousands a year one at a time as a consequence of emissions and mining byproducts.  Nuclear energy in the United States, along with other advanced nations such as France (which gets most of its electrical generation from nuclear power) have never suffered a death as a consequence of nuclear energy production.

With a revamped and solid electrical infrastructure advanced biofuel synthesis (e.g. blue-green algae via aquaculture producing biodiesel) becomes possible, and primary-plug design hybrids (with an auxiliary engine to prevent being stranded away from a charger) become practical.  Our rail system can be converted to electrical overhead feed, removing locomotives from the diesel consumption bucket.  Between aquaculture and a massive upgrade of our electrical plant brought about by nuclear generation we can move 50% or more of our transportation energy use from fossil fuels within thirty years.

Without both we have no chance of achieving this goal.

FDR did this in the wrong order and greatly prolonged The Depression; we must not make this mistake again!

Health Care

Health care reform is arguably one of the toughest areas to “get right”, as it, along with education, have been two areas of our society that have shown the most “leverage” from the imprudent acts of speculators and leverage during the previous thirty years.

To reform health care we must recognize the following facts:

• “Insurance” is not bought against probable or certain outcomes.  It is a certainty that you will require health care at some point in your life.  Therefore, routine medical care is not purchasable via “insurance”; such a claim is fraud in the first instance.
• We cannot provide the best and most desirable health care to all irrespective of ability to pay.  That is, while all the “wonder drugs” and “wonder procedures” that have been discovered over the last 20 years are great medical advances, we simply cannot provide them to all who desire them but have no ability to pay.  This is a matter of mathematics, not science or political will.
• In the 1970s, as a way around wage and price controls, health “insurance” became coupled to employment.  This has led to enormous distortions in the marketplace with those who are unemployed, retired before becoming eligible for Medicare, or who work for firms that do not (or cannot) offer insurance becoming tremendously disadvantaged.  If you are in this situation and develop a chronic disease at some point you become almost completely uninsurable.  This must be reversed.
• The provision of care to those who cannot pay is currently passed on to those who have insurance.  This must end; serious reform must take place in the provision of hospital care in particular to those who are unable to pay, whether this be through direct federal assistance or other mechanisms, especially when emergency care that can cost hundreds of thousands of dollars is involved.  At the same time the abuse of emergency facilities for routine medical care needs must end.

As a start I recommend we begin with all of the following:

• No politician or other government employee should be able to access medical care plans that ordinary citizens cannot.  That is, if a United States Representative or Senator is charged $500 a month for his medical insurance from his salary I should be able to purchase the same policy he buys for the same money, irrespective of my employment.  We will only see meaningful reform when the political class pays the same amount for their care as ordinary Americans do for theirs.  This needs to happen now.
• We should have policies that force insurers to provide catastrophic coverage (e.g. for expenses beyond $5,000 in a calendar year) at a reasonable cost without qualification as to age or medical record while providing zero coverage for routine care below the threshold.  Such a policy should be able to be issued with a living will that specifies “DNR” for “heroics”, and that should go into the premium computation.  This will encourage people to both seek routine care and negotiate for its provision, as well as paying close attention to the cost of prescription drugs and participate in the selection thereof.  Most of the time there are multiple choices for a given pharmaceutical to treat a given condition with varying effectiveness and cost is and should always be a factor that the patient is involved in when it comes to the decision which to prescribe!  Finally, it will force to the forefront the issue of provision of extraordinary care (“heroics”) in the case of serious acute events that justifiably should leave one with a valid choice of treatment (or not) with a cost (or not.)  If, as a single person with no dependants, I wish to specify “DNR” for such events (which would result in a huge reduction in cost of treatment) I should be both able to do so and enjoy the significantly-decreased premiums that would result from such an election.
• Patent abuse must end.  Currently there are all sorts of games in formulation and format within the pharmaceutical industry that are used to extend patent life.  This must stop.  Patents provide sufficient protection and incentive for development of therapies without “gaming the system”; firms that attempt it should be punished under the law.
• We must codify that medical and dental records are the property of the person who they refer to, and nobody else.  My medical history is none of anyone’s business but mine; it is as unique as my person and nobody should have access to it without my written permission.  Strong, effective privacy controls with strict statutory damages for privacy breaches must be passed and enforced.
• We must have an open discussion and debate in this nation on what we can afford, what we can’t afford, and how we are going to spend the limited number of public health care dollars that exist.  Statistics are that you spend 90% of your health care dollars in the last year of your life.  Whether society is responsible for providing you that last year at no cost to you is a debate that we as a nation must have.  We do not like to talk about our own mortality and death, but both are facts we can no longer ignore and sweep under the rug of fiscal imprudence.

There are no simple solutions to the health care mess, but we must begin somewhere.  Inflation in health care costs has grossly outstripped general inflation in the economy and has largely occurred due to inefficiency, de-coupling of payment from the recipient of service, a sense of entitlement (without regard to ability to pay) among the American People, and an ever-growing demand for “that last year.”  All of this has produced a system that is unsustainable and on the verge of economic collapse, and the above steps will begin the process of reversing this trend without destroying the underlying medical system in the United States.

Released for unlimited public distribution as required under President-Elect Obama’s guidelines for his transition team, submitted to John Podesta, Obama-Biden Transition Project, and published at http://market-ticker.org