The Dominant Campaign Question

What issue(s) dominated the presidential campaign two months ago—foreign policy, taxes, health care? That seems like ancient history now. The one question that everyone wants Barack Obama and John McCain to answer now is: What will you do to fix the economy? This question is certainly understandable, but breathtakingly preposterous and pathetic.

Naturally, America’s attention is focused on the economic crisis. It is clear that something—actually, a lot of things—have gone terribly wrong. Our financial system is in tatters, the housing market continues to deteriorate, and even once-mighty GM appears terminal. We worry about our banks being safe, our jobs being secure, and our retirement plans surviving the ongoing economic earthquake. We are uncertain, scared and/or stunned. More than anything else, American voters want the candidates to reassure them that everything will be okay and that a President Obama or President McCain will restore normalcy.

As natural and understandable as everyone’s concern is, the glib question posed by journalists and pollsters—“What would you do to fix the economy?”—is preposterous. Do you really think that the presidential toolbox contains instruments to determine the “right” price for each of the millions of houses; the “right” interest rate for each of the millions of mortgages; the ability to unwind trillions of dollars of leverage in the financial system; the wisdom to manage banks, insurance companies, pension funds, etc.—and to attempt such undertakings without causing painful economic disruptions? Forget the Constitution here (the political class already has). Even if you give the president unlimited powers, he and his team—no matter how bright they are and how hard they try—cannot possibly “fix” our enormous and complex economic mess.

It is pathetic to see Americans holding out blind hope that a mere president has some sort of magic wand that can make these problems go away so that we can live happily every after. The very question—“What can you do to fix the economy?”—is shockingly ignorant. It presumes that the President of the United States either has supernatural powers (see “President, Savior, or Santa Claus”) or that he has or should have the political power to construct a “great society” with a vibrant economy through central planning. Such a question is more appropriate for a communist country than for a free (formerly free?) society.

Neither candidate is speaking economic truth. There is no clear explanation of how government policies caused this mess. Neither candidate understands that if markets are allowed to adjust prices to reflect actual values, then the economy will return to solid footing faster than if government continues to nationalize businesses, inflate credit, and engage in the hubris of central planning.

Instead, economic nonsense emanates from both camps. McCain, for example, wants government to prop up housing prices even though the housing crisis was caused by policies and practices that resulted in houses reaching prices far beyond the affordability level of many Americans. The market is trying to correct over-inflated housing prices to lower, more rational levels, yet those who would be president want prices to remain at lofty, unsustainable levels. Of course, the reason for this is to try to keep the myriad financial assets based on home mortgages from crashing. But until those malinvestments are liquidated, the scarce capital will be used to prop up essentially bankrupt firms instead of creating new wealth, thereby retarding economic growth.

Speaking of capital, the Federal Reserve is reported to be supplying trillions of dollars of capital to financial institutions. These reports aren’t quite accurate. True capital represents actual savings. When the Fed “injects liquidity” into the financial system, it is creating ersatz capital out of thin air. That “capital” has no economic substance, but it does have the potential to distort economic decisions, just as any other inflationary policy distorts activity by making capital appear to be more abundant than it really is.

Politics is entirely responsible for the present crisis being as extensive as it is. The reason is that no president wants to let market corrections happen on his watch. Thus, instead of letting Long Term Capital Management collapse in 1998, which would have punctured the stock market bubble and triggered demands for prudent limits on the creation of derivative instruments by financial firms, President Bill Clinton and the Fed managed to pull some strings, paper over the problem, and issue easy credit. The result was a bigger stock market bubble and the beginning of the real-estate bubble. Rather than let the market sort things out after 9/11, Bush leaned on the Fed to lower interest rates, and the housing bubble really took off.

Today, because of those earlier political interventions, there are more malinvestments than ever. The liquidation of these massive malinvestments would be so jarring that all of official Washington is striving to postpone the day of reckoning with government controls and more easy credit from the Fed. Sooner or later, though (and it looks like sooner) economic reality will prevail and the necessary adjustments will take place. To the extent that any president can delay that inevitable process, the ultimate adjustments will be that much more painful.