Financial Matters

by Roland Straten

Contents:

1.  Free Market Economy

2.  2008 Financial Crisis

3.  What needs to be done

The Free Market Economy

Summary

A free market economy is one where individuals make their own economic decisions.

It is an elegant theory, which leads to a society growing without government enforcement.

There are three problems with free markets:

1)    They tend to cycle

2)    They can be thwarted by monopolies

3)    There are some commodities where free markets do not work.

When I get to Washington I will:

1)    Be an advocate for free markets with minimal regulation to smooth out short term cycles

2)    Support legislation to prevent monopolies especially companies that become “too big to fail”

3)    Look very closely at any legislation where it is claimed that free markets do not work.  Vote no if it is determined that free markets will work

The Economy and the Government

One of the key issues this election is the economy.  Yes, government has a role in the economy, but it must be restricted, well defined, and executed properly.

There is a range from a free market economy to a centralized planning economy.  Do not confuse a free society versus dictatorship with free markets versus centralized planning.  While centralized planning is usually associated with a tyrannical government, the two are separate.  By and large the US has had both a free society and a free market.  The Soviet Union had both a tyrannical government and centralized planning.  China has very limited freedom, but a relatively free market.  I cannot think of an example of a free society and centralized planning except that some of the European countries are tending in that direction with their movement toward socialism.

What is a free market economy?  It is an economy where individuals are free to make economic decisions based on their wants and needs.  The supply/demand curve is defining.  When individuals produce something, the supply goes up driving the price down.  When individuals want something, the demand goes up driving the price up.  The concept is elegantly simple and in the long run demand will match supply because price will alter both the supply and demand until they are in balance.  Its primary benefit is that millions of individuals can do what they feel they do best and reap the rewards or costs based on what they do.

This system does not require enforcement by a higher authority.  It balances on its own and as individuals increase their own wealth, society as a whole benefits.

There are a few problems with the simple model.

The first is that the natural order of things will cycle.  Any dislocation such as a change in weather can cause the system to go out of balance.  Most dislocations will be quickly brought back into balance, but sometimes people overreacting can magnify a slight out of balance situation.  When the overreaction is too great, it will create a bubble or depression that will hurt many people until the system naturally returns to balance.

The second is that the normal supply and demand can be thwarted by large monopolistic organizations that can override market forces.  Government is the major monopolistic organization and can cause the most damage to a free market.  But large companies and extremely wealthy individuals can also control the market by artificially influencing either supply or demand.

Finally, there are some commodities whose nature does not allow a free market to operate efficiently.  Examples are roads, police, fire, and electrical distribution.  Either government ownership or a high degree of regulation has been accepted for these types of commodities.  The problem is that government tends to expand its control into areas where a free market works.  Two examples of areas where free markets work, but are taken over by government are health care and education.

You have read the theory.  How does this translate into practical actions for someone planning to go to Washington and set the economy straight?  Here are three actionable items derived from the above:

We need an advocate for the free market wherever it will work.  Government does have a role in smoothing out the really deep cycles such as circuit breakers in the stock market, controls on over excessive speculation, but government controls should be short term.  Limiting the amount that a particular stock can rise and fall in one day would be such a control as long as in the long run the stock is allowed to find its proper level in the market.  Bailing out failing companies is not one.  If a company such as General Motors, who basically owned the automobile market in the 50’s, runs itself into the ground by poor management, billions of dollars from individuals and small businesses who have already been hurt by that mismanagement should not pay to keep it alive.   I will be an advocate to keep government out of the free market except for short-term regulations to curb excessive cycling of markets.

Government also has a place in making sure companies do not grow too big.  I will be an advocate of small business and encourage legislation that will prevent companies from becoming monopolies or too big to fail.

We need to be very selective when determining which industries need to be government owned or regulated.  There are very few of them and the government should keep its hands off the rest.  I will vote against any legislation where a free market would be better than government ownership or tightly controlled regulation.

The 2008 Financial Crisis

Probably one of the biggest issues facing Congress in the next few years is how we can continue to have a stable economy that provides jobs and products to our citizens.

One of the key elements in a smooth stable economy is our banking and financial system.

In 2008, the system experienced a near meltdown.

As your potential Congressman, you deserve to know my analysis of the crisis and what I would do about it.

Before going into details, it is important that you understand a bit of my background.  I studied engineering at Duke University, served in the military, and received an MBA from Tuck School at Dartmouth.  I worked for a number of years in the financial planning department at Union Camp Corporation where much of my time was spent analyzing economic conditions for the company.  I successfully predicted the downturn of paper prices in 1970, created a computer simulation of tree growth, and performed many analyses of potential acquisitions.

This experience plus the forty years of running a small business has given me the knowledge necessary to make the needed decisions.  My expertise is clearly far above that of our current Congressman.

What caused the 2008 crisis?  It started with something called the Community Reinvestment Act (CRA). This law, which was enacted in 1977, was designed to encourage the banking industry to provide mortgages to people in low and moderate income neighborhoods.  While this act was laudable in its purpose, which was to allow home ownership to disadvantaged, minority, and low income people, it went too far.  Every bank received a CRA evaluation depending upon its performance in investing in the CRA communities.  A low evaluation could prevent a bank from getting approval for additional branches.  Slowly over time, this law was interpreted and modified so that it was forcing banks to lend to people who could not possibly meet the payment obligations.

At the same time, the financial industry developed creative solutions to the problem of a bank having to hold mortgages that were clearly risky.  Financial instruments called Collateralized Mortgage Obligations (CMO) were developed that would allow banks to sell their mortgages to consolidators who would join many mortgages into bonds.  These bonds would then be sold investors.  At first these instruments were rather benign, many being sold by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC) all government sponsored corporations.

The availability of easy money spurred the housing market bringing more and more people into riskier purchases.  This demand put pressure on the financial markets creating an opportunity for large investment banks.  In 2001, large investment banks such as Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns decided to get into that market.  The atmosphere of deregulation, the repeal of Glass-Steagall by the Financial Modernization Act of 1999 (“Gramm-Leach-Bliley Act”), and the deregulation of credit default swaps by the Commodity Futures Modernization Act of 2000 allowed the large investment banks to: 1) create ever more aggressive CMO’s and 2) insure them with credit default swaps which would allow them to be resold as high quality investments.

More easy money resulted in ever-increasing housing prices that in an upward spiral fueled an even larger demand for easy money creating the now well-known housing bubble.  Since the entire market was dependent upon increasing housing prices so that those with poor credit and speculators could easily refinance, even a pause in housing prices would lead to disaster.  When this happened, our financial market suffered a near collapse causing the current economic crisis.

Government intervention in the private sector skewed the market.  What might have been a minor cycle in housing became a serious irrational bubble followed by a major collapse that caused a major recession if not depression.

What needs to be done

My slogan is Less Government – More Jobs

It really says it all.  Small businesses have been the major contributors of new jobs to the economy.  They have been over-taxed, over regulated, and harassed every step of the way.

Removing the shackles of government from businesses and allowing the free market to allocate capital and resources efficiently is the best way to create jobs and have an economy that benefits all of our citizens. The government must allow private enterprise — especially small business — to flourish, not by government spending, but by eliminating over regulation and excessive taxation.

We need smarter regulations.

We need lower taxes.

We need to help small business.

In every vote I cast, I will consider whether the issue at hand could be better resolved by lower levels of government. Part of our economic problem stems from the federal government getting involved in matters that should be handled by states and municipalities. Instead of expanding and getting unnecessarily involved in even more aspects of the economy, the federal government should focus on becoming more efficient and lowering taxes.

First Priority – Allow Business to Create Jobs

Republicans are continuously attacked as being the party of NO. The truth, however, is quite the opposite. The solutions offered by Republican candidates are largely ignored. Even though the recession has been officially declared over, tell that to those who are feeling the effects of a 9.6% unemployment rate. Some very important actions are needed to provide a vibrant economy.

Since Bill Pascrell and Nancy Pelosi do not understand Economics 101, which covers the concept of free markets and the supply/demand curve, I am forced to give them a failing grade and move on to Business 101.

The first lesson in Business 101 is that the massive stimulus package that was to give us an 8% unemployment rate during the summer of recovery did nothing of the sort. Instead, it gave us a 9.6% unemployment rate and the largest deficit in the history of our country.

The second lesson is that business does not like uncertainty. Corporate leaders will do anything do avoid uncertainty.

The third lesson is that business hates surprises, especially from Washington. Business wants to know the bad stuff up front so they can plan for it. I used to tell my employees to give me the bad news right away so that I could take the needed action to minimize the effect on the company.

Three major sources of uncertainties and surprises are:
1) Taxes
2) Health Care Costs
3) Cost of Capital (Interest rates and loan availability)

For business to expand, invest, and hire, it needs an end to the uncertain ty about what Washington will do next year. Businesses are just completing their budgets for 2011. How can they plan effectively if they do not know what their tax rate will be, if they do not know what their health care costs will be, and if they do not know if they can get a loan or what that loan will cost should they need one?

Right now congress is fiddling while Rome is about to be burned with a massive tax increase. No one knows for sure what will happen. We hear that congress will do something, but we have no idea what that something is. Everything is on hold until we get some insight on what Congress will do next year. Unless Congress, acts we will have a massive tax increase on Jan 1, 2011. Unless Congress acts, we could have a massive incre ase in health care costs next year. And finally, loan costs could skyrocket or loans could become totally unavailable.

As a result business is sitting tight not spending, not buying, not hiring — doing nothing until they find out the bad news so they can plan.

Our federal government must take three simple actions and business will start hiring and investing ending the no job recession. I forecast that if we take these three simple actions, the unemployment will rate will be 8% or lower 2 months after they are signed into law.

The three actions are:
1) Make the current tax code permanent. (extend the current tax code permanently)

2) Repeal the current health care bill known as the Patient Protection and Affordable Care Act. Address the key health reforms that need to be made: Allow purchase across State lines — Tort Reform – Delink healthcare policies from Employers — Health Policies should be transportable — Reduce Mandated benefits — Keep Medical Decisions in hands of Doctors in Patients

3) Allow the federal discount rate to increase to 2% (the federal discount rate is now .75%) — this allows banks to borrow at almost nothing and lend out from 4.75% to 18% — individuals get minimal return for their investments and need to get some return on their investment. Interest rates must be set by market forces, not kept artificially low to give a windfall to the banks.

If Washington does these three simple things, I forecast that within two months unemployment will drop to 8% or below.