Lester Thurow on Sub Prime Credit

It is always nice to propose a bold solution to an economic crisis and to see it mirrored by a leading economist a couple of weeks later. See my post march 17 on credit stabilization

Lester Thurow makes three recommendations. His first on marking the mortgages to market, eating the loss and saving the borrowers differs from my proposal only in not going the extra mile whereby a fifty percent stake over strike price is retained in the property until sold years later. This is a disaster internal to the USA that has been partially passed on to the global financial system. The USA oversight mechanism has been caught napping and must accept guilt and pay the piper. This is the best possible fix. Right now, our failure is toying with putting the global economy into a massive tailspin and global economic contraction that will take a decade to recover from.

The alternative is to allow the destruction of wealth to continue its natural course over the next several years. The real losers will still be the same lenders, and most of that money likely came from pension funds whose net worth will contract. The individuals will walk away and spend years putting it all back together slowly. The proposed solution will hugely shorten this recovery period.

Imagine the damage if the savings and loan debacle of the mid eighties had been solved by stiffing all the depositors.

The sooner we get started on this emergency legislation the better.

Lester’s other two recommendations are not nearly as compelling or even wise.

$100 oil exists for a very good reason and that is to encourage a crash program of energy expansion. This is happening now. The only glitch is that it takes a few years for the influx of fresh capital to be organized and deployed. The most critical investment in THAI started last year with a mere $40,000,000. Next year that will be $500,000,000 and then it will be five billion and then perhaps between 2010 and 2015 it will be fifty billion. Thereafter, this technology will be generating many millions of barrels of oil per day and prices will slowly subside to levels that balance demand. While this is all happening, the global economy will pass through a massive readjustment with necessary new energy strategies and economies.

Outsourcing is another false economy. The global economy is driven by consumption. The consumer has a finite supply of cash in his jeans. Perhaps fifteen percent of that cash ends up going to the primary manufacturer’s labor force. The rest goes to the fine art of delivering those goods into our hands. All that money gets spent domestically.

Yes our manufacturing job sector is expanding very slowly, but the rest of the economy has boomed getting those imported goods into our hands. Quit chasing those lost milling jobs that paid sweat shop wages to poor immigrants (now illegal) and support high end skilled jobs in the industries we are good at. It worked for the Europeans and it will surely work for us. There is a lot to be said for dynamic destruction.

Do you really think that we would have had the wide screen TV screen anytime soon if the manufacturers were relying on production runs aimed solely at the USA market? The market is now a global middle class of one billion on the way to two billion. Our ultimate share of that market is going to be fifteen percent and declining.

The market is inevitably taking care of the latter two issues and the USA is not necessarily a leader there for much longer. This has the benefit of producing an army of natural economic allies that share our interests and will carry a lot of the heavy lifting. I would much rather see Europe and Japan negotiate beneficial terms of trade than to be dragged into it as lead and getting blamed for every misstep.

The sub prime issue is made at home and we must do our own housecleaning. It cannot and must not be exported as the great depression was exported in the thirties. If we do this fix, the housing market will rebound quickly and within five years it will be largely a bad memory just as was the savings and loan debacle.

It's got to hurt before it gets better

There are solutions to high oil prices, the housing crisis and outsourcing, but they require some sacrifice.

By Lester C. Thurow

April 11, 2008

The financial crisis in the United States is not a crisis if you do not want to sell your home, do not have a house with a sub-prime mortgage and have a good job that you are not about to lose.

Very few Americans have to sell their homes right now. Those who bought a house on speculation get what they get. After all, they "speculated" and lost. Very few Americans have a sub-prime mortgage. Those with bad credit have bad credit. Most have a job they are not about to lose.

So what is all the fuss about? The meltdown of the financial markets.

Shouldn't we just let the big guys lose? After all, they are big guys. The answer is no. The credit markets, like those before the 1929 crash and during the Depression, affect us all.

What should be done?

The answer starts with the heart of the problem: the sub-prime mortgages. These mortgages have to be written down to less than the current value of the house so that if the borrower walks away, he or she has something to lose. The government (taxpayer) is going to have to pay to write down these mortgages. This is the subsidy -- and the only subsidy -- that should be given to the lenders.

If the borrowers don't walk away from their sub-prime mortgages, there is no crisis in the financial markets.

In the future, we can regulate the markets to prevent sub-prime mortgages. But that is the future. Let's get to the real crisis: the rising cost of oil and the outsourcing of American jobs.

There is a solution to the rising cost of oil, but it is a painful one. Let's say there is a lot of $20-a-barrel oil in the world -- deep-sea oil, Canadian tar sands. But who would look for $20-a-barrel oil if someone else (Saudi Arabia) has lots of $5-a-barrel oil? The answer is: no one.

Basically, American taxpayers have to guarantee potential producers that the price in the future will not fall below $20 a barrel and that they will not lose their investments.

This is easy to do. The U.S. needs to guarantee that it will buy all of its oil at $20 a barrel before buying anything from OPEC. This forces the price of oil down to $20 a barrel, but it eliminates the possibility that it will ever go back to $5 a barrel.


Outsourcing has an equally simple solution. Let us encourage the dollar to fall. At some value of the dollar, it will pay producers to bring jobs back to the United States.

Suppose the dollar has to fall a lot -- let us assume 50%. Who cares? Only those Americans who plan to take foreign trips or buy something abroad. It costs them more. For those who want to go to the tropics, there are the U.S. Virgin Islands. If the solutions are so simple, why don't we do them? Because all of them are painful.

Write-downs for sub-prime mortgages cost money. Oil at $20 a barrel guarantees there will be no $5-a-barrel oil. A lower dollar guarantees foreign trips and purchases will cost more.

We have Herbert Hoover when we need Franklin Roosevelt. Luckily, we will have a new president and a new Congress come January, but January is a long time away.

Basically, we require changes from President Bush now. He needs to propose a write-down in the sub-prime mortgages, propose a guarantee in the price of oil and let the dollar fall. Unfortunately, the first two are not likely. Only the third will happen with or without his approval. As long as we have a large current account deficit, the dollar will fall. It has to for some very simple reasons.

To get foreign currencies to pay for the deficit, we must borrow from abroad. Eventually, foreigners get tired of lending because they will lose money on their holdings of dollars if the dollar falls further.

At the same time, the big American guys move money into foreign currencies to take advantage of the falling dollar. When they move money back into dollars, they have more dollars. Essentially, they have an infinite amount of money to move.

As they move money, the current account deficit gets bigger and bigger, and the pressure on the dollar to fall only grows.

We need to do something! Take painful actions! Gridlock is the worst of all worlds.

Lester C. Thurow is a professor of management and economics and dean emeritus at the MIT Sloan School of Management. His latest book is "Fortune Favors the Bold: What We Must Do to Build a New and Lasting Global Prosperity."

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