Politics & Policy

The Great Deflation

We must address the clear and present threat to our economy.

Our prosperity stands on the precipice. Concerned Americans demand an explanation of how this happened and leadership that will walk us back from the cliff. But in the White House and along the campaign trail, the purported leaders fail to recognize or refuse to acknowledge the clear and present threat to our economy: the Great Deflation.

The failure to differentiate between an economic recession and this Great Deflation will cause an economically doomed generation.

#ad# But this need not happen. The strength of our economy — its capacity to generate employment, opportunity, and growth — is determined by the quality of its factories and its technology and innovation; by the depth and freedom of its marketplace; and by the ingenuity and efforts of its people. By these measures, we Americans should continue to have the strongest economy in history, and one which continues to grow.

So while our economic challenges are daunting, they can be surmounted. It is only a question of our will to take action.

The Crux of Our Problem

For many years, a cancer grew in our economy — a rapid rise in government spending and debt; an explosion of debt in our banking system spawned by irresponsible leveraging and fueled by in-flows of savings from China and elsewhere; and a rapid rise in home-mortgage debt driven by unsustainable increases in home prices wrought by a massive increase in leverage and lending by government-controlled Fannie Mae and Freddie Mac, and by unscrupulous lending practices. In 2008, this debt cancer decimated our financial system.

Panicking amid this crisis, Washington got it wrong. Instead of reining in government spending, requiring banks to reduce their indebtedness, and providing a plan to help struggling homeowners cope with their debt, Washington made matters worse by:

1. Using taxpayer money to bail out the managers, shareholders, and creditors of banks, and not requiring the failed, bailed-out banks to restructure to reduce their indebtedness. Washington passed TARP to protect bank bondholders and shareholders from suffering losses — and used your money and the money printed by the Federal Reserve to do it. As a result, while bank bondholders and shareholders were made whole (by the taxpayer), the banks remain over-indebted and cannot lend to new businesses. In fact, since 2008 we have been living through the very first period in modern American history in which banks have actually reduced the amount of money they lend. Now, small businesses, innovators, and workers — the primary job generators — lack sufficient access to credit to finance economic expansion and job creation.

2. Massively expanding the federal government’s size and spending on misguided and failed “fiscal stimulus.” In consequence, ratings agencies have downgraded the once premier “full faith and credit” of the U.S. government. Now, it will cost our government much more to borrow money to pay its bills. This is a national disgrace, and it will cost us dearly if we do not fully restore our credit rating.

3. Ignoring the problems created by massive home foreclosures. These include the devastating impact on families who lost their homes, falling home values in neighborhoods blighted by foreclosures, and the negative impact on the economy of families forced to drastically reduce their purchases of goods and services from our producers.

4. Ignoring our trade deficit with Communist China and its predatory, mercantilist trade practices — including selling us subsidized manufactured goods and, instead of buying our goods, hoarding our money and lending it to our government and our banks.

5. Engaging in a policy of “quantitative easing.” While we are in a period of “debt-deflation” — a vicious circle of falling asset prices begetting debt defaults, and requirements for more collateral on loans begetting yet further asset-price declines — the Federal Reserve’s policy of monetary expansion has not spurred the economy and risks eventually igniting inflation, with all of its ill effects.


The Solution

With our stagnant economy burdened by Washington’s failed responses to the Great Deflation, we must immediately commence rectifying these mistakes:

1. We must rein in government spending in a transparent and credible way. A good start would be to immediately convene the deficit-reduction committee appointed as part of the debt-ceiling deal, and ask them to quickly adopt a no-gimmicks, honest set of cost reductions that will restore investor confidence in the fiscal responsibility of the U.S. government. The members of this committee should rise above partisanship and perform their task as patriotic Americans in a time of crisis. This will inspire confidence and increase investment in the U.S. economy, which will spur job growth.

#ad# 2. We must require our banks to immediately reduce their indebtedness — so they have the capital to resume lending to our small businesses — and without any more taxpayer money. If a bank cannot raise more equity capital by selling shares, then it must convert some of its non-depositor debt into equity — even if this causes bondholders and shareholders to suffer losses. Banks should be required to have 20 percent of their assets in the form of readily available capital (tier 1 capital, Basel III definition), 15 percent of it in the form of shareholder equity. Once the banks have achieved this goal, they will not only have sufficient non-debt capital to resume lending, but they will have a large equity cushion that will make taxpayer bailouts unnecessary in the future.

3. We need to resolve our mortgage crisis. Nearly 30 percent of homeowners have mortgages that exceed the value of their home. This is not necessarily their fault, as we have lived through the largest decline in home values in our history. Life savings have been wiped out. We need to take action to stop this devastation. When lenders foreclose on homes, they typically suffer losses that exceed 30 percent of the value of the home Therefore, we need a voluntary program to offer homeowners a deal whereby, in exchange for reducing their mortgage debt to a level equal to 90 percent of home value, they would commit to pay their lender half of any future sale or refinance proceeds they receive.

This should not cost the lenders anything, because they would save on foreclosure costs (through reduced foreclosures), and gain from future appreciation in the value of the homes. Fannie Mae and Freddie Mac, which currently own over half of home mortgages and are controlled by the federal government, should immediately make this offer to all their customers, and our bank regulators should adopt a rule assuring any bank that makes this offer to its mortgage borrowers that it will not suffer a reduction in the regulatory capital value of the mortgage. Any issues arising from implementing this proposal for mortgage-securities pools should be addressed so as to remove the obstacle. This plan will end the devastating foreclosure fever and stem the erosion of home values, once and for all.

4. We need to comprehensively combat Communist China’s predatory trade practices, including its currency manipulation, which unfairly enables its manufacturers to undercut our manufacturers and allows the PRC to accumulate savings that fuel debt in our financial system.

Once implemented, these urgent reforms will mark the beginning of the end of the Great Deflation; and the end of the beginning of restoring our prosperity and affirming American exceptionalism in the 21st century.

— U.S. Representative Thaddeus McCotter represents the 11th District of Michigan, and is seeking the Republican nomination for president. 

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