Government cannot stimulate PERMANENT or temporary growth.

I agree with the first statement and disagree with second. Although Government CAN create permanent jobs, that would mean either bigger government or socialism. Both are bad ideas. Having said that, government can and must lead temporary job growth. The reasoning is simple. If private industry will not start new projects, the government has to. There is no third party which will suddenly start hiring people.

Let me also clarify that I am not talking about “job growth”. I am talking about temporary jobs generated by awarding government contracts. I am talking about purchases made by the government that create jobs in the private sectors. From the point of view of pure job creation, it doesn’t matter what value the jobs deliver, as long as most of the money spent here, flows back into the economy and doesn’t get saved. Money that flows back into the economy creates more jobs and has a domino effect. Money that gets saved, sits in someone’s bank account, and the banks aren’t lending. Of course, considering the fact that this money will need to be paid back some day, it is better to spend it on projects that matter, but liquidity has to be the primary focus.

Secondly, the key word again is STIMULATE, not socialism. If the effort is big enough and quick enough, the banks will start lending again and the private industry will take over the job creation. At that point, the government must focus on balancing the budget.

It was FDRs and Hoovers meddling with the economy that made a recession into a depression. I see a lot of FDR in President Obama and I see a combination of INFLATION and Unemployment ahead. Please read “The Forgotten Man” and Bert Fulsom book on the depression of the 30s. You will see a lot of parallels to today.

I haven’t read either book, so I can’t comment on them. Nor can I comment on parallels between FDR, Hoover and Obama. I will say this – today’s United States is far removed from pre-WW II United States. Back then, it was just another country, powerful, but far removed from the rest of the world. After WW II, US became the center of global economy. Even after the Bretton Woods System of fixed exchange rates is long gone, what US thinks and how US behaves has a huge impact on global economy.

2nd, Government is the root cause of our current problem. If government did not create the artificial demand in housing via the Community re-investment act and create cheap money, none of this would have occurred.

I wish it were as simple as that. As we all know, monetary policy is a moving target. You make it too tight and you risk economic slowdown. You make it too loose, you risk inflation. That is why the government is constantly tweaking it to try and match it with the industry outlook. I should also point out that no government gets it right all the time – precisely because this is a moving target. Singapore is an exception, but it is much too different to be used as a model for the US economy.

My explanation of the housing market is misalignment of interests of the players compounded by complex financial instruments (i.e. securitization and the notorious credit default swaps). Let me explain.

Here is how the housing industry works. The mortgage brokers sell the mortgage for an upfront one-time commission. They are not responsible for what happens to the mortgage. The bank lends the money, and then, in turn, sells the mortgage to consolidators like Freddie Mac. The consolidators securitize the mortgage and sell slices to institutional investors, university investment funds, sovereign funds, etc. The bank, thus, recovers its cash to lend again and the cycle continues. The problem was caused by two parts of this chain – the brokers and the securitization.

Firstly, the misalignment between sales people and operations (we all in business world know this). Sales people get paid on revenue generated, while operations people get paid on profits made. In case of the housing market, the sales people were the mortgage brokers who sold as many mortgages as they could without bothering to check if they will ever be repaid. The bank, which would, under normal circumstances, ensure the quality of the loan, didn’t scrutinize hard enough. They saw the housing market boom, expected it to continue, and figured that even if the borrower cannot pay back, the property will appreciate enough to pay for itself. So, the bad mortgages went unnoticed.

Next problem was securitization – in this case mortgage backed securities. Securities are created by pooling bunch of loans together and then selling slices of these loans at different interest rates. For example, the entire pool is expected to yield 10% with default risk of 5%. The consolidator creates three slices – low risk, medium risk, and high risk. Low risk yields low interest rate but has minimal default risk – good for fixed income funds. Medium risk yields a bit higher but has a higher default risk, and so on. Nothing wrong with securitization per say, because it makes the mortgages more fluid. The problem was with the expectation of default risk. In hindsight, as it turns out, the default rate was underestimated. When the defaults hit, all of these securities lost tons of money, causing the market crash.

Finally, what about Credit Default Swaps (CDS)? These were created as insurance for funds that were invested too heavily in the securities mentioned above. So, if you had X dollars of securities on your books, you bought a few CDSs. If some of the securities indeed defaulted, your insurance would make the pain less severe. While CDS is intended to work like insurance, the difference is that you don’t actually need the security to buy a CDS to protect you from default. You can buy “naked” CDS in speculation of a default. Some firms did that, and as we know, AIG went in the red.

Could the government have done anything to prevent the chain reaction? Certainly, in hindsight, they could have increased the interest rates to tighten the money supply. They couldn’t have, however, prevented people from believing in the housing market boom. That belief, and not the money supply, in my opinion, is the root cause behind loose lending.

I don’t know if Obama is socialist, nor can I comment on his (or the democrats) involvement in creating the problem. I do, however, believe that most of what he is doing now is economically sound (barring cash for clunkers program).

3rd, who is doing the due diligence on any of these policies? There are passing sweeping legislation e.g. Cap and Trade, the health care bill, the so-called stimulus without any due diligence. We are going to have massive inflation. When China and other countries stop buying our bonds – what is going to happen to the dollar?

That is a fair question. If we are going to go on the hole, are we prioritizing correctly? I don’t know if we are and I don’t know if we are not. I do know that we will not have a massive inflation.

This is not the thirties anymore. For a country like the US with large international trade, inflation will mean currency devaluation. Since WW II, US has been the center of the world economy. While prolonged consumerism has deteriorated its position, the next best economic entity, the European Union, is far from taking over the central spot. So, the world can not afford for the US to go into massive inflation, least of all the Chinese.

China (and others) can’t pull the plug on buying our bonds. Like it or not, they are joined at the hip with us. China has to continue to export to the US for the sake of its own economy, whether it gets paid in cash or US bonds (As recently as few weeks back, the Chinese premier whined about American irresponsibility, but stopped way short of suggesting that they should stop buying US debt). If they don’t continue to export to us, they will either have to export a whole lot more to other countries, somehow create massive domestic demand, or slow their economy down. None of these alternatives are very promising to China. While I am tempted to continue to blabber about why China can’t exercise any of these alternative, I think that it is best that I stop here.

I will just add one more thought on how US can get out from under massive debt. My answer is the same it was before the current economic slowdown – savings and investment. American people need to stop spending more than they earn and save for their future. That money, and not money lent by the Chinese, needs to be the growth engine for the US economy. If Americans can pay for their purchases in cash, obviously the foreign debt also gets repaid.