I agree with Paul Krugman on at least one thing: the continued prospects for high unemployment in America is a bad thing. In his NYT column Monday, Krugman the Keynesian wrote:

The damage from sustained high unemployment will last much longer. The long-term unemployed can lose their skills, and even when the economy recovers they tend to have difficulty finding a job, because they’re regarded as poor risks by potential employers. Meanwhile, students who graduate into a poor labor market start their careers at a huge disadvantage — and pay a price in lower earnings for their whole working lives. Failure to act on unemployment isn’t just cruel, it’s short-sighted.

Unemployment is currently 10.2 percent, and if you factor out the part-time workers it is 17.5 percent. Banks aren’t lending to the limited demand from manufacturers, further depressing employment opportunities. And the recovery outlook right now is bleak. Krugman is right, we have to do something.

His plan, however, is not the answer. Not even close.

It’s time for an emergency jobs program….  Such a program should shy away from measures, like general tax cuts, that at best lead only indirectly to job creation, with many possible disconnects along the way. Instead, it should consist of measures that more or less directly save or add jobs.

So Krugman wants another stimulus package. Just a question first though, uh, wasn’t the point of the first stimulus to create jobs? And how did that work out?

Krugman responds:

The 2009 Obama stimulus bill was focused on restoring economic growth. It was, in effect, based on the belief that if you build G.D.P., the jobs will come. That strategy might have worked if the stimulus had been big enough — but it wasn’t.

That is something Krugman has repeatedly harped on—the stimulus was too small. But this ignores that GDP growth stimulated by government spending is not sustainable. Roughly 85 percent of the GDP growth from the third quarter this year was due to Cash for Clunkers,  the First-Time Homebuyer tax credits, and direct government spending (defense and non-defense). This is not a recipe for a strong, vibrant economy.

What does Krugman envision the new jobs focused stimulus to look like?

One such measure would be another round of aid to beleaguered state and local governments, which have seen their tax receipts plunge and which, unlike the federal government, can’t borrow to cover a temporary shortfall. More aid would help avoid both a drastic worsening of public services (especially education) and the elimination of hundreds of thousands of jobs.

Okay, let’s stop and consider something. Imagine someone gets a good paying job and keeps it for five to six years. During this time, that person buys a house, a car, a boat, a couple jet skis, and goes into significant credit card debt. But it is okay because the good job allows the person to make payments on the items every month. Then the job goes away. Suddenly all that debt isn’t so easy to handle. This is what happened to the states.

State and local governments aren’t beleaguered as much as they are obstinate. They just don’t want to make necessary cuts. When times were good (roughly 2002-2007) the states ramped up spending given their increased revenues. Now the revenues are gone, but states aren’t making the hard budget choices. They aren’t pursuing efficient government opportunities like divesting assets and streamlining state operations. Sell the boat, get a smaller house, divest the jet skis.

When it comes to stabilizing services, as Krugman suggests, it is also unnecessary to throw more money at them. According to research for the Reason Foundation, if states had limited increases in their budgets from 2002 to 2007 to just the rate of inflation, plus increases in population, then the 50 states collectively would have had a $2.2 trillion surplus to get them through the recession. Yes, the states increased spending on state services by $2.2. trillion more than they had to during the years of plenty. On the whole, state services aren’t suffering as much as they are returning to reasonable levels.

A “job creating” stimulus focused on keeping states from having to make hard, but necessary choices in their state budgets won’t solve the employment problem in America.

So what should we do? Well, stop trying to help. The more companies get bailed out, the more the government is inflating wages, decreasing how many people firms can hire. The more the government taxes companies and increases their compliance costs, the less people those firms hire or keep on. The more the government decreases the incentives to start new businesses, the less places there are to find employment.

There is no silver bullet to fixing employment overnight, but the government can take the necessary steps to ensuring it doesn’t perpetuate the problem further into the future.

A version of this first appeared at Out of Control: A Job Stimulus Is a Bad Idea

Dodd’s plan for overhauling Wall Street regulations, released mid-November, includes a proposed new organization: the Agency for Financial Stability (AFS). This new regulator would be tasked with identifying and addressing “systemic risks posed by large, complex companies as well as products and activities that can spread risk across firms.” This represents one piece of the most extensive proposal to reform financial services regulation—topping even the ridiculousness of the Obama plan and Barney Frank plan. Which is saying a lot.

An Agency for Financial Stability would enjoy unprecedented power over the private sector. To read what kind of power, and how Dodd’s AFS would have the authority to treat Wells Fargo or UBS like Al Capone and the Bonanno crime family, see my recent article at Reason Online.

In a somewhat surprising decision yesterday, former Bear Stearns hedge fund managers Ralph Cioffi and Matt Tannin were found not guilty by a jury of their peers in federal court. Nearly a month to the day after their trial began, the jury ruled that Cioffi and Tannin did not mislead investors nor commit fraud. The AP reports:

A jury in federal court in Brooklyn deliberated about eight hours over two days before finding Ralph Cioffi and Matthew Tannin not guilty of conspiracy and other charges in an alleged scheme that cost 300 investors about $1.6 billion and nearly caused the demise of Bear Stearns itself. The firm avoided bankruptcy in a rescue buyout by JPMorgan Chase & Co.

Both men had been charged with three counts of securities fraud and two counts of wire fraud. Cioffi was also charged with insider trading.

After the verdict, some jurors told reporters that they concluded that the evidence against Cioffi and Tannin was flimsy and contradictory. Other suggested the pair were being blamed for market forces beyond their control.

Having not been in the court room for any of the trial, it certainly would be unfair for me to completely disagree with the decision—especially since it is possible they are not guilty on technical grounds. Nevertheless, I am disappointed by the decision.

To begin with, I certainly don’t believe Cioffi and Tannin should be held to account for what is technically not against the law. We should not judge people ex post facto in this country, not matter the distaste. Neither am I in favor of a Wall Street witch hunt, or of the opinion that the court system should be used to mediate cultural justice. But that said, for all practical purposes, Cioffi and Tannin did mislead investors. And that needs to be addressed.

First, Cioffi was not upfront about pulling his own money out of one account that was losing money. He should have told the other investors he did that, and why. If it’s not against the law to disclose selling your own stock in a fund while it is losing money rapidly, we should consider something to that effect (provided such a rule didn’t create unintended negative consequences).

Second, while Cioffi and Tannin were selling “AAA-rated” securities, the underlying assets of the securities were subprime crap. And it is pretty clear that the fund managers realized this well before communicating anything of the sort to investors. Why else was Tannin so torn up about their investment choices? (This was chronicled in emails from Tannin to Cioffi later published in William Cohan’s House of Cards.) And why did Tannin and Cioffi use wives email accounts to discuss problems with the fund? They had knowledge which they did not share. This is a fiduciary responsibility issue.

It’s not that they lost money. Sure, they pumped Bear Stearns money into the funds as they were going down, praying for a surge in the marketplace. That is just being bad at your job. But when you mislead investors who are trusting you with their money and you not only refrain from being upfront with them, but pull your own money out in fear of a loss, there is something wrong going on.

It might be that they didn’t brake a technical law. In which case, the jury should be praised for not letting their emotions get in the way. But Wall Street shouldn’t take this jury decision as permission to avoid transparency and disclosure. Wall Street should understand that, in exchange for a (relatively) relaxed and free market, they must obey the letter and spirit of the laws. Corruption, dishonesty, and the use of technicalities are crony capitalism, and do not help to make a prosperous society.

This originally appeared at Out of Control on Reason.org: Cioffi and Tannin Found Not Guilty

Those mandates, policy stemming back to the 1960s, were driven by compassion, but have turned out to be the chief cause for the current rampant rates of default, foreclosure, and economic pain striking particularly hard at low-income families.

Such is the story Charlie Gasparino tells in his new book, The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System. Gasparino notes that Cuomo as much as boasted in the late 1990s about forcing Fannie Mae and Freddie Mac to expand their subprime mortgage portfolios. Not slowing down, the George W. Bush appointed Martinez carried the ball forward with great speed, presiding over a period of time where Fannie and Freddie grew to hold a combined $1 trillion in subprime mortgages.

These government-sponsored entities were the tools the government used to try and expand housing opportunities to more and more Americans. A noble goal, but one executed by disastrous means. To begin with, the policies—explicitly set forth by members of Congress and the executive branch—were directly a part of creating the housing bubble. Gasparino nails it in his book, saying:

One of the ironies of the bubble Fannie and Freddie helped create through their guarantees and purchase of subprime loans is that it made housing less affordable, not more so. To own a home, working-class and poor families were now more reliant than ever before on the various gimmicks the mortgage business offered—the adjustable-rate mortgages and “no-money-down” loans that allowed families to live in their homes at minimal initial cost, only to have their mortgage payments skyrocket later.

Government housing policies of the past several decades were the cause of other problems as well, including creating incentives for banks to over securitize mortgages. The implicit support Fannie and Freddie had allowed it to borrow cheaply, spend freely, and act irresponsibly. You, the taxpayer, had their back.

All the while, corruption at the highest levels was rampant. Gasparino also writes of the “Friends of Angelo” scandal, where the CEO of Countrywide gave sweetheart deals to allies on Capitol Hill—including the top Senate banking and housing overseer, Chris Dodd.

Ultimately, the story of The Sellout might be summed up by this line from President Bush at the height of the bubble about the goal of expanding homeownership to more low-income families, particularly minorities:

There’s all kinds of ways that we can work together to meet the goal. Corporate America has a responsibility to work to make America a compassionate place.

That is the attitude that has sunk us today. The crisis started with compassion, it was driven by excessive confidence, and we are paying the price today.

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For more on this topic, also see my Reason Online article looking at other ways the government has been complicit in causing the crisis: The Myth of Financial Deregulation.

Japan spent most of the 1990s screwing around with monetary policy, increasing taxes on its citizens, and spending trillions on stimulus projects. Sound familiar? The result was 10-years of stagnant economic growth, out of control unemployment, and national debt rising to double the rate of GDP, all while the rest of the world laughed at the nation that appeared to be returning to empire status. And that is where we are headed.

Over a year after the start of the crisis, we’re still on a road towards more economic pain. The question at hand has become: is the U.S. economy turning Japanese? That is the question Christopher Wood, author of “The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ’80s and the Dramatic Bust of the ’90s,” asks in The Wall Street Journal this morning:

With the U.S. government stepping in to keep markets from clearing, today’s U.S. economy in many ways resembles the post-bubble Japanese economy of the 1990s. Ultra-loose monetary policy and low demand for credit, combined with high unemployment and consumer deleveraging, could lead to a prolonged slump. [...]

[In post-bubble Japan] banks took years to be cleaned up as a result of regulatory forbearance. The same kind of forbearance is preventing America’s increasingly distressed commercial real-estate market from clearing. Similarly, as was the case with Japan, monetary-base growth has exploded in the U.S. over the past year courtesy of the Fed, while bank lending is declining. This is why there is every reason to fear that America is already in a Japanese-style liquidity trap.

I agree with Wood that we are facing a long period of economic decline and malaise, not a rapid takeoff in the economy. We are not the trough of a V-shaped, or even a U-shaped recession. There are still many things buried in the economic infrastructure of America that need to get sorted out before we have a full recovery. We are facing a W-shaped, double-dip recession… or worse. Consider this:

1. A recovery of the stock market does not necessarily translate into recovery for the real economy. While the Dow is up 50% from its low in March 2009, other indicators, such as unemployment and consumption numbers, haven’t been positive.
2. The Wall Street recovery doesn’t have a stable base. It is being driven by confidence in big firms, but that confidence stems largely from (and is at least dependent on) the government bailout of major financial institutions. And a recovery propped up by “too big to fail” policy is a recovery destined to fail.
3. There are still significant problems in the banking industry. Toxic debt is still hanging around. The securitization markets aren’t functioning (and what little growth there has been is dependent on the government). And bad business models and pay structures were left intact by the bailout process. These problems are likely to manifest in a big way in 2010 as the reality of the faux-recovery sets in.
4. There are still significant problems in the housing industry. Foreclosure rates are continuing to rise. Mortgage default rates will like not peak until the end of 2010. And while the decline in sales from the housing bubble pop seemed to have bottomed out this year, housing sales out West appear to be headed back down, signaling the potential for a nationwide re-decline, (beyond the season adjustment we’re going to encounter over the next few months). Thus, housing troubles are likely to plague the economy for the next 6 to 12 months at least, damping hope for banks to rapidly stabilize their balance sheets, leaving the economy weak.
5. We have still yet to see viable plans for exiting fiscal and monetary policies that are propping up the economy.

We can’t have real recovery without the government out of the way. We need to clear the decks and get all the toxicity (of mortgages and otherwise) out of the system. This is what the market tries to do with recessions, but we haven’t let it yet.

And thus we are starting to look like Japan. Our best bet is to move towards the monetary and fiscal exits and understand what a recovery process means. For more, check out my study on “Avoiding an American Lost Decade” and the corresponding article in Reason magazine, “Turning Japanese.”

Big banks are squaring off against smaller banks in the debate over consolidating national banking regulatory powers. All banks are lining up against financial institutions like hedge funds on the regulation of products like derivatives. Even the regulating agencies are competing against each other in hopes of garnering more power.

Unfortunately, if Congress makes choices on political criteria alone, reforms are likely to damage the country’s economic recovery.

Instead, there are three guiding principles that lawmakers should bear in mind when writing new regulations for Wall Street.

Principle #1: Facilitate competition; don’t stifle innovation

The foremost goal of financial services regulation is to establish a framework for competition by providing a common set of standards—the rules of the game—that offer accountability and enforce the law. Those standards need to promote market discipline, provide incentives for good banking practices, prevent information asymmetry where a few people have significantly better information than the average investor, and discourage harmful business practices.  The rules must not impede the wealth creation process or give certain firms special advantages.

“We don’t want to stifle innovation. But I’m convinced that by setting out clear rules of the road and ensuring transparency and fair dealing, we will actually promote a more vibrant market,” President Obama said when he released his plan to overhaul rules for Wall Street.

The current reforms in Congress aim to avoid future problems by limiting the risk that financial institutions can take when investing. But if facilitating competition is the principle, why not limit new rules and increase the consequences for failure?

Financial institutions should be allowed to limit or expand their own risk, knowing that reformed bankruptcy rules allow for the government to rapidly take them over and break them up if they become insolvent.

This would result in firms competing over safety and soundness, leading to the healthy vibrant marketplace the president wants.

Principle #2: Build resilience into risk management

There is a tension between regulations that anticipate risks and regulations that establish resilience during economic downturns.  Anticipation seeks to preserve stability by planning for and avoiding foreseeable risks. Resilience takes a flexible approach to risk management, accommodating variability, preparing to take acceptable losses in a downturn while making modest gains in strong economies. The best regulations, like the recently updated mark-to-market accounting rules, contain a healthy mix of both approaches.

Regulators themselves are fallible, with plenty of knowledge about the past, but no crystal ball for the future. It is impossible to know every risk and predict every danger. There is value in designing regulations that accept the reality of some financial risks. There will be economic downturns. Some companies will go out of business. And some investors will lose money. You can’t regulate away those realities. Simple, common-sense regulations can provide basic protections and then the market will absorb blows as they come.

Principle #3: Beware of creating perverse incentives

Regulations always have the potential to create perverse incentives that distort decision-making and restrict wealth creation. Bailouts have sent the signal that the bigger a financial institution becomes, taking on increased risk, the less likely it is to fail.

In July, bankruptcy-bound small business lender CIT Group was refused a bailout. Some experts said it was because the company didn’t take on enough risk or grow quite large enough to get a bailout. Even though CIT was ultimately rescued by the market, it wasn’t considered “too big to fail” by the government.

When CEOs see Citigroup or AIG bailed out, but CIT left to the market, the signal is clear: make sure you are too big to fail.

The biggest mistake in President Obama’s proposed Wall Street regulation overhaul makes is that it formalizes “too big to fail.”  Yes, it requires more oversight and regulation, but it actually encourages firms like CIT to unnecessarily take bigger risks so they are eligible for bailouts.

Wall Street reforms should make the consequences of failure uncomfortable. If failure means going out of business, Congress won’t need to set executive pay restrictions and micro-manage capital requirements. Companies will be forced to be more prudent if they are told that there will be no more bailouts and “too big to fail” is a thing of the past.

Getting regulation right is hard work,. Even with their good intentions, regulators too often skew market activity and create perverse incentives for investment. Although many financial sector regulations are out of date and problematic, the restructuring process could cause even more damage if it is not done properly.

This article first appeared at Reason.org.

Which is the same attitude every American should have when it comes to the new consumer financial protection laws President Barack Obama and Rep. Barney Frank (D-Mass.) want to impose on businesses.

Obama first proposed the idea of a Consumer Financial Protection Agency (CFPA) in June as a part of his grand plan to overhaul Wall Street regulations. But it has come under considerable attack recently for fear it would smother businesses and end up hurting consumers. As I write for Reason Online, in its current form, the CFPA will pile on burdensome new rules, restrict innovation, hurt small businesses, increase the cost of doing business, spawn a massive bureaucracy, and create severe conflicts between state and federal law. Frank’s proposed version would even allow the new agency to write and enforce laws beyond the scope of existing legislative authority.

Read the whole piece at reason.com here.