iF: Some are saying that U.S.-led capitalism is dead. How do you respond?
SF: U.S-led capitalism will revive again once we fully grasp that it was government policy, not a failing of the private markets, that made possible this disaster. The main cause of this crisis was the Federal Reserve creating too much money five years ago.
Everyone talks about the bubble, that money poured into housing, with all those crazy derivative instruments. Well, where did the money come from? It came from excess money being printed by the Fed, which is why there was a commodities bubble in 2004, and then the housing bubble, and the subsequent disaster.
The government also created Fanny Mae and Freddie Mac. Then the government compounded mistakes with such things as mark-to-market accounting rules, which destroyed bank capital, and removing barriers to short-selling.
This made possible the conditions that led to the excesses we saw.
iF: do you blame Alan Greenspan?
SF: Alan Greenspan was the head of the Fed when this started. Ben Bernanke succeeded him at the Fed and continued Greenspan's policies. So, yes, they are to blame. Treasury Secretary Hank Paulson bears the blame for our weak dollar policy, something he wanted. The SEC [Securities and Exchange Commission] is responsible for mark-to-market accounting rules, and for not enforcing the rules against short-selling abuses. So, there are plenty of culprits to blame.
iF: Will the Obama stimulus plan work, or will it create massive debt for future generations? How would you have done it, had you been charged with creating a stimulus plan?
SF: The stimulus spending will have a minor impact in terms of economic growth. The rebates it gives taxpayers are one shot deals; they are not permanent. The spending is simply a grab bag of programs that liberal chairmen and chairwomen in the House had wanted to enact for years.
If leaders had wanted a true stimulus spending program, they would have cut payroll taxes, the FICA tax, in half for two years. That would have cost the same amount of money, or less. In fact, it would have been a "two-fer."
First, people would have gotten more money right away because the amount in payroll tax exacted would have gone down. The cost of hiring and employing people also would have gone down, because that 12.4 percent payroll tax, or 15 percent payroll tax, is on both employer and employee. If you reduce that tax, you reduce the cost of hiring people.
I would also have introduced a flat tax, but that's not on the table right now.
iF: I want to get to that in a minute. But first, what about the current socialist-style approach to health care?
SF: We should have learned from the experiences of Canada, Europe, and Japan. A socialized health care system destroys innovation. It also makes for shortages in health care, which is why patients in these countries experience longer waits for elective surgeries, such as hip replacements, than patients in the U.S. do.
So, it's like what took place in the Soviet Union. Everything was cheap, but everything was in short supply.
iF: Getting back to tax reform, where do things stand on that front?
SF: Well, tax reform has been on the back burner for this administration. They appointed Paul Volker [chairman of the newly formed Economic Recovery Advisory Board]. He is to come up with recommendations in early December, so we'll see where that goes.
However, we should keep in mind that 25 countries around the world have enacted a flat tax, and it has worked very well where it's been applied. So a flat tax is no longer theoretical. It now has real world experience behind it.
The danger in this country with tax reform such as a flat tax is that liberal democrats might try to combine it with a European-style Value Added Tax [VAT], which we don't want.
iF: How are things shaping up in Detroit? What are your views on the auto sector?
SF: Well, what they've done is turn Chrysler and GM over to the UAW [United Auto Workers]. We'll see if the UAW can manage an auto company any better than the auto industry managers did. The markets are now betting that Ford will emerge as the strongest company, precisely because it has avoided getting caught in the government's clutches.
iF: Didn't Ford avoid this by recognizing their problems earlier than the rest, and taking steps sooner to restructure?
SF: The management at Ford, a couple of years ago, all recognized the looming problems. The new president, Alan Mulally, was an outsider. He had a very clear-eyed view of things. He not only cut costs, but also raised every penny he could by selling assets. He raised money when it was plentiful, selling off Jaguar, when he could so. He acted while others did not.
Chrysler's new management came in too late. By the time Cerberus took the company over, the market was already starting to crater, and the credit crisis was hitting.
iF: What about the health of the U.S. banking sector? Will the major banks like Citi and Bank of America survive?
SF: They should be able to survive. Citi, I think, will be broken up or undergo major divestitures, bringing it back to what it was before Travelers took it over in 1999. It will then be a viable company.
Bank of America has some very good franchises. It should be able to survive. The key is whether the government will let it survive.
iF: Some say the other shoe is about to drop, since much of the crisis was caused by the collapse of the housing market. They say the commercial real estate sector is next to fail. Will this precipitate another crisis in the balance sheets of the banks?
SF: Well, what is unusual about the current commercial real estate situation is that unlike times in the past, this one is not primarily a problem of empty buildings. The buildings have tenants, but will the government get the economy moving again before those tenants have to break their leases?
In this instance, the Fed could play a useful role in getting credit out into the system. Everyone is worried about inflation, but short-term, the Fed has been very tight since December.
iF: So, are we due soon for massive inflation?
SF: That is in the hands of the Fed, whose members need to read Milton Freidman so they will recognize that inflation is a monetary phenomenon.
If the Fed doesn't monetize the government's debt in the years ahead, there will be no inflation. There will be other disruptions from government misbehavior. But inflation won't be one of them if the Fed plays its role properly. But, tell me, do you think Ben Bernankeâ€”or whoever his successor isâ€”will be up to the task?
iF: What has America learned from the Madoff affair?
SF: America learned that good returns for too long are too good to be true, that the world does not go in one direction, and, most importantly, that if you have a private money manager, make sure that another institution has custody of the securities.
iF: What has America learned about these complex financial instruments, mortgage-backed securities, and the other things that got us into this mess?
SF: The key with this is that anything misused can be a weapon of mass destruction, including an automobile. This was where government was asleep at the switch, when these things really started to mushroom a few years ago.
The government should have mandated that clearinghouses and exchanges be created, so that the instruments could have been brought out into the open. They would have been standardized, and then people would have been able to see if they needed more collateral, or if they were taking on more in obligations than they could sustain.
Instead, it was all shrouded, and so it spun out of control.
iF: Does this mean a new role for the SEC?
SF: Well, whether it's the SEC or the Commodities Commission or whateverâ€¦ yes. This stuff needs to be out in the open. We need to bring the trading out into the open.
iF: How does that reconcile with less government?
SF: Government's role is to set safe rules of the road, such as speed limits in areas around schools, having your indicators working and in use, etcetera. When something new comes along, it's the government's responsibility to make sure there is transparency.
iF: Some are now saying that buy-and-hold is no longer the right strategy, given that it has failed so many baby boomers who are ready to retire. What's your response?
SF: The correct strategy for your retirement money is to follow the rule of Jack Bogle, the man who created Vanguard. His rule is that you should have your retirement assets in short-term financial instruments equal to one percentage for each year of your age. So if you are 60, then 60 percent should be in short-term instruments. If you're 50, then 50 percent. That way you're well diversified. So, if the markets tank, you'll have some balance.
iF: The question on everyone's mind: Have we hit bottom yet?
SF: We've hit bottom. The question is, how quickly will we get off the bottom and how high will we climb. The answer depends on how we decide the great upcoming debates in health care, energy, taxes, and unionization. If we win those, yes, the economy will snap back pretty quickly.
iF: And if not?
SF: If not, we will have a period that mirrors the 1970sâ€”a very sluggish recovery. Then we'll have to work even harder to revive those Reaganesque principles in 2012.
iF: Thank you, Steve.
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