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“Honey, I Shrunk the Economy”

This morning, Thomas Friedman suggested that the Obama administration adopt a “come-to-Jesus strategy” for the banking system.  Round up the presidents of the 300 biggest banks, herd them into the East Room, and tell them they caused the downturn in the economy.  Then the New York Times columnist would inform these culprits that the Federal government will nationalize and shut down the insolvent institutions, merge the weak, and give capital to the strong.

Well, I suppose that’s possible, Tom, but this course of action will not solve problems.  The bankers didn’t cause current economic troubles.  Yes, they made imprudent choices, but those bad decisions were virtually inevitable once trillions of dollars of excess liquidity flooded the international financial system.  Banks, important intermediaries in that system, took advantage of the easy money, extended credit freely, earned billions, and grew like crazy.  “As long as the music is playing, you’ve got to get up and dance,” Charles Prince famously said when he was still Citigroup’s chief executive.  And those that didn’t dance were then punished by the market.

Now, of course, the music has stopped.  Treasury Secretary Henry Paulson, hoping to stimulate lending, has shoveled billions into the banks, but they’re reluctant to part with the new-found cash from the government.  And Friedman’s proposal will not make credit available either.  Why?  Who wants to make new bad loans?

At this moment, the world has too many iron ore mines, car factories, and luxury good retailers.  Governments can try to stimulate their economies, but they will not succeed.  We will see genuine recovery only once excess capacity has been closed down.  In short, we have just experienced a bubble of grand proportions, and, despite what politicians may say and pundits may write, economies will need to become smaller.  “No amount of stimulus will work without a healthy banking system,” Friedman wrote this morning.  Yes, but there cannot be a healthy banking system without a healthy economy.  And there won’t be a healthy economy until there is wrenching change.

The Great Depression ended only when demand picked up due to the need to rearm and fight a global conflict.  Unless Mr. Obama wants to wage a worldwide war himself, he will succeed in creating the conditions for prosperity only when he can look Michelle in the eye and say, “Honey, I shrunk the economy.”



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