Alternative to QE? The Lehman Bros. Plan.

People often ask me, "What do you think the government should do instead of QE inflation?" My stock answer is that the government should not try to fight the depression with government spending and cheap credit. Trying to stop the market from correcting the errors of the past only delays the consequences and makes them much worse.

Government should balance its budget. There should be no new credit expansion by the Federal Reserve. Most importantly, government should not meddle in markets to try to soften the consequences of the correction. Specifically, that means no bailouts, stimulus packages, or new public-works projects. Do not prop up wages. Allow competition to lower the prices of land, labor, and capital. The only positive steps for government to take are implementing tax cuts and spending cuts, eliminating regulations, and allowing free trade.

Now, I have a name for this policy. It's called the "Lehman Bros. plan," after Lehman Brothers, the large financial firm on Wall Street that was allowed to go bankrupt in September 2008. This plan relies on allowing big firms to fail. Had this policy been followed from the beginning, I have little doubt that the crisis would already be over and we would not have added to the debt problem.

Henry Lehman got started in business in 1844 with a dry-goods store in Montgomery, Alabama. After his two brothers joined him a few years later, they named the business Lehman Brothers. They accepted raw cotton in exchange for their goods. This increased the volume of their business because people had more cotton than money, and it increased their profit margin because they made money selling the goods, and then they made more money selling the cotton. They later opened an office in New York and helped start the New York Cotton Exchange in 1870. Later, they joined the New York Stock Exchange and helped take companies such as Sears, Macy's, B.F. Goodrich, Woolworth's, and Studebaker public by selling their initial public stock offering. It was a great American success story from Dixie.

Unfortunately, in the beginning of the 21st century, Lehman Brothers was heavily involved in the subprime-mortgage market, and even though they quickly exited the market for new junk, they still held vast quantities of the lower-quality, higher-risk securities on their books. They got left holding the bag. They went into bankruptcy, where their assets were sold off to other firms to meet the company's obligations to creditors. Creditors received a share of their money back, but they did sustain losses. Retail clients were largely unhurt, except by those losses sustained generally in the market. The big losers were the stockholders, with the biggest pain borne by those who were running Lehman Brothers — the same people who made tons of money during the boom. The world did not come to an end.

At this point a mainstream economist will complain that if you allowed liquidation, it would result in contagion and runaway deflation, and the economy would enter a black hole. Let's take a look at the role of deflation during a crisis.

First, under deflation, the prices of capital goods fall dramatically. This initially happens with stock prices plunging, but eventually the prices of office buildings, warehouses, retail stores, etc., also fall.

Second, the price of labor will fall as the unemployment rate rises. Wage rates are somewhat "sticky" compared to stock prices and leasing rates for commercial space, but they do tend to fall in real terms if they are not propped up by government intervention and unemployment insurance.

Third, the prices of consumer goods will also fall — but not as much. The demand for "nondiscretionary" consumer goods is not elastic. Things like milk, flour, tobacco, electricity, daycare, and iPhone apps have what economists call "income-inelastic demand" because we don't change the amount we buy either when our incomes increase or decrease. In the past, for example, the quantity demanded of margarine has actually increased when our incomes go down.

This means that in the deflationary-corrective process, the prices of land, capital goods, commodities, and labor are falling relative to consumer goods. This provides potential profit opportunities for entrepreneurs to purchase these greatly depreciated resources in order to make products to sell to the consumer. In other words, the deflationary process is more like a shock absorber than the black hole imagined by mainstream economists.

Not only do profit opportunities emerge, but wage-labor opportunities are scarcer and less attractive. Both influences encourage entrepreneurial behavior, and this is a key factor in any corrective recovery process.

Following the Lehman Bros. plan will result in a contraction in bubble-generated activities and an expansion of consumer-generated activities. Saving will expand relative to consumption. The largest firms will shrink or go out of business, while smaller firms will expand to capture remaining market share. New firms will be started to take advantage of profit opportunities — and to respond to the lack of employment opportunities. It is a well-known fact that small firms create the bulk of new jobs — however, what is not as well-known is that new small firms create the most jobs of all.

Remember that during the minidepression of 1980–82, Paul Volcker raised the federal-funds rate to 20 percent, ending the stagflation of the 1970s and ushering in one of the most prosperous periods in American history. This period also provided an economic environment rich with cheap resources that Microsoft took advantage of to become a huge success in the PC-software market. Note too that the dot-com meltdown provided the same environment for Google to take advantage of in order to become the king of the search market.

The Bernanke/Bush/Obama approach results in nothing but misery and mounting government debt. The Lehman Bros. plan rebalances the scales between the fat-cat, "too big to fail" corporations and the entrepreneurs who will help shape our future.

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