Impact events and the subprime fallout

You probably know this already, but occasionally my thoughts on economics delve into flights of fancy. I have thought about, for example, what to do if a meteorite hits the earth and wipes out 99% of the world's population - how would surviving governments react to such a disaster? How would a central bank respond best in such an event?

In the aftermath of such an event, any comparatively well off economy - ie, those which are located on the other side of the world from the impact area - would naturally still be able to function but at a very impaired rate.

Let's say that a meteorite hits the East coast of the USA. The blast and thermal pulse manages to kill off 99% of the world's population. The only remaining and functioning economy is South-Eastern Australia - which is pretty much directly opposite to the East Coast of the USA when you look at a globe. Basically the populations of New South Wales, Victoria and Tasmania have survived intact, while the populations of South Australia and Queensland have been severely damaged. Western Australia, sadly, has not survived, while Darwin in the Northern Territory is pretty much toast (literally).

An emergency cabinet meeting is then convened, with both sides of Parliament represented. Because of my glowing reputation as an economic thinker (ahem) someone invites me to advise the cabinet as to what to do. I walk into the room and the politicians look up. "Mr Cameron", says PM Kevin Rudd, "What are your ideas?"

Well, apart from trying to reduce the size of my cranial capacity (fictional cabinet laughs as they break the fourth wall), the most obvious problem is that the nation's economy, so dependent upon overseas trade, now has to support itself. Everything that Australia's economy needs that was once imported now needs to be made here. With a population now of 15 million (25% wiped out due to the impact event) that would pose a great difficulty. Moreover, Australia's exports are no longer needed. So, on the one hand, we have a massive increase in demand for things we can't make, and a massive decrease in demand for the things we do make and used to sell overseas.

In this situation, GDP will naturally shrink. The country will go into a massive recession. Inflation will also increase markedly - people are panicking and stocking up on basic needs, thus devaluing the currency and encouraging hyperinflation. Millions are likely to lose their jobs and businesses all over the place are likely to go bankrupt.

Well the first thing I would do is get the Reserve Bank to raise interest rates to control inflation. This may seem counter-intuitive, but a functioning economy needs a stable currency. Moreover, as the years of recovery go by, businesses will form that will begin to produce goods that we used to get from overseas. In effect, the economy will begin to rebalance itself - though at a low level.

But the second thing I would do is for the government to take upon itself every single piece of debt left in the economy. All debt - personal debt, household debt and corporate debt - should be transferred to the government. The result of this will be people who no longer have mortgages and businesses that no longer have to pay back loans. This will allow people and businesses to feel more "settled" as they take stock of what is going on. The government, now saddled with massive amounts of debt, will need to take drastic action over the long term in order to pay back this debt (ie tax increases, spending cuts, a combination of the two or maybe even an attempt at the taxless economy idea I have developed). This won't solve all the problems, but it will allow the government to take up a lot of the economic pain inflicted by the impact event.

Of course there are other problems that need to be solved as well - namely, how to survive without much sunlight over the next 10-20 years; how to deal with the massive injuries sustained by survivors; how to battle the newly awakened race of super-intelligent reptiles whose ancient underground city was located directly underneath the impact site... and so on.

But let me bring this fantasy back to reality here. Personally I think that the subprime mortgage crisis hitting America should just be let to burn itself out. But what if it gets really, really bad? And by bad I mean a few magnitudes worse than what we're likely to experience over the next 12-18 months?

And although it would be great if the US of A suddenly adopted Absolute Price Stability and my Taxless Economy idea, I need to be realistic. Is there anything that the US government could, in fact, do?

Well here's a thought - why not buy all the mortgages? Not just mortgages in trouble, not just mortgages that have been foreclosed - all mortgages. This won't simply be the government buying everyone's house, but simply the government paying off everyone's mortgages.

And where would the money come from? Well, it could probably come from the Federal Reserve - they print it and create it using seigniorage, give it to Congress, who then use it to pay off the mortgages of every American.

But of course such a move is inflationary. In fact it would probably be hyperinflationary. So what would be the point? Well, for starters, the Federal Reserve could increase interest rates to contain such a massive increase in the money supply. It could also increase the Reserve Requirement and even apply it to M3 rather than M1, thus removing more money from the economy and, via the mechanics of the money multiplier, prevent money creation "down the line".

The result of this would be a balancing act. On the one hand, a certain market in the economy - the housing market - is saved. On the other hand, the entire economy takes a hit with higher interest rates. It's a way of transferring a deadly hit on one section of the economy into merely a painful punch on the economy as a whole.

But my idea here of paying off people's mortgages doesn't have to extend to paying it all off. It could simply mean that the government pays off a substantial amount via money creation - say between $50,000 and $100,000 per mortgage - and rebalances it via high interest rates. That won't be enough to save every mortgage or lender, but it will affect that sector of the economy positively. Rather than throwing money at big businesses like Bear Sterns, the money gets thrown at mortgages which eventually find their way back to the big businesses over time. Rather than just benefiting businesses, households AND businesses benefit.

Of course, such a proposal is fraught with risk. If it happens this time around will it happen again? Is it really the government's job to act in such a radical fashion? And although this is an idea of mine, I'm not certain that it should be implemented - barring impact events of course.

And then there's the basic theory behind this idea - will it work? Will printing money and then raising interest rates really be balanced out? And surely this idea has its roots in my own Taxless economy proposal? Guilty as charged.