We’re still probably at least a year from the stock market bottom, but as the market continues to drop towards what I believe to be its fair value of around 5,000 on the Dow Jones Industrial Index and 600 on the S&P 500 Index, it’s worth thinking about what should be done to get the world economy out of the hole that the market drop is creating.

First, something will need to be done to restore confidence in the stock market. For those without a theological faith in fundamental valuation, who weren’t expecting more than a modest market decline, a drop of 57 percent from the peak on the Dow and 62 percent on the S&P 500 will seem like Armageddon. Since investors will also have been treated to a steady diet of headlines about corporate “sleaze” there will be a huge reluctance to venture back into the market. Until investor confidence in equities is restored, economic growth will be very difficult to come by, so it would be good if such confidence does not take a couple of decades to restore, as it did after 1929 in the U.S., and may after 1990 in Japan. A little “overshoot” of the target levels, perhaps to Dow 3,500 and S&P 450, would be a healthy thing, but once the market gets to around those levels, a healthy snapback, with the return of investor commitment to equities, would be highly desirable.

That healthy snapback is not going to be caused by favorable trends in corporate earnings, because nobody will believe them. It is now well known that corporate management spent the late 90’s designing ever more abundant stock option schemes, the expense of which they didn’t have to report on the income statement, while at the same time devising ways to goose earnings so that the stock price soared ever further into the stratosphere and they could cash out their options profitably. This is of course something of a travesty of the truth, but not by much.

Making sure the cost of stock options is expensed properly is essential, for two reasons. First, it will show investors how much their genius managements are actually costing. Second, in the long run, by reducing the volume of stock options granted, it will redirect management’s attention to building long-term shareholder value, and away from short term earnings manipulation. Of course, since stock options generally have a life around 5-10 years, there will be options granted in the “hog heaven” days of the late 90’s to haunt us, and dilute shareholder interests, for a while yet even if this reform is adopted. However, given the behavior of the markets since March 2000, in only a few cases will options granted several years ago actually be worth much, and hence, provided options re-pricing (a particularly egregious rip-off of shareholders) is avoided, most of the outstanding options will expire harmless and worthless. In any case, to restore the integrity of the markets, and investor confidence in earnings, this reform is essential — its importance is currently being demonstrated by the strength of the self-interested management lobbying against it. Unlike some of the other proposed reforms, the sooner it is implemented, the better.

Once stock options accounting has been corrected, many of the accounting shenanigans of the late 90’s will cease — assuming that options accounting reform results in fewer stock options being granted, the incentive for short term cheating will be much less. However, to improve investor confidence in financial statements further, we should institute the other governance reform I have called for, the granting of audit work contracts for public companies by competitive tender, with all qualified tenders being compelled by law to be submitted to the annual shareholders meeting. If options reform is carried, this auditor selection reform becomes less essential, but it would still be useful in breaking up the oligopoly of what is about to become the “Big Four” accounting firms.

Even with both these reforms, shell-shocked investors after the slump will no longer believe in earnings forecasts, and their potential to deliver reliable capital gains. However, this is not a disaster; until 1985 or so investors did not rely on capital gains for their returns — to do so requires acceptance at face value of the “greater fool theory” under which there will always be a greater fool to buy the shares in the future, even if they are overvalued. Instead, to increase the attractiveness of equities for investors, we need to refocus their attention on actual cash returns, in the form of dividends, and the possible future growth thereof.

At present, dividends, unlike other forms of income, are subject to double taxation, at both the company and the recipient level. This needs to be reversed, by making dividends paid by companies deductible against taxable corporate income (not fully, but pro rata to the domestic share of the company’s global taxable income — otherwise, the U.S. tax authorities would subside foreign tax authorities for multinational companies). This could cost about $40 billion per annum on static revenue analysis. However, it would quickly produce revenue generating effects, in that companies would be able to use dividend payments to reduce their tax bill, and so would be sharply questioned by shareholders if they used other means to do so, such as tax shelters or transfers through tax haven subsidiaries.

Naturally, because of the tax saving, dividends paid on U.S. common stock would then increase as a percentage of earnings (which increase would itself be tax neutral, because the dividends would still be fully taxable at the taxpayer level) and thus investors’ minds would be re-focused on buying stocks whose dividend yield was secure, and greater than that of long term bonds. At the Dow 5,000/S&P 600 level, with this tax reform, there would be plenty of these.

This reform should be introduced only once this lower level has been reached, and the bubble duly deflated; if introduced earlier, it will produce a revival of investor “animal spirits” that would cause a spurious surge in the stock market, and delay its arrival at the appropriate valuation level.

In order to raise revenue for this desirable tax change, without unacceptable redistribution from poorer Americans to the wealthier taxpayers with substantial stock portfolios, we should reduce the subsidy to house purchase inherent in home mortgage interest being tax-deductible, by limiting its deductibility to a maximum of $10,000 in interest per family (this would approximately equalize the tax gain from this source with the tax lost through abolition of double dividend taxation). This would affect only upper-middle and upper income families, because at today’s interest rates interest on the first $160,000 of home mortgage would remain tax-deductible.

The economic case for doing this, and for compelling Fannie Mae and Freddie Mac, the government sponsored housing finance enterprises, to compete with the private sector on a level playing field is considerable. For several years now, the United States has been advising Japan, increasingly shrilly, that it needs to reform its postal savings system, which collects a huge proportion of people’s savings and invests them in unproductive infrastructure. However, the U.S. housing finance system is also subsidized, and also directs savings towards unproductive infrastructure, in this case ever more oversized “executive homes” that clutter up the landscape and dwarf the minute plots of land on which they sit.

A postwar U.S. tract housing development is now a disturbing sight. It no longer consists of neat, more or less uniform rows of modestly sized, similar homes, spaced like a row of gleaming teeth manipulated into shape by an expert orthodontist. Instead, during the housing boom of 1997-2002, every fifth or tenth house has been rebuilt, or new houses have been erected on the vacant plots. However, the new houses are no longer modest, but instead, for good economic reasons (the land, being relatively close to the city center, has risen sharply in value), they are far larger and more dominant than their neighbors, even though they rest on similar small plots of land. The even row of teeth beloved by U.S. dentistry has been replaced by an eldritch horror, with oversized vampire fangs at irregular intervals scattered through the mouth. Aesthetically as well as economically, the housing subsidy has to go!

From experience of the 1930’s, when Britain pulled out of recession far more quickly than the U.S., there are two other policies that need to be implemented for recovery to be relatively speedy: free trade and government spending restraint.

In the trade area, the 1930’s saw the notorious Smoot-Hawley tariff as well as the implementation of U.S. agriculture subsidies, and a collapse in the level of world trade from the previous decade. Britain, too, introduced an Imperial Preference tariff in 1932, but only at a level of 10 percent, far below that of the U.S. and its other major trading partners. In this area, the Bush administration has so far been largely damaging, with anti-dumping duties on steel and Canadian lumber, and an expensive farm bill that reverses the move towards free trade of the 1996 Freedom to Farm Act. These measures encourage protectionism in Europe, and severely hamper exports from the generally impoverished Third World. The Doha trade negotiations, which have the potential to move the world towards free trade, and at last open Western markets properly to Third World goods, have so far made no progress. Bush’s protectionist policy thus needs to be reversed, and until reversal takes place, the future of world trade is severely endangered.

In government spending, the U.S. needs to follow the restraint and spending cuts of Britain’s Neville Chamberlain, and not the misguided big-spending policies of the Hoover and Roosevelt administrations. Allowing in a recession the public sector to soak up more and more of the national resources, whether financed by taxation or borrowing, simply restricts the private sector from ever recovering properly. This was demonstrated by the endless years of grinding recession in the U.S. 1930’s, which never recovered properly before World War II; it has been demonstrated again by the endless recession, now 12½ years long, in Japan, where the government has devoted more and more of the national pie to unproductive infrastructure. It is public expenditure control, not banking reform, that is the number one need in Japan; fortunately in this area Prime Minister Koizumi has shown considerable determination and has achieved at least a measure of success.

Here Bush’s record, and that of the nominally Republican Congress, has been abysmal. The swing in the budget, from a $200 billion surplus in the year to September 2000 to a $200 billion deficit in the year to September 2002, has been very largely caused by a lack of spending restraint. The GOP-controlled House, once it had defenestrated Newt Gingrich, appears to have regarded public spending restraint as an ideological shibboleth, that could be discarded; equally, the compassion in Bush’s “compassionate conservatism” has come largely at the expense of the public finances. The bill for this has now to be paid. With the economy in recession it will require several years of grinding cutbacks in public spending before the state’s share of GDP can be returned even to the relatively elevated 2000 level. For recovery to take place, a halt in the public sector’s appetite for swallowing economic activity is essential; it is currently nowhere in sight.

The political cycle is against speedy recovery. Unless the stock market and the economy enter a short term bounce before November, it is likely that the GOP will lose both houses of Congress, and Bush will become, like his father, a lame duck President with Congress controlled by the opposition. The result will inevitably be new public spending programs; these, combined with the stock market drop towards Dow 5,000/S&P 600 that we expect, will produce an unhappy economy that is likely to help Democrat presidential candidates, probably those well left of president Clinton, in 2004. From 2004, therefore, we are likely to see a substantial further move towards Socialism (in the sense of increasing state control of the economy) in the U.S., which will produce only a grudging, prosperity-less recovery like that of 1933-36.

Further developments will depend on the election of 2008. If the GOP follows its 1936 script, and nominates a nonentity with policies well towards the governing Democrats, without repudiating the Bush mistakes on spending and trade, (as they should have repudiated Hoover’s in 1936) then the result will presumably be the same as that of 1936 — a Democrat landslide, further encroachment of government, and an economy that can only be rescued by world war. If, on the other hand, the GOP nominates a 1994-style free-marketer (maybe even former speaker Gingrich himself) who follows the policies outlined above, then in 2009-10 there is the chance of a true economic recovery, and a resumption of growth for the U.S., the U.S. stock market, and the world economy as a whole.

Either way, it seems a long time to wait.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.