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Is Taxing Capital Income Fair?

Sep 28, 2012Mike Konczal

In light of Mitt Romney's recent tax returns, the economic blogosphere has been kicking around the issue of capital taxation. Ryan Chittum at Columbia Journalism Review has an excellent overview of what people have been writing with "The capital gains preference." This is a response to Dylan Matthews and Matt Yglesias, who each present arguments from economists that capital gains taxes should be lower than other taxes, even potentially set at zero percent.

Many economic arguments are about tradeoffs, but the argument for the zero tax rate of savings, also similar to the arguments for a consumption tax, is usually phrased as an argument about fairness. In order to frame the fairness argument, economists bring up a story of two similar individuals with one as a saver and one as a spender. Yglesias has the framework in his post:

You imagine two prosperous but not outrageously so working people living somewhere—two doctors, say, living in nearby small towns. They're both pulling in incomes in the low six figures. One doctor chooses to spend basically 100 percent of his income on expensive non-durables. He goes on annual vacations to expensive cities and eats in a lot of fancy restaurants. The other doctor is much more frugal, not traveling much and eating modestly. Instead, he spends a lot of his money on hiring people to build buildings around town. Those buildings become houses, offices, retail stores, factories, etc. In other words, they're capital. And capital earns a return, so over time the second doctor comes to have a much higher income than the first doctor. [...]

In the world where investment income is taxed like labor income, the first doctor says to the second "man you're a sucker—not only are you deferring enjoyment of the fruits of your labor (boring) but when the money you've saved comes back to you, it gets taxed all over again. Live in the now.  And the thinking is that world number one where people with valuable skills take a large share of their labor income and transform it into capital goods is ultimately a richer world...

Taxing savings by having an income tax punishes the Saver Doctor relative to the Spender Doctor. If you just taxed what they consumed, they would be treated equally.

Yglesias leans on the idea that we'll be a richer world without taxing savings, because people will respond to the incentives against savings here. I don't believe the research bears this out. I'm not an expert, but I believe the impact, if any, is small. In their excellent summary book on taxation, Taxing Ourselves (2004, 3rd edition), Joel Slemrod and Jon Bakija conclude that a "large number of studies have attempted to address these problems to some degree, and they generally come to the conclusion that saving is not very responsive to incentives."

But if the efficiency argument is weak evidence, the fairness argument is assumed to make the case, and make it for zero percent taxation. It is unfair to tax the Saver Doctor even a penny more than the Spender Doctor. Scott Sumner gives a similar example at The Economist: "The proper tax rate on capital income is zero [...] To see why this is so, consider twin brothers who each make $100,000 in wage income. Most people would regard these two people as equally well off, even if one freely chose to consume his income now, while the other chose to consume later. But not advocates of the income tax. They insist the more patient twin brother is 'richer' and deserves to be taxed at a higher income tax rate." Gilles Saint-Paul argues in the same forum that fairness requires that we shouldn't "penalise future consumption relative to current consumption."

In Joanathan Gruber's popular undergraduate textbook Public Finance and Public Policy, the two people are actually Homer Simpson and Ned Flanders!

Consider two individuals, Homer and Ned, who are identical except for their preferences for saving. Both live for two periods, earning $100 in the first period and nothing in the second period. Homer is impatient: he wants to consume his entire income in the first period and nothing in the second period. Ned is more patient; he wants to consume in both periods. Initially, they are both subject to an income tax, which taxes all labor earnings and interest income at 50%.The interest rate earned on savings is 10%. [...]  In present discounted value (PDV) terms, Homer pays only $50 in taxes across both periods, but Ned pays $51.11. Thus, savers such as Ned are penalized in an income tax regime.This tax treatment of savings is both horizontally inequitable (because Ned is taxed more simply for making a different choice) and inefficient because it may reduce the incentive to save (because savings leads to higher tax payments).

Let's stick with Homer and Ned. Is this fairness argument against the "inequitable" treatment of Ned either impressive or conclusive? I'd argue no. I'm going to rely on arguments from Barbara Fried's excellent "Fairness and the Consumption Tax" for the following to identify some problems, and I'd recommend her essay if you are interested in learning more.

The first issue is the assumption that Homer and Ned should pay in accordance with their consumption, or that equal spenders should have equal tax burdens, or, technically, that the present value of their tax burdens should be identical. This presupposes what is up for debate, which is what the appropriate tax base is. If the tax base is explicit wealth, then income from savings should also be taxed. There are significant advantages to owning wealth, including security, peace of mind, power, the ability to direct private investment, political control, and much more. It isn't clear why these shouldn't be part of the tax base.

A second issue is that it assumes that all income from savings is the result of delayed compensation, when much of it doesn't even come from the individuals themselves. We don't know how much of the United States' capital stock comes from the gifts, bequests, or inheritance that constitute intergenerational transfer, though averages of studies say about 50 percent. Fairness arguments become a lot more complicated here.
 
A third issue is the assumption that, since Homer and Ned are equally ranked in well-being in a no-tax world, they should be equally ranked after any tax comes into play. This equal ranking is the engine behind a lot of the fairness arguments -- as Gruber says, we don't want to penalize Ned for "making a different choice." Since a tax on savings would fall on Ned the Saver but not Homer the Spender, they would no longer be equally ranked, as Homer would end up better off than Ned with an income tax. It isn't clear how much savers would be disadvantaged relative to spenders, as some of that tax will fall to borrowers. But the general point remains.
 
But even granting this, a new question arises: why do we care about maintaining equal ranking from a "no-tax" world, and why would it be unfair to change it? This is only a claim to fairness if Homer and Ned, or savers and spenders more generally, have a claim to their relative ranking in a "no-tax" world. It's not clear that they do. They certainly don't under an entitlement theory, as the value the saver gets in this example is just the random quirk of his or her preference structure. It also presumes that the ranking in a "no-tax" world was just in-and-of-itself and thus worth preserving, which requires a lot of libertarian heavy lifting.
 
It also presumes a myth of ownership, or the idea that you can conceptualize the economy without the government or that tax policy isn't just one of many ways that the government affects interest rates. Sumner and Yglesias, for instance, believe the Federal Reserve should do some major things to raise nominal GDP, which would have a dramatic effect on the relative ranking of savers and spenders compared to a non-Federal Reserve world. How are they any different from this tax policy, other than the fact that they justify it within a larger set of social institutions, especially ones that produce the patterned world of full employment?
 
A fourth thing to consider is the issue of generalizing this critique to other examples. Another way of reading the fairness issue in the example is that since both Homer and Ned start off equal, and had equal capability to generate wealth, they should have an equal tax burden, akin to an endowment or faculty tax.
 
If a tax on savings is removed, taxes on wages would have to go up. Now imagine that, in addition to Homer and Ned, there's Barney at time zero. Barney hates working but loves leisure, so he doesn't work at all but enjoys just as much utility as Homer and Ned when they consume their net present value of $100. Raising taxes on wages leaves Homer and Ned equally well off but punishes them both relative to Barney. Should taxes on wages therefore be set to maintain their ordering? Would we have to abolish taxes on consumption then? If so, then it isn't clear we can have a coherent tax policy period.
 
But we could have a coherent tax policy, especially if we focus on what kind of economy we want to build and use tax policy as one of many levers, working in concert with all the others, to create it.
 
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Simpsons images used without permission from 20th Century Fox.
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The GOP's Zombie Dodd-Frank Would Lose the Core Logic of Financial Reform

Sep 20, 2012Mike Konczal

Republicans might not repeal Dodd-Frank outright, but they'd eliminate the system of rules that make it work.

Republicans might not repeal Dodd-Frank outright, but they'd eliminate the system of rules that make it work.

It was just announced that Tim Pawlenty will become the head of the bank lobbying group Financial Services Roundtable. The powerful financial lobbying group, which represents groups like JP Morgan and Bank of America among other big financial sector players, appears to be aligning itself more closely with the Republican Party and betting on the idea that Republicans will control at least part of Congress. But what do they want? Earlier in the year, I argued in Washington Monthly that they'd like to repeal the core parts of financial reform.

Recently, Phil Mattingly had an article at Bloomberg Businessweek about how the GOP and Mitt Romney would approach Dodd-Frank. This is with a hat-tip to Reihan Salam who notes that this article "has confirmed something I’ve heard from well-informed insiders" and makes additional arguments [1]. So it seems well-sourced.

Mattingly's argument is that it is unlikely that the Republicans will outright repeal Dodd-Frank. "Instead, President Romney would likely try to give the financial industry something it wants more: a diluted financial reform law that would relax restrictions on some of its most profitable—and riskiest—investments but maintain enough government oversight to give the banks cover."

So what would the Republicans try to dilute and remove? Mattingly:

"Wall Street wants to loosen rules governing the swaps market, which generated $7 billion in revenue in the first quarter of 2012, according to government records. The banks would also get rid of restrictions on bank investment in private equity and hedge funds, pare back the power of the new federal consumer protection agency, and block the Volcker Rule, which bars banks from trading with money from their own accounts, a practice that can put customer deposits at risk. [...]

Wall Street doesn’t oppose everything in the law. Banks support the “resolution authority” that spells out how and when the government can seize and wind down struggling banks before they catastrophically fail."

So they want to go after derivatives rules (swaps), the Volcker Rule and the related law on restrictions on hedge fund investments, and also the CFPB. It's important to understand this isn't like removing random parts of the bill, as strict as they may be, but is instead gutting the core logic of the law. It's the equivalent of Republicans saying they'd keep the Obamacare bill, but stop the exchanges, remove the individual mandate, and lose the ban on pre-existing conditions while getting rid of the means-tested subsidies and Medicaid expansion. We'd understand that all of the parts of this system are interconnected and inseparable; the ban requires everyone to be in the market, which requires subsidies and well-developed markets.

Let's make sure we understand how derivatives, the Volcker Rule, and the CFPB all work together. Imagine that we're car engineers, and we want to design a car and road system so that if the car crashes, it does so as safely as possible. There are four things we can do. We can put airbags and seatbelts in the car and other cars so that when it does crash the damage is limited and controlled. We can design the car with things like a brake override system so that if it hits a rough patch the driver can keep control of it and make it less likely to crash.  We can put some speed limits on the road, as well as clear traffic signals to guide cars from running into each other. And we can have some protection for pedestrians, like cops watching for DUIs or barriers to prevent cars from driving into crowds of people. Easy, right?

Now let's think of Dodd-Frank. There are the legal powers that deploy to resolve a firm if it fails, like an airbag, which are called resolution authority. This allows the FDIC to take down a failed financial firm as if it were a bank, subject to serious rules and restrictions.  And, like requiring certain car features, there are specific policies for large, systemically risky financial firms, like enhanced capital requirements, limits to investments in risky hedge-funds, and the Volcker Rule, which are designed to make it less likely for a firm to crash.

Dodd-Frank also introduces speed limits and rules of the road in the financial sector, designed to make the system as a whole less likely to crash or spiral out of control when a panic does happen. One primary place it does that is through derivatives regulations. And "cops on the beat" is the metaphor for the Consumer Financial Protection Bureau.

So there's Dodd-Frank law to allow a firm to fail, law to make it less likely a financial firm fails, laws to prevent the interconnected financial markets from going into crisis if a firm does fail, and law to gives consumers a representative in dealing with the regulatory field. This is like thinking of Dodd-Frank as a system of deterrance, detection, and resolutiion, a related model we've developed elsewhere.

If Wall Street and the Republicans are looking to seriously gut the Volcker Rule, derivatives, and the CFPB, then they're looking to gut the entire logic of the bill. Interestingly, they are less interested in "resolution authority," the legal process to fail a financial firm. This is evidently no problem with everything else removed, perhaps because they believe congressional bailouts will then happen. This should remind us that resolution authority is strengthened and made more credible by other strong regulations, including things not in Dodd-Frank, like size caps or Glass-Steagall. Preventing these diluations is crucial to building a regulatory system for the financial sector that works in the 21st century.

[1] Reihan notes that banks "also understand that [Dodd-Frank] favors incumbents over new entrants, particularly incumbents with the legal acumen and lobbying resources to shape the emerging regulatory regime. My strong preference, very much in line with conservative and libertarian sensibilities, would be for a financial reform that would aim to facilitate rather than stymie entry."

I'd like to see more on how Dodd-Frank as blocking new firm entry works. While this is a generic complaint of regulations in general, I'm not sure in what ways it applies to Dodd-Frank. Parts of Dodd-Frank actually are designed to scale up with size and risk, e.g. Sec. 171 requires capital requirements to scale with "concentrations in market share for any activity that would substantially disrupt financial markets if the institution is forced to unexpectedly cease the activity," which is not for new entries. The idea is to hold larger and riskier firms to tougher standards and higher capital, which is regulation that scales with size.

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On the Occupy/Strike Debt "Debt Resistors'" Manual

Sep 14, 2012Mike Konczal

People have been talking a lot about the one-year anniversary of Occupy Wall Street. There is special interest with the movement's turn to organizing around the idea of debt as a "connective thread" for the 99%. The most recent issue of The Nation has two articles on the topic, with Astra Taylor witing "Occupy 2.0: Strike Debt" and David Graeber writing "Can Debt Spark a Revolution?"

People have been talking a lot about the one-year anniversary of Occupy Wall Street. There is special interest with the movement's turn to organizing around the idea of debt as a "connective thread" for the 99%. The most recent issue of The Nation has two articles on the topic, with Astra Taylor witing "Occupy 2.0: Strike Debt" and David Graeber writing "Can Debt Spark a Revolution?"

There's a Strike Debt/Occupy Wall Street group, and they have put out a Debt Resistors' Operations Manual, which is embedded here at the end of this post and available at that link as a pdf. You can pick up a hard copy of the document tomorrow, Saturday, in Washington Square Park from 10:30 a.m. till 7:30 p.m. and at Judson Church from 7:30 p.m. till 9:30 p.m.

Reading it, I agree with Yves Smith's assessment that it "achieves the difficult feat of giving people in various types of debt an overview of their situation, including political issues, and practical suggestions in clear, layperson-friendly language." You should read her review in its entirety, and check it out for yourself. I want to talk a little bit about it from a different angle, noting how each half of the book builds out a new direction for Occupy.
 
Over the summer, Jodi Dean argued that debt would be a difficult connective thread to pull off for a political movement. It's too individualized, too prone to viewing people as failed market agents, too moralized, and it can mimic unhelpful reactionary arguments against the welfare state and the government. I know people involved in organizing homeowners, especially underwater and deliquent homeowners, and I can say that these are all very accurate problems. Beyond that, nobody likes their identity as a struggling debtor. People can take pride in their role as workers, as citizens, and as numerous other things organizers can build on, but debt is a real challenge. The failure part runs deep.
 
So there's a couple of interesting things in the Strike Debt booklet that I think are useful as a political statement. The first half of the book is about the major types of consumer debt -- medical, housing, education, and credit card -- as well as the credit scoring agencies. And the book places runaway consumer debt in the context of larger institutions that are failing to meet the needs of the population.
 
The medical debt chapter calls for universal health care, the student debt chapter calls for free public colleges, and the credit card chapter is titled "The Plastic Safety Net," directly alluding to weakness in income maintence and basic income support. The credit scoring chapter points out how these debts, and your ability to pay them, are tied to your ability to gain access to basic needs like utilities, phone lines, and health care.
 
These are all essential goods for our lives, and we choose the institutions that will deliver them. They can be publicly provided, based in principles of social insurance, decommodification, and access independent of wealth. Or they can be provided in individualized ways, ones that replace social insurance with self-insurance through individualized, large debt loads, while also working to the benefit of private agents.
 
But these are both choices. And this focus on debt is a way of understanding the wrong choices we've made as a society in providing for these goods, and who benefits and who loses from them. People should understand their debts as part of a system's design, rather than its failure. If developed, it could turn into a powerful statement for the commons and for a more progressive and social democratic approach to all of these topics.
 
It also approaches the 1 percent issue in a new way. Instead of a lot of arguments about the just deserts of the richest, the 1 percent and the "financialized" sectors of the economy are those who profit from inserting themselves between social goods and those who desperately need them. The second half of the book focuses not on individual debts but structures that benefit creditors. From municipal debt to the "expensive to be poor" areas of fringe finance to debt collection and bankruptcy, there's a whole series of institutions that work against debtors, the poor, and civic infrastructure.
 
Here the banks aren't just nefarious agents taking too much of the pie; they are the people overcharging the poor to be able to cash a check or otherwise engage in trade. They are the people ignoring the Fair Debt Collection Act, harassing your family on old debts they bought on the cheap. And they are the ones privatizing municipal structures, collecting the gains while socializing the losses. And that's a new way of understanding the 1 percent's power, and how to resist it, and ultimately overcome it in the kind of world we want to build, which is a major step forward.
 
As Astra Taylor wrote in her Nation piece, "As individuals, many of us are in debt because we have to borrow to secure basic social goods—education, healthcare, housing and retirement—that should be publicly provided. Meanwhile, around the world, debt is used to justify cutting these very services, even as the game is further rigged so that the 1 percent continues to profit, raking in money from tax cuts, privatization schemes and interest on municipal and treasury bonds."
 
Will it be enough to spark a genuine political movement? Who knows. But it is a document worth your time, and the issues it brings up will hopefully form a core narrative of all future political struggles.

Occupy Wall Street/Strike Debt: The Debt Resistors' Operations Manual

 

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Misleading Advertising is On the Rise: Four Ways the FTC Can Fight Back

Aug 22, 2012Asha M. Fereydouni

Consumers need regulators to step up yet again to protect them from risks in the marketplace.

Consumers need regulators to step up yet again to protect them from risks in the marketplace.

Last year, President Obama created the Consumer Finance Protection Bureau, a new agency to protect American consumers with the explicit purpose of preventing some of the risky practices that led to the crisis of 2008. It took one of the greatest financial disasters in history to initiate regulatory change. But there were a number of small failures leading up to the disaster that indicated things were going poorly. Had the CFPB existed at any one of these smaller junctures, much of the disaster could have been averted.

Today, the United States is at a similar juncture: consumers need additional protection, misleading advertising is on the rise, and the current agency responsible for regulation—the Federal Trade Commission (FTC)—is not doing enough.

In May 2012, POM Wonderful lost a lawsuit to the FTC for misleading advertising. Two days later, the company released an ad campaign selectively quoting from the judge’s ruling. The advertisements read, "Competent and reliable scientific evidence supports the conclusion that the consumption of pomegranate juice and pomegranate extract supports prostate health." But in the very next line of the ruling (which POM did not advertise) the judge states that while it might want to think that its product has the advertised health benefits, "the greater weight of the persuasive expert testimony shows that the evidence relied upon by [POM Wonderful] is not adequate to substantiate claims that the POM products treat, prevent or reduce the risk of prostate cancer."

The FTC tried its best, but it was unable to do a thing—the ads are still running, and POM has not paid a cent in fines.

But it’s not just POM. From Sketchers to CVS, each has been subject to misleading advertisement suits in just the last six months. If things aren’t changed, and companies are able to follow POM’s example in getting away with repeated instances of false ads, consumers will pay the price. We face the risk of purchasing a product, thinking that it has certain benefits, then realizing that our money has gone to waste. We may not be able to trust what is right in front of our very eyes. 

So what can the FTC do to strengthen its efforts in combating misleading advertising? Here are four places it can start:

1. The FTC can impose monetary punishments on companies the second a judge rules them in violation. Currently, companies that are sued for misleading advertising only face a monetary penalty if three conditions are met. First, the company must continue false ads after the judge’s ruling; second, the FTC must get those ads admitted to the record; and finally, the judge must find it guilty of committing a “double violation.”

The punishment for a double violation is steep. The FTC fines companies $16,000 PER advertisement, PER day—that’s no joke, even for a multimillion dollar company. The penalty works great as a deterrent for double violations, but there needs to also be a deterrent for a single violation. Fines ought to apply for any advertisement that, after being tried in court and ruled by a judge, is found to be misleading the American people.

2. The FTC can institute more stringent requirements as to what kinds of clinical studies are required before health claims are made. With the POM case, the FTC tried to set a new precedent of requiring double-blind studies and FDA pre-approval before POM (and, potentially, other companies) could make claims about the health benefits of its products. While the FTC’s efforts must be commended, it was ultimately unsuccessful in adding the new requirements. Further, the FDA by no means has the capacity to pre-approve and substantiate the medical claims for every company that presents health-related advertisements.

A plausible compromise would be for the FTC to implement requirements for certain standards in clinical studies. Among other things, the FTC could require companies to present studies that have a control group (a non-trial, comparable group to ensure that the products are actually having an impact) and the repeated achievement of stated results in at least three instances. In doing so, the FTC can begin to rein in how companies substantiate the medical claims behind their products.

3. The FTC can request more transparency in how companies advertise the medical benefits of their products. Currently, there exist loose standards as to what companies must disclose to consumers. The FTC ought to require that companies disclose on some part of the advertisement the funding source and basic information about the clinical trial that occurred to substantiate the product’s health claims.

4. The FTC can be internally consistent when it comes to measures to improve existing regulations. In July of 2011, the FTC announced that it would review each and every existing regulation. The goal of this comprehensive review was to “promote greater efficiency, transparency, and public participation.” In conjunction with this internal review, the FTC also asked for public comment and publicized its criteria for evaluating the existing regulations. It asked for comments on the rule's economic impact, its necessity, whether it conflicts with local laws, and if it's outdated.

Notice that there is no question of efficacy. On initial glance, it would seem as if the FTC doesn’t care whether the regulations actually work. However, after taking a closer look at the briefs released for each specific regulation, it would seem that the FTC did in fact care about how the regulations were working. It also asked, “What modifications, if any, should the Commission make to the Rule to increase its benefits or reduce its costs to consumers?”

While the detailed brief shows that the FTC does in fact care about the efficacy of its regulations, this desire ought to have been a component of its initial press release. A comment made by the Heritage Foundation is most illustrative of this lack of clarity. Heritage lists the FTC’s four criteria that were released in the initial press release and structures its analysis based on those criteria. It had no idea that there were expanded requirements. By not clearly asking what it wanted to know, the FTC was unable to get complete answers and left itself short-changed.

The FTC can take these steps now to combat misleading advertising. In doing so, it can take a proactive position, stand up to large companies, and protect American consumers. 

Asha M. Fereydouni is a member of the Roosevelt Institute | Campus Network who is a senior at the University of California, Davis and is currently doing research on the FTC in Washington, DC.

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What's the Best Liberal Case Against Principal Reduction?

Aug 21, 2012Mike Konczal

Binyamin Appelbaum has an article in the New York Times about the administration’s terrible response to the housing crisis.

Binyamin Appelbaum has an article in the New York Times about the administration’s terrible response to the housing crisis. The administration “tried to finesse the cleanup of the housing crash, rejecting unpopular proposals for a broad bailout of homeowners facing foreclosure in favor of a limited aid program — and a bet that a recovering economy would take care of the rest.” This has several responses, including David Dayen at firedoglake, as well as Ezra Klein writing about the administration's response from a balance-sheet recession and housing point of view. That got a response from Dean Baker arguing that this balance-sheet recession point of view, and the subsequent focus on mortgage debt reduction, is a distraction from better policy.

With President Obama pushing for a wider refinancing plan and the debate over refinancing and principal reduction back in the headlines due to the book Bailout and the fight over the GSEs, it might be useful to formalize the best liberal case against principal reduction. It'll give us a set of arguments to wrestle with so that we can then work backwards toward better arguments. So what is the best case? I see three broad arguments.

1. Wealth Effect Means It Doesn't Matter

This is the approach Dean Baker takes, and I think it is influential among many liberal wonks. The housing crashed destroyed a lot of housing value, leaving us feeling poorer, which means we spend less. An important way to understand this argument is that if every house during the housing bubble was paid for with cash instead of a mortgage, and we had the same housing bubble and crash but no mortgage debt overhang, our recession and slow recovery would look virtually identical. Reducing housing debt in our situation won't help the economy as a whole (though it will help the individuals involved), because housing debt hanging on the economy isn't the drag.

Foreclosures are still bad in this argument (and Dean has been at the forefront of fighting against foreclosures), but they only need to be stopped in the sense that all bad things should be stopped; housing crisis policy will help some and hurt some, but it isn't a check on the recovery. It is not necessary and isn't effective in getting us back to full employment.

I think there are some empirical problems with this argument. The elasticities people are finding are an order of magnitude bigger than realistic expectations. Declines in housing prices are nonlinear against wealth distribution. Something else is in play. See this interview or this paper for more on these arguments. The administration seems to be moving in this balance-sheet direction. Let's say we reject this wealth effect argument -- should we change policy?

2. Fiscal and Monetary Uber Alles

Christina Romer would say no. She, like many, would argue that housing debt is probably a drag on demand, but we should respond to it with fiscal and monetary stimulus. She would stay out of the policy in the purple circle above, which is the mapping I use around here to approach how people think of the recession. Romer, from September 2011:

[One argument is that the] bubble and bust in house prices has left households burdened with too much debt. Until we deal with this problem — perhaps by providing principal relief to the 11 million households whose mortgages are larger than the current value of their homes — we’ll never get the economy going.

The premise of this argument is probably true: recent evidence suggests that high debt is holding back consumer demand. But it doesn’t follow that the government needs to directly lower debt burdens to stimulate job growth.

Recent research shows that government spending on infrastructure or other investments raises demand even in an economy beset by over-indebted consumers. Another effective approach is to aim tax cuts and government payments at households that would like to spend, but can’t borrow because of their debt loads (such as the poor and the unemployed).

History actually suggests that the “tackle housing first” crowd may have the direction of causation backwards. In the recovery from the Great Depression, economic growth, which raised incomes and asset prices, played a big role in lowering debt burdens. I strongly suspect that fiscal stimulus will be more cost effective at speeding deleveraging and recovery than government-paid policies aimed directly at reducing debt.

There's a general critique of the president's stimulus program that argues it was too focused on tax cuts instead of long-term investments, which have a better bang for the buck. The same critique can be used on spending money on principal reduction. It's money that by definition isn't spent (it was already spent), so you need second-order effects for it to go. We'd prefer just giving people money (tax cuts) over principal reduction in the same sense that we'd prefer infrastructure over tax cuts.

And one doesn't need to be a conservative worried about helping the "losers" or someone who is uncomfortable with the fairness of mortgage debt reduction to think there are better ways to spend this money. Consider having $250 billion dollars to spend, one benchmark put forward as the amount of money that could have been spent from TARP. You could hand it out in some manner to pay off underwater debts, perhaps a matching scheme with the banks. That wouldn't reduce overall mortgage debt that much because there is a lot of it.

Meanwhile, with $250 billion dollars, you could build 5,000 miles of high-speed rail. You could fund universal pre-K for a decade. You could take the 13 million people unemployed under the traditional unemployment measure and give them a basic income of almost $10,000 for two years. You could build infrastructure, create social goods designed to foster egalitarianism, or tackle poverty. These are all better investments for us to make, plus they build a better society and they get us to full employment faster. Tackling mortgage debt produces none of these benefits.

When Geithner's argued against principal reduction, saying that it would be "dramatically more expensive for the American taxpayer, harder to justify, [and] create much greater risk of unfairness," he followed it up by saying "The whole foreclosure crisis across the country now is really driven by what happened to unemployment and what happened to the income of Americans. The best things we can do now to help mitigate that risk is to help get the economy. growing again, bring unemployment down as quickly as we can, put people back to work." I view that as in line with Romer's argument.

By itself, I think this is correct. But one important response to that is that principal reduction can often pay for itself, especially in situations where a borrower is at risk. A lender will want a consistent, if lower, payment stream rather than to take ownership of an abandoned house in a depressed market. As Lew Ranieri said, "You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure." So it is good economics, especially in a distressed market. Another response is that few people propose just giving money away, but instead want to tie it to some sense of risk and reward, or reaccounting of the banks' balance sheets. So how does that play out?

3. Upsides and Downsides

One reason giving away money to pay off underwater debts is a bailout, and thus politically unpopular, is that there would be a disconnect between who absorbed the costs on the downside and who gains the potential value from the upside. If taxpayers just paid off mortgage debts, banks and homeowners would gain a windfall that isn't directly shared with taxpayers. One way to deal with this is either to force creditors to eat a cost upfront -- they absorb the downside and then can benefit from the upside. The other is for taxpayers to gain from the upside, usually through the mass purchase and/or refinancing of mortgages. Let's look at the first way.

Why aren't bank servicers doing writedowns? There's a mix of bad incentives and poor resources that result in bad practices. The administration hasn't been aggressive with using financial fraud, like the range of practices including robosigning and documentation fraud, to force reform here, instead focusing on removing legal liabilities from the banks. Maybe that task force will someday do something, but from my read even sympathetic observers think it was a wasted opportunity. 

But even if policy is centered on forcing servicers to clean up their fraud, there's a lot of creditor free-riding in ad hoc debt writedowns that becomes problematic. Is writing down first mortgages good policy even if junior mortgages, often held by the biggest banks, are untouched? If home equity lines of credit are acting as a last line of income maintenance and credit for households in this weak recovery, is it wise to push policy to extinguish them to adjust first mortgages? If you wipe out both, isn't that a giant transfer to other creditors like auto lenders, private student loans, and credit card companies? Should we be concerned about moral hazard from the debtor's side? You need some mechanism to coordinate and bind the collective behavior of creditors while preventing free riding and also bringing in impartial adjudication, which is a traditional function of bankruptcy. Bankruptcy reform was famously not pushed by the administration, and to me that was its biggest mistake.

The other approach to avoid a bailout is for the government to gain a share of the upside for taking on the downside. This is one reason writedowns for the GSEs make sense: we gain the upside, as we own the GSEs, and we're already on the hook for the downside, so the risk on the downside isn't a "bailout" but prudent policy.

When it comes to dealing with the broader housing market, a lot of the programs proposed, like revitalizing HOLC or Senator Merkley's plan on refinancing, would have taxpayers put up money but gain in the upside. Even the IMF is now encouraging the United States and other countries to investigate bringing back something like an HOLC. The two counter-arguments would be that HOLC still had a high redefault rate, a rate that would have a lot of people crying foul. The second is the problem of what to pay for the mortgages. Recent attempts to use eminent domain to purchase mortgages at below-market rate in order to compensate taxpayers for absorbing these risks in a terrible market also have a lot of people crying foul.

My general thought is that moral hazard can be a problem, but the misery and wasted lives of mass unemployment is a much bigger problem. That said, bankruptcy and these government programs eliminate most moral hazard concerns. Bankruptcy can be done in such a way to hit homeowners as well; for the government program you'd want people to be trying to take advantage of them. That's why so many people have been shocked that the administration hasn't pushed on either.

What I find interesting is that all these articles about what could have been done with housing take the way TARP played out as given. But starting a HOLC program, rebooting the broken servicing model, or otherwise writing down mortgage principal would have been significantly easier if the banks were put into a receivership in early 2009. TARP policy, which was to protect the banks' balance sheets at all costs, worked counter-productively, putting administration resistence to enacting even the lowest-hanging policy fruit. Receivership would have cost more upfront, but it would have been significantly easier to tackle these problems. There is a major debate to have on this topic.

 

Mike Konczal is a Fellow at the Roosevelt Institute. Follow or contact the Rortybomb blog:

  
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Rediscovering Government

A Big Banker’s Belated Apology

Jul 30, 2012Jeff Madrick

This op-ed originally appeared at NYTimes.com.

This op-ed originally appeared at NYTimes.com.

Last week, in a CNBC interview, Sanford I. Weill, the former chairman of Citigroup, said that America should separate investment banking from commercial banking. This separation, of course, was the prime purpose of the Glass-Steagall Act of 1933, a piece of legislation that Mr. Weill and other bankers had successfully watered down, with Alan Greenspan’s support, before Mr. Weill helped engineer its official demise in 1999. Now, Mr. Weill, the creator of what was once the largest financial conglomerate in the world, suggests that Citigroup and others should be broken up. Banks can no longer “be too big to fail,” he told CNBC.

But what was most eye-catching was Mr. Weill’s claim that the conglomerate model “was right for that time.” Nothing could be further from the truth.

Mr. Weill’s original business concept — the justification of financial conglomeration — was to provide one-stop shopping to any and all customers. This could now include clients for investment banking, stock research, brokerage and insurance. Then, with the 1998 merger of his Travelers Group with Citicorp, it could include savers, business borrowers and credit card users, too. But few, even among his own executives, ever believed the strategy would work.

Rather, conglomeration bred conflicts of interest in Mr. Weill’s firms, and others — the very conflicts that the original Glass-Steagall Act was designed to prevent. This inevitably led to investment in and promotion of risky, poorly run and, in some cases, deceitful companies that brought us the high-technology and telecommunications bubble of the late 1990s.

Indeed, Mr. Weill’s Citigroup was a primary underwriter of and one of the two largest lenders to the oil and futures trading firm Enron, whose accounting charade resulted in what was in 2001 the biggest bankruptcy of its time. Citigroup was a major underwriter for the telecommunications giants Global Crossing and WorldCom, which would later go bankrupt as a result of flagrant accounting deceptions. There were many other, if less visible, debacles.

Read the full article here.

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Bubble Standards: Why the Poor Are on the Hook for the Housing Crash

Jul 23, 2012Mike Konczal

When it comes to assigning losses from an economic bubble, we apply one set of standards to elite investors and another to struggling homeowners.

When it comes to assigning losses from an economic bubble, we apply one set of standards to elite investors and another to struggling homeowners.

Many are discussing a potential collapse of a housing bubble in Canada and what could be done about it right now. Here are posts on that subject from Matt Yglesias, Dean Baker, and Worthwhile Canadian Initiative. As I read the literature being written on this crisis, the key issue to watch for is whether the rapid growth in housing prices is matched by a similar growth in household mortgage debt. To see why, it might be useful to contrast the aftermath of the United States' housing bubble with the stock market bubble.

The IMF recently studied a series of 25 OECD countries from 1980 to 2011. These countries experienced a total of 99 housing busts ("turning points (peaks) in nominal house prices"). It divided these housing busts into ones with a high run-up in household debt and ones with a low run-up, and found that "housing busts preceded by larger run-ups in household debt tend to be followed by more severe and longer-lasting declines in household consumption...real GDP typically falls more and unemployment rises more for the high-debt busts." This happens with or without a financial crisis occuring at the same time as the housing bust.

Why is this the case? Let's look at the allocation of losses that occur from the collapse of a bubble.

Within a short time after the internet dot-com bubble popped in 2000-2001, people had a sense of the size of the losses and who would take those losses. The equity holders of collapsing dot-com firms, the ones who held companies' stocks, would be wiped out, and the creditors would take huge hits, as there was very little property to be auctioned off or value to be retained. Trying to reorganize and resurrect the dot-com firms under Chapter 11 bankruptcy wouldn't have helped because they were new firms with no real revenues sources, their high-skill employees would flee, and there was little in terms of assets to use as collateral to secure future funding.

Since the firms were mostly webpages and had small-scale intellectual property, they were auctioned off very quickly under Chapter 7 bankruptcy rules. Even telecom firms that went bankrupt but had a large amount of assets and were eventually relaunched took less than two years. Global Crossing, for example, went bankrupt in January 2002 and relaunched in December 2003. These bankruptcies involved heavy losses for creditors. According to bankruptcy expert Edward Altman, "Default recoveries continued at persistently low average levels, weighed down by the enormous supply of new defaults and communication firms’ 16.6% average recovery." (h/t Greg Ip) But within a two-year span, the losses were understood and allocated.

It has been roughly five or six years since the United States' housing bubble popped. Have we finished assigning the losses yet? Robbie Whelan at the Wall Street Journal reports that we have a range of estimates from 23 percent of homes with a mortgage being underwater, owing a total of $715 billion more than their homes are worth (CoreLogic's estimates), to 31 percent of homes with a mortgage being underwater, owing a total of $1.2 trillion more than their homes are worth (Zillow's estimate). The evidence is clear that where households are most underwater on their mortgages, consumption is weakest, job losses are the worst, and income gains are struggling.

Mortgage debtors aren't shareholders, but it is fascinating to contrast their fates. In the dot-com bust, losses were assigned very quickly. In the housing bust, losses stick with the equivalent "equity" holder years and years out (and hang like an albatross around the neck of the economy as a whole). The losses that are allocated come about in large part through painful foreclosures, which create more losses by fire-selling assets into a weak marketplace. This system is designed to destroy all possible value and drag out the procedures in long, painful ways.

Crucially, in the dot-com bust there weren't the same moral and political arguments that we see in the current one. Economists who demand to know why U.S. mortgages don't stay with people who walk away from their homes didn't demand to know why the equity holders of Pets.com didn't have to dip into their personal savings to pay off the losses creditors took. Very Serious People wonder if debtors' prisons are necessary for homeowners who would walk away from a mortgage or view bankruptcy as an exit strategy, yet no Very Serious People called for the mass imprisonment of Webvan or Flooz shareholders after those firms declared bankruptcy as an exit strategy. Nobody argues that the shareholders of the dot-com era received a gigantic government bailout through the law when they were not personally on the hook for sticking creditors with an 83.4 percent average loss. Meanwhile, efforts to allow for a cleaner way of allocating the housing bubble losses, from retaining value of the household through bankruptcy reform to local municipalities taking action through eminent domain, face a minefield of political and financial industry opposition that gives the impression that the banks "own the place."

When it comes to assigning losses among elite financial institutions, like shareholders and creditors, there is a clean system in place to make sure that it runs efficiently without dragging the entire economy to a halt. When it comes to assigning losses between household mortgage debtors and elite financial creditors, we sit in a perpetual quasi-recession six years out. As the antropologist David Graber finds historically, "[d]ebts between the very wealthy or between governments can always be renegotiated and always have been throughout world history. They’re not anything set in stone... It’s, generally speaking, when you have debts owed by the poor to the rich that suddenly debts become a sacred obligation, more important than anything else. The idea of renegotiating them becomes unthinkable." This time isn't different.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Research Papers

How Mortgage Debt is Holding Back the Recovery: Konczal Makes the Case for Principal Reductions

Jun 28, 2012

Three years into the recovery, Americans are still struggling with underwater mortgages and economic growth remains slow and painful. This paper marshals the most recent and robust research to prove that there is a clear link between between economic stagnation and high levels of household debt, indicating the need for mortgage principal reductions.

Key Findings:

Three years into the recovery, Americans are still struggling with underwater mortgages and economic growth remains slow and painful. This paper marshals the most recent and robust research to prove that there is a clear link between between economic stagnation and high levels of household debt, indicating the need for mortgage principal reductions.

Key Findings:

  • Several years into this recession, the overall amount of underwater mortgage debt is still very high. Recent estimates show that a third of all houses with a mortgage owe more than the home is worth, and the total amount of underwater mortgage debt could come to $1.2 trillion.
  • The most recent empirical evidence, from academic quarters to the IMF, shows that underwater mortgage debt is creating a drag on the economic recovery. The recovery is weaker in places where mortgage debt is the highest, as more mortgage debt results in lower consumption and higher unemployment.
  • Other explanations of the relationship between the housing crash and the weak economy, such as structural unemployment created by the house bubble, contain serious weaknesses.
  • Debt writedowns, foreclosure mitigation, and other housing sector specific policies are a crucial tools in dealing with this “balance-sheet recession” and getting the economy started again.
  • Foreclosures exacerbate these problems by creating vicious cycles of destructive economic activity. Some estimate that foreclosures have caused an additional 25 percent of the decline in economic activity.
  • The market is not likely to sort this out by itself. There are numerous conflicts within the system of servicers that manage mortgage debt that incentivize saddling consumers with greater burdens.

Read the paper: "How Mortgage Debt is Holding Back the Recovery."

Download a PowerPoint presentation on the paper.

 

Underwater home image via Shutterstock.com.

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The Rent(al Income as a Percentage of GDP) Is Too Damn High, and Households Severely Burdened with Housing Costs

Jun 15, 2012Mike Konczal

Here's a great graph from Mike Norman Economics:

Here's a great graph from Mike Norman Economics:

Rental Income is "Rental Income of Persons with Capital Consumption Adjustment" (which you can find in FRED here). What's that? According to the BEA: "It consists of the net income from the rental of tenant-occupied housing by persons, the imputed net income from the housing services of owner-occupied housing, and the royalty income of persons from patents, copyrights, and rights to natural resources."

And, starting in the late 1980s it skyrockets as a percentage of our economy. It declines in the mid-2000s (the BEA explains why here), but is returning with a vengance. (Update: This data includes imputed rents homeowners pay themselves, and that is driving a lot of the increase, and we should emphasize that it makes straightforward analysis more complicated.)

But we are concerned with this impact on real people. What does the rental market look like on the ground, especially for people with high rents? The Joint Center for Housing Studies of Harvard University just released their 2012 State of the Nation's Housing.

(Aside: do we have too many houses? Study: "Given that the number of new homes added in 2002–11 was lower than in any other ten-year period since the early 1970s, it is difficult to argue that overbuilding is dragging down the housing market. Instead, the excess housing supply largely reflects the sharp slowdown in average annual household growth in 2007–11 to just 568,000—less than half the pace in the first half of the 2000s or even the 1.15 million averaged in the late 1990s." This household formation drop is due to the unemployment crisis and "a sharp drop in immigration." There are some good charts that explain this.)

For the purposes of our rentier economy, I want to look at something they emphasize: people burdened by housing expenses. They find that, from 2007 to 2010, there was an increase of 2.3 million households paying more than half of their income for housing (what they define as "severly burdened"); that brings it to a total of 20.2 million. That is no doubt impacted by the unemployment crisis, but this is a longer-term trend too. There was an increase of 4.1 million people paying more than half their income for housing from 2001-2007:

That 20.2 million severly burdened households are equal to 18 percent of all households. 27 percent of renters fall into this severly burdened category, with homeowners roughly half that number.

Who falls into this category? Older people are vunerable, with a rise from 12 percent to 16 percent of 55-64 year olds falling into the severly burdened category from 2007 to 2010. Metropolian areas, especially core cities, are places where this is prevalent. It impacts poorer people the most, with over 60 percent of those making less than $15,000 in this category, and 30 percent of those making between $15 and $30 thousand dollars a year as well. It's negatively correlated with education, with those with a college degree having the lowest rates - so this isn't a matter of young college graduates overpaying to live in a nice city.

Indeed It is worth noting that poor families with children paying more than fifty percent of their income on housing spend less on other essentials. "Among families with children in the bottom expenditure quartile, those with severe housing cost burdens spend about three-fifths as much on food, half as much on clothes, and two-fifths as much on healthcare as those living in affordable housing." No doubt some of these cost burdened households love living where they do, save on transportation and don't mind the spending; others are spending much less on food for their children because they need to spend so much to keep a roof over their heads.

This is what it looks like when working people get squeezed by rents.

 

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Rediscovering Government

The Case Against Tax Breaks for Private Equity

May 23, 2012Jeff Madrick

Private equity disproportionately rewards privatization companies while others are burdened with the risks. 

Private equity disproportionately rewards privatization companies while others are burdened with the risks. 

I wanted to wait a few days before commenting on Newark Mayor Cory Booker’s spontaneous criticism of Barack Obama for picking on Mitt Romney's experience at Bain Capital. Booker doesn’t know much of anything about private equity, but many financial services donors have his ear. He took in nearly half a million dollars in campaign donations from the industry over the last nine months, and he frankly sounded like its mouthpiece.

Booker backtracked, but it would be nice if he knew something about the private equity business before he spoke publicly about it. This expectation of knowledge should also apply to widely read columnists like David Brooks, who, as usual, reflexively defended the Wall Street practice without presenting evidence. He issued a piece of public relations diatribe that no doubt soothed the right but contributed nothing to our understanding. The contention is that these buyouts turned fat American companies into lean and productive ones since the 1970s. Other pundits less well known for their conservative reflex responses have also given partial defense of private equity.

So let’s begin with one point: there is a place for private equity. In a privatization or leveraged buyout, a company is bought by an investment partnership with moneys borrowed against the company itself. The new money can be used productively even when levels of debt against the company’s assets and profits soar. A smaller company that cannot raise adequate equity can raise money by being bought by a private equity partnership. A company that is doing poorly can benefit from added capital and new management. Sometimes trimming labor costs in the process makes sense, of course. 

But the record of leveraged buyouts and private equity reflects its excesses, and most importantly, the lopsided nature of the financial incentives for doing the deals in the first place. Companies like Romney’s Bain or Steve Schwartz’s Blackstone or Kohlberg Kravis Roberts, the early industry leader when privatizations were called leverage buyouts (LBO), take advantage of a major government-provided benefit. The interest on debt is tax-deductible, and high levels of debt are the source of profits in these transactions. It is just like buying a house with a small down payment; if you can sell as the value goes up, the return on the down payment is high and the interest was deductible all along. In the meantime, the house is collateral for the loan. Similarly, partners are rarely if ever on the line for the debt; the company being privatized is. The one difference is that if the collateral value of the house falls, as it has recently, the homeowner is on the line. This is usually not so with privatizers.  

Great deal? You bet. The owners of the privatizing firm put up very little capital; it is their limited partners who put up more.  Then they borrow like mad from banks, pension funds, hedge funds and so on. If the new company can be sold or brought to market again at a higher price, they make a bundle compared to their equity down payment. The CEOs of the company, or the new executives brought in, are given huge amounts of stock. They too make a bundle. Are these incentives conducive to good business decisions?

Most likely, the investment decision is based not on how much the company can be improved, but how much can be borrowed against its assets. The second concern is the interest rate on the debt. There is no evidence that privatizers mostly buy struggling companies to resuscitate them.

Moreover, companies with high levels of debt are subject to great risk of bankruptcy. Macy’s did one of the first leveraged buyouts of its size, the CEO made out wonderfully, and soon Macy’s was in bankruptcy. It reorganized and reemerged successfully due to its retailing skills, but these were not enhanced by the LBO partners.  

Data shows the newly bought firms create fewer new jobs—or result in more lost jobs—than firms that are not subject to private takeover. But what about the much-lauded productivity gains? On balance, these target firms mostly increase productivity by selling or closing low-productivity units. Arguably, they also make their employees work harder. The fear of lay-offs can enhance productivity. There is no evidence that these firms improve productivity mostly by investing in new technologies, new managerial methods, and so on, which is often their claim.

And of course what productivity gains they have had (overall they are small) did not reinvigorate the American economy. The two main sources of productivity gains in the U.S. were high-tech companies and the retailing behemoths led by WalMart. Many retailing targets of privatizations eventually went bankrupt.

The best recent paper on private equity was written by Eileen Appelbaum of the Center for Economic and Policy Research and Rosemary Batt of Cornell University. The David Brookses of the world will cry that these researchers are of a liberal bent. But read the paper to see how carefully it is done. The exegeses of much of the right in defense of private equity are essentially outright propaganda.   

However, the basic point comes back to government and regulation. A major tax advantage gives rise to these buyouts. The privatization partnerships are lightly regulated. After-fee returns to the limited partners seem to be below average. But as for their benefits to society, privatization rewards investors by cutting short-term costs. For a long time, the stock market pushed up the stock prices of companies that kept short-term earnings growing. The influence of such corporate governance has been to keep downward pressure on wages and stoke fear in employees for three decades.

Let’s be clear; some private equity investments were healthy and some of these partnerships do a good job. But all in all, it is clear most are simply exploitations of tax law, market fashions, and their power to borrow money. There is no reason America should reward these investors with a tax break on their huge loans.   

Privatizers didn’t rebuild America. They were rarely the people who planted the garden, watered it, or designed it.  They were by and large the ones who weeded it, sometimes recklessly, throwing out the gorgeous roses in the process. Gardens do need to be weeded, but should those who do the weeding, often heedlessly, make so much more money than those who do the planting? And with the added help of government tax breaks?

In the end, Romney’s Bain made money even though its takeover target, American Pad & Paper, went out of business. Consult Appelbaum and Batt on how some of these strategies work, involving mortgaging real estate holdings and transfer pricing to reduce taxes. Privatization was mostly, if not entirely, about working the system, not building capitalism.  On balance, evidence suggests it hurt more than helped. Any way you read the evidence, it is clear the rewards for private equity firms clearly exceeded the risks. That’s not good for free markets.  

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author of Age of Greed.

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