Unintended Consequences

The Senate on Wednesday passed a $15 billion jobs bill that offers a tax break to companies that hire people who have been unemployed for at least 60 days. This should help create some jobs. But it will probably also have unintended consequences. Unfortunately, the legislation actually encourages companies to fire existing employees and hire unemployed people to capture the tax credit. This problem will particularly afflict unskilled laborers who require little training and are easily replaced, but have managed to avoid the chopping block despite the current downturn. The tax credit may even trigger layoffs: companies often delay layoffs as long as possible because the costs of rebuilding a workforce once demand picks up in the future are substantial at many firms. By making hiring so much more attractive, this bill likewise makes firing much easier for firms. The Senate ought to have just lowered payroll taxes for all Americans, but by a lesser amount.

Bank Busters

The Obama administration's schizophrenic affair with investment banks took another unfortunate turn this week. While Wall Street has been busy doling out compensation packages that rival the bonuses of the frothiest days of 2007, the White House has been busy trying to position itself as the avenger of Main Street. A hundred billion dollar bank tax is now on the agenda for debate (see recent post). But the proposal that has the greatest potential impact on finance as we know it is a prohibition on banks using customer deposits to finance trading operations.

While I support some sort of special tax, I do not support the proposed ban on risky investing by banks that accept customer deposits. It is clear that the government does not want banks to stop investing and trading altogether. Despite the tumult of the last two years, it is important to remember that the core business of finance is actually good for the world: moving capital from lenders to borrowers does wonders for real economic development. The difficult problem we face is how to regulate that process so as to foster economic growth, create fair outcomes, avoid systematic meltdowns, and keep taxpayer dollars out of Wall Street's hands.

Separating deposits from banks' trading operations would not improve the financial system. It might very well make it worse. Recall that in the Fall of 2008 firms with large reservoirs of customer deposits were best able to ride out the storm. Bear Stearns, Lehman Brothers, and A.I.G., on the other hand, did not have significant customer deposits. This is because F.D.I.C. insured deposits were a remarkably stable source of capital for banks. As the financial world unraveled, customers happily left their deposits in their accounts at J.P. Morgan Chase, Citi and Bank of America. Other sources of bank capital - the repurchase market, the commercial paper market, and the bond market - dried up. Without access to capital, banks were forced to sell assets at fire-sale prices to repay their obligations as they came due. The result was a market collapse and trillion dollar government interventions. One of the major lessons of Fall 2008 is that banks were buying risky assets with capital that could dry up very quickly. Customer deposits were a bright spot on banks' balance sheets; they were a source of stable capital throughout the crisis.

So why would the administration want to discourage banks from using a more stable source of capital? I don't know. Perhaps they believe that by taking away one source of capital they can reduce the amount of investing that investment banks do. This is probably correct. But surely we would want to restrict the sources of capital that are least stable first. And remember that we do indeed want banks to take some risk; investment is a good thing. Cutting off deposits from investment banking removes a stable source of capital. Such a policy could increase risk while decreasing investment and economic growth. Obama's team needs to go back to the drawing board.

Also check out this Bloomberg article about the proposal.

Obama's Bank Tax

President Obama this week unveiled a plan to raise about 100 billion dollars by taxing big banks. The overall thrust of the plan - replenishing government coffers with a slice of the profits made by institutions that were saved from destruction by government largesse - seems fair. And the U.S. Treasury could surely use the cash. So I support this effort to get taxpayers some of the money that is rightfully theirs.

However, this tax is far from ideal and raises some troubling questions about the future role of government in the financial sector. A system in which politicians run about deciding which industries they like and which they would like to tax is a bad one. Tax policy should be predictable so that investors can confidently invest without fear of retributive taxes. And taxes should not target certain industries; targeted taxes interfere with the free market and hinder economic growth. Another unfortunate consequence of a system in which Congress picks winners and losers in business is that such a system encourages lobbying and tends to corrupt the political process. Perhaps worst of all, this tax does little to remedy the hyper-leveraged risk taking that brought down the financial system in the first place. In fact, the tax has the unfortunate consequence of increasing leverage by reducing the firms' equity.

One desirable feature of the tax is that it hits bigger firms harder (the amount of tax owed is a percentage of certain types of assets and only kicks in if a firm has 50 billion in such assets). This may in some small way reduce the too big to fail problem, but the benefits of being big will still outweigh the costs of the tax. Other than that, the proposed levy does little to reform the financial system to make it more stable in the future.

A variety of superior alternatives exist. The first that comes to mind is an F.D.I.C. controlled investment bank bailout fund modeled after the current F.D.I.C. deposit insurance program. Firms would contribute to an annual fund that would be used for future problems and the amount contributed would be based both on a firm's size as well as an estimate of its risk. An important feature of an F.D.I.C fund would be the orderly wind-down of any firm that needed assistance. The F.D.I.C. has already successfully wound down hundreds of failed deposit banks and could extend this expertise to the investment bank behemoths. Funds would not be used to keep the firm alive or to bail out investors. Only customers would get bailed out and even they might be forced to take a haircut on their assets.

Another alternative would be a tax that accounts for leverage as well as size. Banks' excessive leverage was a much more significant factor in the financial meltdown than was size.

It is also worth quickly reviewing some T.A.R.P. history to point out how this tax is inconsistent with earlier theories used to justify the terms of the bailout. Many argued - including myself - that the terms of any bank bailouts should be much harsher for the banks' investors. Paulson - in conjunction with a Congress controlled by Democrats - doled out cash on generous terms. They argued that they were not trying to punish banks, but to encourage lending. Despite the fact that Warren Buffet was simultaneously extracting much better terms for his investment in Goldman Sachs, Paulson believed that he should not do so on behalf of the taxpayers who employed him. Had the government demanded much larger equity stakes and/or concessions from bondholders, taxpayers would have fared much better and banks would have learned a much sterner lesson about the dangers of excessive risk.

Obama is doing the right thing by trying to capture some of the profits that were made possible by taxpayers. But his tax proposal is a blunt tool that undermines political integrity and confuses investors. It also fails to discourage the types of behavior that caused the financial crisis in the first place. It would be easy to improve this bill.

How Much Debt Is Too Much Debt?

Just about everyone in Washington seems to agree that the U.S. deficit is large and unsustainable over the long term. But there are few signs that Congress has the discipline to reduce the deficit anytime soon. The Obama administration and many Congressman talk about deficit reduction. It remains unclear how they aim to achieve it. It will be especially difficult to cut the deficit if the economy does not recover as Washington is hoping; another downturn could make it tricky for politicians to cut popular - and expensive - stimulus programs. Keep your eye on how Congress handles the upcoming expiration of the $8,000 first-time homebuyer credit for early indications about how much willpower exists to reduce spending (there has been a lot of chatter about extending and/or expanding the program).

Policy makers have a difficult balancing act: cut spending too much and economic activity could plummet; spend too much and the United States could have a fiscal crisis replete with inflation, high interest rates, and a weakening of the dollar. Both scenarios could be disastrous to Americans' well being. But there has not been a thorough public discussion about how close we are to the latter outcome. How is Congress supposed to balance these monumentally important constraints when so little is understood about how much debt is too much debt?

Recent articles in the Economist and the New York Times have examined this question. The Economist suggests that the high amount of government debt may weigh on growth in the future, but will not cause a crisis. This thesis largely rests on a comparison of the United States with Japan. Japan's government debt to GDP ratio is actually much higher than America's ratio. The Times makes a similar comparison, but raises questions about how useful such a comparison will be in reality. The Times correctly points out a crucial difference between the United States and Japan that the Economist failed to mention:

One hugely important difference is that Japan is rich in personal savings and assets, and owes less than 10 percent of its debt to foreigners. By comparison, about 46 percent of America’s debt is held overseas by countries such as China and Japan.

In other words, Japan owes Japan money and the United States owes other countries (including Japan, incidentally) money. By some measures, America actually looks much worse than Japan. A useful statistic that receives insufficient attention in discussions about debt is the net international investment position. The NIIP of the United States measures the value of foreign investments held by Americans minus the value of investment in the United States owed to international holders. This accounts for all types of investment (stocks, bonds, and direct ownership) by all sorts of entities (government, businesses and consumers). Japan has a positive NIIP, meaning that other countries owe Japan more money than Japan owes the rest of the world. The NIIP of the United States, on the other hand, is negative.

Considered in this context, it appears incorrect to find comfort about America's debt levels by comparing them to Japan's debt levels. So how much debt is too much debt? I don't know. But the current plan of spend now, figure it out later, and don't worry because our government debt to GDP ratio is lower than Japan's seems dangerous and ill-informed. Economists and Congress should be scrambling to determine just how much debt the United States can sustain without triggering a new financial crisis. Armed with a better understanding of how much debt is sustainable, policy makers will make much smarter choices about spending.

Home Prices Should Not Go Up

The collapse of home prices in the United States is a major cause of the financial sector's current woes and the severe economic decline we are currently suffering. I do not dispute that. But I do dispute the notion that using government money to attempt to stabilize or increase home prices is the correct policy response.

Home prices declined because they were far too high to begin with. They got so high because fancy mortgage products enabled people to buy homes that were more expensive than they could actually afford. And people bought homes that were more expensive than they could afford because they assumed (wrongly) that they could refinance on more advantageous terms sometime later or sell the house at a price higher than they paid for it. The government exacerbated the bubble by encouraging the GSE's (Fannie Mae and Freddie Mac) to subsidize the mortgage market, thus making it easier to borrow money for a home purchase.

There are many reasons why government policies designed to prop up home prices are a bad idea. The first one is that low home prices are a great thing. Like milk, gas, and healthcare, housing is something everyone needs. The lower it costs, the better. It is pretty straightforward to understand why the approximately 1/3 of Americans who do not own homes would benefit from lower housing prices. Of course, many Americans own their homes. And they seem to want their homes to be worth more money. But if you think about it, the vast majority of homeowners do not realize any benefits when home prices rise. Higher home prices mostly make people feel wealthier; owning a more expensive house does not result in more money in someone's bank account unless she is willing to sell that house and begin renting or buy a smaller house. Most homeowners, however, aspire to live in their homes for a long time or to move up to a bigger and better house when they can afford to do so.

The government has enacted many policies designed to make home ownership more affordable: tax credits for first-time home buyers; an aggressive policy of printing money to buy mortgage-backed securities from financial firms designed to drive down mortgage rates; and propping up Fannie Mae and Freddie Mac to make it easier for Americans to obtain mortgages. These policies may make homes more affordable for people in the near term. But they also create more demand for housing and result in higher home prices: people are willing to pay more for houses because interest payments on their mortgages are lower and they can receive tax incentives for buying.

Unless the government is going to continue to plow money into the housing industry forever, these policies are creating future problems. If the government cuts these subsidies, housing prices could fall, perhaps drastically. Because current policy encourages people to buy homes today at artificially high prices, we might have a whole new wave of people who owe more on their mortgages than their houses will be worth in the future. This might create yet another economic crisis. And it would ensnare a whole new group of homeowners who managed to escape the current crisis and are fortunate enough to be able to buy a new home today.

Another unfortunate consequence of policies that prop up home prices is that they result in resources being diverted from more economically productive industries toward home construction. Building bigger and better homes is nice. But it does not result in a more productive economy. (It does lead us to consume more energy, however). By increasing the demand for homes - and the resources that go into home construction - we take resources from other industries that create economic progress and make America more competitive.

The dangers of a housing bubble are clearer than ever. The United States needs to stop feeding a new one and let housing prices decline to a natural equilibrium. Although this may upset some banks and those homeowners who are planning to sell, it will benefit the broader economy by reducing the risk of a future housing collapse and increasing our economy's productivity.

TARP Repayment: Good News, But Banks Still Have Government Money

Today the Treasury announced that 10 large banks would be allowed to repay funds they received under the T.A.R.P. program. This is good news for the American taxpayer. However, it hardly signals some sort of "all clear" for these institutions. Banks that repay T.A.R.P. money are not necessarily operating without massive amounts of government financial assistance. Remember that the T.A.R.P. represents only a fraction of total government support to the financial sector. The Federal Reserve, through a variety of other bailout programs, has lent billions of dollars to Wall Street. Perhaps this has received less attention because reporting on it is so difficult: the Fed refuses to disclose who it has loaned to and on what terms. Meanwhile, the F.D.I.C (and ultimately the taxpayer) continues to guarantee billions of dollars of debt issued by some of the very same banks that have repaid T.A.R.P. funds.

If every single bank were to repay every dollar ever lent through T.A.R.P., Wall St. would still have lots of government money. And the government would still be on the hook for massive amounts of bank liabilities if some of these institutions ever become insolvent in the future. It remains unclear when and how the Fed and the F.D.I.C. will untangle themselves from these arrangements.

Usury

To a foreigner you may charge interest, but to your brother you shall not charge interest, that the LORD your God may bless you in all to which you set your hand in the land which you are entering to possess. (Deuteronomy 23:19,20)

I usually try to avoid Biblical quotations, but this time I just could not resist. To be honest, I do not really agree with the quote. I am, after all, a fixed income trader whose career hinges on the usefulness to society of lending money at interest. I include it here to make a point: throughout history, the charging of interest has been a controversial topic. Some argue that it leads to investment and progress. Others argue that it is immoral and contrary to scripture. I would argue that the controversy stems from the fact that while it does lead to economic progress in the majority of instances, there are also times when lending can be predatory and immoral. Lending money to a small business at 9% sounds like a good deal for everyone. But lending money at an annual rate of 25% to a single mother who is struggling to put food on the table does not result in economic progress. Rather, it results in richer guys getting richer and poorer people staying poorer.

So, I was quite disappointed today when the Senate killed a proposal by Senator Bernie Sanders, Independent from Vermont, to put a cap on the rate banks charge credit card customers. Unfortunately, Congress lacks the will to inhibit the type of irresponsible lending that financially cripples families and leads America further down a seemingly never-ending hole of bad debt.

In general, I oppose Congressional interference in business matters. But today an exception to that rule should have been made. Taxpayers are currently propping up Wall Street banks for the good of the country, or so we are told anyway. It is perfectly reasonable for that assistance to come with some strings attached. One very good string would prevent bailout recipients from engaging in a practice (usury) that exacerbates the very same problem (a debt crisis) that the bailout money is intended to resolve.

I would have liked Sander's proposal even more had it only applied to bailout recipients. That way the problem of interference with free markets would be irrelevant. But either way, it is very disappointing that our government has again failed to protect American families because the interests of banks got in the way.