Charitable organizations form a vital part of America’s safety net. Ideally, foundations would be able to make greater payouts in hard economic times when needs are greatest. Unfortunately, the design of today’s excise tax on foundations undermines and in fact discourages such efficiency.
Under current law, private foundations are required to pay an excise tax on their net investment income. The tax rate is 2 percent, but it can be reduced to 1 percent if the foundation satisfies a minimum distribution requirement. The dual-rate structure and distribution requirements obviously introduce complexity. The stated purpose of the tax in legislative history—to finance IRS activities in monitoring the charitable sector—has never been fulfilled.
In the recent recession, the impact of the excise tax was especially pernicious, as it penalized those that maintained their level of grantmaking.
How? As Martin Sullivan and I first described in 1995, the excise tax penalizes spikes in giving; under the current formula, a temporarily higher payout results in a higher excise tax when payouts fall back to previous levels. A foundation that reduced its grantmaking during the last recession would not be subject to an increased excise tax because the amount the foundation paid out would be measured as a share of current net worth.
One proposal would replace the excise tax with a single-rate tax yielding the same amount of revenue. While a flat-rate tax would remove the disincentive to raise grantmaking in bad times, it still raises taxes for some foundations and not others.
A related law applying to foundations is the required payout rate, now set at 5 percentage points. Many experts have debated how high that rate should be. The current rate is believed to approximate the long-term real rate of return on a foundation’s balanced portfolio of assets. However, if foundations follow a strict rule of paying out the minimum 5 percent every year, they, too, will be operating procyclically, paying out more in good times when stock markets are high and less in bad times.
If we wish foundations to operate more countercyclically—to pay out more when needs are greater—we need to address both the excise tax and the natural tendency, reinforced by a minimum payout requirement, to make grants and payouts as a fixed percentage of each year’s net worth.
Nothing better exemplifies our gridlock over the future of 21st century government, as well as how to recover from the Great Recession, than the false dichotomy of austerity versus stimulus.
The austerity thesis, reduced to its simplest form, suggests that government has been living beyond its means for some time, only exacerbated by the actions that accompanied the recent economic downturn. Sequesters, tax increases, and spending cuts become the order of the day.
The stimulus hypothesis, reduced also to simplest form, suggests that more government spending and lower taxes puts money in people’s pockets and helps cure a country’s economic doldrums. Once the economy is doing better, government spending will naturally fall and taxes rise.
The debate then plays out largely over deficits: do you want larger or smaller ones?
But reduced to this form, the debate is a fallacy, for several reasons.
First, one must define larger or smaller relative to something. Last year’s spending or taxes or deficits? What’s scheduled automatically in the law? The public debate often glosses over these issues. Which is more expansionary when keeping taxes at the same level: an economy whose growth in spending is cut from 6 to 4 percent or one whose growth is increased from 1 to 3 percent?
Second, a country’s ability to run deficits depends on its level of debt. A recent debate over whether at some point higher debt starts to slow economic growth doesn’t change the fact that lenders want to be repaid. People won’t loan to Greece now, but they still find the U.S. Treasury securities a safe haven for their money.
Third, and by far the most important, what timeframe is involved? Is the Congressional Budget Office pro-austerity or pro-stimulus when it concludes that sequestration hurts the economy in the short run, but is better in the long run than doing nothing about deficits? No one on either side suggests that debt can grow forever faster than the economy. Everyone implicitly or explicitly believes that to accommodate recessions when debt grows faster there are times when debt must grow slower.
So where’s the rub? Here you must understand the emotional systems, usually veiled, that lie behind those on both sides trying to force the problem to an either/or solution.
Start with hardline austerity advocates. Many of them don’t just want smaller deficits. They want smaller government—or, at the very least, they want to prevent the government from taking ever larger shares of the economy, even given changing demographics. Essentially, austerity advocates don’t trust their pro-stimulus adversaries, some of whom can almost always find an economy going into a recession, in a recession, coming out of a recession, or attaining a lower-than-average growth rate and, therefore, needing some form of stimulus. Austerity advocates have learned from long experience that once government spending is increased, it’s hard to reduce. So they feel they have to get what deficit reduction they can now that the public’s attention to recent large debt accumulations is creating pressure to act.
Now for many the hardline stimulus advocates, their support for additional temporary government intervention cannot be entirely disentangled from their sympathy for a larger future government. Else why not agree to cut back now on the scheduled acceleration of entitlement programs, particularly fast-growing health and retirement programs? That would bring the long-run budget, at least as currently scheduled, back toward balance. It would simultaneously please many of their austerity opponents and allow for more current stimulus.
The hidden agendas are complicated further by inconsistencies on both sides. Many hardline austerity advocates, at least in the United States, don’t want cuts to apply to defense spending. For their part, many hardline stimulus advocates would be glad to pare growth in tax subsidies.
Regardless, the dichotomy falls apart once one realizes that a solution can involve a slowdown in scheduled growth rates in spending and a higher rate of growth of taxes, accompanied by less short-run deficit reduction and an abandonment of poorly targeted mechanisms such as sequesters.
Consider the buildup of debt during World War II, the last time we saw U.S. levels above where they are today. Debt-to-GDP fell fairly rapidly after the war all the way until the mid-1970s. While the growing economy certainly helped, tax rates that were raised substantially during the war were largely maintained afterward, and spending had essentially no built-in growth (actually huge declines when the troops came home). Just the opposite holds now even with recovery: there are limited tax increases to pay for past accumulations of debt or wartime spending, and spending is scheduled to grow long-term, even after temporary recession-led spending and defense spending on Afghanistan declines.
Both sides—pro-austerity and pro-stimulus—want desperately to control an unknown future, either by not paying our current bills with adequate taxes or by maintaining built-in growth rates in various programs, mainly in health and retirement. The false dichotomy between austerity versus stimulus has fallen by the wayside, and what we see through the veil are two sides in mutual embrace trying to control our future, whatever the cost to the present.
COAUTHORED WITH DOUG WISSOKER
A recent paper by Bayer, Ferreira, and Ross on mortgage delinquencies and foreclosures finds that people of color had greater problems once Recession hit than did many others in roughly equal circumstances, such as income and location, but with different racial backgrounds. We believe this is a useful, though not surprising, finding in ongoing studies of the impact of the Recession on different types of households. Yet we worry about how its results get extrapolated into policy recommendations.
The paper concludes that their research “raises concerns about homeownership as a vehicle for reducing racial wealth disparities”. We believe that one needs to be very careful in extrapolating lessons from the market of the mid-2000s to any market and to policies that would apply over time. Paying off mortgages is the primary means by which the majority of households, particularly low and moderate-income households, save over time. Discouraging such saving could easily add to already unequal distribution of wealth in society.
First, a quick summary of the findings. Combining several sources of data to look at racial differences in delinquent payments and foreclosures for mortgages for purchases and refinances originated between 2004 and 2008, the authors find that black and Hispanic borrowers had substantially higher delinquency and foreclosure rates than whites and Asians, even controlling for differences in circumstances such as the borrower’s credit score, the size of the interest rate spread of the loan, and the identity of the lender. In addition, the authors conclude that the racial gap in delinquent payments and foreclosures peaked for loans originating in 2006. From this, they conclude that people of color entering the market at the peak of the housing boom were particularly vulnerable to adverse economic conditions.
The authors attribute the racial difference found for blacks and Hispanics, even after trying to control for income or other differences, to items they couldn’t measure, including lower wealth and an accompanying lack of a financial cushion. This seems crucial to us and is also consistent with studies that income an incomplete predictor of upward or downward mobility. Work from the Urban Institute (here) shows that wealth differentials by race are much greater than income differentials. These differentials can play out in multiple ways across generations. For instance, wealthier families provide more inheritances and intergenerational transfers that support homebuying and downpayment levels that reduce foreclosure risk.
However, the authors’ concern about homeownership as a vehicle for reducing racial wealth disparities does not follow logically. Evidence here is at best circumstantial. Among other sources of disparate outcomes, consumer groups would point out that these types of findings more than anything highlight the disparate impact of abusive lending at the height of the housing boom.
Portfolio theory requires looking across different types of assets and debts, along with their associated expected returns and risks. Homeownership has risks, but so does renting. In fact, rental rates at times rise faster than the costs of homeownership, and in many parts of the country it has become cheaper to own than rent for those likely to be in a home long enough that transactions costs do not eat away at the ownership returns. Similarly, a household often must choose among debt instruments. Mortgages tend to have lower interest charges than most other forms of debt.
Most vehicles for getting a decent return on investment involve some risk. Saving accounts now paying negative, after-inflation, returns only prove the point in spades. If saving were proportionate to income, for instance, but lower-income individuals invest only in low or negative return assets, then wealth inequality necessarily would grow to be much greater than implied by levels of saving, potentially compounding adverse outcomes over time. Conversely, without discounting lessons from the Great Recession, low-cost, well-structured mortgages continue to be supported by the government (whether through FHA or the GSEs) partly for the very purpose of diversifying risk and effectively spreading wealth ownership.
This study is based on patterns of delinquency and foreclosure rates observed during a limited time period with unusually high foreclosure rates. But, wealth accumulation occurs over a very long time. Thus, even on this paper’s own terms, it’s not clear that reduced rates of homeownership would make low-income households or people of color better off over extended periods. We have found that most homeowners buying a decade or so before the Great Recession came through the longer period in good shape. Our own work also tends to show that black homeownership rates, even after controlling for income, are disproportionately low in both good and bad markets, raising serious questions about whether they are missing out on opportunities available to others.
Regardless of the effect on the difference in wealth disparity by race, homeownership is an effective way for many, though certainly not all, low- and moderate-income households to save. Equity in a home is the primary asset owned by low- and middle-income households, including blacks and Hispanics, by the time of retirement. Paying off a mortgage is the primary mechanism by which these households save, with all the virtues of a more automatic and regular saving vehicle. Reductions in the already low homeownership of people of color would almost certainly exacerbate over time the unequal distribution of wealth.
The young have been faring poorly in the job market for some time now, a condition only exacerbated by the Great Recession. Now comes disturbing news that they are also falling behind in their share of society’s wealth and their rate of wealth accumulation.
Signe Mary McKernan, Caroline Ratcliffe, Sisi Zhang, and I recently examined how different age groups have shared in the rising net wealth of the U.S. economy. Despite the recent recession, our economy in 2010 was about twice as rich both in terms of average incomes and net worth as it was 27 years earlier in 1983. But not everyone shared equally in that growth.
Younger generations have been particularly left behind. Roughly speaking, those under age 46 today, generally the Gen X and Gen Y cohorts, hadn’t accumulated any more wealth by the time they reached their 30s and 40s than their parents did over a quarter-century ago. By way of contrast, baby boomers and other older generations, or those over age 46, shared in the rising economy—they approximately doubled their net worth.
Older Generations Accumulate, Younger Generations Stagnate
Change in Average Net Worth by Age Group, 1983–2010
Source: Authors’ tabulations of the 1983, 1989, 1992, 1995, 1998, 2001, 2004, 2007, and 2010 Survey of Consumer Finances (SCF).
Notes: All dollar values are presented in 2010 dollars and data are weighted using SCF weights. The comparison is between people of the same age in 1983 and 2010.
Households usually add to their saving as they age, while income and wealth rise over time with economic growth. If these two patterns apply consistently and proportionately, then one might expect to see, say, a parent generation accumulate $100,000 by the time its members were in their 30s and $300,000 in their 60s, whereas their children might accumulate $200,000 by their 30s and $600,000 by their 60s.
This normal pattern no longer holds for the younger among us. However, this reversal didn’t just start with the Great Recession; it seems to have begun even before the turn of the century. The young increasingly have been left behind.
Potential causes are many. The Great Recession hit housing hard, but it particularly affected the young, who were more likely to have the largest balances on their loans and the least equity relative to their home values. If a house value fell 20 percent, a younger owner with 20 percent equity would lose 100 percent in housing net worth, whereas an older owner with the mortgage paid off would witness a drop of only 20 percent.
As for the stock market, it has provided very low returns over recent years, but those who hung on through the Great Recession had most of their net worth restored to pre-recession values. Bondholders usually came out ahead by the time the recession ended as interest rates fell and underlying bonds often increased in value. Also making out well were those with annuities from defined benefit pension plans and Social Security, whose values increase when interest rates fall (though the data noted above exclude those gains in asset values). Older generations hold a much higher percentage of their portfolios in assets that have recovered or appreciated since the Great Recession.
As I mentioned earlier, however, the tendency for lesser wealth accumulation among the younger generations has been occurring for some time, so the special hit they took in the Great Recession leaves out much of the story. Here we must search for other answers to the question of why the young have been falling behind. Likely candidates for their relatively worse status, many of which are correlated, include
- a lower rate of employment when in the workforce;
- delayed entry into the workforce and into periods of accumulating saving;
reduced relative pay, partly due to their first-time-ever lack of any higher educational achievement relative to past generations;
- their delayed family formation, usually a harbinger and motivator of thrift and homebuilding;
- lower relative minimum wages; and
- higher shares of compensation taken out to pay for Social Security and health care, with less left over to save.
When it comes to conventional wisdom and media attention to distributional issues, there’s a tendency simply to attribute any particular disparity, such as the young falling behind in wealth holdings, to the growth in wealth inequality in society. But the two need not be correlated. Disparities can grow within both younger and older generations, without the young necessarily falling behind as a group.
Whatever the causes, we should also remember that public policy now places increased burdens on the young, whether in ever-higher interest payments on federal debts they will be left or the political exemption of older generations from paying for their underfunded retirement and health benefits. At the same time, state and local governments have given education lower priority in their budgets; pension plans for government workers now grant reduced and sometimes zero net benefits to new, younger hires; and homeownership subsidies post-recession increasingly favor the haves over the more risky have-nots.
Maybe, more than just maybe, it’s time to think about investing in the young.
The press recently had a field day reporting the decline in wealth from 2007 to 2010, as measured by a recently released Survey of Consumer Finances. Be careful interpreting those results. A decline in the valuation of wealth does not necessarily mean any decline in collective well-being or consumption in a society.
Think of a decline in the price of gold. Society doesn’t necessarily consume any less of anything, and the loss for the gold seller is a gain for the gold buyer. More relevant to the current crisis, take the value of a house. It doesn’t produce any fewer services just because it sells for less. And the buyer gains what the seller loses. A retiree’s hope for selling and then spending down those assets in retirement may be reduced, but his children’s earnings go a lot further if they decide to buy a house.
There are, of course, real and agonizing losses from a recession. They largely come from the decline in output of society and of the corresponding income of its citizens. There are too many unemployed and underemployed resources, both people and capital. When a decline in society’s aggregate wealth reflects a reduction in the collective value of all the future things it can produce or buy—for instance, because factories produce less—then there are total net losses that are never recovered. Even here, however, one must distinguish between when the decline in wealth valuation occurs and when the losses to society really take place. Greece’s economy, for example, was long on a downhill curve, which the markets finally realized. In fact, if the reform effort succeeds, Greek citizens may end up with a more, not less, wealthy economy than they had when stocks and bonds started tumbling downward.
Today’s budget problems aren’t America’s first. High debt levels accompanied our major wars, but they were quickly reduced soon after. “Deficits as far as the eye can see” in the mid-1980s were followed briefly by surpluses in the late 1990s. In all these cases, economic growth helped solve the problem. Today, that’s no longer possible.
Failure to understand the causes of today’s historic impasse will stymie those budget reformers tempted to believe we can use the traditional pro-growth strategy to get our fiscal house in order. Most of history is on their side: in almost all past U.S. budgets—indeed, the budgets of most nations—revenues were scheduled to grow automatically along with the economy, and expenditures were scheduled to grow only if there was new legislation. Thus, revenues in some future year would always exceed that past expense, no matter how high any current deficit. But under the laws now dominating the budget, expenditures essentially are or will be growing faster than both revenues and the rest of the economy. In fact, we’re now locked into automatic expenditure hikes that will outstrip revenues under almost any conceivable rate of economic growth.
In the many budget policy reform discussions I’ve been part of, this disconnect from the past blocks understanding of our present fiscal situation. Thus, both liberals who want to maintain spending programs and conservatives seeking to keep taxes low seem to think—or, at least, want to think—that economic growth can once again solve our problems.
Just what is different now? Today, we are facing two fiscal problems, while before we had just one. In the past, fiscal imbalance was mainly a temporary, current issue only. Yes, Congresses would occasionally spend much more than they collected in taxes, sometimes heedlessly. But as long as revenues over time rose with economic growth and most spending was discretionary, push never came to shove as long as the next Congresses weren’t too profligate
In effect, during the nation’s first two centuries, all that was required to get the nation’s house in order was for future Congresses to limit new spending increases or tax cuts. Since future surpluses were always built into the established law at any one point in time, sound fiscal policy meant not turning those surpluses into unmanageably high deficits year after year.
Take the case of World War II, when our national debt ballooned. It’s usually cited as the great example of successful fiscal policy overcoming a depression. If in 1942 Congress had developed ten-year estimates of the deficit under “current law” on the books, the estimates would have shown massive surpluses. Spending was scheduled to drop dramatically in absolute terms and as a percentage of the economy or GDP once the war was over. Meanwhile, higher tax rates imposed to support war spending would stay in place until future Congresses saw fit to reduce them.
Jump ahead to today. Now, so much spending growth is built into law in permanent or mandatory programs that these programs essentially absorb all future revenues. Meanwhile, we’ve also cut taxes—widening the gap between available revenues and growing spending levels.
But why won’t even higher economic growth solve the problem? If spending growth were limited so it couldn’t exceed some fixed rate, then higher economic growth might increase the revenue growth rate enough to help restore balance. Unfortunately, spending growth is not set at a fixed rate. Instead, it generally is scheduled to grow faster when the economy grows faster.
Consider government retirement programs, such as Social Security. Most are wage indexed insofar as a 10 percent higher growth rate of wages doesn’t just raise taxes on those wages, it also raises the annual benefits of all future retirees by 10 percent. The same doesn’t hold for discretionary programs such as education, even though we might expect that teachers’ salaries would need to rise with economic growth. Instead, teachers’ raises must be appropriated every year. Meanwhile, in most retirement systems employees stop working at fixed ages, even though for decades Americans have been living longer. When spending rises with both wages and extra years of retirement benefits, extra economic growth just doesn’t provide much if any reprieve from fiscal imbalances.
Health care is a bit more complicated. Health costs tend to rise more than proportionately with incomes. If our incomes rise by 10 percent over the next few years, we tend to demand at least 10 percent more health care. With 20 percent income growth, we want even more than 20 percent increases in health goods and services. Of course, it’s not just a demand phenomenon. The higher economic growth may reflect improvements in health technology, along with its higher costs.
Today, so much of government spending is devoted to health and retirement programs that their growing costs tend to swamp gains we might achieve in holding down the ever-smaller portion of the budget devoted to discretionary spending. Some other programs add to the problem, since they, too, tend to grow with the economy: mortgage interest deductions as we demand more housing, subsidized pension contributions and other employee benefits as our wages go up.
Built-in automatic spending growth like I’ve just described means that balancing the budget today is far harder than simply putting the brakes on new tax cuts and spending increases. A do-little Congress can no longer save the day. Our elected officials are in a bind they hate: they must both say “No” to many new give-aways AND go back on unkeepable spending and tax promises made by past lawmakers…
The thumbnail version: seek economic growth, but don’t expect it to provide the budget slack it did when most spending was discretionary. Congress has already spent the revenues that economic growth will provide, so we need to weed our government’s garden as well as water it.
From Deficit to Surplus: How Budget Projections Used to Look under Current Law
How Budget Projections Look Today under Current Law: With and Without Additional Economic Growth
With economic recovery from the deep recession in view, a double-headed challenge remains. Reducing the deficit requires cutting back government spending, but we still need to promote employment and work, and that won’t come free. Given this administration’s progressive leanings, its attention to low- and moderate-income workers is surprisingly modest.
So how hard is it to spend less overall but more on lower-income workers? Presidents George H.W. Bush, Bill Clinton, and Ronald Reagan all expanded wage subsidies for some low-wage workers through the earned income tax credit (EITC) while and reforming taxes and significantly lowering the deficit.
Shifting policy toward low-income workers brings other benefits, too.
It increases employment more per dollar spent than many current subsidies that go to higher-income individuals and to those who do not work at all.
It helps reduce the long-term costs of added crime and depression borne of long spells of unemployment.
Done right, it can reduce the marriage penalties in many wage subsidies and welfare programs.
This administration and Congress have hoped that their biggest initiative—saving and subsidizing Wall Street and lowering borrowing costs—would trickle down benefits for everyone else. Maybe so, but more money for low-income workers can also trickle up. And it costs far less to subsidize a low-wage job than a high-wage job.
The biggest direct wage subsidy enacted so far has been the Making Work Pay tax credit. For most eligible working households, however, it’s just a $400 credit ($800 for married couples). It’s really not a jobs subsidy so much as an across-the-board tax cut to spur consumption.
The Obama administration’s latest ventures include such items as a $5,000 tax credit for small businesses for each new employee hired this year. Puny relative to the economy’s size, this incentive also gets mired in all sorts of definitional issues. What is a small business? (Your maid service? Your friendly billionaire’s 20th venture?) Who’s new? (Your kid? Someone already on your to-hire list?). Why discriminate against struggling businesses? And why not count the worker they would otherwise let go?
Wage subsidies for low- and moderate-income earners, by contrast, traditionally have fans on both the left and the right. More progressive than most other subsidies, they also offer an alternative to welfare and unemployment insurance, which can discourage work. Indeed, past EITC increases helped give low-income households a foothold that allowed President Clinton and the Republican Congress to reform and deemphasize welfare in 1996.
The Obama administration does support expanding EITC for families with three or more children a bit. And, arguably, its proposed extension of the child credit to include some very low earning households who generally don’t owe taxes subsidizes part-time or part-year work. Nonetheless, most moderate-income workers are excluded from these expansions, which send money mainly to one-parent households and only to households with children.
What’s the most sensible approach? For my money, it’s concentrating additional work support to the largest groups now left out: low-wage single workers and many married, two-earner, low-wage families. Especially key is an EITC-like subsidy for the low-wage worker based mainly on his or her earnings.
That way, we reach single people with no kids, including many of the males hardest hit during this recession and still ineligible for most government programs. And we reach many households who marry or contemplate marriage, only to realize that tying the knot means losing or jeopardizing thousands of dollars worth of EITC, Medicaid, welfare, and housing subsidies annually. Better to stay unmarried, even if living together.
And if we don’t take these steps? For starters, we ignore the fundamental policy lessons that leaving millions of productive people jobless has long-lasting costs. Unemployed people are more depressed, less entrepreneurial, more risk averse, more bored, more inclined toward substance abuse, and more likely (especially if they are young men) to turn to crime. Just as failing to create jobs for more Iraqis right after Saddam Hussein’s fall was a big foreign policy mistake because many turned to more violent pursuits, neglecting job creation now could be a colossal domestic policy mistake that plays out long after our economy is back on its feet.
Our national sense of fair play is at stake here too. The recession hurt low-income workers most, but they were largely left out of most stimulus programs.
Policy two-fers are often rare. But this policy shift is a five-fer that appeals to both liberal and conservative principles: reduced spending, greater progressivity, higher employment per dollar spent, reduced crime and depression, and fewer penalties for marriage. And with predictions of only slow employment growth ahead, the timing is right for confronting unemployment more strategically.
It’s an old story. Come a financial collapse, somebody’s got to pay to get the nation’s financial house back in order. While many on Wall Street made millions losing money for their companies, every young American is now saddled with tens of thousands of dollars of additional government debt. While buyers walked away from homes when they went underwater, others who had mustered large down payments simply absorbed their losses—in some cases, wiping out years of saving. While speculators who borrowed to buy stock or real estate shrugged off debt by declaring personal or corporate bankruptcy, those who invested in their 401(k)s helplessly watched their retirement savings erode.
Real loss and suffering run through the country’s financial straits, and so does a profound sense of unfairness. Once the downward spiral started, prudent investors, savers, and reasonable risk-takers got little direct government help, mainly because they were still standing. But their losses were no less real. First, the recession hit their pocketbooks and portfolios. Then many of them lost their jobs or watched friends and families lose theirs. Next, interest rates on their bank deposits fell, while fees on credit cards rose.
The crowning blow, of course, came when these model taxpayers got the honor of subsidizing the big risk-takers who got us into this mess. A Treasury Department watchdog says that taxpayers probably will never recoup tens to hundreds of billions of dollars transferred to failing companies. The Government Accountability Office released a study stating that the federal government is unlikely to recover much of the $81 billion invested in automobile companies and their related financing companies.
The apparent lesson from all of this? Irresponsibility pays. The ironic truth? Building a more vibrant economy requires fewer, not more, people playing by the “heads I win and tails you lose” rule. It means “de-leveraging” the economy: reducing the extent to which some people, through borrowing and similar efforts, can undertake unnecessarily risky gambles with others’ money. This isn’t easy, since at the same time we want more borrowing if it helps stimulate saving flowing to sound investment, we also want investors, financial managers, and financial institutions to exercise due prudence by having more of their own money at risk.
Why de-leverage? Recessions are less severe when more investors, risk-takers, and consumers can stand fast like dominos that don’t fall once a potential crisis gets under way. This helps explain why the burst of the stock bubble in 2000 didn?t lead to nearly so severe a recession: more of the losses were borne directly by those who first incurred the losses.
All this means that some unity exists behind seemingly disparate headlines about financial, corporate, and tax reform. In effect, those fights rage over who bears the costs of the next recession.
One well-publicized battle has been over opening up financial institutions’ books—especially where the government makes explicit or implicit guarantees that these companies won’t go under. While some officers at large financial institutions worry that regulation could stifle innovation and growth, others twist that legitimate fear into an excuse to resist reforms that would expose their freedom to gamble with our money and our guarantees.
Some of the same financial institutions that once ate our lunch also oppose stricter capital standards. But they are wrong. To protect against future collapses, we must demand that lenders keep greater reserves on hand relative to the size and riskiness of their portfolios. Similarly, we need greater ownership of banks by stockholders who would bear a larger share of the cost of failure.
Paul Krugman, among others (“Bubbles and the Banks,” http://www.nytimes.com/2010/01/08/opinion/08krugman.html) looks to reforming banks to help deter future financial collapses. But the implications of financial reform extend far beyond the banks.
Across the board, individual and corporate borrowers must also put more of their own skin in the game. This means higher down payments for homes and greater collateral and equity stakes for those who flip real estate or whole corporations for quick profit. If the government continues offering new homebuyers’ credits, it needs to ensure that they get added to minimum down payments, thus reducing risks of default later. And the auto industry must dump lending strategies that turn their financial arms’ IOUs into public obligations whenever the economy slows and throngs of car-buyers can’t pay off their loans.
Meanwhile, corporate and financial managers—just like the rest of us—need to experience risk’s perils, not just its rewards. While Kenneth Feinberg, Washington’s pay czar” for bailed-out corporations, may have trouble enforcing cuts in the compensation packages of top managers, he clearly set one right example by requiring that extravagant cash bonuses be converted into incentive pay in company stock that can’t be sold for years. Stockholders and mutual fund managers need to demand similar reform across the entire corporate sector.
Finally, the president and Congress—just barely getting their toes wet on this issue—need to look hard at how our tax code subsidizes borrowing so heavily and then do something about it. Any future tax reform clearly should remove the ingrained bias that favors corporate debt and discourages corporate equity.
Even then, major incentives remain for individuals and partnerships to borrow heavily—deducting interest payments while avoiding tax on gains in the value of their assets. Gaming like this leads to far too many financial transactions that make little or no real economic sense, while once again shackling everyone else with additional risks and tax burdens.
Now that a recovery is under way, some lobbyists probably hope public pressure for financial, corporate, and tax reform will subside or that the confusing technical details behind reform will weaken Congress’s will to act. But, in many ways, reform is needed more than ever during a recovery, when growth requires getting savings into the hands of sound investors who can spur more growth. Without reform, there’s little to prevent losses from the next recession being laid, once again, at the feet of the prudent investors, businesses, and consumers.