WHAT'S A FREE MARKETEER TO THINK? Volume 4
In light of the continuing financial crisis, a week ago I invited think tank and other colleagues from around Minnesota and the nation to take on the question: “What’s a free marketeer to think?” Here are four new columns, bringing the running total to 18.
My thanks to former United States Senator Rudy Boschwitz; King Banaiain of St. Cloud State University and the Minnesota Free Market Institute; Jim Van Houten, formerly CEO of MSI Insurance Companies; and Gary Palmer, president of the Alabama Policy Institute.
Please note these columns were written before the House of Representatives on Monday defeated a proposal aimed at remedying the problem. American Experiment will continue publishing important pieces like these as we receive them over the next week or so.
Many thanks, and as always, I welcome your comments.
Founder & President
Center of the American Experiment
Failure to Act will Cost Much More in Dollars and Pain
By Rudy Boschwitz
I regard this bailout as a positive, as it’s something only the federal government can do. The result of not doing it would be far more costly to the people of our country in many ways, and the Federal government would lose far more tax revenue from a serious economic downturn than the cost of the bailout. I believe the bailout will cause the economy to bottom out and start upwards again – far sooner than would occur without this government action.
It is not going to cost $700 billion as the press irresponsibly trumpets. The government may indeed buy $700 billion of mortgages or mortgage packages that are in trouble. If the underlying real estate covered by the mortgages is worth zero, it will indeed cost the government $700 billion. But the underlying property is far from worthless. You may remember the Savings & Loan crisis of the late ‘80s. The government took over many S&Ls which had gone broke for somewhat different reasons than the root cause of the present mess – though the S&Ls were also a mess.
Those S&Ls held several hundred billion dollars of real estate through defaulted mortgages. The government created the Resolution Trust Corporation (RTC) to sell the real estate and recovered 65-70 percent of the value of those mortgages through an orderly sale of the property. In hindsight I think they rushed the sale of the real estate a bit and could have recovered more if they held on to it longer and given the market more time to recover.
It's the same with the "bailout" of AIG. The press gives the impression that present action by the U.S. government has already cost the taxpayer $85 billion. Not so unless you count the value of AIG at zero and it is far from that. It is (purportedly) the largest insurance company in the world. That’s big! The government got rights to about 80 percent of AIG stock. Remember the "bailouts" of Chrysler and Lockheed? As I recall the government saved both companies and made some money in the process by obtaining rights to some of its stock in exchange for guarantees and capital infusion – very much like what Warren Buffet has now done in providing additional capital for Goldman Sachs.
I was involved in another similar situation which occurred in agriculture in the late-1980s. The farm economy was very stressed due to falling land prices plus low commodity prices. Because farmers were stressed, their principal lender (for farm land), the Farm Credit System, was headed for bankruptcy. The FCS was an independent government agency. If it had failed, it would have cost the government many billions. In the Senate the FCS came under the jurisdiction of the Agriculture Committee, of which I was a member. More directly, it came under the credit sub-committee of the ag committee. Sen. David Boren, a Democrat from Oklahoma, was its chairman and he recruited me to be a member specifically to deal with the farm credit crisis. So I became the ranking Republican on the sub-committee.
The FCS was organized in nine (as I recall) districts around the nation, with one of the headquarters in St. Paul. The president of our district, a very smart banker named Larry Buegler, had come to me stating that if we gave the FCS some flexibility, some time, and the ability for healthy districts to absorb failing districts, they could work their way out of it.
Farm land mortgages generally had a single payment a year (after the crop came in), not monthly payments like your home mortgage. As I further recall the FCS could not accept less than the full payment so farmers were either paying it all or nothing - and enough of them paid nothing to create the problem. So Dave Boren and I held hearings. Then we drafted a bill, got it passed in both Senate and House, which gave the FCS both time (for land prices to stabilize) and flexibility in dealing with the farmer borrowers. Several weak FCS Districts combined with healthier ones. The result: Time did its work and helped stabilize land prices and the Farm Credit System worked its way out of its problems and didn’t cost the government a dime. The oversight agency we created was disbanded (not many government agencies ever are!) when the FCS was once again healthy. It was a proud achievement for Dave and me.
I tell these stories to say: credit problems are not new. Nor is government intervention new. The same mistakes keep being made but always with new wrinkles and twists.
The government is right to act. Failure to act will cost the economy and the American people far more in dollars and pain. The government would be right to restrict huge payments or parachutes to officers of these companies. The cost to the taxpayer will not be nearly as high as the press is saying. Our country and our economy have survived far worse. Indeed, the economic jolt of 9/11 was probably worse than this credit crisis – and a crisis it is that requires the government to act.
Rudy Boschwitz served as a United States Senator from Minnesota from 1978 to 1991.
“As in a Bomb Going Off”
By King Banaian
The free market has taken an enormous amount of abuse as regards the current financial crisis. It shouldn’t; it had nothing to do with it, as many of the other authors in this series have pointed out (and will). To the extent that the market has failed, it has done so largely because of government coercion over the years.
The “free market” did not get us into this mess, but we need the free market to get us out. For that to happen, the free market needs government as a partner, whether conservatives like that idea or not.
Free markets have always had booms and busts. This is the nature of Schumpeter’s “creative destruction,” of which some think this crisis is just another example. Some think this would be good for our economy.
They are wrong. Those who see in the current crisis only creative destruction underestimate the dose of simple destruction – as in a bomb going off – we are facing, and the magnitude of that destruction.
In creative destruction the boom that follows the bust needs to have credit to stoke its engines. The genius of capitalism is the movement of capital from the investor who seeks returns to the entrepreneur whose new innovation will help drive the next boom.
The current crisis threatens the engine of capitalism – finance – and hence we cannot sit idly by as the crisis deepens.
Financial markets are susceptible to a variety of maladies. Gearing is the ratio of an owner’s equity to borrowed funds. The use of derivatives – themselves the result of innovation – created an ability to leverage assets like our world has never seen. One of these innovations are insurance policies investors could buy to protect them against the default of another firm. This innovation – that a private firm could insure against the defaults of many other firms – ended up assisting firms in gearing, and was in retrospect a mistake.
Free markets are not free of mistakes; they just make fewer mistakes than governments. When a big enough mistake is made by either government or the market, panic ensues.
Panics are not new, and neither are the solutions. Panics have occurred when we have had central banks and when we have not (e.g., 1907 and 1929.) The history of those panics before the founding of the Federal Reserve was largely of liquidity crises: Many banks had assets greater than liabilities, but no ability to convert them to cash. In those times with smaller, more national than international markets, private banks could and did work together to solve their problems without government help.
But we suffer from more than a liquidity crisis at this time, and the most disconcerting for the free marketer is that many assets and derivatives on the banks’ balance sheets have an undetermined price. Mortgages on real properties are relatively easy to liquidate, but some other bank assets are relatively new securities innovations that turned out to be bad ideas. How these will be liquidated is unknown.
Ideally the government can act as a “market maker of last resort” in these securities, just as the Federal Reserve was envisioned as a lender of last resort for the liquidity crises of old. If the government can create a market where none exists, our system might recover without too much violence done to it.
Free markets do not mean always private markets. Free markets mean markets with an absence of coercion. It is possible for government to step forward for a missing market and not be coercive. A bailout that did not consume taxpayer dollars would be one example. Forcing banks to alter their lending standards would be coercive and unfree.
The problem we face is the absence of a market. Government can help create a free market where none exists today, and that would be a good thing. It may be that we cannot avoid costs associated with previous government meddling in the market that helped create this crisis, but we can all hope that the costs will not extend beyond those already sunk.
King Banaian is a professor of economics at St. Cloud State University and an economics fellow with the Minnesota Free Market Institute.
Goodbye to All That
By Jim Van Houten
In 1929 Robert Graves was 33 when he wrote his bestselling book, Goodbye to All That. In biographical form it describes his boyhood in English public school and the heady experience of being a member of the British Foreign Service in Cairo. When the narrative moves into his experience during the First World War (then the “Great War”), the tone becomes ominous. Graves’ concerns were mainly post-war. And we now know he was right: the British Empire never regained its stature and world influence after its “victory” in 1918.
Similar to Great Britain during the First World War, the United States now faces a great uncertainty which may result in both a tactical “victory” over its current financial markets problem, while suffering a strategic loss in world confidence in its historic free market philosophy. To achieve the former without the latter is the task at hand. So far the outlook is discomforting.
The London Times, among others, has written extensively of the damage being done to the world economy (which the World Bank estimates at $54.3 trillion in nominal GDP) by the U.S. financial crisis. (The World Bank estimates U.S. GDP at $13.8 trillion; or 25 percent of world GDP). TheFinancial Times reports that the new French president, Nicolas Sarkozy, is calling for an emergency G8 meeting for the world to address the U.S. problem. The Financial Times also quotes G8 member Peter Steinbruck, Germany’s finance minister, saying that, “the U.S. will now lose its status as the super power in the world financial system and be replaced by the emergence of better capitalized centers in Asia and Europe.” And Reuters reports that Venezuelan President Hugo Chavez ($0.2 trillion, or 1.5 percent of U.S. GDP) is telling anyone who will listen that this is a crisis of capitalism, and that socialism is the only solution to the world’s economic problems.
It’s not surprising that the media are reporting every scary opinion given the readership benefits which result from a big story. However, it’s surprising that much of recent reporting (the New York Times, for example) has been prescriptive rather than informational – advocating for government to manage broad aspects of complex financial markets without noting that previous meddling by those same players is a major cause of the current crisis. Few are urging caution and thoughtfulness in what the Economist called “the argument by some that the Federal Reserve and the U.S. Treasury are nationalizing the economy faster than you can say Hugo Chavez.” And few have reminded their audiences that there is a dearth of evidence that beneficial long-term effects follow when a nation increases government’s role in free markets.
U.S. history in this regard is telling. Franklin Delano Roosevelt regulated almost everything, including the price to be charged to press a pair of pants, but could not end U.S. economic stagnation during the Great Depression. In April 1938 unemployment remained at 20 percent, about the same as when he took office in March 1933, five years before. At the time he was also being warned by the liberal but policy-exhausted economist John Maynard Keynes that, “it is a mistake to think businessmen are more immoral than politicians.”
So far the only group consistently “standing athwart history yelling ‘stop’ ” (paraphrasing William F Buckley, Jr.) is the minority party in the U.S. House of Representatives. Whether or not they can win this argument with a majority party less concerned about free markets remains to be seen. If they fail we will be ready for another bestseller with Graves’ title.
Jim Van Houten is a former CEO of the MSI Insurance Companies and served as a member of American Experiment’s board of directors during the Center’s early years.
Using Assets Subject to the Inheritance Tax
By Gary Palmer
It is evident that American taxpayers are angry about what it appears Congress is going to do: a $700 billion taxpayer bailout of the ailing financial and mortgage institutions. According to a USA Today/Gallup poll (September 24), 56 percent of the American people want a different plan. Unfortunately, this is very likely an article about what Congress could have done instead of what they will do to recapitalize our nation’s financial markets.
Apparently, the dire warnings from the Bush administration and others that the economy is on the brink of failure are not enough to persuade American taxpayers that a bailout is the answer to the financial crisis. The perception is that the federal government is forcing the taxpayers to pick up the tab for the problems created by the mismanagement and corruption of greedy corporate executives and their enablers in Congress.
The fact is the bailout is more of a buyout. The package that Congress is considering would commit the federal government, i.e. the taxpayers, to spend hundreds of billions of dollars buying mortgages. This means the federal government will be in the real estate business, at least until it can sell its new real estate holdings, hopefully at a profit.
This action is supposed to result in the recapitalization of the financial industry. Could there be another way to unclog the financial arteries of the nation’s economy without adding $700 billion to $1 trillion to our federal debt?
The answer is yes.
Congress could create an opportunity for private sector funds to be used to recapitalize banks and the housing industry by using assets subject to the inheritance tax. It is estimated that between $1-1.5 trillion in assets will be transferred to heirs over the next ten years. In 2009, under current law, estates with assets worth more than $3.5 million will be subject to a tax of 45 percent on everything above the exemption. And, unless Congress renews the Bush tax cuts, in 2011 the exemption will decline to $1 million and the tax will increase to 55 percent on the amount above the exemption.
In order to get more private equity into the financial and mortgage markets, Congress should create a 12-month window in which anyone with assets subject to the inheritance tax could use those assets to purchase residential real estate or mortgages. The assets used within that time frame would never again be subject to an inheritance tax.
If the real estate purchase produces income, such as rental income or increases in value, the estate owner would pay the usual income and capital gains taxes. However, if the investment resulted in a loss, investors would not be able to deduct the loss on their income tax return.
A 45 or 55 percent tax is a hefty penalty for dying and there is a lot of incentive to try to avoid paying it. Because every dollar of private money infused into the real estate and mortgage markets would replace a dollar that the federal government would have to spend in a bailout, this option could significantly reduce the size of a bailout and save billions of taxpayer dollars.
Given the dire circumstances we face, members of Congress should be willing to consider this option. It will benefit all American taxpayers as well as those faced with paying inheritance taxes. Moreover, even though some portion of the inheritance tax would be eliminated, directing those assets into the financial and real estate markets gives it the effect of a tax in that the resources are being directed to a specific purpose.
There is another idea that also makes sense. Congress should create a six-month window in which investors could purchase residential real estate and receive a tax credit of 20 percent of the purchase price as an incentive to buy. The tax credit could be taken in the first year or it could be carried over in successive years until it is used up.
Currently there are more than four million houses on the market nationwide. Given that the median price of a house is around $196,000, it would take about $400 billion to cut that inventory in half. Using the above figure as a baseline, by offering a tax credit of 20 percent of the purchase price, the cost to the federal government of the tax credit would only be $80 billion.
Perhaps the most important thing about a private sector solution is that it would help restore market discipline. A taxpayer bailout increases moral hazard; i.e., the likelihood that this will happen again. Keeping these transactions entirely within the private sector would not only stabilize the market, but would also enforce a degree of accountability and responsibility on those who created the crisis. As a result, those who made the really bad deals will still suffer some consequences for their actions.
These ideas will not totally eliminate the possibility of direct federal action. But if the federal government eventually has to act, it would be at a significantly lower cost to the taxpayers and with significantly less danger of nationalizing the mortgage industry.
Clearly, Congress is going to address this problem. Will Congress pay attention to the American people and consider alternatives such as allowing the private sector to be a part of the solution? Unfortunately, it appears at this point that some congressional leaders believe the only plan is a taxpayer bailout.
Gary Palmer is president of the Alabama Policy Institute, in Birmingham.