Squaring the Culture

I want to spend a little time this morning explaining why the Republican alternative to the Bush administration’s bailout proposal is a good idea.

First of all, recall what the proposed bailout does: it gives the US Treasury Department the authorization to buy assets that nobody else wants to buy. This provides liquidity to the market; as Megan McArdle explained earlier this week, the problem Sec. Paulsen is trying to address is not that some big companies are going out of business (though they are), but rather that capital markets have frozen in fear. Banks and large investors are so afraid of their assets losing all value at this point that they’re trying to dump huge blocks of them, driving the prices of those assets (Money Market instruments, formerly thought to be as safe as buying a house!) into ridiculously low numbers. With this going on, there’s a danger that there won’t be any short-term capital for banks and businesses to borrow for their day-to-day operations — and then the economy would simply screech to a halt. It’s an ugly doomsday scenario to which we are alarmingly close. Paulsen’s plan relaxes the tension by making the bad assets more profitable than they’d be otherwise.

The problems with the bailout are many. It grants the government immense power. It rewards bad behavior, in that it uses the money of taxpayers who behaved well in economic terms, and directs it into the hands of businesses that behaved badly in economic terms. It relies for solution on the very institutions that caused the problem in the first place. It saddles the government with buying assets for far more than they’re worth; the money would be wasted. It’s a response to a market panic with a government panic; it’s a knee-jerk, and that’s a very bad way to make policy.

Based partly on the responses of some very influential Senators, and partly on proposals from well-known conservative think tanks, Republicans in Congress suggest four specific actions instead of approving the Paulsen plan:

1. Suspend the capital gains tax completely for two years.
2. Schedule Fannie and Freddie for privatization.
3. Suspend “Mark to market” accounting rules.
4. Repeal the Humphrey-Hawkins Full Employment Act of 1978.

In order:

They want to suspend the capital gains tax for two years. This would encourage those who are afraid to invest, to invest immediately in sound assets, not in failing institutions. This provides liquidity to the market as certainly as Paulsen’s plan, only it does it by encouraging investors rather than direct spending by the Treasury. In effect, the Paulsen plan uses the government as a middleman between taxpayers and the market, and suspending the capital gains tax cuts out the middleman. It would reduce tax revenues to the government in the short run, but not nearly as much as the Paulsen plan would shell out in already-collected tax revenues, so even if you don’t buy supply-side economics it’s the cheaper solution. However, because supply-side economics really does work, the amount of business created by eliminating the capital gains tax would probably increase overall tax revenues within a year or two. This is a stupendous idea.

The objections from leftist blogs are awfully silly. The one I’ve seen most frequently is “there are no capital gains from the sale of bad investments!” This proves that they don’t have the faintest idea what the real problem is, let alone how to fix it. The problem is a lack of short-term capital to drive the economy, not just that some big companies are failing. The Paulsen plan rewards lousy investments by putting money directly into the hands of those who made the worst investments; the Republican plan rewards sound investments by putting money into the hands of those who have been functioning properly all along. Both plans create liquidity in the capital markets, though, which is what solves the current crisis.

The second most common objection is that it allows rich people to get richer. This is as opposed to allowing certain rich people who mishandled assets to remain rich; I don’t see how that’s any better. I think it’s time we all stopped allowing envy to make our economic decisions for us. People ought to be rewarded for good economic behavior, and everybody benefits from a robust economy.

China and Singapore both operate with zero capital gains taxes. American investors have the second highest capital gains taxes in the world. We need to unleash the American economy, not increase the power of the government.

Second is to privatize the GSEs (Government Sponsored Enterprises). This is at least 30 years overdue, and has been prevented by Congressional Democrats. There is no reason for the US government to be creating businesses; it’s probably not even Constitutional. Cut Fannie and Freddie loose, and make them sink or swim according to how well they actually perform. It’s the cozy relationship between the GSEs and their sponsors in Congress that allowed this disaster to develop in the first place. Break the relationship.

Third is to abolish the “mark-to-market” rule. This is technical but crucial, so pay attention.

This is a change in FASB, the Financial Accounting Standards Board decisions that make up the rules of Generally Accepted Accounting Principles (GAAP) for auditors. The mark-to-market rule was created by FASB rule 157 in September of 2006. It requires accountants periodically to adjust the values of assets in public financial statements to reflect the current fair market value of those assets including the risk of non-performance — that is, how much the investor would get if the mortgagor didn’t pay and the mortgagee had to foreclose. This practice is actually the immediate cause of the current crisis; investors are panicking because financial companies holding mortgages as assets are forced by FASB 157 to adjust the stated value of those assets downward as the market value of the home drops, and investors are seeing their long-term investments shrink in value before their eyes.

Now, it sounds like FASB 157 is good disclosure policy, but it’s really not; rather, it makes investors focus on short-term, worst-case conditions rather than long-term expected value. The reason mortgages were considered safe investments is not that homes have never gone down in value, but that they’ve never gone down in value for long — they always recover. However, because of FASB 157, the books were saying “These mortgages are worth half of what they used to be” when in fact the mortgages were probably worth as much as they always were in the long run. Even with sub-prime loans figured in, all but about 2% of all mortgages get paid off in good order at face value plus interest over the long haul. FASB 157 forced investors to view their assets as though 100% were going to default, and this caused a panic when no panic was in order. If investment companies had been allowed to report mortgage face value instead of market value in case of default, there would have been no crisis at all.

The alternative to FASB 157 is not a lack of disclosure, but simply a return to the previous accounting practice of valuing assets according to one of several accepted methods (most likely face value), and then disclosing the method in footnotes to the financial statements. Anybody who reads financial statements knows they need to read the footnotes; anybody who reads a financial statement and skips the footnotes a) is proving he’s either a rookie or a fool, and b) is asking for trouble. GAAP always required disclosure; FASB 157 required a specific type of accounting that’s not even particularly accurate in this case.

Abolishing mark-to-market is a good way to prevent this crisis from recurring.

I’m going to have to defer the last item for somebody who knows more than I do; I honestly don’t know what the Humphrey-Hawkins Full Employment Act of 1978 does to the Fed in anything but very general terms. The items I’ve read suggest that it requires the Fed to use “full employment” as one of its goals for adjusting the discount rate (the mechanism for setting the interest rates on loans throughout the financial sector). The authors of the Republican alternative would prefer it use “price stability” as the primary goal. If somebody comes up with a good explanation of what this measure is supposed to achieve and how it’s supposed to achieve it, please leave a comment with a link. I was unable to find such an explanation. (Author’s update: apparently this is an attempt to pare down the role of the Fed. I don’t know enough to comment further.)

For my own part, I’d like to see three other items added:

Repeal Sarbanes-Oxley. It saddled publicly-own companies with millions of dollars worth of paperwork, discouraged a number of profitable companies from going public (they remained private to avoid Sarb-Ox paperwork,) and did not measurably improve financial reporting.

Repeal the Community Reinvestment Act of 1977. This is the one that leftist activists are using to force banks to make loans to home buyers who can’t repay.

Impeach Sen. Christopher Dodd (D, CT) and Rep. Barney Frank (D, MA) for their role in protecting the Enron-like misrepresentations by the executives of Fannie Mae and Freddie Mac. Allowing them to remain in office would be like allowing a member of Enron’s Board of Directors to remain on the board after finding out that the Board member knew of the improper accounting but said nothing. I’d love to see these two jailed, but the behaviors that we know about are not explicitly criminal; they are, however, grossly irresponsible and corrupt.

The Republican alternative illustrates why Republicans should be in charge of Congress rather than Democrats. These are sensible measures directed at fixing what’s broken. The Democrats, by contrast, are spinning like tops attempting to cover up their complicity in the mess, and at the same time focusing on meaningless and tyrannical measures like capping executive compensation — as though stupidly paying CEOs tens of millions dollars is responsible for the loss of hundreds of billions of dollars. I mean, if you really want the government telling businesses how much their employees are worth, go ahead and advocate that — I won’t be supporting it, but you can advocate it if you want to — but it has absolutely no plausible effect on the current crisis. It’s a red herring, another Democratic instance of pursuing symbolism rather than addressing substance.