Friday, December 07, 2018

Loving the Bank Run Scene in It’s a Wonderful Life

Loving the Bank Run Scene in It’s a Wonderful Life

By Robert E. Wright

NOTE: This is the original, and much more personally revealing, version of the piece that appeared on 6 December 2018 on Zocalo here under the title "What George Bailey's Building and Loan Company Can Still Teach Us About Banking."

The bank run scene in It’s a Wonderful Life always makes me cry the tears of one whose lover may never return from prison, or battle. If you care about America, you should love the scene too, because it is a brilliant piece of cinematic storytelling but more importantly because it encapsulates the promise of the financial system, the reason that policymakers not only tolerate but actively encourage the development of institutions and markets powerful enough to make, or break, the lives of all Americans.
Technically, the scene fulfills all the requirements of brilliance laid out in Robert McKee’s classic Story: Style, Structure, Substance, and the Principles of Screenwriting (1997). It builds tension through a progression of “beats” that constantly defies the viewer’s expectations as protagonist George Bailey battles antagonist Henry F. Potter, first with his words and vision and then with a timely infusion of cash. The protagonist starts the scene in a negative position but ends in a positive one, with the stakes in his struggle with Potter over the fate of Bedford Falls higher than ever, helping the story to arc towards its bell-ringing climax.
The scene begins with George and Mary in the back of a taxicab on a cold, rainy day when the driver informs the newlyweds that a run on the local commercial bank, the only one in town given the policies of the era, appears to be in progress. George immediately hustles to his beloved eponymous Building and Loan, only to find it closed and hence in mortal peril. He lets his distraught depositor-investors in and opens for business. He learns that the bank ordered the immediate repayment of the loan it made to the Building and Loan, thus denuding the mortgage lender of all its cash.
That premise was plausible because financial intermediaries often made short-term loans to each other that stipulated repayment upon demand. The subtext revealed in this and a previous scene is that the Bailey Building and Loan needed to borrow from the bank because some of its own borrowers were in distress and not making payments. Rather than foreclose, evict, and sell, George, like other community bankers with the means, allowed delinquent borrowers time to get back on their feet. The loan did not seem risky to George because at the time he took it out the bank was not yet under Potter’s complete domination.
But then the evil Potter telephones to offer George his backhanded assistance, threatening that if George doesn’t sell out to him on the cheap like the bank just did, he’ll have to dispatch the police to prevent the “mob” from doing bodily harm to George and his relatives/employees after the Building and Loan goes bankrupt before the official close of business at six that evening.
George hangs up and attempts to talk his way out of the jam but wailing sirens immediately trounce his attempt to calm the fears of his customers by asserting that the economic crisis, one of the several waves of bank failures that swept the nation during the Great Depression, “isn’t as black as it appears.”
When Tom demands repayment of the $242 he invested in the institution, George correctly explains to him that building and loans are not commercial banks and that Tom owns time deposit-like shares in the institution payable in sixty days, not a checking deposit payable on demand. Despite George’s heartfelt, and accurate, reminder that the Building and Loan’s assets consist of long-term loans to his neighbors, Tom insists, implying that something must be wrong if the institution cannot pay out a mere $242.
Randall then enters and tells the crowd that they can sell their shares in the Building and Loan to Potter for fifty cents on the dollar, cash. Tom immediately threatens to sell his shares to Potter because “it’s better to get half than nothing.” As the crowd starts to head for the door, George vaults the counter and blocks their path while plausibly explaining that if enough of the Building and Loan’s investors sell out, Potter will gain control of the institution and monopolize the town’s financial system and housing market, which will allow him to raise borrowing costs and rents to oppressive levels.
An intimate knowledge of his investors and borrowers, the telltale attributes of a good community banker, enables George to draw out the implications of Potter’s control in personal, detailed terms, which stops the crowd long enough for him to expose Potter’s intent: the old codger is buying shares, not selling them, because he is using the financial crisis to get rich at the expense of the poorer and presumably less astute and informed townsfolk.
The crowd seems to agree with George’s assessment, which triggers Americans’ long-standing hatred of monopolists, but the atmosphere remains thick with panic because everybody needs cash to feed their kids, pay medical bills, and hold them over until a family member can find employment once again. That’s when Mary steps up with $2,000 in honeymoon money that George begins to lend out, starting with $242 for the recalcitrant Tom. The next two customers, however, request only $20 each and George foreshadows the end of the run when he kisses Mrs. Davis for seeking only $17.50.
The scene ends with the Building and Loan with just $2 left at the close of the business day, the employees drinking and joking that they hope the two bills will make love and reproduce like rabbits in the safe that night. Unstated is the fact that if the Federal Reserve System (“the Fed”) had been doing its job, it would have lent funds to the local commercial bank (or its correspondent bank in Manhattan), which then could have remained independent of Potter and would have had no reason to demand immediate payment of its callable loan to George’s institution.
Then, as now, one of the Federal Reserve’s major functions was to act as a lender of last resort, to make emergency loans to troubled but solvent banks during crises. It failed to do so during the Great Depression, greatly exacerbating the misery. Since then, the federal government and its central bank have gone too far in the other direction on several occasions, bailing out bankrupt institutions that took on too much risk and should have been liquidated in an orderly fashion instead. Worst of all, its policies, most notoriously Too Big to Fail doctrine but numerous others as well, have actually increased the likelihood of financial crisis.
As McKee shows, many other scenes in cinematic history are technically perfect but few of them, even those designed to elicit powerful emotions, make me cry more than once, let alone every dang time. My emotions arise not so much from lusting after Donna Reed or even the film’s hoary, classic arch plot of “good versus evil” as they do from the details of the struggle, which poignantly illustrate a point that I have been trying to establish since my pitiable career began a quarter century ago: To remain prosperous, America needs a robust, innovative financial system, but its policymakers need to ensure that Americans do not have to rely on a lucky good guy (George or the Federal Reserve) to thwart the numerous bad guys who happily hurt others (cause a financial crisis) in order to “make a bar” (Wall Street slang for a million dollars). Crises ultimately stem from the structure of incentives, institutional and individual, and hence that is where regulators should concentrate their efforts.
That seems like an easy point to establish but it is not when almost everybody, Left and Right, approaches financial system regulation with more ideological baggage than they could check gratis on a Southwest flight. A cacophony of “isms” that block clear thinking and stymie learned judgement reduces incentive structures to “greed,” with the Left clamoring for less and the Right for more. But the devil lurks in the details, in precisely what people are rewarded for doing, and not so much in the amount they will be paid for doing so.
In an age, however, when “capitalism” contends with “capitalisn’t” in sound bites and tweets, many swapped by people who cannot clearly differentiate supply from demand or micro from macro, making good sense just is not good enough. So I labor and blubber on, hoping not to end up some snowy night on a bridge over an icy river next to some modern day community banker, knowing full well that, despite our best efforts, America has become Pottersville.


Wednesday, November 28, 2018

Econogogy: Embedding Economics Concepts in Pedagogical Decision-Making

I have been so busy, I forgot to blog! I think the slides capture the gist of my STL Fed presentation earlier this month: 

Saturday, June 23, 2018

Reducing Financial Discrimination in America

Reducing Financial Discrimination in America

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana University for the ASHE/NEA Conference in Polson, MT, June 2018

America’s financial history is rife with examples of financial exclusion, discrimination, and predation. Exclusion occurred when women or people of certain ethnicities, races, religions, or sexual orientations were as a group denied access to portions of the financial system. It was outlawed, more or less, and is relatively rare today because it is costly to work around even for the most committed bigots.
Discrimination, whereby specific individuals are denied credit, insurance, or other financial service despite being objectively qualified for it, is more subtle and hence difficult to detect. Sometimes, instead of outright denial, it takes the form of higher interest or premium rates but always for ostensibly objective reasons. Its extent is difficult to discern statistically and real world experiments, whereby people with practically identical qualifications but different genders, ethnicities, skins colors and so forth apply for financial services at the same provider, cannot, for legal reasons, go all the way to the formal application stage.
Predation is the inverse of discrimination, occurring when an individual who objectively does not qualify for a financial service, usually a loan, is allowed, even encouraged, to contract under the expectation of default and a windfall for the lender. Again, pinning down exact numbers is fraught in our messy real world, but predation certainly occurs and of course was common in the subprime mortgage and payday lending markets of the early Third Millennium AD. Determining the extent of predation is difficult, too, because high rates of interest are not prima facie evidence of it, as it is costly to make small, short term loans and of course annualizing rates can be deceptive. Most people balk when they hear a loan has a 1,000% interest rate but when that loan is described as costing $23 and was taken out to avoid a $50 late fee, it suddenly seems like a mutually beneficial transaction.
Three ways of reducing financial discrimination have been tried in the U.S. The worst approach was implemented in the 1990s, when regulators began to encourage lenders to lower credit standards. That approach encouraged predatory lending by granting lenders ample access to borrowers with poor or no credit histories, few assets, and relatively little secure income. In other words, targeting borrowers most vulnerable to predatory lenders became acceptable, even mainstream. Lowering credit standards also encouraged mortgage securitization and ultimately led to the subprime mortgage crisis and resultant financial panic and global recession, the negative effects of which are still being felt.
Lowering credit standards was the regulatory response to failed attempts to mandate an end to financial discrimination via laws like the Community Reinvestment Act or CRA, which, regulators had hoped, would be as effective as outlawing outright financial exclusion had been in the 1960s. Alas, it was much easier to enforce a law stating that banks and insurers could not reject the applications of all women, African-Americans, Hispanics, Native Americans and so forth than it was to cajole them into not discriminating against individual members of those same groups. Lenders and insurers had to have the last say in who they would lend to or insure and of course the government itself did not want to directly enter the loan business. Various U.S. colonies and states had tried that game and gotten burned more often than not, even when making loans to presumably prime borrowers.
Traditionally, the U.S. had handled discrimination not with top-down regulations like the CRA, but rather via markets. This third approach is not a panacea for reasons I will explain later but it was more effective than eroding standards or trying to regulate institutions that have proven themselves both too big to fail and too big to regulate. It was called self-help and entailed regulatory gatekeepers allowing groups that felt discriminated against to form their own financial institutions. The logic was that if a group that felt discriminated against was really not, if it was composed of individuals who should not receive loans or insurance or whatever, or if group members could indeed obtain service at existing companies, the new institution would soon fail. That would impose a cost on the regulatory safety net but a light one. If members of the group were actually being discriminated against, then the new institution should succeed, thrive, grow, and so forth, thus reducing if not ending the discrimination. Self-help, in other words, was a market test of discrimination and a way of allowing Gary Becker’s insight that competition destroys discrimination to work itself out in the real world.
The Lumbee Guaranty Bank, for example, charges its borrowers a higher interest rate than the local bank run by Euroamericans. So Dobbs Oxendine, a Lumbee entrepreneur, borrows from the latter. The very fact that he can do so suggests that the Lumbee Guaranty Bank may not be necessary. Regulatory approaches that rely on markets have a far better chance of success, of actually helping those groups that regulators purport they would like to help, than those that try to repress markets.
The self-help approach worked amazingly well throughout U.S. history. Early in the nation’s history, commercial banks catered mostly to wealthy merchants. When artisans, farmers, and manufacturers complained, lawmakers allowed them to form their own commercial banks. They did, and it was good, as the new entrants thrived and the established institutions began to re-think their prejudices. Then philanthropists created new institutions, called mutual savings banks, that allowed another unbanked group, the poorest of the poor, to safely earn market returns on any pennies they were able to save. Members of the working classes took note and, excluded from both the savings banks by maximum deposit regulations and commercial banks, which would not cater to consumers until the twentieth century, they gained permission from lawmakers to form their own financial institutions, which they called building and loans. Later, the working classes would form and join credit unions, Morris Plan banks, and industrial banks. Their fraternal organizations competed with industrial life insurers in the provision of low-cost burial and life insurance.
Members of the immigrant groups that streamed into America over the course of the nineteenth century also found it difficult to gain access to established financial institutions. In case you aren’t aware of this history, many Americans considered Irish Catholics to be almost simian. But when they wanted to form their own commercial and savings banks, building and loans, credit unions, and life insurers, lawmakers allowed them to, setting a precedent followed by all the subsequent waves of European immigrants, from the German Forty-Eighters fleeing political persecution to Eastern Europeans seeking a better life.
Some of those immigrants were Jews who found themselves discriminated against on Wall Street. So they established their own investment banks, including Kuehn Loeb and Goldman Sachs. Well after World War II, various big investment banks, brokerages, life insurers, and investment funds were associated with different religious groups, some Jewish, some Catholic, some WASP.  The rhetoric of free enterprise meant that any group that could put up their own capital and/or find financial backers had the right to enter and compete for business on any basis. There were even African-American brokerages by the 1950s.
Blacks, Hispanics, women, and even some American Indians joined the self-help bandwagon and formed their own banks and insurers. Black-owned life insurers were particularly successful, as were black-owned banks where ever African-American businesses thrived, as they did in Tulsa until the infamous white riot there in 1921.
In 1943, Edwin Embree, a high ranking executive in several important philanthropic foundations, summarized the state of black financial enterprise prior to World War II as follows:
The insurance companies, which grew out of the widespread burial and mutual societies, have flourished because of the discrimination against Negro policyholders by the large white companies. Banks, which despite a number of failures rank close to insurance in financial importance, have as one of their chief reasons for existence the refusal of general banking institutions to give credit on equal terms with others to Negro individuals and businesses.
Self-help was less effective when levels of bigotry were high, however, because the self-help institutions themselves were discriminated against. In early postwar Chicago, for example, 21 lending companies with assets of almost $8.9 million were run by African-Americans but they found raising adequate capital “all but impossible” because “non-Negro institutions” would not buy, or lend on the collateral of, their mortgages. Savers therefore tended to eschew them for the higher rates or greater safety afforded by lending institutions run by whites. At the same time in Philadelphia, however, a black banker named Edward C. Brown leveraged his reputation for financial wizardry to obtain loans on favorable terms from institutions run by whites.
So some banks owned and operated by African-Americans, women, Hispanics, and other oppressed groups did manage to survive and even thrive. And new ones continued to form, though at a rate barely above the rate of exit, a few from bankruptcy but most from mergers. The great merger waves that swept the life insurance and banking industries, the latter following the deregulation of first intra-state and then interstate branching in the final three decades of the last century and the first decade of the present one, greatly reduced the salience of self-help. Between 2000 and 2014, for instance, the number of banks owned and operated by American Indians increased from 14 to just 19 on net. Regulators apparently did not find the stagnation of self-help problematic as they believed that the CRA and/or lowered credit standards had, or would, virtually eliminate discrimination. They were wrong about that but enough time has passed since its heyday that few regulators remember the historical importance of the self-help approach.
And it hasn’t helped that de novo banking went extinct for everybody following the Panic of 2008, when I was part of a group, led by a wealthy paraplegic, just starting to develop a proposal for a bank to service people facing a wide range of physical and psychological challenges. Yes, a handi-bank for lack of a better term. Discrimination comes in many forms, which is why we should prefer market responses. Markets, after all, are usually much more nimble and subtle than top down regulations.
The effectiveness of self-help can also be reduced when few members of the group being discriminated against possess the human capital, the skills, education, and experience, needed to successfully enter banking, insurance, or other financial services. Thankfully, commercial banking is not rocket science. One does not need an MBA from a top tier business school to become a good community banker. In fact, such a pedigree would probably be a disqualification.
Actuarial work is rocket science -- almost literally as many actuaries trained as physicists -- but actuarial and other highly technical services can be outsourced, at least at first. Where you need members of the group being discriminated against is in the trenches were loan and insurance applications are received, processed, and decided. That is where their understanding of their own group can do the most good, first by enticing people to apply and second by providing more nuanced judgments about applicants’ ability to repay or minimize claims.
A banker from off the Reservation, for example, may think that an applicant’s income is too low but a fellow American Indian might realize that the applicant has significant income that he can’t show as it may come from the applicant’s own subsistence activities or in-kind aid from members of his clan. An outside banker also doesn’t understand land tenure systems on Reservations and has little incentive to, but an Indian banker would. An outside banker won’t make a loan on a car that she can’t find an approximate market value for on the Internet, but an Indian banker can estimate the value of a Rez car. And so on and so forth. And similar scenarios can be imagined for every group that can’t get loans or insurance, from members of the LBGTQ community to rednecks to African-Americans.
None of this means that regulators should allow just anyone to enter any financial service and completely wing it. Philanthropies and regulators can help jumpstart self-help success by supplying start up capital and subsidizing the education and maybe even some work experience for members of groups underrepresented in the financial services sector and work with them to help build their businesses. But they need to step aside at some point and allow the bank or insurer to sink or swim on its own merits.
Recently, the Minneapolis Fed and the Philadelphia Fed, implemented programs designed to help African-Americans and American Indians to create their own financial institutions. Much more remains to be done but regulators need to combat the inclinations of incumbent financial institutions, which would rather face ineffective top-down regulations like CRA than additional competition.
Regulators should also work to minimize business-to-business discrimination. A bank owned and operated by American Indians or, I don’t know, Furries, should not have to pay a higher interest rate for overnight funds than any other bank of its size, region, and longevity. Insurers should be able to obtain reinsurance on rational terms, and so forth.
I cannot stress enough that self-help is not a panacea. It cannot overcome systemic racism. But it is a more market-oriented approach than top down regulations and much less of a systemic risk than lowering application standards. Throughout U.S. history, it frequently worked completely but even where its success was limited we have to remember that self-help banks and insurers still helped their customers to obtain needed financial services, even if it was just for a few years or decades, or in just a few places. Moreover, some groups may be able to make more headway with self-help than in the past as bigotry and prejudice, while still lamentably powerful, are perhaps not quite as ubiquitous as in the past. There is only one way to find out and that is for regulatory gatekeepers to once again encourage new entry by any group that believes it is being discriminated against.
Thank you!

Friday, June 01, 2018

Capitalism Has To Go. Same with Socialism.

Capitalism and socialism are deeply flawed and need to be eradicated. I speak not of the economic systems sometimes labeled capitalist(ic) or socialist(ic) but rather of the intellectual constructs, which consistently obscure more than they reveal. Capitalism and socialism are to political economy what air and wind are to climatology, much too vague to be of significant analytic value.

Karl Marx and other political economists popularized the terms capitalism and socialism in the nineteenth century. Like many other -isms, neither enjoy a clear, quantifiable definition. Like beauty, capitalism and socialism reside in the eye of the beholder. Like pornography, experts believe that they know it when they see it.

Unsurprisingly, definitions of both terms reproduced rapidly, culminating in 111 discrete definitions of capitalism according to legal historian Edward Purcell. Economists Kate Waldock and Luigi Zingales recently responded to this jargon sprawl with a clever podcast call Capitalisn’t.

Socialism has been similarly fecund, spawning libertarian, religious, and other hyphenated offspring logically possible only by liberally contorting the core concept. “Definitions of socialism,” John Martin noted, “are almost as numerous as the combatants for and against socialism.” (If you have not heard of John Martin, that is probably because he wrote those words in the American Economic Review in 1911!)

Many on the Left use the term capitalism as a sneer or a schmear, as a sort of trump card whenever their logic or knowledge of economics flags or falters. In their view, everything wrong in the world, including problems clearly caused by governments, stems from capitalism, which controls all in a vain attempt to satiate its inherent greed and bloodlust.

Many on the Right have deified and reified the term capitalism, essentially reducing it to competition or economic freedom so they can use it to bludgeon sundry apostates who dare question the Citizens’ United decision or the corporate governance status quo. For many conservatives, capitalism can do no wrong, even when the financial system implodes and CEOs get big bucks for bankrupting their own companies.

Conversely, conservatives have recently conflated socialism with hyperinflation in Venezuela. Milton Friedman, who famously said that inflation is always and everywhere a monetary phenomenon, must be spinning! At the same time, many liberals seem to think that socialism, their version of it anyway, would be a panacea for all our socioeconomic ills.

If they are ever to understand America’s economic system thoroughly enough to aid its functioning, scholars, pundits, and policymakers need to be more specific than X-ism. If prices seem too high, they should investigate market power (monopoly; monopsony), not capitalism. If income seems maldistributed, they should not blame capitalism, but look instead at tax incidence and the redistributional effects of Social Security. If corporate welfare waxes in importance, they should invoke concepts like rent-seeking and regulatory capture, not banalisms like capitalism.

And conservatives need to understand that capitalism does not make nations wealthy, good institutions that create incentives for individuals to work harder and smarter do. Regulations do not hurt capitalism, they hurt some economic entities while benefiting others. Competitive markets, not the financial well-being of wealthy capitalists, drive efficiency gains.

Economic policymaking cannot improve if members of this nation’s reputed intelligensia continue to discuss crucial economic policy issues using only hackneyed, vague concepts like capitalism and socialism, any more than analysis of the climate could improve if scientists only spoke of air, instead of its constituent gases and their many, complex interactions. So the next time you hear Bernie or Sarah Sanders invoke capitalism or socialism, ask them to specify precisely what they mean. If they cannot, consider instead the policy advice of someone with a more nuanced grasp of our nation’s economic and policy landscape.

Monday, April 23, 2018

Legalizing Mary Jane and Freedom

Many people across this great (again?) land are finally joining the pot legalization bandwagon. I like the groundswell though I have never touched the stuff myself and hope never to do so. I wish, however, that more people could extrapolate from marijuana to ... LIFE.

Why did we ever let the government tell us what we can legally put into our own bodies in the first place? Are we a free people or not? If X's actions endanger no one except X (and maybe not even X him or herself) what business is it of anyone else's? Americans should be free to smoke pot, take experimental medications, change their genders, work for any sum of money they can negotiate (including volunteering), and pay whatever rent or interest rate they think fit, so long as they aren't hurting anyone else in the process. (Yeah, abortion gets a bit tricky so I won't discuss it here.)

Oh, you say, but the people who do Y need more assistance from Public Program Z. That may or may not be (they might cost Medicaid more but never collect Social Security, for example) but did you ever think that maybe Public Program Z shouldn't exist in the first place? Cardi B wants to know where her taxes are going. The short answer is ... the Upside Down, the Sunken Place, the Onion's bottomless money pit ... doing things that most Americans don't want done at all, or wouldn't want done if they would simply think about their negative effects on the economy and our individual freedoms.

So I won't thank Trump for reducing taxes, but I will thank him when he cuts total federal expenditures by getting rid of wasteful stuff, like the enforcement of federal marijuana laws.

Tuesday, March 27, 2018

A Non-Lethal Solution for Mass Shootings

A Non-Lethal Solution for Mass Shootings

It is 2020 and about twenty twenty-somethings are in an open office setting that looks like an updated Houston mission control station. In front of each of these modern day "Top Guns" sits a monitor and joystick and a huge screen, currently black, looms at the front of the room. The young men and women joke and jibe with each other, various limbs akimbo as friendly insults and soft objects crisscross the room.

Suddenly, an alarm goes off and Stacy's monitor lights up. In a flash, her hands are in control of a drone just released from a liar so secret that only a few know of its existence, let alone its exact location. The others don't even flinch and some look bored until Stacy blurts out, it's a school, and this is not a drill. Almost instantly, a supervisor buzzes into the room and the Top Guns take up their stations as the big monitor at the front pops into life. 

Some take control of drones from nearby buildings and race them to the scene, just in case. But Stacy has this. The shooter, barely 15, is wearing goggles so she deftly switches from mace to Taser and is on him so fast that he barely gets a shot off at the drone as three of his classmates scamper to safety. A split second later, he is on the ground, convulsing. Stacy instructs the school's security system to sound the all clear, a unique series of sounds only the teachers know the meaning of.

Just as she does so, however, another Top Gun, a geeky looking male who got his job by winning an international first person shooter video game tournament, shouts "Second shooter, 6 o'clock!" He's too far for her second Taser so Stacy switches to the tranquilizer gun and puts one into the assailant's chest, toppling him. Meanwhile, the supervisor has switched off the all clear chime, alerting teachers to remain on lock down. Stacy then hits the first shooter, who is starting to recover from the Taser, with a tranquilizer. 

The backup drones begin to arrive but both shooters remain motionless until later revived by EMTs, after law enforcement personnel secured them to ensure that they cause no harm to themselves or others. The Top Guns then return to a typical boring day of false alarms, equipment tests, and training drills. 

Like other first responders, the Top Guns actually want their days to be uneventful, but as employees of an entrepreneurial company, they know full well that their success will only induce those with evil intent to change tactics. The big boss is already adding electronic bomb sniffing devices to the drones and thinking about ways to stop truck attacks with a level of violence far short of RPGs.

This story is obviously fictional, and highly dramatized, but the events described are technologically possible TODAY. Why are Americans debating the Second Amendment, again, instead of discussing practical, humane, do I daresay Christian, steps to reduce the impact of gun violence? Do we want to save innocent lives or score ideological points of no real value?

Monday, March 19, 2018

U.S. Tax Policy, Inflation, and the Euthanasia of the Individual Investor in the 1970s: The Views of Gadfly Journalist Wilma Soss

U.S. Tax Policy, Inflation, and the Euthanasia of the Individual Investor in the 1970s: The Views of Gadfly Journalist Wilma Soss

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana University[1] for the Philosophy, Politics, and Economics Society Annual Meeting, New Orleans, Louisiana, 16 March 2018.

Since the financial fiasco of 2008, some U.S. investors have been subjected to a subtle but invidious injustice: they have paid income taxes on interest earnings that are below the rate of inflation. Although they enjoyed nominal gains they suffered real, by which I mean inflation-adjusted, losses. This has not become a major policy issue because many such investors did not itemize their deductions and many fewer will do so under the “Tax Cuts and Jobs Act” of 2017. Moreover, the difference between the savings and inflation rates was just a few percent at most and interest rates have been so low that interest earnings typically pale compared to income. The stakes are simply too low to get riled up about the situation.
But what if the U.S. economy were to suffer a major bout of inflation? Although the Federal Reserve has found it difficult to increase inflation to its target, key policymakers and economists have admitted that they do not understand why that is the case. The Panic of 2008 and Great Recession basically broke their models, and all the Fed chairperson’s economists and all the Fed chairperson’s computing power has not been able to put the econometric Humpty Dumpty back together again. Nobody seems much concerned about this but the last time the Federal Reserve was as clueless about the causes of changes in the price level was in the wake of the shocks that occurred in the early 1970s, including the end of the Bretton Woods gold exchange standard and the oil crises. Those events triggered a decade-long bout of inflation unparalleled in peacetime America. That episode, commonly known as the Great Inflation, exposed the grave injustices of a tax code built upon nominal values.
Bracket creep is a fairly well understood injustice from the era, a time when tax protesters “sent in band-aids with their returns to show it hurts … a lock of hair to indicate that they’ve been scalped … and a piece of shirt off their backs” (PN, 4/12/70).[2] Basically, as inflation drove up nominal incomes, taxpayers in essentially unchanged material circumstances were forced to pay a higher percentage of their incomes in taxes, as if their real incomes had increased. The euthanasia of fixed-income investors, who saw their real incomes decline as nominal prices rose, has also been studied by researchers such as Niall Ferguson in his classic The Cash Nexus (PN, 95/1973). Less well understood is the fact that the financial death of investors in bonds and stocks was aided and abetted by a tax code that treated nominal income from coupons and dividends as income even when it sagged far below the rate of inflation and that did not adjust asset prices for inflation when computing capital gains.
One of the leading popular critics of the nominal tax code was Wilma Soss, a corporate activist, or “gadfly” in the parlance of the day, and the host of a radio show called Pocketbook News that ran weekly coast-to-coast on NBC Radio from 1954 until 1980. Although less famous than Sylvia Porter, Wilma, a 1925 graduate of Columbia’s then new school of journalism, wrote and produced the show herself and kept its quality high throughout her career. In fact, her show’s final decade was arguably its best, as Wilma leveraged her long investment experience and vast network of professional contacts, which ranged from big banker David Rockefeller to monetary expert Franz Pick, to help her listeners to understand the titanic shocks that rocked the American economy throughout the 1970s. Born in 1900, she finally gave up her show at age 80 and died just a few years later.
Although not formally trained in economics, Soss had studied the subject in college and was constantly interacting with economic experts for her show and as founding president of the Federation of Woman Shareholders in American Business, an NGO dedicated to corporate governance reforms aimed at aiding small investors, over half of whom were females in many companies. A Republican in politics, Soss gravitated towards standard neo-classical theory infused with practical understandings gained over decades of managing her own investment portfolio.
For the most part, Soss jousted with the corporate grandees who had seized control of American big business and turned companies into personal piggybacks to be raided at will, always at the expense of stockholders, or shareowners as Soss came to call them to stress their proper relationship to management as she saw it. When government policies threatened the value of her investments, however, Soss turned on the responsible parties in Washington. That included Republican president Richard Nixon, whom Soss at first admired, after it became clear that his New Economic Policy price controls included de facto ceilings on corporate dividend payments (PN, 10/10/1971) and that he favored Big Labor over small shareowners (PN, 11/20/1971).
Soss, who took the last name of her husband Joseph, enjoyed what appears to have been a very modern marriage. The childless members of the Soss pair enjoyed relatively lucrative and interesting careers. Soss even commuted weekly from their apartment in New York to her P.R. job in Detroit during World War II and to a similar position in Philadelphia after the war, both by train of course. She claimed on air that Joseph did the couple’s shopping but that she paid many of the grocery bills (PN, 10/15/1976). Soss undoubtedly at least worked with Joseph on their taxes and she may have filed an individual return in some years. In short, she had working knowledge of the individual tax code and personally felt the pressures caused by rising prices and lagging returns. On 18 March 1977, for example, she complained on air that she “received a $6.00 3 months dividend on 12 shares of International Paper at the same time as a bill for $7.10 for two veal chops!”
Soss understood that “inflation is in itself a tax” on money balances (PN, 12/24/1972) and at least twice even called it the “greatest tax of all” (PN, 9/8/1973; PN 3/16-17/1974) and considered it a “cruel tax” (PN, 7/15-16/1974) or even the “cruelest tax” (PN, 3/25/1976?). She argued that any inflation above 2 percent was “terrible” though “not too terrible” if held below 4 percent (PN, 06/25/1972). But other inflation costs lurked, virtually unseen, in the nation’s tax code.
As early as 18 January 1970, Soss warned investors on air that their after-tax yield on bonds was likely less than the rate of inflation. On 25 July 1971, Soss, who had been born in San Francisco but spent much of her life in New York City, went on an anti-New York City tirade that included the complaint that the 7 percent city sale tax rate when “you get 5% for your money in the savings bank” was “immoral.” “It should be illegal,” she argued that day, “to have a sales tax higher than the people’s basic interest rate on savings on which they have to pay income tax besides.” She left off that somewhat nonsensical line of reasoning but on 23 January 1972 she noted that all of the gain in personal income in 1971 had been erased by increases in inflation and taxes. That was no good because, as Soss noted in her broadcast of 9 December 1973, “there is an old axiom that the cost of money has to be twice the cost of living if, after taxes, the lender [i.e., the investor] is to stay ahead of the money game.”
And Soss meant the actual cost of living. The government’s own inflation statistics, she believed, had a discernible downward bias. On 7 October 1973, she told listeners that “there is generally suspicion that government statistics have become politicized and cosmeticized. The official index for the rate of inflation seems hardly to match anybody’s family budget.” Years later, she claimed that she kept a bust of British Prime Minster Benjamin Disraeli on her desk to remind her of the claim (whether it was actually his or not) that “there are three kinds of lies -- white lies, damn lies, and statistics” (PN, 3/25/1976?) She also realized that changes in the price level could affect states, regions, and metro areas differently (PN, 4/27/1974). She knew, for example, that in the early 1970s the cost of living in New York City rose four times faster than the national average (PN, 3/20/1971).
Soss also understood that risk requires compensation so on 21 January 1973 she challenged her listeners to imagine a 10 percent increase in stock prices but then to deduct “the rate of inflation, your taxes, worry and risk. Try that on your pocket calculator and see what you have left.” A week later she complained that Exxon’s common stock yielded only 4.7 percent “while bank interest is 5 to 6%,” a very bad bargain indeed given the risk involved. “Stockholders are not an eleemosynary institution,” she reminded corporate executives and policymakers. “We invest our savings to add to our earnings or as a pension,” not as a charitable donation.
To her listeners, Soss also explained that rising stock prices might reflect nothing but fake profits generated by antiquated or even improper accounting methods. The latter stemmed from the ability of managers to manipulate financial outcomes. “Earnings,” she warned listeners on 18 January 1970, “are what management and the accountants want them to be.” (She also noted that the Ford Foundation was “critical of corporations that achieve earnings gains through liberal accounting practices” [PN, 6/7/1970]). The former was due to using inventory accounting techniques (PN, 10/14/1973; PN, 11/25/1973; PN, 12/301973; PN, 5/7/1977; PN, 4/14/1979) like FIFO, or “first in, first out,” instead of LIFO, or “last in, first out.” FIFO, she explained, “is likely to beef up profits and make earnings look better than they really are” (PN, 7/20/1974). Soss even went before the Financial Accounting Standards Board (FASB) to argue for what she called “price level accounting” in the name of transparency and full disclosure. As she explained to listeners on 11 July 1975, “if a dividend hasn’t been raised, say, since 1971, it has been cut, since the dollar has lost about 24% in purchasing power since then!” She lauded the Indiana Telephone Company for stating its earnings in constant dollars, using the GNP deflator, one of only a handful of companies to do so (PN, 4/24/1974).
All of those considerations led Soss to advocate a tax credit based on a realistically computed CPI. She never made the details clear but obviously she believed Americans should be compensated for the lost purchasing power of the dollar and inflation-adjusted capital losses. She argued on 5 March 1973 that “19% devaluation of your dollar within fourteen months means that some, possibly many of you will be paying capital gains taxes on what are capital losses, not to mention the universal tax of inflation on your income, for which there are no tax credits.” And on 12 August of that year: “Women investors are beginning to ask what good is 8% and even 9% interest on your money on which you have to pay taxes when the price of food is going up 20%?” And on 24 April 1974: “Many of us are paying taxes on non-existent profits and income.” And so forth, on and on and on (PN, 5/18/1974; PN, 7/13/1974; PN, 7/15/1974; PN 6/1/1975; PN, 3/24/1979; PN, 4/7/1979), culminating on 10 March 1978 when she reiterated her call for an inflation tax credit and argued that “it is outrageous to have to pay income taxes on five percent interest when the rate of inflation is 8 and 9%, not to mention double digit!”
To provide an income tax credit for actual inflation and to calculate capital gains on a real basis would of course reduce the government’s incentive to cause inflation in the first place, so Soss’s proposal was a political non-starter. Political economists today, however, might consider trying to work such inflation disincentives into the tax code while inflation remains relatively tame. Ensuring that the government’s revenue automatically will decrease if it tries to inflate away its debts could do more to protect future generations from another Great Inflation than the Federal Reserve’s ever tenuous political independence.
Soss had plenty else to say about taxes. For starters, there were too many of them. She recalled for her listeners, for example, a study conducted in the 1950s that showed that bread was taxed 151 times before its consumption (PN, 9/17/1972). Even worse were taxes on tobacco products imposed at the same time that the federal government heavily subsidized tobacco growers (PN, 1/13/1978). Soss also reminded listeners that taxes, once implemented, almost invariably trended upward, like a teaser interest rate. “Remember how low the income and social security taxes started?” she asked on 6 February 1972 in response to calls for a European-style Value Added Tax of just 2.5 percent.
America’s tax codes, Soss argued, aided and abetted margin speculators while discouraging savings and promoting a “borrow and spend” mentality. “So long as interest rates are less than the inflation rate and the interest [paid on debts] can be deducted from taxes,” she noted on 2 February 1980, “people will borrow and spend.” Or, a month later, “there is little incentive to save under our tax structure” (PN, 3/?/1980).
The most insidious taxes of all were those that threatened corporate democracy, Soss’s antidote to Soviet communism and European-style socialism. “The whole capitalistic dogma falls apart,” Soss argued on 24 April 1974, if investors were not able to earn decent risk-adjusted returns after taxes and inflation. By the time Soss retired in early 1980, the end of corporate democracy was already well underway. At the end of 1968, individuals owned 80 percent of all corporate shares (PN, 2/1/1970). During the 1970s, individual investors began to pour out of the securities markets (PN, 12/26/1975; PN, 7/2/1976) due to higher commissions before the May Day 1975 brokerage deregulation (PN, 2/15/1970; PN, 7/12/1970), poor real returns -- the annualized nominal growth rate of the Dow Jones Industrial Average between 1 January 1970 and 31 December 1979 was a mere .47 percent ( and dividends dropped from 75 to 40 percent of corporate earnings (PN, 11/7/1971; PN, 4/24/1974; PN, 12/11/1979; PN, 12/29/1979) -- and also the continued double taxation of dividends and other anti-small investor tax policies. On 3 September 1972, contemplating a victory by Democratic presidential candidate George McGovern, Soss noted that a “McGovernment” would not end the double taxation of dividends and would likely impose the capital gains tax on inherited stock, prompting one irate listener to wonder “why do they hate children in this country?” Soss also noted that the 100 percent deductibility of short term stock market losses, compared to the 50 percent allowed on longer term investments, “encourages speculation” and “discourages investment” while it fattened brokerage commissions (PN, 9/17/1972).
Soss became hopeful in August 1973 when the Senate began “studying tax changes to spur more people to invest in common stocks” (PN, 8/5/1973), again in July 1975 when Treasury Secretary William E. Simon made some noises about tax reform, and in the summer of 1976 when double taxation was again discussed in high policy circles (PN, 7/16/1976; PN, 9/17/1976). But ultimately nothing came of any of those attempts (PN, 7/22/1977) because, as Soss noted, “the moral aspect of double taxation appeared to bother no one” (PN, 7/11/1975).
When individual investors came back into the markets after the rise of discount brokerage firms like Schwab, most did so as so-called day traders, or short-term speculators. “Inflation with a couple of stock market crashes in the seventies,” Soss explained to listeners on 11 December 1979, “killed investors’ appetite for stocks. The shift has been from long term investment into short term speculation.” Traditional, buy-and-hold value investors switched from direct ownership of shares to low cost mutual funds, most of which refused to intercede in matters of corporate governance. After sundry poison pills killed off leveraged buyouts and other forms of market discipline, corporate executives were virtually unchecked. The accounting scandals of the early Third Millennium AD and the financial fiasco of 2008 were direct results. Soss was long dead by then but would have turned over in her grave had she not ordered her remains, like those of her beloved Joseph, cremated.
Thank you!

[1] The author gratefully acknowledges the aid and input of Jan Traflet, a professor in Bucknell’s Freeman School of Management and his coauthor of a forthcoming full-length biography of Soss. Any errors of fact or interpretation found herein, however, remain Wright’s sole responsibility.
[2] References in this form refer to the transcripts of Soss’s Pocketbook News radio show, followed by the date of broadcast, all of which can be found in Box 9 of the Wilma Soss papers housed at the American Heritage Center, University of Wyoming, Laramie, Wyoming.