Compensation Incentives and Financial Instability

It’s official. America’s financial system is a mess once again. It isn’t a good feeling, being the laughingstock of the world. (If you haven’t yet seen the hilarious PowerPoint presentation called “The Subprime Primer” or the even funnier YouTube video, “The Long Johns – The Last Laugh – George Parr – Subprime,” by all means find them as soon as you are done clicking on the ads supporting this blog.) Suffering through an economic recession, caused by the subprime debacle and exacerbated by decades of governmental, corporate, and personal financial profligacy, is even less fun, especially if you lose your job, car, credit rating and/or house during what could become a long and ugly shakeout period.

In the past, Americans have responded to financial and economic turmoil with hasty and ill-conceived reforms. From the Panic of 1792 to the accounting scandals earlier this century, crisis has spawned regulations, some salutary, most not. I hope things will turn out differently this time around. What regulators and reformers need to concentrate on is what really matters, the nature and timing of compensation for everyone from the CEO to the lowliest trader. If the last year or so has shown anything, it is that people do precisely what they are given incentives to do. If you pay people upfront to originate 15- or 30-year mortgages, they will sign up everyone they can, even “ninjas” (people with no income, no job or assets). If you give people outsized annual bonuses based on what they appeared to do for your company that year, they will create, support, and implement crazy, short-sighted schemes. Many people on Wall Street knew that the subprime bubble was unsustainable. But what does that matter when those most responsible for letting it happen raked in seven-figure bonuses for a year, or two, or maybe five? The huge golden parachutes most executives wear these days are inducements to take big risks. If those in charge messed up, their parachutes opened and glided them comfortably to earth even while their former employer bursts into flames.

What rogue traders, accounting scandals, and the subprime mess tell us is that it is as easy to fake financial profits in the short term as it is for Meg Ryan to fake a raging orgasm in a crowded restaurant. (When Harry Met Sally for the uninitiated.) Longer term, the truth becomes known but irresponsible millionaires, and sometimes billionaires, have already been made. That is not to say that some Bear Stearns managers aren’t feeling a bit crimped for cash right now – they owned about a third of the failed investment bank, the share price of which plummeted from $170 to $2 over the last year – but don’t expect to see many of them in soup lines.

It doesn’t have to be this way; there are examples of how to do it right. “Conservative” financial institutions, for example some mutual life insurers, counter short-term thinking by deferring compensation, paying comfortable monthly salaries but reserving big bonuses until profits are actualized, not merely booked. They have long done so for their sales agents, who otherwise would try to saddle them with terminal cancer patients, daredevils, and Alaska crab fishermen, and more recently have extended the idea to executives and board members. Other financial institutions should consider following their example. If they don’t, the government will sooner or later try to do it for them, with predictably unpredictable consequences.

Financial crises and economic recessions are not the end of the world. They are costly, however, so it is important to try to limit their number and extent. In the future, we need more proactive analysis of skewed incentives, unintended consequences, and conflicts of interest and less reliance on reactive monetary and fiscal policies. Will managers and shareholders clean their own house or will they have it scrubbed for them?

The National Debt and the Poor

At first glance, America’s poorest citizens ought to be indifferent about the national debt. To pay if off, or at least down, the federal government will have to begin to spend less than it earns and that means some combination of tax increases and spending cutbacks that may injure society’s least well off. Another look, though, suggests the poor should hate the national debt, which now stands at about $9.3 trillion or over $30,000 per person.

The economy appears to be going to Limbo if not Hades itself. To stop its descent, the Federal Reserve is cutting interest rates like mad and inventing (or reinventing) new ways of adding liquidity to the financial system and shoring up confidence. It may succeed, as it did in the wake of the S&L crisis, when it stopped a stock market panic in 1987 and kept the 1990-91 recession short and mild. Its predecessor, the Bank of the United States, made similarly short work out of the Panic of 1792. Even if we get out of the current mess relatively unscathed, however, we will remain poised for another bout of financial indigestion at some point in the future, perhaps the very near future, because the Fed’s actions, while necessary, reward risky behavior. (That is what economists and pundits mean when they refer to “moral hazard.”)

The government is just as likely to fail to stop the slide. In 1929, the government did too little. Prices dropped, companies went out of business, millions lost work, defaults climbed, and banks began dropping like flies. It took years to recover and guess who suffered most? That’s right, the poor. Today’s government certainly doesn’t want another depression but one of its hands is tied. In addition to easing monetary policy (cutting interest rates), governments can thwart economic downturns with fiscal stimulus, cutting taxes or borrowing and spending in order to stimulate demand, keep companies in business, and people employed. Our monstrous national debt, coupled with the weak dollar, means the fiscal path is almost closed. The government could do more than the paltry tax rebate checks it has promised, but not much more.

So the Federal Reserve has had to reduce interest rates rapidly and will likely make more cuts. But here looms another bogeyman, runaway prices, as during the “Great Inflation” of the 1970s and early 1980s. Guess who gets hurt most by inflation? People rich enough to buy TIPs, gold, and other inflation hedges? Professionals who can easily negotiate higher fees? No, it is the poor, who will have a difficult time increasing their wages enough to match the higher cost of “little luxuries” like gasoline, electricity, clothes, and food.

The Founding Fathers knew better than to paint themselves into this corner. The new nation ran up a large debt winning its independence, fighting pirates and the French, and buying Louisiana. But it paid it all off by the mid-1830s because its leaders knew that a large, perpetual debt would injure the poor by redistributing resources from the masses to bondholders. The Founders also knew that too much debt would weaken the nation militarily. War threatened the safety of the entire country but weighed especially heavily on those who would have to join the line, then as now overwhelmingly the poor.

Not much can be done about the national debt right now, except to watch it grow. When the financial system and the economy regain their footing, however, we need to have a long, hard conversation about how to repay what we owe, if not for our own sake then for those most threatened by it, the poor.

Broken Bridges and the National Debt

The good news is that nobody was killed last month before authorities shut down a busy 2-mile stretch of I-95 in Philadelphia to repair a badly cracked concrete pillar. The bad news, besides the inconvenience the shutdown caused commuters, truckers, and various Philly neighborhoods, is that we may not be so lucky next time. This is not hype. A bridge collapsed in Minnesota last summer, killing 13 and injuring five score more, and thousands of U.S. bridges and overpasses are in need of repair. Solving this pressing problem will not be easy.

A hike in the gas tax is not in the cards, not with oil above $100 a barrel. (In fact, John McCain, Mr. Alleged Fiscal Conservative, is calling for suspending the gas tax this summer!) Using general tax revenue raises sticky questions of equity like why non-drivers should subsidize automobile ownership. We could borrow and worry about repaying later but unfortunately that little game may be just about over. The national debt is now about $9.3 trillion. That’s over $30,000 for every person legally resident in the country. With the dollar so weak – it takes about 2 of them to buy a British pound, over 1.5 of them to buy a euro, and about 1 of them to buy a Canadian dollar – foreigners are understandably wary of purchasing Treasuries. At home, fears of inflation loom larger every time the Federal Reserve cuts interest rates and that is bad for bonds. (To his credit, Philadelphia Fed president Charles Plosser wanted the Fed to cut the overnight rate only 50 basis points instead of the 75 it ultimately decided upon on Tuesday.)

Another approach is to try to make the construction industry more efficient. As Barry LePatner (with help from myself and Tim Jacobson) argued in Broken Buildings, Busted Budgets (2007), there is a lot of fat in the industry. Trimming it would help taxpayers get more bang for their infrastructure buck, regardless of its ultimate source. But it will still take a lot of money to fix all of our crumbling bridges, money we don’t seem to have.

The Founding Fathers offer yet another approach. They groaned under a massive national debt, incurred fighting wars and buying Louisiana, that they wished to pay off as soon as it was economically prudent to do so. They succeeded in the 1830s in part because they kept the federal government out of the infrastructure business altogether (with a few minor exceptions). Ingenious early state governments farmed the job out to corporations – for-profit toll bridges, turnpikes, and canals. Pennsylvania led the way in 1792 with its charter of the Philadelphia and Lancaster Turnpike. The system worked tolerably well then and could work even better today because technology has greatly reduced the cost of collecting tolls. New Jersey recently considered selling or leasing its turnpike to a for-profit corporation before jettisoning the idea after a popular uproar. That may have been a mistake; corporate-owned for-profit roads have succeeded elsewhere despite barriers built into the tax code against them.

I know having corporations in charge of our roads, tunnels, and bridges will seem like a big step for many Philadelphians and Americans more generally but they have little to fear. Corporations can maintain our roads and bridges more cheaply than governments currently do. They have incentives to complete construction projects quickly, with few disruptions, because they do not want traffic volume and hence tolls to suffer. Because they can be sued and need insurance, infrastructure corporations are also safety-minded.

Clearly, our bridges need repair. The question is how best to pay for all the work that needs to be done. Letting corporations do the job in exchange for tolls is a very old idea whose time may have come again.

How Historians Caused the Subprime Mortgage Mess

A hopeful sign that the credit crisis precipitated by the subprime mortgage disaster of ‘aught seven’ has run its course is that the blame game has begun in earnest. With typical abandon, liberals cast aspersions on the market while conservatives chastise the government. Poor Alan Greenspan, a conservative who long served as chairman of the government’s primary monetary policy instrument, the Federal Reserve, has been forced to walk a tenuous tightrope as he tries to vindicate both himself and the financial system. Almost simultaneously, The Economist ran an article suggesting that the root cause of the subprime debacle was a deficient educational system. Apparently, Americans, Brits, and the citizens of most of the world’s nations know so little about money they can’t be trusted with any, especially their own. Economists strenuously demur, preaching to an increasingly incredulous audience that humans are innately rational beings.

I want to join the blame game because it looks like such great fun. It doesn’t take much effort to concoct some controversial yet plausible-sounding monocausal explanation for our economic ills. All of us chiming in can get on television and talk past each other in short, vacuous, but strangely alluring sound bites. Nothing of value will come out of it, but we’ll have a grand time defending the indefensible while distracting people from ‘slightly’ more important topics like the war in Iraq, the burgeoning national debt, and global climate change. So here goes …

Historians caused the subprime mortgage mess. They did so by spending the last umpteen years studying increasingly narrow cultural topics to the exclusion of important stuff. Broad concerns about race, ethnicity, class, and gender devolved into minute studies of if not nothing then next to nothing. Those who preferred to stay off the cultural bandwagon were marginalized, shunted aside, and barred from the profession’s most important associations and laurels. One by one, the great pillars of the discipline’s once mighty edifice crumbled. Political, diplomatic, military, and economic historians fled for the greener pastures of retirement or professional schools. The Queen of the Social Sciences, as History was once known, abdicated her throne.

Few outside of academe knew, or cared, much about this strange transformation. It did not take long, however, for them to lose faith in the new cultural historians, who tended to be either ivory tower types with obvious, and often radical, political agendas or glib public intellectuals who supplied gobs of edutainment but little depth. Both quickly sank into irrelevance; policymakers public and private increasingly turned to political scientists, economists, and other non-historians for guidance about the past. Though adept with statistics and mathematical models, social scientists of the past often lacked skills that historians exude in ample quantities, especially archival research skills and the ability to think contextually. Largely devoid of those crucial skills, the social scientist of the past also proved insufficient to the task of providing deep historical insights relevant to major policy questions but clouds of fancy math and jargon delayed recognition of the fact.

While historians stood in the corner talking to themselves about next to nothing and social scientists of the past obsessed over their numbers and models, American investment banks blindly stumbled onto a ‘new’ idea, securitization, or the packaging of mortgages into bundles for resale to institutional investors throughout the world. The idea appeared brilliant because it took the risk of a mortgage default and spread it out, ostensibly to the point of eliminating it. Predicting whether in a given year a particular mortgage would go bust was as difficult as predicting whether a specific individual would die. But thanks to the law of large numbers, the percentage of a population that will die in a year can be known with great precision. So, too, it was thought, could the number of mortgage defaults. Investors could therefore buy even the riskiest mortgages so long as they diversified their portfolios by buying a lot of them offered together in a single security or bond.

One problem with that reasoning is that people usually do not want to die, but their desire and ability to pay their mortgage can change over time, and quite dramatically at that. Another problem is that life insurance agents typically receive their commissions over a period of years in order to give them incentives to sign up healthy people with safe occupations and lifestyles. Mortgage originators, by contrast, receive their payments upfront, at closing. They therefore have no reason to concern themselves with borrowers’ ability to repay their mortgages and in fact had incentives to help weak applicants to borrow the most they possibly could. NINJA loans (no income, no job or assets) and other absurdities are the result.

The most damning evidence against securitization, however, was purely historically. Between the Civil War and World War II, six America mortgage securitization schemes went belly up. None caused as much economic heartache as the current one but they nonetheless left ample evidence in the historical record. Each centered on a profitable-looking new market, eastern, western, rural, urban, local, and national. And each failed after a few years for precisely the same reason the subprime market was bound to, the skewed incentive scheme discussed above. A few scholars, those conversant with Kenneth Snowden’s chapter on the topic in Anglo-American Financial Systems (Michael Bordo and Richard Sylla, eds., 1995), knew about those foreboding precedents. It was difficult for them to get a word in edgewise, however, because they were few and not well respected by their historian or social science colleagues. That, in turn, rendered it impossible for them to gain the ear of regulators and investment bank executives. The rest is, or rather will be, history. Or will it? If the lessons of securitization are allowed to slip out of our historical consciousness again, our children or grandchildren could suffer a similar debacle, perhaps involving Artic beachfront property.

Historians need not drop what they are doing and rush off to study financial institutions and markets. It would be helpful, though, if they recognized the importance of their own discipline and unique scholarly skills to all aspects of contemporary life, not just culture. That might entail rendering their journals fairer and more inclusive, giving awards and other laurels to a wider group than hitherto, and occasionally hiring someone whose research might help save the nation from its next political, military, diplomatic, or economic crisis.

I did not forget you, Libertarians!

Some libertarians are all in tizzy because I didn't mention their party in my Los Angeles Times op ed today: http://www.latimes.com/news/opinion/la-oe-wright18mar18,0,3662044.story. I'm sorry there wasn't enough space to work y'all in. The Libertarian Party deserves many more words than I was given space for. Moreover, I'm not sure that it fits the bill as it tries to cover too many areas. What I'd like to see is a party narrowly-focused on getting our economic, financial, and fiscal houses in order. Then we can worry about gun control, national id cards, immigration, abortion, and all that very divisive jazz. On its website, the LP (http://www.lp.org/article_85.shtml) says it is the third largest party in America, but it only has about 200,000 registered voters nationwide. That isn't very big; there are more people in my neighborhood! I think most Americans are centrists, both left to right (Democrat to Republic) and up to down (libertarian to statist). To win national or big state elections, you have to be close to the center, to found common ground upon which to unite the most people possible. I think that means appealing to things like the budget and the debt and keeping one's mouth shut on social issues. To the extent that other issues impinge on the budget/debt, they should be discussed in those "dollars and sense" terms rather than in ideological ones (e.g. governments or markets suck).

What Does Spitzer Have to Do With the National Debt?

How are Eliot Spitzer and the national debt linked?

Most importantly, for me, his story got my op-ed in the LA Times bumped into next week!

Seriously, his little ... indiscretion ... shows, once again, that our elected officials are as human as the rest of us. Some of them have trouble keeping their penises in their pants, others can't keep their hands to themselves, their mouths shut, or their driving safe and sober. Still others couldn't balance a checkbook if their lives depended on it or, more importantly, balance the government's budget if the entire national economy depended on it. This is why it is so important to look for structural ways of tying politicians' hands, of building more checks and balances into what matters most, the power of the purse.

One idea I throw out in One Nation Under Debt is to make one house of Congress responsible for spending and the other for taxing and borrowing. That way, the spending house (the House of Representatives?) can't spend more than the taxing and borrowing house allows. It'll give 'em what economists call a binding budget constraint. During wars and disasters the other house (the Senate?) would provide ample resources but in fat years will have a better chance of keeping a lid on spending. Chew on that.

Universal National Service

Finished reading Sabato's A More Perfect Constitution today. (A very interesting read for a wonky scholar like me. The writing is fluid but doesn't soar.) In Chapter 5, Sabato advocates the formation of a near mandatory Universal National Service, two years of public service for young people. The idea is to get our yutes to join the military, Habitat for Humanity, the Red Cross, something. Unless they opted for the military, they'd only get minimum wage or so but they would also get a great experience, some job training, friends for life, and a sense of civic responsibility.

I find the proposal interesting for two reasons. For starters, I suggested the same thing a few years ago in my ill-fated book ms., "America Down: The Failure of U.S. Higher Education ..." In that ms., I suggest that putting 18 to 22 year olds out in the real world instead of the college classroom would benefit everyone. They could sow their wild oats and earn some dough for college, so work, sex, and drugs don't distract them from their studies when they get to college at age 22 or 23. Secondly, Sabato claims that "the benefits that will accrue as a result of Universal National Service will far outweight the annual price tag for the federal Treasury" (173). He doesn't really demonstrate that in any rigorous way but the idea is fascinating ... with a slight nudge, our wayward youth could be put to work to help pay off the national debt instead of increasing it by wasting the massive educational subsidies we lavish upon them at frat parties and football games. ... Hey, I'm allowed to dream aren't I?

Line Item Veto

At the end of One Nation Under Debt I discuss some radical ways to make our government less prone to take on gobs of new debt in good times and bad. In his A More Perfect Constitution, Larry Sabato makes some less radical but no less valid recommendations, including bringing back the line item veto (Pres. Clinton saved us almost half a billion dollars by lining out pet pork projects before the Supreme Court ruled the practice unconstitutional) and decreasing the president's warmaking powers. The latter is a good idea for non-fiscal reasons as well. Of course the easiest way to end the debt death spiral would be for voters to make it clear to politicians that they need to stop running massive budget deficits. That Ron Paul garnered so much support shows that millions of Americans are fed up with the current system. Not enough millions to get him nominated but enough to strike fear in the heart of the status quo.

Why Does Every (Non-incarcerated adult) Get One Vote?

In my new book, One Nation Under Debt, I mention that we might want to consider allowing taxpayers to allocate their taxes themselves. Under our current system, we elect politicians to do this for us. The problem is that to get elected and stay in office, politicians have an incentive to spend more than the government brings in as taxes or other revenues. That creates chronic deficits which over time leads to a mammoth national debt, now over $9 trillion or $30+k per person! (And that is just the recognized part of the debt. Various contingent liabilities are much larger but nobody knows precisely how much.)

Early in our history, we managed to repay our national debt because both politicians and voters thought maintaining a debt was bad policy. We also had a relatively popular tax base (duties and customs, especially in the North) and little desire in either party for bigger government. None of those conditions hold today.

Many things could be done to alleviate the current situation. One is to make politicians start talking about what they are going to do about federal deficits and the debt and voting for the one with the best plan. Good luck with that one! Larry Sabato also has some interesting ideas on a balanced budget amendment in his A More Perfect Constitution.

Another idea is to allow taxpayers to decide how their taxes are spent. The goal here is to increase tax revenues by giving people an incentive to pay their taxes. Through April 15, millions of Americans will huddle with their "people" or their own consciences and decide, within parameters, how much to pay in federal income taxes. Most will shoot for the low end of the range, reasoning that everybody engages in tax aversion (if not evasion) and that most of the money will go for unwanted projects (the occupation of Iraq, bridges to no where, etc.) anyway. If people could decide where their taxes went, they would pay more in taxes I believe. Increasing taxes and holding the line on expenditures is of course the only way to relieve our debt problem.

When I floated this idea before, some people got very angry because they foresee the rise of a "plutocracy," or rule of the rich. I find this objection confusing because we're pretty close to that already. Everybody knows the rich (and famous) can afford the lobbyists and big campaign contributions that can gain politicians' ears. I think my proposal is actually conducive of democracy because no group could use the tax system to expropriate resources from other groups. As more taxes are taken from a group, the more voting power the group gains under the system, thus giving it the power to repeal or reduce its tax burden.

A similar system has worked well for corporations. Since the founding of the republic, corporations, with a few early and late exceptions, have allowed shareholders to vote based on the number of shares they owned, sometimes 1 to 1, sometimes with caps (no more than 10 or 100 votes), sometimes on what Alexander Hamilton called a "prudent mean" basis. If every shareholder had just one vote, few investors would risk much and hence equity finance would be much more expensive. What we have in the political realm is analogous -- very few wealthy people are vested in the current government in any major way. So they think little of shifing jobs overseas, setting up tax havens, etc.

Another objection is that extremists would rule the system. In fact, extremists would essentially cancel each other out, just as they do in the marketplace. Maybe X says put all my money into national defense while Y says all mine into education, and so forth. It'll all come out in the wash, as they say. And of course most people won't be so extreme and interest groups (AARP, NRA, NAACP, etc.) would be entitled to propose allocations which anyone would be free to adopt if they see fit.

Voting on the basis of taxes paid would essentially take back the proverbial power of the purse, the power to spend our own money the way we see fit. Some current programs would be pared back, others would disappear for lack of funds. No just war or other important project, however, would die for lack of funding. And if the American people don't want to burden their children and grandchildren with debt they would have the power to pay what they owe instead of looking on helplessly as politicians borrow and spend to the hilt, year after year and decade after decade.

I'm Back in the Blogosphere!

Almost a year it has been since last I blogged.

I'm back, and with a vengeance, to support my new book One Nation Under Debt: Hamilton, Jefferson, and the History of What We Owe (New York: McGraw Hill, 2008) as well as a forthcoming project called FUBARNOMICS (that's trademarked, dawg!). One Nation Under Debt (ONUD) is already attracting considerable media attention, including a long interview on the Joey Reynolds Show [http://www.wor710.com/pages/46370.php], which you can listen to here:
http://www.wor710.com/topic/play_window.php?audioType=Episode&audioId=1581373

In forthcoming blog posts, I will elaborate on the more controversial portions of ONUD as well as FUBARNOMICS to help stir debate.