The GAAP between politics and economics

Congress has thrown everything it can at the financial crisis, and has left appropriate concerns -- whether moral hazard, corruption, subsidies, or upholding contract law -- to the side. This may well be a sensible approach: with workers out of work and the financial system collapsing, Congress and the Administration had to step in to prevent a potentially devastating negative cycle. But one must question a break for the financial system that occurs by deliberately obscuring the truth, which is exactly what Congress's call to suspend mark-to-market accounting did.

Mark-to-market, the process of valuing assets at the price of the last sale in the marketplace, has been a staple of accounting for financial assets under Generally Accepted Accounting Principles (GAAP). Congress, in arguing the practice should be suspended, is agreeing with financial firms that claim mark-to-market is creating the appearance that banks are losing money on assets when in fact the assets continue to perform as expected. This is particularly troublesome for banks that have to maintain capital buffers above expected losses -- the marks cause bank capital to fall, eliminating buffers and requiring banks to raise new capital. The financial industry, and their lobbyists to Congress, want to eliminate the need for new capital by failing to mark assets to the appropriate value.

This point of view makes sense from a regulatory capital perspective. If banks are holding these assets to maturity (as opposed to trying to sell them now), the assets make continue to perform and make required payments, posing no capital adequacy issues. However, mark-to-market accounting is not simply used for regulatory purposes; it is also used by investors. For this purpose, mark-to-market makes infinitely more sense. Instead of buying assets from a bank, an investor could buy those assets in the marketplace at the current lower price. If instead they buy a bank with the same assets, one would reason that the assets should be thought of at the current market price. Pundits cite this logic when arguing against suspending mark-to-market.

This creates a gap (sorry!) between GAAP accounting for investors and regulatory accounting. Congress is attempting to provide regulatory relief to the firms, but is inadvertently (or perhaps deliberately) making it difficult for investors to assess the value of financial institutions. Furthermore, and even more troubling, the alternative to mark-to-market is to leave valuation to the discretion of bank management. From this, troubles abound -- leaving accounting to judgment is inviting abuse. A little short on profit this quarter? Presto chang-o! Remark some assets! About to have regulatory problems because your bank issued bad loans? Zam! Not any more, we just changed our "judgment" on the value of some assets... and so on.

Alas, the banks won the issue, and Congress threatened the accounting industry (specifically, the Financial Accounting Standards Board, FASB) with legislation to change GAAP. Congress has done this before, on stock options expensing, with high-tech firms arguing it would spell the end of Silicon Valley. Last we checked, the Valley is doing fine, even now that they have to tell the truth about their financial condition -- and FASB told Congress tough luck and implemented options-expensing. Perhaps FASB sensed more was at stake here, but this blog thinks they would have been better off to dare Congress to intervene in independently set accounting standards.

Oh the places you'll go!

The details of the 2010 budget have been handed over to Congress, and they are indeed mindboggling. Over ten years, the federal government will spend $42 trillion dollars. It will take in $35 trillion in taxes, leaving a $7 trillion deficit. Individual income tax receipts will nearly double, as will corporate tax receits and social security outlays.Medicare and Medicaid will more than double, as will net interest payments on the national debt.

This is...a forecast, of course. If our last presidency was any guide, forecasts aren't exactly FASB compliant.

A look at forecasted outlays vs. actual:

Forecasted receits vs. actual:

A combined picture:

And the resulting deficit:

With these table stakes, let's just hope that past events aren't indicative of future performance, otherwise our credit rating will be on the fast-track to subprime.

Finance's shrinking piece of the pie

This year just keeps getting worse for the financial industry. As if the crash and the TARP fiasco weren’t enough to dent their public image, Congress and the Obama administration have maintained a constant barrage of criticism. Earlier this week, the President excoriated hedge funds for holding out during bailout negotiations, stating:

I don't stand with them. I stand with Chrysler's employees and their families and communities. I stand with Chrysler's management, its dealers and its suppliers. I stand with the millions of Americans who own and want to buy Chrysler cars. I don't stand with those who held out when everybody else is making sacrifices.

While it remains to be seen if the courts will uphold the government’s prepackaged bankruptcy, the public damage to the industry has been done. In a far ranging interview with the New York Times Magazine, President Obama made it clear that he expects the financial industry to shrink in the near term, either as a result of natural economic rebalancing or due to specific government actions:

What I think will change, what I think was an aberration, was a situation where corporate profits in the financial sector were such a heavy part of our overall profitability over the last decade. That I think will change. And so part of that has to do with the effects of regulation that will inhibit some of the massive leveraging and the massive risk-taking that had become so common… Wall Street will remain a big, important part of our economy, just as it was in the ’70s and the ’80s. It just won’t be half of our economy.

Whatever one believes the relative merits (or inequities) of the financial sector to be, Wall Street represents nowhere near half the economy. Clearly the president was speaking figuratively, but his comments highlight a misperception that many people have in the country- that going into the crash the financial sector was the biggest part of our economy, and that it was too large by orders of magnitude. In reality, the financial sector has never been a majority or even a plurality of the U.S. economy, nor has it been all that overpaid. According to Thomas Philippon, a professor at NYU Stern and a leading researcher on this subject, the financial sector as a percentage of GDP grew from 2.5% in 1947 to roughly 8% in 2008. During that time period, the percentage of wages capture by the financial sector was consistently higher than its contribution to GDP, but rarely strayed by more than a percentage point.

By contrast, during that same time period, the government’s share of the government has risen from 20% to nearly 35%, representing a smaller relative increase, but a nominal increase that is twice the size of the entire finance sector.

So why did the financial sector grow so much, and what is the "optimal" size? Philippon presents an intriguing argument for the rapid post-war growth of the financial services industry. According to his research, the growth was fueled by an increase in the corporate finance sector, which was responding to increased demand for financial intermediation services. This increased demand for intermediation services stemmed from a shift in the types of investment opportunities available to investors- namely, away from large firms and towards smaller, riskier firms. According to Philippon:

After the War, large established firms with high cash flows appear to have the best investment projects. As a result, the demand for financial intermediation is small. Starting in the 1970s, investment opportunities shift away from large profitable firms towards young firms with low current cash flows, and the demand for intermediation increases. These predictions of the model are consistent with the historical evidence on General Purpose Technologies, the role of Electrification in the 1920s and Information Technology starting in the 1970s

His research provides some compelling evidence of this trend. Since WWII, the percentage of financial services provided to corporations with low cash flows (read: higher risk) has grown dramatically. These services are necessarily more complex, requiring more intermediation (read more fees) thus fueling the rise in the financial services industry.

Philipon’s equilibrium model suggests that the finance industry will need to shed roughly 700,000 jobs to bring it back into equilibrium. Concordantly, the degree of intermediation and complexity will decrease, and investment opportunities in larger, higher cash flow firms will be relatively more attractive.

Food, Feed, & Fuel - the Biofuel Battle

The battle over renewable energy rages own, California recently adopted new fuel standards which could pose a serious threat to Midwestern corn farmers. It was projected that ethanol would eventually account for a third of US corn production. California has typically been a leader in automobile emission standards and the recent announcement could be the first domino to fall in a nationwide alternative fuel debate. On May 1, in an email to the DTN Ethanol Center, the US Environmental Protection Agency (EPA) stated that the EPA was considering revisions to the renewable fuel standards.

The University of Nebraska recently revised their report, Indirect Land Use Emissions in the Life Cycle of Biofuels; the report attempts quantify the opportunity cost of land, such as rain forests being converted to farmland for the production. The report highlights the competitive forces in biofuel markets. Corn has three main usages, food, feed, and fuel; as corn shifted from the first two alternative to the later, corn prices rose. Increased demand for corn led to the conversion of grasslands and forests to farmland. This conversion depletes the carbon offset opportunities.

This land conversion was previously not considering in assessing the most efficient and environmentally friendly fuel sources. The California Air Resource Board (CARB) used the Global Trade Analysis Program (GTAP) from Purdue University to evaluate various fuel options. The analysis assigned traditional gasoline a "life cycle intensity" value of 96 grams of CO2 per megajule. Prior to the life cycle analysis, corn-based ethanol was assigned a value of 69; however, the recent studies have assigned a value of 30 to the land use of corn. The new life cycle intensity of 99 has effectively eliminated corn as a viable alternative fuel in California and delivered a hard blow to corn farmers and ethanol producers.

On either side of the aisle, the role of the government is to provide public goods and correct market failures. Air quality is a public good that often suffers from the tragedy of the commons and thus requires government action to correct failures. The classic economic theory points to sheep grazing in England. Shepherds that utilized the land for grazing lacked incentive to prudently use the land, the would be over used, depleting the land. A regulatory body is required to manage the land and restrict the number of sheep grazing. Legendary links courses in Scotland are the greatest positive externality to arise from grazing lands. Deep burns and bunkers sheltered the sheep from the salty sea breeze.

Unfortunately, government action can create new distortions and market inefficiencies. Minnesota has recently opened the ethanol subsidy for debate, the state of Minnesota has awarded $314 million in subsidies since the program started. The subsidies were designed to incent building and production of ethanol in belief that as production came on line, the scale would enable plants to produce ethanol at efficient prices. In retrospect, state and national subsidies likely created overbuilding in the industry. Additionally, supply distorting practices by the OPEC countries artificially inflated oil prices, further incenting inefficient building of production capacity. The result has been financial difficulties for US ethanol producers, notably VeraSun with its October Chapter 11 Bankruptcy filing.

In the current scenario, the US Government originally picked, likely as a result of heavy lobbying, corn ethanol as the preferred alternative automobile fuel. Another example of the government picking winners; with another change of the rule in the middle of the game, now ethanol is the loser. An alternative route would be to tax fossil fuels, artificially raising the price of traditional options and leveling the playing field for new sources. The market would be free to choose petroleum, corn ethanol, sugarcane ethanol, or biodiesel. Similarly, the Government could provide an 'award' for developing new technologies, similar to the battery proposal.

Generally, the Government plays a vital role in correcting market failures, but should focus on not creating new inefficiencies. The environment is a public good that is easily exploited beyond an individual's allotment. Government action is required to correct this particular inefficiency, but has done so incorrectly in the past. New solutions are required that create prudent investment and usage of fuels. Energy independence is not easily achieved. However, when push comes to shove and oil, gas, and coal are no longer available, the market it innovate and solve the problems, with or without Government assistance.

Car Creditors Cry Foul

Two of the US top automakers will soon be controlled by their retirees and the Government. Today, Chrysler announced it would file for Chapter 11 bankruptcy. The current plan results in the UAW owning 55%, the US Government owning 8%, and the Canadian Government owning 2%; additionally, Fiat would initially own 20%. Under the current proposal, the UAW and the US Government would own 89% of General Motors. In both cases, the bondholders are crying foul. The secured lenders would like to preserve the integrity of the US capital markets. The table below breaks down the proposals:

Source: Barron's

In General Motors case, the bondholders are looking for a greater equity stake given there secured position. The bondholders’ counterproposal calls for a division of equity in accordance to claims against GM; the bondholders would receive 58%, VEBA (UAW health-care obligation entity) receive 41%, and current equity holders would retain 1%. The Government’s $20 billion loan would remain just that, a loan.

Likewise, a group of investment firms were blamed for the Chrysler bankruptcy. Obama stated,

“While many stakeholders made sacrifices and worked constructively, I have to tell you, some did not,” Obama said. “In particular, a group of investment firms and hedge funds decided to hold out for the prospect of an unjustified tax payer-funded bailout.

Where as, the group of 20 hedge funds said they were ‘systematically precluded’ from negotiating with the Government and Chrysler. The hedge funds’ disapproval of the bankruptcy is warranted; Obama felt a group of creditors owning 70% of the debt were cooperating. This group of creditors, Goldman Sachs, JPMorgan, Morgan Stanley, and Citigroup are fresh of long meetings with Congress trying to save their good names. Those entities have received billions in TARP funds and in Citi’s case the US Government is a significant shareholder. Huge conflicts of interest exist with the 'banks.'

In both the GM and Chrysler case, the bondholders’ proposals appear to have fallen on deaf ears. The bondholders have been accused of speculating, but many of these individuals and entities make a living, albeit a good one, restructuring firms. Some of these firms need only a new balance sheet, while others require a significant shift in strategy – the automakers fall in the later. Neither party and neither administration is innocent; the US Government Officials appear to make a living changing the rules in the middle the game, not balancing budgets, and monetizing the debt.

Changing the rules continues to put pressure on the stagnant credit markets. The regulatory risk premium on loans makes it difficult for lenders to put money to work. Credit investing is based heavily on legal documents and understanding the course of action when a debtor breaks a covenant or defaults on their obligation. The most successful creditors have extensive experience negotiating with the debtors for creative structures to allow the companies to continue to operate (hopefully profitably) and continue to service the outstanding or restructured debt. Lenders are perhaps fearful that all new and existing credit agreements can be amended or simply place in the vertical file by the current administration.

Obama’s claim that hedge fund holders are holding out for a bail out may indeed by the case. With the exception of Lehman Brothers, the Government has shown a strong appetite for throwing money at all ‘systemic’ institutions; most of which were financial institutions. The probability of future Government aid was probable, but the restrictive nature is far from preferable. These speculating investment firms likely felt the implicit Government backstop place nothing more than a floor on their investment. A value creating restructuring would provide a far greater return on investment than additional Government equity or loans.

Furthermore, the investment firms often do create value for multiple stakeholders. GM bondholders claim their proposal would save US taxpayers $10 billion; the new structure would enable GM to service the Government debt, ultimately resulting in the return of principle and interest. A prudent restructuring of both Chrysler and GM can at least return a few flagship brands to the world of mediocrity.

The Obama administration is preaching fuel efficiency, the probably should be preaching sales. People are buying Japanese and German automobiles because of style, performance, and reliability. The Government cannot design automobiles, manage a diversified investment institution, or price debt securities. The faithful public servants need to stick to public policy. America’s meteoric rise to the World economic superpower was a rocky road for the first 160 years. After the Great Depression, America was surprisingly stable; short sighted policies today run the risk of stifle the growth and innovation of the next 160 years.

Dollar, Dollar Burning Bright

The most adverse effect of expansionary US fiscal (see Stimulus Bill) and expansionary US monetary policies (see Federal Reserve balance sheet) in an economy with stable demand conditions is inflation. Simply put, more currency exists in circulation for the same basket of goods. In countries with similar patterns of inflation, one would expect nominal exchange rates to remain constant. If the US had higher inflationary expectations than the Euro zone, one would expect the US Dollar to fall in value against the Euro.

One of the most interesting outcomes of today's crisis is actually that the Dollar has risen against the Euro. Since the summer of 2008, the US Dollar has appreciated by 20%. This seems completely contradictory in the face of lower real interest rates in the US than in the Euro zone. Fortunately for US consumers, this "flight to quality" in the world currency market means that they can continue to run a trade deficit (import oil and Chinese manufactured goods) in the face of a domestic economic policy that would have sank any other country's currency.

This is the pattern of facts at the heart of China's current consternation. The Chinese central bank is the largest foreign holder of dollar denominated assets which they have built up over the years by reinvesting their trade surpluses in order to keep a fixed exchange rate. Any inflation in the Dollar will pose a risk to all of the financial assets held by the central bank, but any decrease in the real Yuan-Dollar exchange rate would sink China's export led economy. Hence in the current equilibrium, the Chinese central bank finds itself in the odd position of having to increase its own Dollar reserves in order to maintain the fixed exchange rate, despite the fact that these assets are losing value as they are being accumulated. China's proposal has the effect of creating a new standard for international reserves, which are the "special drawing rights" as set up by the IMF. The SDR was originally designed to replace gold in international transactions and consists of a basket of currencies. The Dollar only comprises 44% of this basket; the Euro, GBP, and Yen make up the remainder. It is the hope of the head of China's central bank that this will allow countries to maintain reserve currencies in such a way that will not make their financial systems as tied to the US. For China, the additional benefit is to offload much of its dollar reserves without accidentally triggering a devaluation.

China has come to realize that the US consumer-led world economy is unsustainable. The American government and American consumers have been allowed to increase their liabilities in an effort to maintain a standard of living not supported by real income growth. Interestingly, it is possible that the world returns to the status quo after this current recession has abated. Developing countries can subsidize the United States' domestic inflation as it slowly winds it way out a debt problem. The US once again becomes solvent and serves as the consumption center for China who has now dodged an unemployment problem. However, their reserves would then be worthless. What China really wants is to somehow maintain low levels of unemployment and decrease its dependence on the US economy, all while unwinding $2 trillion in reserve dollar assets.

Where does the future of the Dollar lie? It serves as the reserve currency for most of the developing and the undeveloped world. The US is also the world's largest economy and actor in international trade and thus its currency serves as the medium exchange for transactions in the financial and real sectors. Most of all, the power of the US Dollar lies in the faith of governments and private individulas around the world that it will hold its value because the US economy will always be stronger than those around it. True decoupling does not yet exist, and as the current crisis is proving, most other places are in worse shape than the US. If China does walk the tightrope, the US Dollar could start to lose its place of importance in international finance. When that happens, it will be harder for the US to borrow in its own currency, and all of us will have to accept a lower standard of living as a result.

Regulatory Turf Wars

During times of economic duress it is standard practice for the states and the federal government to try and grab power from each other. But the ever evolving concept of federalism in the United States sometimes creates unusual situations when it undergoes rapid mutation.

Today’s WSJ featured an article highlighting one such example. Against the backdrop of rapidly expanding federal authority in everything from industrial planning to health care, the states are flexing their muscles over the issue of bank regulation.

At issue is the legal concept of “pre-emption”, which asserts that in areas where the federal government has clear constitutional authority it can pre-empt/overturn any attempts by states to regulate an industry, in this case the banking industry.

New York Attorney General Andrew Cuomo is appealing the Supreme Court to overturn a lower court decision that ruled in favor of the Office of Comptroller of the Currency (OCC). The OCC is the bureau of the Treasury Department that charters, regulates, and supervises all national banks. It also supervises the federal branches and agencies of foreign banks.

The case was originally brought against the OCC by disgraced Gov. Eliot Spitzer. In 2005, then-Attorney General Spitzer began investigating whether banks were issuing high-interest (predatory) loans to minorities at significantly higher rate than to white borrowers. His office began issuing subpoenas to national banks, which formed a group (dba “Clearing House Association”) and filed for an injunction in Federal Court. The court ruled in favor of the banks, a decision later upheld by the 2nd Court of Appeals.

So what’s going with this appeal? On the one hand, we have state governors exhorting the government to take greater control of the financial system, while at the same time state attorney generals are suing the federal government for having too much interference in the banking industry. We’ve actually stumbled into a regulatory turf war that is spilling over from the 1990’s.

Less than a month before Spitzer’s prostitution scandal, he penned an editorial indictment of the Bush Administration in a Washington Post op-ed, blaming the administration for standing blindly by while minorities borrowers were being exploited:

"Predatory lending was widely understood to present a looming national crisis. This threat was so clear that as New York attorney general, I joined with colleagues in the other 49 states in attempting to fill the void left by the federal government…Not only did the Bush administration do nothing to protect consumers, it embarked on an aggressive and unprecedented campaign to prevent states from protecting their residents from the very problems to which the federal government was turning a blind eye.

Let me explain: The administration accomplished this feat through an obscure federal agency called the Office of the Comptroller of the Currency (OCC). The OCC has been in existence since the Civil War. Its mission is to ensure the fiscal soundness of national banks. For 140 years, the OCC examined the books of national banks to make sure they were balanced, an important but uncontroversial function. But a few years ago, for the first time in its history, the OCC was used as a tool against consumers.

In 2003, during the height of the predatory lending crisis, the OCC invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks."

Spitzer is right in that the Bush administration sought to block states from regulating national banks, but his actions largely followed the example set by previous administrations, which have sought to preserve the federal government’s autonomy in the realm of national bank regulation. In 1996, the OCC adopted a regulation clarifying that, under federal code “the exercise of visitorial powers over national banks is vested solely in the OCC.” Visitorial powers include:

(i) Examination of a bank

(ii) Inspection of a bank's books and records

(iii) Regulation and supervision of activities authorized or permitted pursuant to federal banking law; and

(iv) Enforcing compliance with any applicable federal or state laws concerning those activities

In 2004, John Hawke Jr., head of the OCC and a Clinton appointee (1998-2004), issued a ruling in further support of that interpretation, as

“not grant[ing] state or other governmental authorities any right to inspect, superintend, direct, regulate or compel compliance by a national bank with respect to any law, regarding the content or conduct of activities authorized for national banks under Federal law”

The federal courts agreed with that interpretation. In the appellate court’s ruling against the states, they upheld federal pre-emption of state regulation, arguing that

“the purpose of the visitorial powers restriction is to “prevent inconsistent or intrusive state regulation from impairing the national system.”

The near unanimous support of pre-emption has been echoed by the federal courts in similar cases in Michigan and Georgia. Yet the debate still rages on. Last fall, BusinessWeek did a great piece that described the battle between the OCC and state regulators over the issue of pre-emption. The debate has been heightened as both sides attempt to saddle each other with blame for the regulatory failures that helped lead to the sub-prime meltdown.

The states blame the OCC (whose charter is to oversee the financial stability and ongoing legal adherence of national banks) for a failure to properly regulate the issuance of sub-prime mortgages. They accuse the OCC of catering to the financial services lobby, allowing banks to hide behind pre-emption so they could avoid state investigation of their activities. The OCC argues that the states did nothing to regulate sub-prime the mortgage brokers who were originating these risky loans and engaging in high-pressure sales tactics with no thought of the consequences. Both arguments have merits.

The real issue is who will own regulation of the banks, the states or the federal government? Once again, both options have merits:

1) State regulators are closer to their constituents and are more likely to be held accountable for regulatory oversights than would the federal government. At the same time, a centralized federal agency would certainly be more coordinated and effective in prosecuting oversights. Compare any state AG’s office with the U.S. Attorney’s office. The NY Attorney general certainly didn’t bring down the mafia.

2) State regulatory laws are easier to adapt to changing circumstances and would provide fewer loopholes, but that leaves the unpalatable scenario of the banking system having to accommodate fifty separate regulatory regimes. For an example of how well that works, look at the insurance system in this country.

3) State elected officials have every incentive to rule against out-of-state banks and in favor of their constituents, which could quickly devolve into a state-by-state race to the bottom. Yet at the same time, the OCC has its own conflict of interest. It is not funded by congressional appropriations, but rather by fees it collects from the very banks it is supposed to regulate. Remind anyone of the ratings agencies?

Realistically what will happen is that the Supreme Court will uphold pre-emption and the federal government will retain regulatory control of the banking industry. But in response to the outcry sure to follow from the states, the OCC’s focus will be shifted and the agency will be charged with taking a much more aggressive stand against predatory lending.

The next head of the OCC- they serve five year terms, with the current term ending in October 2010- will undoubtedly have a more activist, prosecutorial background. The previous two appointees were solidly grounded in the banking deregulatory mindset of the 1980’s and 1990’s. This appointee will be forced to take a much more collaborative role with state AG offices looking to investigate potential lending abuses, and the OCC will become a dramatically different organization.

The $2 trillion hole in the U.S. economy

No, it's not hole in the banking system. It's the incremental $2T worth of GDP our education system could provide. McKinsey & Company released an very interesting report detailing the economic impact of the various education gaps between the U.S. and other countries and within the U.S. itself.

McKinsey quantifies the effects on GDP from closing various achievement gaps:

• Closing the racial gap between black and white students generates $310-525B in GDP
• Closing the low-income to high-income gap is worth $400-670B
• Bringing the worst-performing states up to the levels of high-performing states is $425-700B

Closing these gaps (note that they are not additive - the total impact of closing all three would less than the sum of the three) could generate a substantial boost to GDP -- enough to easily offset losses from the current economic slowdown for example. If the U.S. was solely able to address these gaps, it would be a tremendous accomplishment.

What factors then contribute to the achievement gap? First, it should be noted that the data show the gap almost indisputably exists. The Department of Education tests students from across the nation through the National Assessment of Educational Progress. Scores in core subjects including math and reading show substantial gaps between white and black students.

Studies show a range of factors could contribute to this gap, from funding differences to cultural differences to parent involvement. Regardless, something needs to be done to address that gap.

But what happened to that $2 trillion mentioned in the headline? That is the gap between the U.S. and other nations (actually, McKinsey estimates the gap at between $1.3-2.3%). Despite high per-pupil spending, the U.S. consistently lags OECD countries in education performance.

Both gaps -- within the U.S. system and compared to other nations -- scream for meaningful education reform. With the price tag attached to the outcome (somewhere between one and three trillion dollars), the U.S. needs to make wise investment decisions to capture this potential GDP. This is an important frame of reference. Expenditures on education, wisely structured, need not be considered spending, but rather investment. In this case, an investment in future GDP growth, lower incarceration rates, fewer health problems, and the resulting benefit to society through GDP growth, improved tax revenues and lower public expenditures.

A key question is what separates investment from spending. Investments should be based on the expenditures that are expected to have a return of that capital in the future. Not all expenditures would qualify. Consider one easy example: if teachers received substantial increases in pay, it would likely entice more qualified applicants to the field. However, many existing qualified applicants would simply be paid more. In the latter category, the teachers benefit more than students do. Investments in education should be structured to avoid windfalls to any group of participants (teachers, administrators, contractors and suppliers, etc.) that would not deliver commensurate returns. This would argue, for instance, not simply increasing teacher wages, but changing the way teachers are paid to incentivize better teaching and attracting teachers who believe they would do such a good job they could earn substantial bonuses. It is not that higher teaching pay wouldn't improve outcomes -- it is just that that same money could improve outcomes even more if structured wisely.

Thus, items like performance pay, charter schools, and directed spending on specific programs (like early childhood development) would be viewed more favorably through this investment lens. They may not work, and educators need to play an important role in designing them, but with $2 trillion at stake every year, the time has come for the U.S. to start considering how to invest in schools, not simply fund them.

Iowa's Stimulus Plan - Same-Sex Marriage

In an Iowa Supreme Court ruling Varnum v. Brien on April 3, 2009, the State effectively legalized same-sex marriage in the State of Iowa. On April 27, 2009 Iowa joins the likes of Massachusetts and Connecticut and soon to be joined by Vermont as the only states in the US that allow same-sex marriages. Several states, California, Colorado, Maryland, New Hampshire, New Jersey, New Mexico, and Washington recognize civil unions between same-sex partners, each providing varying degrees of benefits to the partners. In Iowa, Massachusetts, and Connecticut, same-sex couples are offered the same rights as opposite-sex couples at both

the state and federal level.

The Economics Policy Review will not make any arguments for or against same-sex marriage based on economic impact or based on morality or religious beliefs. The article serves merely to assess the potential impact on the state of Iowa with same-sex marriages beginning later this month.

Many have regard Iowa as a recession resistant state due to the high reliance on agriculture, low consumer debt, and less dramatic real estate impact. Iowa reported an unemployment rate of 4.9% verse 8.1% for the US as a whole. Despite this, the potential impact on state budgets for major legislation cannot be ignored. The Williams Institute at UCLA provides in depth analysis of same-sex partnerships on state budgets. Following the initial district court hearing on Varnum v. Brien, the Williams Institute published The Impact on Iowa's Budget of Allowing Same-Sex Couples to Marry in April 2008. The study estimated a $5.3 million per year net benefit of same-sex marriage. The study moves step by step through the relevant categories of fiscal impact, income tax, inheritance tax, public assistance, sales from increased tourism, administrative fees, and employee benefits.

The study was published prior to Connecticut legalizing same-sex marriage on November 12, 2008. Additionally, Massachusetts does not allow out-of-state couples to wed, thus eliminating any precedent for tourism revenues. According to the 2005 American Community Survey there were 5,833 same-sex couples in Iowa; extrapolating the 2000 and 2005 data forward at a compound annual growth rate of 9.8%, there is an estimated 7,714 same-sex couples in Iowa at 2008 year-end. Using similar extrapolation, the neighboring states would have 120,728 same-sex couples to draw on for marriages and thus tourism dollars. See Chart below:


The Williams Institute assumes 50% of Iowa's same-sex partnerships and 25% of neighboring, using similar data, 34,039 couples would wed over the next three years; of which, 3,857 would be Iowa residents.

Using the fiscal impact categories above, the Williams Institute assumes inheritance tax (decrease in revenue) and income tax (increase in revenue) effective net. The assumptions seem fairly valid. The study assumes that many same-sex couples are DINKs (double income no kids), thus in a joint filing, Iowa's progressive tax structure would increase the effective tax rate on a large majority of couples, generating an additional $700 per couple. Despite a detailed discussion, it is difficult to reproduce the Williams Institute calculations. The following assumptions will be used: 50% marriage rate and a similar break-down of 85% have an increase in taxes, 5% no impact, and 10%, using 5,833 couples in 2005 and 7,714 couples in 2008E. There is a net income tax increase of $1.7mm with the 2005 population and $2.2mm using the 2007 estimated population.

The inheritance tax requires a number of difficult assumptions to forecast, average death rate, wealth of deceased, etc. The Williams Institute uses a probability distribution of wealth, charity assumptions, and gifts to children to estimate the annual impact is a decrease in revenue of $1.5mm or roughly equivalent to the $1.7mm increase in revenue.

The tourism impact could be the most substantial for Iowa relative to its peers. While Connecticut, Massachusetts, and Vermont (Fall 2008) are the only states with legalized same-sex marriages, many of their neighbors have variations that would limit the population draw; additionally, Massachusetts does not allow out of state marriages. Effectively, Vermont and Connecticut are competing for New York, Pennsylvania, Rhode Island, and Delaware marriages. New Jersey, Maine, and Maryland have a variation of civil unions. Iowa will have a virtual monopoly on same-sex marriages to its neighboring states and a population of over 120,000 couples.

The Williams Institute estimate the increased sales tax based on two groups, in-state and out-of-state. The in-state marriages assume an average opposite sex wedding costs $23,000, but same-sex couples due to lack of family support and social stigmas would spend only 25% on their weddings and out-of-state couples would spend 10%, resulting in $5,750 and $2,300 per wedding respectively. As a result, in the first three years following legalization, it can be assumed that in-state couples will spend $5.5 million and out-of-state couples will spend roughly $140 million on weddings. With the State of Iowa's 5% sales tax rate, the state would yield an additional $7.2 million in sales tax or $2.4 million per year. This neglects the benefits of increased employment or the broader multiplier implied by the increased spending. It can be reasonably concluded that the State will benefit considerably beyond the Williams Institute's roughly $2.0 million in sales tax.

The Williams Institute highlights the large area for potential impact is a reduction in state incurred expenses as a result of same-sex marriage. The Williams Institute estimates the level of assistance given to same-sex couples and likewise the savings by applying data from the lower of the 1999 Iowa Census on same-sex verse opposite-sex couples assistance levels to the estimated same-sex couple population. According to their data, same-sex couples receive $9.5 million in public assistance which would be reduced to $2.8 million when partners become eligible on their spouses benefit plans.

On balance, same-sex marriage should provide economic benefits to all current and future states considering the initiative. Iowa presents an interesting circumstance due to the virtual monopoly on same-sex marriages in the Midwestern corridor. Prior legalizations either of competition from surrounding states or do not allow out-of-state marriages. Whether the impact is $1.0 million or $100 million annually, the opponents can rest assured, they will not be paying for a lifestyle to which they are in opposition.

Turning the FDIC into AIG

It looks like Sheila Bair is trying to turn the FDIC into AIG, minus the bonus scandal. The government's latest plan to aid ailing banks, the Public-Private Investment Program, relies heavily on the FDIC to ensure adequate capital is available. Specifically, the FDIC will insure debt backing 85% of the loans made through the PPIP. While the FDIC plans to charge for this insurance, no shortage of evidence exists that the government systematically under-charges for insurance.

This under-charged amount is a subsidy, as it allows the insured parties to be shielded from risks they would otherwise have to pay for. If a private investor with FDIC guarantees never has to use the guarantee, the insurance looks great. This is not unlike a car insurer that would look very profitable if no cars ever got in an accident. But, if the FDIC guarantee is used, the government will take tremendous losses. In this way, the FDIC guarantee is a gamble... no one knows whether it will be used or not. AIG made this exact same gamble (the FDIC program is exactly a credit default swap on the assets in the program), and lost big. And now the entity that insures our deposits is making that same bet, with an uncertain outcome.

What is certain is that this guarantee contains a subsidy, by precisely the amount that the insurance is underpriced. This subsidy will be split between the banks and investors participating in the program. By delivering this subsidy in a relatively obscured manner (this subsidy doesn't require writing an actual check to banks), the Treasury has managed to skirt Congress's need to approve funding for the program. Clever, unless the FDIC loses on its gamble. Then, the FDIC will have to cover potentially enourmous losses from the PPIP, surely enough to swamp the already struggling fund. No one expects the FDIC to go bankrupt, as such a failure would wreck havoc on the financial markets and cause mass panic. Instead, the taxpayers would have to bail out the FDIC, just as we have bailed out AIG.

Ms. Bair has already commented that she does not expect there to be any losses from the program. As the NY Times points out, that sounds shockingly like another executive's declaration:

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

The executive who uttered this line? None other than AIG's Joseph J. Cassano.

Re: A tax by any other name

Last month the review proposed taxing health care benefits as one potential solution for stemming spiraling health care costs. The general argument was that health care benefits, because they are not taxed, offer employees a compensation solution that is dollar-for-dollar more beneficial than additional salary raises. Companies increase benefits to retain key workers, and health insurance companies bid up their rates to capture most of that surplus, raising the cost throughout the entire system. The only "brake" in place today is Medicare. The government sets reimbursement rates (usually below profitability levels for most health care providers), which acts like a tether, preventing private insurers from getting too far away from the arbitrary cost floor.

While the system hasn't worked well, it has functioned. Individuals have reasonable flexibility to choose between health care providers, and those who can't afford it opt into Medicare. The oft-mentioned "coverage gap" is a huge problem, but the fact remains that EVERY one in the country has access to basic and emergency care. This system is inequitable, highly inefficient, and unsustainable without serious revision.

But the proposal by Congress to create a government run health care plan that will compete with private insurers is not a revision of the current system. It is a demolition charge set at the base of the building. In a best-case scenario (the public option sets reimbursement rates at the median of competing plans'), it will recalibrate the arbitrary cost floor and raise prices throughout the system. In the worst-case scenario (the public option undercuts all competitors), it will create a flight to cost, crowding out private insurers and leaving the government in charge of health care in this country.

During the 2003-2004 debate over the Iraqi War, the public didn't even blink while President Bush and the Republican Congress passed Medicare Part D. It was intended to neutralize political exposure on a key election issue, and by all accounts was very effective. It also constituted the largest increase in Federal entitlement spending since LBJ was in office. At the time, everyone was more focused on the billions of dollars being spent on cruise missiles for use in the next month, than on the hundreds of billions of dollars that the government was committing to spend over the next decade.

We seem to be running the risk of repeating recent history again. With the public attention captivated by the ongoing recession, everyone is focusing on the near-term costs of bailout spending measures. It would be very unfortunate if the public failed to take note of yet another long-term commitment that federal politicians seem all too willing to get us into.

Immigration Reform Redux - Part I

Wednesday morning the New York Times broke the story that the Obama administration is resuscitating immigration reform as an issue for this coming year. Most will remember that this issue captured the public attention during the 2006 midterm elections, when it was discussed largely in the context of national security. After reform legislation flamed out in the Senate, the issue went away. Now the issue is being brought up again, this time in an economic context.

There are two major forces at work here: politics and economics. The economic repercussions of immigration reform are tremendous. If successfully implemented, the U.S. could experience an economic boom mirroring those that followed previous economic booms. Alternately, it could saddle large portions with depressed wages and huge tax burdens needed to support an influx of unskilled workers. Politically, it is a land mine field. Catering to one voter group can create repercussions in other groups, and the current economic environment has made immigration a charged issue for many Americans. This two-part article takes a look at the political and economic issues underlining the immigration debate.

Political

Pundits have suggested that this recent restart of immigration reform is a pre-emptive strategic strike by the White House, who is worried that a lingering recession and a bailout-weary populace will hand them defeat in the 2010 midterm elections. The Hispanic electorate is very much up for grabs, and could provide an effective hedge against a Republican resurgence.

In the months leading up to the 2006 midterm election, political insiders on both sides of the aisle began teeing up immigration as one of the hot-button issues. For many in the Republican base, the issue was red meat, evoking powerful emotions around domestic security and cultural/economic preservation. For Democrats, the issue seemed like an opportunity to appeal to one of the fastest growing voter groups in the country. For President Bush, it provided a rare opportunity to act as bi-partisan cheerleader, and he attempted to leverage his declining political capital to push comprehensive immigration reform through Congress. The bill would have granted amnesty to existing immigrants, provided for guest worker program, but it also would have provided for increased border security and the construction of additional fences. After two tries, the bill finally went down in 2007, failing to pass cloture and reach the floor for a full vote. The breakdown of the vote highlights how this issue cuts across party and geographic lines (click here for a map).

* Author’s note: I had a front row seat to this issue. At the time I was working in local government in San Antonio, where the percentage of the population that is Hispanic is well north of 50%, the issue had particular prescience. One of the most hotly contested races in the country was the race between Democrat Ciro Rodriguez and incumbent Republican Henry Bonilla. In a close race, Rodriguez defeated Bonilla, who was the lone Mexican-American member of the House Republican caucus. Bonilla came out in support of tougher border measures, while Rodriguez supported amnesty. The race was extremely ugly, with each candidate trying to he was more Hispanic than the other. In the end, Rodriguez was able to portray his opponent as “Henry Vanilla”, an out of touch aristocrat who had lost touch with his cultural roots.

The stakes could not be higher. Hispanics represent the fastest growing part of the electorate, adding over 4 million eligible voters between 2000 and 2007. Hispanic voters now represent ~10% of the national electorate, a number that will continue to grow. The Pew Hispanic Center projects that by 2050, nearly 30% of the population will be Hispanic, and that Hispanics will constitute 60% of the total growth in U.S. population during that time period. The electoral impact will likely be lessened by the fact that most of the growth will be concentrated in areas that are already highly Hispanic, meaning that heavily Hispanic areas will become more Hispanic. Dispersion patterns have increased markedly (see graphic below), but the growth still remains concentrated in border states like California, Arizona, New Mexico and Texas, as well as in the historical immigration hubs of Chicago, New York and Miami. Nevertheless, if one party manages to emerge as the party of choice for Hispanic voters, it could set in place a congressional realignment that holds for decades, similar to the way the New Deal created a coalition of blue-collar democrats that held together for more than 50 years.

At the same time, the influx and political ascendancy of a new electoral group will put a strain on the parties’ existing relationships with other voting groups. Southern Republicans and Midwestern Democrats, representing largely white populations, are already seeing the effects of cultural resistance to an emerging hispanic social identity that contrasts sharply with the dominant cultural identity of white America. This cultural clash is further heightened by a persistant language gap. In urban areas, African-Americans find themselves increasingly competing with hispanic immigrants for low paying jobs, and are resentful of the perceived downward pressure on wages. This is a familiar pattern in the U.S., where the strongest resistance to new immigrant classes usually comes from those groups at the bottom of the economic structure, who are forced to compete with these new entrangs for jobs.

Navigating this shift can be tricky. Richard Nixon’s so-called “Southern Strategy” was a highly effective response to the Democrat’s successful capture of the black vote in the 1960’s. While the Democrats gained near unanimous support from the black electorate, in doing so it lost a huge chunk of white voters. Over time, Democratic dependency on the urban black vote tied it to a variety of fiscal and social positions that alienated voters in western states, paving the way for the famous Red/Blue state construct that brought Republicans into a decade of power. The emergance of Barack Obama helped break that cycle, but if Democrats attempt to reconstruct the Black/Democrat relationship with the Hispanic electorate, they could re-create the same problem for themselves again.

On Monday, the Review will post the second half of this issue, focusing on the economic issues underpinning the immigration debate.

Carried Interest - Levin's Proposal

In a follow-up to a post in December, on April 3, 2009 a new proposal hit the House floor for the treatment of carried interest, the proposal would result in a significant tax hike for the ever unpopular hedge fund and private equity fund managers. Representative Sandy Levin (D-MI) reintroduced a new version of the carried interest reform bill originally introduced in 110th Congress on a message of fairness.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money. They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%."

The full bill, "To amend the Internal Revenue Code of 1986 to provide for the treatment of partnership interests held by partners providing services" (HR 1935), has not been received by the Government Publishing Office (GPO); however, it appears the entire carried interest will taxed an ordinary income rate of 35%. The prior Economic Policy Review, posting "Carried Interest - Long-Term Capital Gains or Ordinary Income", highlighted multiple options for taxing carried interest, concluding the a hybrid taxation policy would be a good comprise, for example treating the carried interest basis as a non-recourse loan from limited partners.

Rep. Levin marches through various "Myth" vs. "Fact" scenarios, many of which were presented in the prior post. One such "Myth" surrounds the impact of the change on union and state pensions. In the past, many investment professionals would have disregarded the change in taxation as immaterial, arguing incentive compensation fees would increase correspondingly. The current macroeconomic environment is not doing the investment professionals any favors and unfortunately for all but a select few, fees are more likely to decrease than increase. Levin is correct, it is "questionable" if the change in taxation will have any impact on "mom and pop."

While carried interest probably does not have enough "sweat equity" characteristics to be considered in the same light as that of pure entrepreneur, it does not have the same feel as pure incentive compensation either. All too often in the wake of a crisis, politicians over-react and the pendulum swings far past neutral. It probably is not a coincidence that Rep Levin is from the economical troubled state of Michigan, where many affiliated indirectly and directly with the auto companies (UAW pensioners) will be some of the most impacted voters from the current crisis. The bill is in its infancy, but similar legislation was included in Obama's budget, and investment professionals are far from in the good graces of Capital Hill. As such, one can reasonably assume that some change to the current tax policy will be enacted. Here's to hoping congress acts in manner that is truly "fair" and not just popular.

Quantitative Easing – Fed to buy $300 billion Govt Securities

With the target interest rate near zero, the Federal Reserve shifts its main policy tool to quantitative easing. Quantitative easing is a policy tool of central banks to inject liquidity through open market operations or outright printing of money. On March 18, often dissenting Richmond Fed President, Jeff Lacker, finally got his way, the Federal Reserve announced the purchase $300 billion long-term treasury securities. At the January 28 FOMC meeting, Lacker cast the lone dissenting vote, Lacker “preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.” Despite the Federal Reserves best efforts and a target rate near zero, the US monetary base was actually shrinking during the first quarter of 2009. Federal Reserve Bank of St. Louis working paper by R.G. Anderson nicely defines monetary base as follows:

The monetary base in monetary economics is defined and measured as the sum of currency in circulation outside a nation’s central bank and its Treasury, plus deposits held by deposit-taking financial institutions (hereafter referred to generically as “banks”) at the central bank. More generally, the monetary base consists of whatever government liabilities are used by the public to purchase and sell goods and services, plus those assets used by banks to settle inter-bank transactions.

The monetary base exploded starting with the stimulus package in late 2008 at a rate unparalleled in the past 50 years.


However at close examination, the monetary base has been declining of late.


A shrinking monetary base is commonly thought of as a deflationary sign, during Japan’s Lost Decade, the Bank of Japan kept its target rate near zero and allowed the monetary base growth to slow dramatically following substantial growth during the 1980s. This policy action from 1990-1993 added substantially to the destructive deflation of the decade.

Central banks typically have three policy tools, (1) adjusting the discount rate, (2) adjusting the reserve requirement, and (3) purchase securities via open market operations. Open market operations impacts the monetary base (money supply) as follows, the central purchase securities from consumers and institutions there by injection liquidity (cash in the pocket of consumers) leading to an increase in the monetary base (currency), a component of money supply. It is thought that the US is facing a liquidity trap, an economic condition when target rates are near zero (option 1 no longer available) and the central bank attempts to inject liquidity; however, financial institutions are unwilling to lend.

The Fed’s action to purchase $300 billion in long-term government securities should help mitigate the liquidity trap as well as increase the monetary base, reducing the risk of destructive deflation. Most obviously, there will be an increase in currency in circulation through the purchase of treasurys. Additionally, the purchase of long-term government securities dramatically increased the demand for out-of-favor long-term instruments, thereby flatting the yield curve and reducing the rates on credit with similar, longer-term maturities. The key is a reduction in borrowing costs for end-users, mortgages and retail credit; on cue, US mortgage rates fell to 4.85%, the lowest on record. A reduced rate will hopefully increase demand for credit, in turn prudently expanding the balance sheet of financial institutions.

The action does not come without major skepticism from economists focused on inflation, not deflation as the major concern. Interestingly, while a supporter of the policy, Lacker discussed inflation as a potential concern in his speech to business leaders in Charleston. The expansive Fed balance sheet could prove difficult to unwind when the recession end; Lacker noted that skillful central bankers will be required. While inflation, even hyper-inflation could be a concern with the central bank monetizing the debt like a developing nation, the Fed will have far more tools in the tool kit to fight inflation than deflation. The recent announcement should prove timely and coordinated with the Treasury’s initiatives to clean financial institutions balance sheets.

TALF Underway – Help for ‘Main Street’

On March 3, the Federal Reserve announced the revisions to the Term Asset-Backed Securities Loan Facility (TALF). The TALF component of the Consumer and Business Lending Initiative (CBLI) is designed to provide up to $1.0 trillion in lending capacity to consumers and small businesses. Traditional consumer financing, credit card loans, auto loans, student loans, Small Business Association loans rely heavily on the Asset Backed Security (ABS) facilities for funding. The Fed estimates that roughly one-quarter of all non-mortgage consumer loans are financed through ABS SPVs.

Importantly for the March revision, the hair cut and interest rates on the student loans and SBA-guaranteed loans was reduced. Interestingly, the Government’s collateral on the TALF loans are loans which carry and explicit government guarantee. The TALF loans are non-recourse, in the event of default, the Government has the right to seize the collateral (the loans) in order to make good on the TALF loan. Interestingly, as the loan default trickles down the chain, the Government will effectively be paying the left pocket from money in the right pocket. This government guarantee was the rationale for the reduction in rates and haircuts; hopefully we do not see the left-to-right pocket exchange. The potential for a trillion in financing should help expand the economy; as currently drafted, the TALF will provide $200 billion in loans.

Protection for the Tax Payer
As previously mentioned, a few loans carry explicit guarantees, SBA and student loans; loans that do not carry the guarantee must be rated AAA by two approved credit rating agencies. Substantial criticism has been given to the rating agencies handling of the securitized pools of loans; however, absent a better risk assessment system, the AAA rating provides some assurance for tax payers. Second, the “haircut” mentioned above in effect over-collateralizes the TALF loans. For example, a student loan with a 2-3 year ABS life carries a 10% haircut. In order to receive a $90 million dollar loan under TALF, the investor must pledge $100 million in collateral. Lastly, the Government receives an interest rate that corresponds with the risk of the underlying assets. The prime student loan above would be priced at LIBOR plus 50 basis points.

TALF Underway
On March 19, the Fed announced nearly $4.7 billion in loan requests. Requests were linked to $1.9 billion in auto-loan securitization and $2.8 billion in credit card related facilities. Interestingly, no student loans or SBA guaranteed loans were pledged in conjunction with loan requests. As noted, loans need to carry a AAA rating; however, loans downgraded after initial funding remain eligible. Thus, financial institutions accessing TALF funds will likely pledge loans which they perceive to be riskiest, mispriced, or incorrectly rated. Financial institutions are likely most concerned with the state of the over-levered general consumer, pledging credit card and auto loans.

In conjunction with the announcement of initial funding, the Fed announced four additional categories eligible under TALF: (i) ABS backed by mortgage servicing advances; (ii) ABS backed by loans or leases relating to business equipment; (iii) ABS backed by leases of vehicle fleets; (iv) ABS backed by floorplan loans As the pool of eligible loans expands, so does the Feds balance sheet. The exploding balance sheet is a little less daunting when an organization is back stopped by a printing press, not to say the US should or will inflate its way out of the debt problem.

A Scaffolding of Cards for the House of Cards?
Interestingly, the off balance sheet SPVs that appear to have created the credit crisis will be the primary tool for supporting TALF. The Federal Reserve Bank of New York (FRBNY) will create an SPV to hold all ABS collateral received. The SPV will be funded with up to $100 billion on subordinated loans from the Treasury through the TARP and the FRBNY will fund the SPV with a senior loan. In a similar structure to other securitization facilities or CDOs, the investors are ranked and prioritized. The FRBNY holds the most senior position and claims first priority to all cash flows to the SPV, the Treasury holds second priority (mezzanine position), and the residual third priority (equity position) is shared by the Treasury and FRBNY. The scaffolding of cards should hold up, securitization and pooling of assets was not the problem, pricing of the pools was the problem.



On balance TALF should spark consumer and small business lending and is a start down a long, winding road to recovery. Access to credit will enable small businesses to grow and employ Americans. The credit is necessary for capital equipment purchases to create goods and provide services for export and domestic consumption. Purposed slogan: TALF - a $200 billion spark plug for autos.

Unintended consequences, volume 2

Unless you've sworn off TV, newspapers, the Internet, and casual watercooler chats, you have witnessed the enormous backlash against the bonus payments destined for the AIG unit that led to the firm's collapse. Senator Chuck Grassley called for executives to commit suicide. And, if the executives aren't willing to do it themselves, others have written death threats against the bonus-receiving executives. Unions are protesting outside of financial firms' offices. Congress is considering passing a tax that would effectively recapture all of the bonuses. The President is opining on the subject.

This outrage (Mr. Grassley's suggestion and death threats excluded) is understandable and justified. These executives failed, and they are still getting paid. Whoever wrote their employment contract did a horrific job, and policymakers face a monumental challenge in ensuring that executive pay agreements are more appropriately structured in the future. But for all the outrage, the more relevant question is what to do now?

The government is right in asking these executives to voluntarily relinquish bonuses and to plan reforms to ensure that pay structures are better designed in the future. But much more is at stake than $165M dollars:

First, Ameircans should make sure that in their zeal to uphold their principles they do not encourage worst transgressions. There is simply no excuse to call for physical harm to any particpants in this ordeal. Yes, many mistakes were made by AIG executives and employees, but they were mistakes -- not capital crimes.

Second, the government has committed nearly $10 TRILLION dollars to the bailout by some counts. The AIG bonuses are 0.0017% of that total. The bonus issue has hindered Treasury Secretary Timothy Geithner's ability to get things done. Shouldn't we all worry about how he is using the other $9.999 trillion?

Third, consider how this hamstrings the government's ability to restart the economy. The government launched the Term Asset-Backed Lending Facility to help restart consumer lending and get the economy working again. But healthy financial institutions are hesitant to take advantage of the TALF, fearing that they too could get swept up into populist rage against the financial system.

This final point is particularly intresting: it is almost like reverse moral hazard. Companies that don't need taxpayer money might be willing to accept it in order to help get the economy moving again, but only if they won't face fallout or onerous terms in doing so. If they believe that they will catch the backlash even if they don't do anything wrong, they might just decide it isn't worth dealing with -- limiting the government's ability to get the economy moving again. Let's hope that Congress and the Administration can suspend their outrage long enough to realize that the AIG bonus situation makes for great political posturing but isn't getting the economy any closer to health.