Sunday, November 9, 2008

Enlist Private Capital to Combat the Economic Crisis

Barack Obama has a lot on his plate: a financial sector in crisis, an economy in recession, unresolved wars in Southwest Asia, a health insurance system badly in need of reform, a national infrastructure that is sometimes, as in Minneapolis, literally collapsing, a needlessly complex tax system, and a national zeitgeist that is dispirited and has very high expectations of him. At the same time, the resources for addressing these problems look thinner by the day. If one tries to total up the cost of covering the financial sector's losses in mortgages, CDOs, credit default swaps, credit card debt, car loans and other bad loans and investments, the number reaches several trillions. Then, there's the potential cost of assisting defaulting homeowners avoid foreclosure. That's hundreds of billions more, and maybe another trillion.

What are the resources that could be tapped to alleviate the problems? America's gross domestic product is something on the order of $14 trillion. The federal government's budget for fiscal 2008 (the year ended Sept. 30, 2008) was something around $3 trillion, with a deficit of about $450 billion. The total federal debt outstanding is $10 trillion. The government simply can't wrestle trillions more from the domestic economy in order to deal with the financial crisis. Presumably, some of the needed money can be borrowed overseas, since the whole world is sliding into recession and the dollar retains its image as a safe haven. Indeed, about a quarter of the outstanding public debt (or $2.5 trillion) is held by foreign lenders. But borrow another $4 or $5 trillion overseas? Not likely. Even the hundreds of billions needed over the next few months to fund the Treasury Department's continued financial sector bailouts (pursuant to the $700 billion bailout bill enacted this fall) and a proposed $60 to $100 billion stimulus package now being touted by Congressional leaders will seriously test the world's appetite for U.S. government debt.

Plainly stated, the U.S. government doesn't have and cannot get enough resources to fully deal with today's economic crisis. Given the near complete disarray on Wall Street (evidenced by the continued credit crunch), and shrinking options for Main Street companies (does GM have a corporate strategy aside from getting federal bailout money?), the government has to tap new veins of capital or see the economy slide further.

Fortunately, there is a substantial amount of cash sitting in private hands. It's unclear how large this hoard is. But you know it's there from the large amounts of mutual fund and hedge fund redemptions, and withdrawals from money market funds. Trading volume in the stock markets has been very light in recent weeks, which is part of the reason for the extraordinary volatility in stock prices. A lot of investors have yanked their savings from anything that presents risk and parked it in ultrasafe places. And they're not putting it into stocks, real estate or anything else that appears to be a sinking asset. This money represents a pool of funds that, if put back to work in the stock and real estate markets, and through the banking system, could do much to revive the economy.

How can private capital be enticed to assist in the economic recovery?

Home buyers tax credit. All the talk of assistance for defaulting homeowners raises questions of fairness and exploitation of government aid. The large majority of homeowners with mortgages pay on time, even though many are under water. If defaulting homeowners receive government sponsored reductions of principal and interest rates, other under water homeowners have an incentive to cash in on the government program by defaulting as well (even if they can continue to make payments) and angling for a better deal for themselves at the taxpayers' expense. Another way to support real estate prices would be to give home buyers a tax credit--not just for first time buyers, but for all buyers. The point of this credit is to increase demand for real estate and not redistribute income. Maybe some sort of limit could be established to avoid subsidizing rich and famous lifestyles. But a tax credit such as 5% of the purchase price up to a limit of $50,000 would do much to encourage buyers to step in. Mortgage relief will be messy and expensive. A tax credit may be expensive, but it would be simply and direct, and therefore likely to have a faster impact.

Interest and Dividend Income Deduction. It's essential to encourage Americans to save more. That would increase the amount of domestic capital (a good thing regardless of what it is used for, because the U.S. is overly dependent on foreign capital). Since savings would often be placed in bank accounts, the banking system would get a low cost and stable source of funding, something it desperately needs. Other such savings would go into money market funds, and could flow from there into the badly frazzled commercial paper market. Such a deduction should be provided for interest income and dividend income now taxed as ordinary income (like dividends from money market funds). Allowing individuals to shelter from income taxes up to $20,000 per year of interest and dividends would do much to encourage saving, and increase funding for banks and money market funds.

Double the Deductions for Retirement Account Contributions. Increasing the deduction for retirement account contributions (i.e., for accounts like 401(k)'s, 403(b)'s, IRAs, Roth IRAs, SEP-IRAs, etc.) would stimulate savings, because many people use the amount of the deduction as a retirement guideline and save the maximum amount allowed. Even though this isn't necessarily good retirement planning (you should estimate your retirement needs and save enough to meet those needs, not save the amount the tax code allows you to deduct), it's a behavioral pattern that would bring more capital into the financial system and the stock markets. That capital is badly needed. Doubling the deduction would also assist older workers (especially those close to retirement). Many of them have suffered recent losses in the stock market, and would benefit from a larger deduction to beef up their depleted retirement funds.

These measures would negatively impact taxes collected. And most of the tax benefits would go to upper middle class people. But one must offset those considerations against the advantages of bringing private capital back into the real estate and stock markets, and into the financial system. The government can't do it alone; President-elect Obama's remarks last Friday (Nov. 7, 2008) acknowledged as much. We can either let this private capital sit on the sidelines, while the government tries to tackle an impossible task, or we can work toward a combined effort that may help to stave off a really deep recession.

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