...And I Will Advertise It

by Eric Martin

Joseph Stiglitz makes a compelling case for nationalizing troubled banks, rather than continuing the pattern of misdiagnosis and ill-suited (if unbelievably expensive) band aids that fail to address the underlying hemorrhaging - and, perhaps more importantly, the conflicting incentives at the top.

America's recession is moving into its second year, with the situation only worsening.

The hope that President Obama will be able to get us out of the mess is tempered by the reality that throwing hundreds of billions of dollars at the banks has failed to restore them to health, or even to resuscitate the flow of lending.

Every day brings further evidence that the losses are greater than had been expected and more and more money will be required.

The question is at last being raised: Perhaps the entire strategy is flawed? Perhaps what is needed is a fundamental rethinking. The Paulson-Bernanke-Geithner strategy was based on the realization that maintaining the flow of credit was essential for the economy. But it was also based on a failure to grasp some of the fundamental changes in our financial sector since the Great Depression, and even in the last two decades.

For a while, there was hope that simply lowering interest rates enough, flooding the economy with money, would suffice; but three quarters of a century ago, Keynes explained why, in a downturn such as this, monetary policy is likely to be ineffective. It is like pushing on a string.

Then there was the hope that if the government stood ready to help the banks with enough money -- and enough was a lot -- confidence would be restored, and with the restoration of confidence, asset prices would increase and lending would be restored.

Remarkably, Bush administration Treasury Secretary Henry Paulson and company simply didn't understand that the banks had made bad loans and engaged in reckless gambling. There had been a bubble, and the bubble had broken. No amount of talking would change these realities.

It soon became clear that just saying that we were ready to spend the money would not suffice. We actually had to get it into the banks. The question was how. At first, the architects of the bailout argued (with complete and utter confidence) that the best way to do this was buying the toxic assets (those in the financial market didn't like the pejorative term, so they used the term "troubled assets") -- the assets that no one in the private sector would touch with a 10-foot pole.

It should have been obvious that this could not be done in a quick way; it took a few weeks for this crushing reality to dawn on them. Besides, there was a fundamental problem: how to value the assets. And if we valued them correctly, it was clear that there would still be a big hole in banks' balance sheets, impeding their ability to lend.

Then came the idea of equity injection, without strings, so that as we poured money into the banks, they poured out money, to their executives in the form of bonuses, to their shareholders in the form of dividends.

Some of what they had left over they used to buy other banks -- to pursue strategic goals for which they could not have found private finance. The last thing in their mind was to restart lending.

The underlying problem is simple: Even in the heyday of finance, there was a huge gap between private rewards and social returns. The bank managers have taken home huge paychecks, even though, over the past five years, the net profits of many of the banks have (in total) been negative.

And the social returns have even been less -- the financial sector is supposed to allocate capital and manage risk, and it did neither well. Our economy is paying the price for these failures -- to the tune of hundreds of billions of dollars.

But this ever-present problem has now grown worse. In effect, the American taxpayers are the major provider of finance to the banks. In some cases, the value of our equity injection, guarantees, and other forms of assistance dwarf the value of the "private" sector's equity contribution; yet we have no voice in how the banks are run.

This helps us understand the reason why banks have not started to lend again. Put yourself in the position of a bank manager, trying to get through this mess. At this juncture, in spite of the massive government cash injections, he sees his equity dwindling. The banks -- who prided themselves on being risk managers -- finally, and a little too late -- seem to have recognized the risk that they have taken on in the past five years.

After raising and shooting down the "bad bank" option, Stiglitz offers a way forward:

What's the alternative? Sweden (and several other countries) have shown that there is an alternative -- the government takes over those banks that cannot assemble enough capital through private sources to survive without government assistance.

It is standard practice to shut down banks failing to meet basic requirements on capital, but we almost certainly have been too gentle in enforcing these requirements. (There has been too little transparency in this and every other aspect of government intervention in the financial system.)

To be sure, shareholders and bondholders will lose out, but their gains under the current regime come at the expense of taxpayers. In the good years, they were rewarded for their risk taking. Ownership cannot be a one-sided bet.

Of course, most of the employees will remain, and even much of the management. What then is the difference? The difference is that now, the incentives of the banks can be aligned better with those of the country. And it is in the national interest that prudent lending be restarted.

There are several other marked advantages. One of the problems today is that the banks potentially owe large amounts to each other (through complicated derivatives). With government owning many of the banks, sorting through those obligations ("netting them out," in the jargon) will be far easier.

Inevitably, American taxpayers are going to pick up much of the tab for the banks' failures. The question facing us is, to what extent do we participate in the upside return?

Eventually, America's economy will recover. Eventually, our financial sector will be functioning -- and profitable -- once again, though hopefully, it will focus its attention more on doing what it is supposed to do. When things turn around, we can once again privatize the now-failed banks, and the returns we get can help write down the massive increase in the national debt that has been brought upon us by our financial markets.

While shareholders will hurt under this plan, as Stiglitz said, "ownership can't be a one-sided bet" - and if one group has to be on the short end of the stick, it should be the people that volunteered to assume the risk.  Of course, for many in the cult of the free market, this type of shareholder pain just seems so uncivilized.  Despite the protests, it's completely necessary in order to incentivize better management practices in the future.

Speaking of which, at least some of the recent recklessness surrounding risk-management in terms of lending practices stems from a departure from the days when management were also the major stakeholders in these banks.  By taking the banks public, management began to become more divorced from ownership, and more focused on pumping up the value of shares now traded on public exchanges.  Thus, the incentive was to take bigger risks and pursue riskier strategies that could increase share value in the short term, but that could lead to long term downside.  From management's perspective, in the long run, they'd all be dead, so to speak, so why not gamble on ventures that could lead to huge payoffs in the now.

The underlying reality is a human one: it's easier to risk other people's capital, especially when you are guaranteed to get paid huge sums of money either way - more money, in fact, if short term schemes to boost share value work out even if only during that limited time span. 

That is one of the reasons why nationalization makes a lot more sense than multi-trillion dollar giveaways without any strings attached - measures that not only fail to address this conflict of interest, but in fact reinforce it.  

Nationalize it. It's not an ideal solution, just the best available.

Comments

[Ugh]

I keep getting the feeling that nobody knows what's going on or how to fix it, and that we're all doomed.

[shah8]

I have come to the conclusion that the problems with nationalization has considerably more to do with the political economy and the "bond market" the Carville wants to be reincarnated as...

Stiglitz is being just a tad myopic. I favor nationalization too, but I think this is one of those cases that pretty much *all* of the medicine lies in *preventing* something like this from happening, not solving the situation after it happens.

Two things:
1) The issue is transparency. Whatever method one use, public knowledge of true value is a necessity for further confidence. If you nationalize without transparency, you merely do the same thing as if you threw money at it.

2) We allow nontransparency (and overly powerful bond markets) because the political strength of the elites depends on that x > translucent. Many parties will fight against the necessary cramdown on bonds with a ferocity that makes caution and opinion-building a lethal necessity. Nationalization that actually does "net out" obligations along with government obligations to transparency (like the Bloomberg suit for who got PaulsonBucks) is going to show certain entrenched parties to not be as...worth considering as they are.

If you want to get a somewhat clear idea of what this really involves, check out the wikis on certain bank scandals, like Clearstream and Banco Ambrosiano.

http://en.wikipedia.org/wiki/Banco_Ambrosiano
http://en.wikipedia.org/wiki/Clearstream

Obama is messing around with items that involves lots and lots of fragrant nitrogen-rich chemicals. He *has* to be more careful than Stiglitz or Krugman might tolerate. Mancur Olson writes a bunch about this kind of situation...

[bedtimeforbonzo]

Yo, Eric: For a change, I feel smart -- I linked the Stiglitz piece last week in two separate economic threads; I forget which but one of them had to be one of von's Stimulus posts. (I think I'm going to name my next dog Stimulus if we as a country somehow pull it off.)

P.S. If you have time, go to your Open Thread and let me know what you thought about the Super Bowl. Thanks. Perhaps Obama should consult some of the minds behind that annual orgy of red-white-and-blue capitalism for ways to pump up the economy; Springsteen could write the Stimulus Plan theme song, Jennifer Hudson could sing it, Madden could color-commentate the whole thing, Matt Lauer would do weekly fireside chats with Obama (and give us updates on Jessica Simpson's weight, via US Weekly), and FedEx, I'm sure, would be a willing sponsor.

[Morat20]

Oh, they know how to fix it. It's just no one wants to nationalize the banks, because they think the public will crucify them for it.

They're misreading the public. The public is ANGRY. The public feels that, frankly, these businesses have been driven into the ground by greed and stupidity, and they're doubly angry that these businesses are so critical that it's taking everyone else with them.

Right now, I think the public would not only love the banks being nationalized, but would cheerfully rally behind fraud prosecutions, lawsuits, and possibly tar-and-feathering of anyone with an MBA.

[Sebastian]

I don't mind shareholders being hurt by failing banks. The bank is failing, that is what ought to happen to share prices.

I'm concerned about this mode of thinking however "The difference is that now, the incentives of the banks can be aligned better with those of the country. And it is in the national interest that prudent lending be restarted." I'm not super concerned about Stiglitz, because for him the second sentence is the major case of the first.

But I'm concerned because Congressmen aren't as bright and may get confused about other things that might be aligned with the alleged interests of the country if they have a nationalized bank. Things like 'more people ought to be owning their homes so we should change banking structures to make that happen'.

[Slartibartfast]

I think I'm going to name my next dog Stimulus if we as a country somehow pull it off.

Uncertain antecedent; possibly unintentional hilarity.

[bedtimeforbonzo]

"Nationalize it. It's not an ideal solution, just the best available."

Damn right.

I mean, we own a huge stake of the banks now, as it is, and are keeping many of them afloat. Let's just make it official.

[ThatLeftTurnInABQ]

I agree with Stigliz - the "Bad Bank" plan is an abomination, and if the only alternative is nationalization, then let's stop pretending otherwise and get it over with.

Having said that, there are a couple of problems we need to deal with.

The first is that "gettting credit flowing again" is not a panacea. Part of the reason why credit is not flowing is that few parties (of sufficient aggregate size) are left who have any business taking on any more debt than they already have - our debt problem is a demand side problem as much as it is a supply side problem - IMHO the Austrians are correct in this regard.

What we do need is better intelligence is the disposal of liquidity so healthy businesses are not cut off along with the sick ones, and from some of the stuff I've read recently this is not the case. For example in the construction sector everybody is being cut off regardless, without any analysis of their cash flow or business prospects - the banks have decided to just shut down this entire sector en-toto.

The second problem is that the FIRE sector of our economy has to shrink - it is simply not sustainable at circa 2007 size. Once we nationalize the banks, the decision as to how to shrink this sector and whose heads go into the basket will be formally politicized. The resulting orgy of lobbying is not going to be pretty. Better to have it out in the open I suppose, but we will need a tremendous commitment to transparency of process if this is not to turn into the banking/finance/real estate equivalent of Cheney's Energy Task force. And I don't trust Obama's economic team in this regard.

[bedtimeforbonzo]

". . . possibly unintentional hilarity."

Actually, it was intentional.

[Eric Martin]

Things like 'more people ought to be owning their homes so we should change banking structures to make that happen'.

I'm not overly concernd that in this environment, Congress will pressure the Executive Branch to loosen up standards on lending to non-creditworthy applicants.

And if we encounter such a move, we can and should oppose it strenuously.

[Slartibartfast]

I hardly ever let other people pull off my dog, btfb.

[von]

I echo Sebastian's concern: I would have greater confidence in Stiglitz's plan if I had confidence that we would actually get Stiglitz's plan through a nationalization.

Keep in mind that we previously had an experiment regarding whether Congress could strike a balance between sound lending practices and the national interest. So .... how are Freddie Mac and Fannie Mae doing these days?

[Eric Martin]

So .... how are Freddie Mac and Fannie Mae doing these days?

They're not hurting because of Congress.

And this would not be under Congress' control.

Keep in mind that we previously had an experiment regarding whether Congress could strike a balance between sound lending practices and the national interest.

And we've certainly had a long experiment with the private sector's stewardship as well.

[Sebastian]

"I'm not overly concernd that in this environment, Congress will pressure the Executive Branch to loosen up standards on lending to non-creditworthy applicants."

I'm not concerned about that particular error. No one will be making that particular error for at least a decade or two. I'm concerned about that CLASS of error. 5 years ago the Barney Frank quote about Fannie Mae and the unfairness of making tighter restrictions on homeowner loans pretty much expressed the mood of the political class on the subject. Whether or not Fannie Mae et al was a huge part of problem (I suspect medium part of a giant private/public cluster!@$#) it or nationalized banks certainly would have been if Congress had access to national banks at the time.

My concern is that Stiglitz's suggestion is excellent for hammering down on generally understood good bank behaviour but is NOT applicable to general social engineering through bank behaviour.

[bedtimeforbonzo]

"I hardly ever let other people pull off my dog, btfb."

Oh: That part -- not intentional.

[Sebastian]

"What we do need is better intelligence is the disposal of liquidity so healthy businesses are not cut off along with the sick ones, and from some of the stuff I've read recently this is not the case."

In the anecdote department, I have been going to an excellent breakfast café for about 15 years. For at least 10 years there has been a 30-40 minute wait for the place on Friday, Saturday and Sunday. He wanted to expand, but couldn’t until the adjoining business (a smoke shop as it happens) left its lease. In December 2007 he got some plans through for an expansion and he leased the next door space. He got his funding together and started work on the expansion in January 2008. Almost immediately it was discovered that the building had some structural deficiency that needed fixing and it required additional city permits. This ended up taking almost six months to get resolved and then another month or two for the actual repair to go through. In the meantime his contractor went out of business so it took about another month to find a good one that he trusted. Two weeks after they started work, the bank froze his lines of credit along with every other small business nationwide for that bank. So now he has a half finished addition, which has an excellent business case, with a thriving business at the same location which needs to expand, and a lease he has paid a year on, but can’t get the money through.

I have no solution, just throwing it out there that lack of good banking opportunities really can hurt the rest of the market (which was the only reason I was at all interested in anything other than ‘let them sink’).

[Eric Martin]

My concern is that Stiglitz's suggestion is excellent for hammering down on generally understood good bank behaviour but is NOT applicable to general social engineering through bank behaviour.

I don't disagree Seb. But to me, that sounds more like an argument for smarter policy making with respect to attempts at social engineering, rather than an argument against nationalization.

At least we have a vote when it comes to acts of the US government in this respect.

[Sebastian]

"I don't disagree Seb. But to me, that sounds more like an argument for smarter policy making with respect to attempts at social engineering, rather than an argument against nationalization."

I'm not arguing against nationalization (at least not temporary nationalization). But we've already seen arguments that as we nationalize we should also social engineer so ignoring that impulse while we nationalize strikes me as a problem.

You have to work in the real world. Yes, in a perfect world, social engineering would only pick good projects and the government would never use its power unwisely. But as I alluded to and von specifically called out, think of the resistance of Democrats to tightening lending restrictions when it interfered with their plan about more home ownership.

How are we going to avoid that on a larger scale when the government owns the banks in question? If your answer is a vague "things will be better with better policy making" I'm not reassured.

[Ugh]

Keep in mind that we previously had an experiment regarding whether Congress could strike a balance between sound lending practices and the national interest. So .... how are Freddie Mac and Fannie Mae doing these days?

I thought Fannie/Freddie's problems had more to do with how much and what assets they were allowed to buy with borrowed money, rather than any kind of unsound lending practice they carried out (said practices were, IIRC, very sound, whereas the private originators were the ones doing the liar's loan thing).

[Eric Martin]

You have to work in the real world. Yes, in a perfect world, social engineering would only pick good projects and the government would never use its power unwisely. But as I alluded to and von specifically called out, think of the resistance of Democrats to tightening lending restrictions when it interfered with their plan about more home ownership.

As mentioned by Ugh, actual interference with Fannie/Freddie was relatively minimal, and the negative consequences were equally small - relatively speaking.

How are we going to avoid that on a larger scale when the government owns the banks in question? If your answer is a vague "things will be better with better policy making" I'm not reassured.

We should look to past practices in Sweden and elsewhere for guidance. What we know is that the private sector has had a horrendous record in this regard. We must try to build in safeguards so as to prevent government mismanagement. Either way, we must re-incentivize better practices from the private sector - and get a return for taxpayer money.

I'm open to suggestions for those safeguards. Something that needs exploration.

[mds]

Yes, Ugh, but "Barney Frank ruined Fannie Mae by forcing banks to lend money to unqualified borrowers" remains on the list of willfully mendacious right-wing talking points no matter how many rounds of Whack-A-Mole are played with it. (Not to give anyone the vapors by accusing them of bad faith.)

[Sebastian]

"I thought Fannie/Freddie's problems had more to do with how much and what assets they were allowed to buy with borrowed money, rather than any kind of unsound lending practice they carried out (said practices were, IIRC, very sound, whereas the private originators were the ones doing the liar's loan thing)."

Not really because they pretty much set the acceptable terms for what allowable practice was from private originators. (They bought some but refused to buy others, and as the largest player in that market especially in the last two years of right before the pop, Fannie and Freddie had enormous influence in what was actually happening by how they decided which ones to buy.) So yes the orginators were at the root of the problem. But said practices were not sound because Fannie and Freddie set the acceptable practices floor for an enormous part of the market. Further, because of the advantage the government gave them, they were inherently more capable of getting safer loans than private banks. This helped (I do not say FORCED) push banks toward riskier loans. The fact that even the government-advantaged Fannie and Freddie had problems suggests that lots was going on all over the place.

(Which AGAIN is not blaming the whole thing on them. This was an enormous grouping of screwed practices spanning both the private and public sectors. But pretending that it was almost exclusively a private problem makes it much more likely that you will repeat the government mistakes). House ownership has been heavily influenced by government policy for a very long time. The tax advantage for owning is one such example that you don't hear much about...

"Yes, Ugh, but "Barney Frank ruined Fannie Mae by forcing banks to lend money to unqualified borrowers" remains on the list of willfully mendacious right-wing talking points no matter how many rounds of Whack-A-Mole are played with it."

Yes, and defending questionable policies by mischaracterizing opposing arguments is a long-held tradition too. But I won't accuse such people of bad faith, in this case they seem merely uninformed.

Barney Frank was raised not becuase he single handly ruined Fannie Mae or some such proposition. He didn't. He was raised because his policy opposition was wrong-headed because it was influenced with a much larger concern toward social engineering than it was sound business practice.

But thinking that Fannie Mae's practices were basically sound is uninformed. See for example here or here

[Ugh]

House ownership has been heavily influenced by government policy for a very long time. The tax advantage for owning is one such example that you don't hear much about...

Maybe being a tax lawyer I hear more about the tax advantages than most people, but I believe they are well known and while they certainly contribute to overinvestment in housing, I don't think they were a significant contributer to the bubble (but I could be wrong). That is, mortgage interest has been deductible forever, and the tax-break on gains only applies to primary residence that you have lived in two out of the past five years, and you only get it once every two years.

As for Fannie/Freddie contributing to poor lending practices by others, weren't they buying AAA-rated MBSs, not, e.g., individual loans? Either way, I can certainly see how, since the originators can off-load the collection risk to Fannie/Freddie that willingness to buy certain loans could set their terms, but it seems to me that buying AAA MBSs is different than buying individual loans, at least in terms of who can be blamed for what, IMHO.

[ThatLeftTurnInABQ]

Seb,

This isn't entirely directed at you, because you did hedge and qualify your statements above somewhat, but I'm sick and tired of the same "Freddie-Fannie did it" argument coming up yet again, so beware of shotgun pellets.

Not really because they pretty much set the acceptable terms for what allowable practice was from private originators.

With regard to the subprime market this is simply not true. The largest growth in subprime loans during the main phase of the housing price bubble occurred for loans which did not qualify. The GSEs lost market share during that period, and were attempting to catch up, not leading, in that market. See CalcRisk for details. And while you're at it, please read all the way through this post which relates the terms "subprime" (and others) to the actual mechanics of the traditional 3 C's (Creditworthiness, Collateral, and Capacity), which are essential to understanding the details of the various legislative, regulatory and lending orgination hazards and failures which occurred.

Also note that the focus on subprime completely ignores the role of the Alt-A's and jumbo loans in contributing to the mortgage bubble. Did Barney Frank help to push questionable loans in affluent and heavily pro-GOP areas like San Diego and Orange County, CA?

Or as the WaPo recently put it:

But interviews and a Washington Post analysis of available data show that the foreclosure crisis knows no class or income boundaries. Many borrowers ensnared in the evolving mortgage mess do not fit neatly into the stereotypes that surfaced by early 2007 when delinquency rates shot up. They don't have subprime loans, the lending industry's jargon for the higher-rate mortgages made to borrowers with shaky credit or without enough cash for a down payment.

The wave of subprime delinquencies appears to have crested. But in October, for the first time, the number of prime mortgages in delinquency exceeded the subprime loans in danger of default

Also, how (I am left wondering) did Barney Frank also manage to force all those regional banks to make questionable CRE loans? I have a more than passing familiarity with the actual business people who work in that construction market, and I can tell you from personal experience that most of them have probably never voted for a Democrat in their lives. Kinda of a strange clientelle for Mr. Frank to be helping out.

This whole Freddie-Fannie obsession on the right is understandable in purely cynical political terms, but it is based on a mass of omissions, half-truths and distortions which don't stand up to scrutiny. The limited role the GSEs played in the mortgage crisis does not come anywhere close to justifying the amount of ink spilled by the right trying to make them out to be the principle culprits, or to use them as an excuse to tar govt. sponsored programs in general.

[Gary Farber]

Krugman's column today seems relevant.

[russell]

A lot of the significant points have been covered here, but I'd just like to add that the "social engineering" in question here -- efforts by liberals in government to make it easier for minorities to get home loans -- was intended to address another, pre-existing form of social engineering in the private sector.

That pre-existing, private form of social engineering is called "redlining", and is also known as "not writing mortgages for brown people".

IMVHO, it's actually fairly rare for liberal politicians to go searching the land for interesting new ways to bug people and interfere in their lives. Generally, "gummint interference" usually occurs as an attempt to solve a problem.

[russell]

From the Krugman article Gary cites, given as an example of the attitude of entitlement common on Wall St:

“Say I’m a banker and I created $30 million. I should get a part of that.”

What's missing here is a reasonable definition of "created".

Packaging mortgages into securities in ways that makes it impossible to assess their actual value, and then talking other people into paying you $30M for them, is not a useful or meaningful definition of "creating" $30M.

Taking $30M as a fee in return for guaranteeing billions of assets, when the resources you have to cover those guarantees are so heavily leveraged that a drop of a couple of points in the value of the assets you are guaranteeing will wipe you out, is not "creating" $30M.

If any of these things describe your contribution to the wealth of the nation, you've created nothing, and deserve nothing in return.

[ThatLeftTurnInABQ]

Smoot-Hawley 2.0 here we come, if Krugman and Buiter have any idea what they are talking about.

[ThatLeftTurnInABQ]

Also, Robert Reich on cyclic vs. structuralist approaches to this downturn and how we should respond.

[Sebastian]

Smoot-Hawley 1.0 worked sooo well that we should definitely do it again. And this is a perfect exhibit of what I'm talking about Eric. Even though increased protectionism is known to be very likely to deepen the recession, politicians seemingly can’t help themselves. These are exactly the people that you seem to think I shouldn’t worry about being distracted by social engineering issues when they ought to be focused on more basic banking issues.

[Anthony Damiani]

Joseph Stiglitz?
As in, most cited economist on the planet Earth, Joseph Stiglitz?

Yeah, OK, go ahead and nationalize already.

[Gary Farber]

"Smoot-Hawley 1.0 worked sooo well that we should definitely do it again."

This seems entirely unresponsive to what Krugman wrote: perhaps you could respond to that?

[Sebastian]

TLTABQ, you are absolutely right that conservatives are overplaying the role, but you seem to be dramatically underplaying the role.

Arnold Kling On Working at Freddie Mac

His prepared Statement to Congress

I don’t really see how you can think that the holders of about 50% of the mortgage money in the US could count as unimportant influences in the market.

[Gary Farber]

And Buiter's piece is a long screed against protectionism. Did you actually read the links in ThatLeftTurnInABQ's comment, Sebastian, or were you just reflexively responding to the mention of Smoot-Hawley? Because your response doesn't seem to make sense in light of the linked pieces.

[Eric Martin]

These are exactly the people that you seem to think I shouldn’t worry about being distracted by social engineering issues when they ought to be focused on more basic banking issues.

Actually, I said, repeatedly, that you SHOULD worry about them. And that we should build in safeguards, and look to other economies that have pulled off similar measures successfully.

Regardless, the private sector - left to its own devices - has managed to wipe potentially hundreds of trillions of dollars of wealth from the world's ledgers, sending the entire world into a brutal downward spiral that could, when bottom is reached, equal or surpass the Great Depression in terms of impact.

I say, we can't let bankers operate under the same set of perverse incentives with trillions of dollars of taxpayer money and zero accountability.

That is not to say that there aren't pitfalls to look out for with nationalization. There are. We must be vigilant.

But the alternative is far worse.

[bedtimeforbonzo]

"Maybe being a tax lawyer I hear more about the tax advantages than most people . . ."

Ugh: I have mentioned elsewhere how my fellow co-workers are flocking, and fast, to this tax preparer whose M.O. is tax-deductions-on-steroids, walking that thin gray line on various deductions, giving fellows I know who aren't exactly giving types a charitable charitable deduction, deducting dry-cleaning expenses when, like me, the ironing is being done at home, unless they have special equipment that I am unaware of.

I know I may sound like a wussy but I just don't think it's worth the risk to try and beat Uncle Sam out of a few bucks, not too mention the fact that it's dishonest. I figure I've got my mortgage deduct, my dependent deduct, the legitimate charities, etc., and that's enough. Or maybe this idea of having an overly aggressive tax preparer is OK in a society that has given us the likes of Timothy Geithner running the U.S. Treasury.

I'd be interested in your opinion.

[Ugh]

BTFB - people should, of course, only take the deductions they are entitled to under the law. As courts have said over and over, deductions are a matter of "legislative grace."

For individuals who aren't running a business as a sole proprietership, this is generally straightforward, though the larding up of the tax code with various random deductions/credits for individuals lately makes this way more complicated than it should be (we had new windows installed in our home ~4 years ago, which I think we took some sort of credit/deduction for, per TurboTax).

Or maybe this idea of having an overly aggressive tax preparer is OK in a society that has given us the likes of Timothy Geithner running the U.S. Treasury.

Well, I don't think Geithner's issues were too big of a deal. The employment tax wasn't a result of him not reporting income (unlike Daschle) or hiding things, he just didn't realize he had to pay the employer's share of FICA, which was common enough that the IRS stated that 50 percent of similarly situated people did the same thing (which can cut both ways, maybe they were telling each other not to pay it). Him deducting sleep away camp as child care expenses is likely a consequence of the lard I mention above, there really is no reason for all these little mini-deductions/credits for individuals (which, I might add, seem to be a staple of the democratic party). If congress wants to encourage/discourage something, they should do so directly, and not through the tax code.

But that's not to underestimate the impact Geithner's and Daschle's tax issues have on the general public. If people think everyone else is cheating, including people appointed to high public office (who then get confirmed), compliance will go down. It got so bad in the 70s and 80s that, from what I hear, you were considered a rube if you didn't invest in a partnership tax shelter (for some reason doctors seemed especially susceptible). The case law is, literally, legion on sale-leaseback transactions, primarily spurred by the time value of money and the large disparity in rates between ordinary income and capital gains (both of which exist today, I might add).

But from your brief description of your co-workers, it sounds like they're taking deductions they're not entitled to (e.g., I can't imagine a situation where their dry cleaning is deductible, unless they're forced to wear something to work that is not suitable for wearing in regular life, like hazmat suits).

It also sounds like that the tax preparer is trading on (i) the unlikelihood that such deductions will be discovered by the IRS; (ii) the ability to rely on his/her advice to avoid penalties if such impropriety was discovered; (iii) the current economic climate where people need $$; and (iv) the sense that the tax code is so complicated no one can comply, so taking a few extra deductions is blameless.

With respect to this, I would note that New York (I think) recently conducted a sting of tax preparers where they found that some huge % (I want to say 80%, but don't know for sure) were telling clients to take deductions/credits, etc. that the clients were clearly not entitled to (and saying words to that effect to the (faux) client). If your state has a whistleblower reward for tax fraud, there is an opportunity, though probably not worth it.

I know I may sound like a wussy but I just don't think it's worth the risk to try and beat Uncle Sam out of a few bucks, not too mention the fact that it's dishonest.

Taxes are the price we pay for civilized society, and an obligation of being a citizen of the United States. In that vein, a relative of my wife's made a fortune in record stores in the south in the 70s and 80s (I imagine cleek may have bought albums there), a few years ago we were visiting him and for some reason we were talking about taxes (probably because of my vocation) and he said something to the effect of, "You know, I've never had a problem paying taxes. I couldn't have done what I did in any other country."

So, I guess, the moral of the story is not to invest in dry cleaning equipment to get a deduction.

[Gary Farber]

"I'd be interested in your opinion."

I'm the opposite of a tax expert, but my opinion is that anyone using a tax preparer like that is well advised to get a second opinion, if they don't want to risk failing an audit because their tax preparer is a fraud. That happens a lot.

[russell]

There seems to be an assumption in this thread that "social engineering" on the part of the government is bad. As in, inherently bad, such that no argument explaining why is really needed.

I find this wrong and kind of ahistorical.

Some social engineering is not only not bad, but is in fact splendid. The case we're discussing -- making adjustments to the law in order to encourage home ownership by poorer people -- is, I would say, a pretty damned good goal.

God knows we encourage middle-class home ownership, through the tax code and otherwise. Aside from maybe Turbulence, I hear precious few objections to that.

God also knows that we are subject to "social engineering" from the private sector 24/7/365. Nobody except maybe me seems to find that objectionable.

There are lots of points to be made about whether particular goals are worthwhile, and/or about whether particular programs are effective or not at achieving them. But it's far from clear to me that the kind of "social engineering" we're talking about here -- writing the law to encourage behavior that we think is generally useful or beneficial -- is a bad thing.

[Turbulence]

That pre-existing, private form of social engineering is called "redlining", and is also known as "not writing mortgages for brown people".

I'm not sure that you and Seb are referring to the same thing. Democrats did push for a bunch of legal changes to cut down on redlining, but these measures basically meant that banks had to justify lending decisions on objective criteria (i.e., your numbers went into a computer model that knew nothing of your race). In addition to that, politicians of all stripes (both Dem and Republican) have talked about how important it is to increase home ownership rates in general. But these are two separate issues.

The case we're discussing -- making adjustments to the law in order to encourage home ownership by poorer people -- is, I would say, a pretty damned good goal.

I disagree. For some people, purchasing a home is a good idea and for others it is not. But the precise determination in any one case is fairly complex and most people, whether rich or poor, lack the financial sophistication to make that determination. If you can't read and explain a chart showing price to rent ratios for your region, then you really have no business taking out a mortgage IMHO.

[Sebastian]

"This seems entirely unresponsive to what Krugman wrote: perhaps you could respond to that?"

Gary you seem to have failed to read the sentences that followed immediately after the sentence you quote. They contain my point, you should consult them: "Even though increased protectionism is known to be very likely to deepen the recession, politicians seemingly can’t help themselves. These are exactly the people that you seem to think I shouldn’t worry about being distracted by social engineering issues when they ought to be focused on more basic banking issues."

[Slartibartfast]

If congress wants to encourage/discourage something, they should do so directly, and not through the tax code.

*applause*

Rare moment of agreement, Gary.

[russell]

I'm not sure that you and Seb are referring to the same thing.

Could be we are not. In which case, it's time for me to put on my Emily Litella hat and say "Never mind".

I disagree.

Noted. And you make a good argument for your point of view, based on the merits of whether home ownership is something that is worth encouraging.

The argument you do not make is that government should not be in the business of encouraging home ownership, period, whether it's a good thing or not.

If congress wants to encourage/discourage something, they should do so directly, and not through the tax code.

I'm not necessarily disagreeing here, but I'm curious to know why you believe this.

[ThatLeftTurnInABQ]

"Smoot-Hawley 1.0 worked sooo well that we should definitely do it again."

This seems entirely unresponsive to what Krugman wrote: perhaps you could respond to that?

I thought the sarcasm in Seb's 1st sentence was quite clear, so I don't see where there is any confusion in what Seb wrote. I introduced confusion by posting links to two different opinions which are in opposition to each other. Buiter is severely anti-protectionist, and Krugman is making the case that a little bit of protectionism might be a good thing. I imagine the dialog between them might go something like this:

Sir Buiter: We were in the nick of time. You were in great peril.

Sir Krugman: I don't think I was.

Sir Buiter: Yes, you were. You were in terrible peril.

Sir Krugman: Look, let me go back in there and face the peril.

Sir Buiter: No, it's too perilous.

Sir Krugman: Look, it's my duty as a knight to sample as much peril as I can.

Sir Buiter: No, we've got to find the Holy Grail. Come on.

Sir Krugman: Oh, let me have just a little bit of peril?

Sir Buiter: No. It's unhealthy.

Sir Krugman: I bet you're gay.

Sir Buiter: Am not.

The point is, Buiter is describing a tragedy of the commons and its longer term consequences, while Krugman is describing just how potent and seductive are the short term incentives which may lead us into it.

[russell]

The point is, Buiter is describing a tragedy of the commons and its longer term consequences

I'm not embarrassed to say that a lot of what Buiter had to say went over my head.

Can you please explain how "protectionism" equals "tragedy of the commons"? I don't follow you on that.

[Sebastian]

"Can you please explain how "protectionism" equals "tragedy of the commons"? I don't follow you on that."

Individual countries can get very short term gain at the medium to long term expense of the global economy as a whole, hurting themselves in the process as the commons (in this case economic gains possible from screwing your trading partners) quickly evaporate leaving everyone worse off.

Though in the protectionist case, it isn’t even clear that you can get short term benefits on average, many of the ‘gains’ you get in one area (say auto manufacturing) are offset by the large but more diffuse losses (say in consumers being forced to buy more expensive and lower quality cars). This can be especially detrimental if the durable good is of a noticeably lower quality because it will then need to be maintained or replaced more quickly. This is not good for the economy because you could have purchased a cheap/better car and then used the money you will now use on maintenance/replacement on other more productive uses (or even vacations). (If you think that replacing lower quality goods constantly is good for the economy you are falling prey to the broken window fallacy).

[Ugh]

Russell: I'm not necessarily disagreeing here, but I'm curious to know why you believe this.

Any number of reasons.

First, it unecessarily complicates the tax code. If, for example, you think people who have a child should get a $500 tax credit, why not just write them a check instead? In addition, they are often accompanied by phaseouts for upper income taxpayers, which adds to complexity and are effectively back-door tax increases (but politicians don't call them that).

Second, the costs are much clearer if you subsidize/discourage something directly, rather than provide a deduction or credit. Sure, the Joint Committee on Taxation will give you revenue gain/loss estimates for this and that provision, but they're just that, estimates.

Third, credits/deductions tend not to go away; whereas if you have to provide a subsidy in a bill every year, it at least gets re-examined (though I admit these rarely go away too).

Fourth, they're often more helpful to upper income folks than lower income ones. Take the home mortgage interest deduction, it saves a top earner 35 cents on the dollar (or more, if you count state income taxes), but someone in the 10% bracket only gets 10 cents. Some of this can be fixed by providing refundable tax credits rather than deductions, but then refundable tax credits are generally equivalent to writing people checks, so why not do that (as above)?

Finally, direct subsidy/discouragement is more transparent -- you generally know who specifically benefits/suffers and how. Whereas who knows who is taking the enhanced oil recovery credit, for example, and how much money it's saving them.

[russell]

Individual countries can get very short term gain at the medium to long term expense of the global economy as a whole, hurting themselves in the process as the commons (in this case economic gains possible from screwing your trading partners) quickly evaporate leaving everyone worse off.

Thanks Seb. I think I follow the argument now.

I guess what's puzzling me here is thinking of the global market as a 'commons'. I'm not sure that really complies with the traditional sense of what a commons is. Or, at least, with my understanding of it.

Ugh, thanks also for your comments on tax policy. Your points all make sense.

[Sebastian]

"I guess what's puzzling me here is thinking of the global market as a 'commons'."

Strictly it probably isn't but it has some common features. A healthy global economy makes it possible to sell a bunch of your goods, and cheaply buy a bunch of theirs (for various definitions of yours and theirs). A bad global economy makes it difficult to sell your stuff and impossible to buy theirs.

A healthy global economy takes cooperation (like a commons) and can be exploited in such a way as to ruin it for everyone (like a commons).

[Hogan]

I guess what's puzzling me here is thinking of the global market as a 'commons'. I'm not sure that really complies with the traditional sense of what a commons is.

Protectionism may be more like a "tragedy of the enclosure" than a "tragedy of the commons."

[Ugh]

I thought protectionism was an example of the prisoner's dilemma.

[russell]

A healthy global economy takes cooperation (like a commons) and can be exploited in such a way as to ruin it for everyone (like a commons).

I see what you're saying, and IMO it's not a bad analogy.

The oddness here for me was that things held in common, or subject to rights of common, are more or less removed, deliberately, from market economics. So the idea of an economy *being* a common seemed peculiar. But it's an interesting idea, and maybe a useful way to think about international trade in particular, where the terms of participation need to be negotiated between the various parties.

The thing that bugs me about the "tragedy of the commons" meme is that the original article by Hardin presents an example that is basically hypothetical, and is divorced from the actual, historical, real-world practice of common use.

He presents a "commons" as something that is, more or less, available for anyone to use as they wish, and correctly demonstrates that, presented with such a resource, some folks will abuse it.

That's not what common use was, nor is that how it was actually practiced. Common use was an arrangement whereby people in a community had well-defined rights to make use of particular resources, in particular ways, within well-defined bounds.

You had the right to graze a certain amount of certain kinds of animals. You could take so many turves from a bog. You could take whatever deadwood you could gather from a forest or a waste, but not cut living trees.

The point was, very specifically, to *not* exhaust the resource in question.

Hardin's commons is a fiction used by him to make a point that actually argues *for* strong cooperative management of shared, finite resources. And, in fact, that's the argument he ends up making.

In other words, the solution to the "tragedy of the commons" is the commons.

The idea of commons is interesting to me because, historically, it offered an opportunity for a degree of independence from the money economy, which I think would result in a net improvement in a lot of people's lives today. Not independence from a *market* economy, necessarily, but from a *money* economy.

Topic for another time, no doubt.

[bedtimeforbonzo]

Stiglitz suggests how we get out of this Great Recession.

Rich tells us just where we're at -- and it aint pretty, unless you like a steady diet of Campbell's soup, Hershey bars, Spam and Big Macs (come to think of it, that doesn't sound so bad, minus the Spam)

---

Thanks Ugh for the thoughtful and complete response up above.