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I've recently been printing letters from repukes who think cutting taxes and revoking regulations are all that's necessary to fix the economy. Since we as liberals know it was the tax cuts and revoked regulations that caused it, I wrote this. I'd like some actual liberals to proofread it first...have fun!
Let me ask you conservatives something: what, besides demanding tax cuts and spending cuts and writing huge articles explaining why the president is a socialist, a traitor or both, have you actually done to fix the economy?
One of the big differences between conservatives and liberals is there are different kinds of liberals. There seems to be one kind of conservative. On the other side of the fence, we tend to specialize: some of us are labor liberals, others women’s rights and still others gay rights or race relations liberals. This isn’t to say we are into these things to the total exclusion of everything else; a labor liberal will also care about race relations and women’s rights, but he’ll be really sharp on unionization, outsourcing and other labor issues.
And then there are economic liberals, which is what I am. We economic liberals have a five-point plan to fix the economy. It is not a “simple five-point plan” because some of it is not simple at all.
Point 1 is to fix taxes and spending. Both are way too low. My favorite Republican phrase is “liberals think only the government can spend money.” This is true. The government has a very special way of spending money. Let’s talk pickups. If you or I wanted a new pickup, we’d go to a dealership and buy one. The dealer would call Ford or whoever and order another one, who’d deliver it all in good time. If the dealer doesn’t sell trucks he’s going to go out of business, but selling one or two a day isn’t going to accelerate spending, investment or hiring. (Ford says they are going to sell, say, 50,000 pickups a year. If yours is one of that fifty thousand, they expected to sell it so it’s no big deal.) The government will call Ford Motor Company on the first of March and tell them, “deliver ten thousand pickups painted Forest Service Green with tan vinyl seats by the first of October.” Now Ford has to put on another shift at the truck plant to make all the trucks, US Steel has to come up with hundreds of rolls of sheet stock, Goodyear needs to make an extra 50,000 tires, DuPont needs to make 20,000 gallons of Forest Service Green paint…see what I’m getting at? If the trucks cost $25,000 each, “returning it to the taxpayers” in the form of an income tax cut would net each taxpayer about two dollars. I would probably use my tax cut to buy a hamburger…and that hamburger isn’t going to create any jobs because the guy flipping burgers isn’t even going to notice he has to make just one more. You can well believe the woman in DuPont’s car paint factory who has to work 20,000 gallons of ugly green paint into her schedule will notice. Spending by individuals is indeed important, which is why liberals believe in full employment and in making it easier for employers to create jobs through such things as streamlined environmental permitting for plant expansion. But spending by the government is required to really kick the economy into high gear. I mentioned higher taxes: these do one thing, allow the government to spend without excessive borrowing. Conservatives love to discuss the negative effects of taxes: they supposedly stifle investment, discourage production and motivate people not to work or start new businesses. Conservatives and liberals alike point to the 1950s as a glorious era of investment, production, labor and business creation. Conservatives, however, like to gloss over the fact the top tax rate was ninety percent and the government was spending a ton of money on things like breaking the sound barrier, making the world safe for democracy in Korea and Berlin, and building the Interstate Highway System.
Oh, while I’m here let me tell you where this low-tax thing came from. In the 1970s, a third-rate economics professor named Arthur Laffer was lunching with a fourth-rate economist named Jude Wanniski, plus Dick Cheney and Donald Rumsfeld. Laffer mentioned that low tax rates can produce exactly the same tax revenues as high ones. Intrigued, Wanniski asked Laffer to explain. Laffer took a sheet of paper—the legend says it was a paper napkin; Laffer says he eats in places that use cloth napkins—and drew a curve on it which has become known as the Laffer Curve. He then drew a vertical line in the middle. The vertical line represents the ideal tax rate. If taxes are lower than that rate, you’re leaving money on the table; above it and you’re both encouraging tax evasion and discouraging work. I could open a fertilizer factory with that much bull, but let’s go through it. First, we have no idea what the “ideal tax rate” is—in fact, there really isn’t one but rather thousands. There are different “ideal tax rates” for me, the company I work for and the man who owns it. Most of the Internal Revenue Code is a do-it-yourself tax cut kit if you know how to hold it, and contrary to what the Republicans are telling you the IRC in general isn’t that hard to figure out. (There was at one time a section of the Internal Revenue Code that dealt with cash transactions for railroad rolling stock like boxcars and locomotives. It was unbelievably complex; I guess Congress figured anyone who has enough money to buy a locomotive with cash also has enough money to hire an accountant.) Obviously there’s a rate that’s too high—if someone’s paying so much tax he can’t afford to live, his taxes are too high. This is why we tax different amounts of money at different rates. Just as obviously there’s a rate that’s too low—when the amount of money coming in isn’t enough to pay the government’s bills, the rate’s too low. Second, Laffer’s preferred test for determining if the tax rate is correct is to cut taxes. If economic activity picks up, taxes were too high. There are two very large problems with that theory. One is government spending motivates the economy; cutting taxes reduces this spending hence slows the economy. The other is, when the tax cut slows down the economy are you supposed to cut taxes even more to try to increase economic activity? The ultimate conclusion to this is, if we were to completely eliminate taxes the economy would take off like a rocket. But consider: If we were to eliminate taxes we’d also have to eliminate the government. Say we did that. There is currently a law that says you can only buy insurance if you have an “insurable risk”—you can’t buy fire insurance on your neighbor’s house. But let’s say it was legal to do that. Also remember there are no cops, because there’s nothing to pay them with, and there are no laws because if you can’t get punished for something why make doing it illegal? So you buy fire insurance on all the houses on your street. Since fire insurance only pays off if the house catches fire, the night after you buy all these policies you drive down the street with a bottle of Jack and a flamethrower. Right now you’re laughing, but wait until I describe what a naked credit default swap is. But most importantly, the idea that a too-high tax rate encourages tax evasion overlooks the fact that anyone who would evade taxes is gonna do it whether the tax rate is 1 percent or 99. It certainly doesn’t motivate people to not work. Imagine someone walking into the house and saying “honey, I am no longer motivated to work because the tax rate went from 35 percent to 40, so pack up all our stuff; after I trade the Benz in on a used pickup we’re moving from our mansion into an old school bus.” All together now: yeah, right. All kidding aside, Laffer is an idiot, Wanniski was an idiot and Ronald Reagan was dumb enough to believe them when he signed the Kemp-Roth Tax Cut of 1981, which implemented Laffer and Wanniski’s idiocy, into law. There were two results: the gross domestic product—this is the civilian economy, not the government—dropped by 4.5 percent, and Reagan signed the Tax Equity and Fiscal Responsibility Act, the biggest tax hike in history, in 1982. In fact, Reagan spent $2 trillion in borrowed money over the course of his administration and raised taxes in seven out of his eight years, and created a nice robust economy in the process—which would have been even more robust if he would have left taxes alone so he would have had even more money to spend.
One quick Reagan slam: During his first inaugural address, Reagan said the scariest nine words you can hear are, “I’m from the government and I’m here to help.” I don’t know about you guys, but if my house was on fire I wouldn’t want free-market solutions to residential combustibility, I would want six government workers to show up with a big hose and put the damn fire out.
Let’s talk about this really bizarre economic theory the Republicans have that high taxes stifle investment with an example. Duane Hagadone’s corporation owns a printing plant on 2nd Street that prints this newspaper. (Legally, Hagadone Corporation is separate from Duane Hagadone because if a guest at one of the corporation’s restaurants eats a lobster without taking the shell off first and gets injured by it, the person can sue the corporation, and probably lose because a reasonable person would know you’re not supposed to eat lobster shells, but couldn’t go after Hagadone himself.) Double Hagadone’s taxes and he won’t bury his money in the back yard until Congress comes to its senses like Republican orthodoxy says he should; he will build a sheetfed plant and start running junk mail—because by being able to depreciate all the new equipment, deduct the interest on the loans he took out to buy it and deduct the salary he pays the pressmen, platemakers and binderymen who work in there, his taxes will be lower than they were before the tax hike. If you were to lower his taxes in the hope he’ll invest, he will: he’ll buy the Lockheed stock currently held by John, who will use Hagadone’s money to buy Goodyear stock from Frank, who will use John’s money to buy General Mills stock from Albert. Lockheed, Goodyear and General Mills won’t actually see a nickel of any of it. Nor will it really enrich the economy until Albert uses Frank’s money to fly to Hawaii so he can sit on Waikiki Beach and play his bongos for two weeks. Ignore the environmental and social issues inherent in junk mail and ask yourself which would really help the economy more: the Hagadone Corporation paying someone $18 per hour, eight hours a day for the next thirty years, to print Shamwow coupons and invitations to shoot craps in Worley, or Albert sitting on a beach in Hawaii with two drums and a cooler full of beer.
Point 2 requires repealing two Republican mistakes: the Gramm-Leach-Bliley Act of 1999 and the Commodity Futures Modernization Act of 2000. The Gramm-Leach-Bliley Act repealed most of the Banking Act of 1934 (better known as Glass-Steagall); the Commodity Futures Modernization Act barred government regulation of the financial derivatives market. I will go fairly deeply into derivatives in Point 5.
This is mainly about Glass-Steagall. There are three basic segments to the financial services industry. First is commercial banking: checking accounts, savings accounts and loans. Second is investment banking: stocks and bonds. And finally, there’s insurance. You can open any kind of a financial institution you want and it will fall into one of those three categories. Glass-Steagall said to the financial services industry, “pick one.”
There’s one huge reason to separate them, and two huge reasons not to. The reasons not to are easy to understand: first is convenience. It’s nice to be able to go to, say, Chase and have your checking account, your savings account, your mortgage and car loan, insurance on your house and car, and your stock portfolio all managed in the same place. The other is investors move around: if stocks are doing great this week, people take money out of savings and put it in stocks. When money market accounts are doing better, people move out of stocks into those. Allowing a one-stop financial shop to exist lets the bank make money in all those markets. The problem is, allowing a bank to trade stocks and sell derivatives is dangerous. Consider Washington Mutual—I refuse to use their hip new name. I grew up in this area in the 1970s and, back then, Washington Mutual was The Friend of the Family. They had Methuselah as a spokesman, and when he told you your money was going to be safe if you put it in his bank he wasn’t kidding. Then Gramm-Leach-Bliley passed and so did Methuselah—he only lived to 900, after all. All of a sudden Washington Mutual was making really risky loans, combining them into bonds called Collateralized Debt Obligations, and trying to sell them. Oh, and they put ducklings into their ads; I don’t know why. When no one bought the CDOs, they combined them into new CDOs and tried to sell those, and did it over and over and over until the depositors said “enough!” and took their money out. (I’m not sure what happened to the ducklings, sorry.) Now Washington Mutual is part of Chase. To me, the positive effects of separating the businesses far, far outweigh the positive effects of them being together.
This is the thing: You guys in the tea party keep screaming about bank bailouts. If it wasn’t for Gramm-Leach-Bliley letting banks run gambling casinos in the back room we wouldn’t have to bail out banks because the bankers’ bad bets on weird derivatives wouldn’t have put your mom’s grocery money at risk. Did you ever hear of a bank needing to be bailed out when they weren’t allowed to trade securities? No, and there’s a reason for that: They didn’t need to be bailed out because we weren’t letting them get into situations risky enough to kill them.
Point 3 calls for a national interest rate cap. Every so often a conservative will tell us, “all we need to do to fix the problem of high healthcare costs is let people shop for health insurance across state lines.” I have no idea what you people are smoking, but you really need to legalize it because the jails are already too full. The reason I bring this up—the interstate health care thing, not the part about legalizing crack—is allowing people to shop for credit cards and loans across state lines so they could find the cheapest interest rates is what caused the credit card companies to all move to South Dakota—where there are no usury laws because they were repealed to attract the credit industry. The results are exactly the opposite of what was advertised: instead of rates going down they went up, and one intrepid bank introduced a credit card with a 79.86-percent interest rate. (That is not a typo, and it’s not the default rate: the first dollar you borrow from those people, you’re going to send back $1.80. Mafia loansharks don’t charge eighty freakin’ percent.) It is probably a violation of South Dakota’s state sovereignty to take away their right to set, or not set in this case, interest rates for the entire country. It’s a worse violation of Idaho’s state sovereignty to require our citizens to be governed by the credit laws of South Dakota when most of us don’t even go there. Speaking of state sovereignty and original intent, let’s find Peabody and Sherman’s Wabac Machine, set it to Virginia 1789 and visit Thomas Jefferson. We will ask him in a suitably squeaky voice, “Mr. Jefferson, there is a really great fruitcake made in Pennsylvania. It contains wheat grown in North Dakota and ground in Minnesota, butter and milk from Wisconsin, sugar from Utah, eggs from New York, maple syrup from Vermont, cherries from Washington State, pineapple from Hawaii and bourbon from Kentucky. The bakery ships them to a company in Ohio on a truck that belongs to an Arkansas-based corporation. People in Oregon borrow money from a bank in South Dakota to pay for them, and order them on computers made in Idaho running software from California. The company in Ohio puts the cakes on an airplane that belongs to a company in Tennessee to be delivered as gifts to Arizona. Which state’s laws should govern the interest rate involved in all these transactions?” After you convince him there’s such a thing as a really great fruitcake and explain to him what Hawaii and an airplane are, Jefferson will look at you like you’ve gone insane and tell you, “there’s no way it can be anything but the responsibility of the federal government.” And so it is.
Point 4 is to fix the mortgage market by not allowing mortgage companies to pay loan originators on commission, and by requiring a mortgage company to retain an interest in each mortgage they originate. You’re probably going, “huh?” Consider the four most bizarre mortgage types of all time: the Stated Income mortgage, the Interest Only mortgage, the No Money Down mortgage (this one works by—I am not making this up—paying the down payment and fees on the first mortgage with the proceeds from the second mortgage you took out first. This mortgage makes even less sense than that sentence did.) and the Pay Option Adjustable Rate Mortgage—which is better known as an Option ARM. They have three things in common: they allow you to buy more house than you can afford (which also means they make it more likely your family will be living in a van down by the river in three years); they pay higher commission rates than conventional mortgages do because the loan officer has to do more work; and they pay no commission whatsoever if the applicant gets rejected. This means it makes perfect financial sense to grant a loan to someone who can’t pay it back—the bigger the better—and no financial sense to reject one. Loan originators have homes of their own to pay off, which is hard to do if you get fired for rejecting too many loans. It makes no sense to not sell a mortgage to anyone, because you’re going to bury your mistakes anyway by selling every mortgage you originate the second the ink is dry on the contract. Hence this two-part solution. Put loan officers on salary rather than commission and they’ll get paid for doing the work needed to reject an applicant who shouldn’t borrow enough money to buy a house. (Envision an electrical inspector. If he inspects a new house, finds it was wired with the wrong wire and rejects the job, he gets paid exactly the same as if he finds everything done right and approves it. But if a loan officer inspects the finances of someone trying to buy this house and finds he doesn’t earn enough money, she’ll get paid absolutely nothing if she turns the applicant down. There is something wrong with this picture.) Require a mortgage company to retain, say, five percent of the value of a mortgage, and you will greatly cut down the number of shaky mortgages that get approved. If you sell a $200,000 note, you’re going to be on the hook for $10,000 of it—a large-enough company can absorb an occasional loss of this size without self-destructing, but it’s enough to catch your attention. You folks with the hats made out of teabags keep saying you want to take America back; how about we take it back to the time when there were consequences for making loans you knew couldn’t be paid back?
Point 5 and Final is to fix the credit derivatives market.
First, this:
Credit Derivative. Noun. A financial instrument which serves as one of the few legal ways for a private citizen to print his own money.
A derivative is a bond. There’s a big difference between a regular bond and a derivative, though. If General Electric issues a bond, the money is going straight to GE so they can build a bigger light bulb factory or something. If GE Capital issues a derivative, what’s under it is a portfolio of loans made to other people.
This is why derivatives are so entertaining. The GE bond is pretty easy to figure out. General Electric is a very good company, at least financially. If you buy this bond, you are definitely going to be repaid in accordance with the repayment schedule on the back. There is essentially no risk, so therefore you are going to make essentially no money. Derivatives are a different story. There are usually about 20 loans in one. Some of the people who hold these loans will pay them back on time. Some will pay early, some late and a few not at all. The things are the world’s worst pigs in pokes. You can’t really put a price tag on one.
There are a lot of kinds of derivatives, and most are pretty specialized. Take the Collateralized Loan Obligation, which is debt from a leveraged buyout. The four types we’re going to concern ourselves with are the Asset Backed Security, or ABS; the Mortgage Backed Security, or MBS; the Collateralized Debt Obligation, or CDO; and the Credit Default Swap, or CDS.
Asset-backed securities and mortgage-backed securities are basically the same thing, except for the debt underlying—mortgages in an MBS, anything else in an ABS. How these work is pretty simple: first, loan money to a lot of people and keep doing it until you get about $10 million worth of debt on your desk. Next, put the debt into a pool and slice, or “tranche” (tranche is French for “slice,” hence the term) it according to risk. You basically want four tranches, and this is what they go for. You evaluate every loan for risk, and put all the ones you know are gonna default in the “equity” tranche. If you tranched the debt exactly right, all the debt in that tranche will default and none of it in the upper three will. Next, divide the tranches into bonds and have them rated by someone who rates bonds like Moody’s. Next, go out and sell the bonds. People in the Investment Chapter of the More Balls Than Brains Club buy the equity tranche because it pays a lot of interest. (There are ways to hedge these so you don’t lose more than you want to. We’ll talk about that later.) The most senior tranche is investment grade. Anyway, the people who have the loans that were sold into this thing (hopefully) pay them back, and as they do the bondholders receive payments. When the loans are paid back in full, the bondholders get however much of the principal they own.
For added excitement, there are two forms of risk here. First is the obvious one: default, which kills your principal stream. The other is early repayment, which hurts your interest stream. If you don’t mind that, these are pretty vanilla investments.
Next is the Collateralized Debt Obligation. This is a form of asset-backed security, but here the assets can be anything. These are what you do with ABS and MBS you can’t sell. You can also throw in some whole mortgages, money market certificates, or anything else you might want to make the pot sweeter. You’re thinking, “can I put another CDO in one?” Why, yes you can! But if you do that, you have made a “CDO-squared.” If you build CDOs out of CDO-squareds they are CDO-cubed, which becomes a CDO-4, which goes on and becomes the biggest bank run in the history of mankind if you get stupid like Washington Mutual did.
I talked about hedging. You do this with a Credit Default Swap, which is kinda like an insurance policy on a derivative—you pay premiums, and get money if your derivative croaks—with two huge differences. Up until the time the financial reform bill was passed you were allowed to sell these regardless of your ability to pay them off if you had to. The other is, you don’t have to own the derivative underlying to buy one. This is a naked CDS. Remember the joke about buying fire insurance on someone else’s house then burning it down for him? This exact thing can happen here. Let’s say I was a little tyrant, and I owned a large factory. If I was planning to move the factory to China and throw a couple thousand people out of work, one of the first things I’d do is to buy naked CDS against the MBS and CDOs that have my soon-to-be-ex-employees’ mortgages in them because you know at least some of those people will lose their homes. I’d do great.
You need to know what a CDO is and what a CDS is to understand what a synthetic CDO is, but they’re really fun. Start by creating some CDOs. Next, sell CDS against them. Take the premium stream off your CDS products, and put it in something like a money market account. Tranche the money market certificates, and you have created a synthetic CDO. I have no idea who thinks up this stuff.
Here are the problems:
Derivatives amplify risk. If you have a mortgage that’s tranched into a MBS, that’s tranched into CDOs, which are themselves tranched into CDO-squareds, and are then hedged with naked and covered CDSs…each of those securities has a value, and it adds up. If the woman who owns the house defaults because she was working for me in the last paragraph, instead of a $200,000 hit on the economy we’re looking at a million-dollar hit.
Derivatives aren’t worth anything. The only thing anything in this world is worth is what someone will pay for it. Right now there is no market for CDOs and there’s not much of one for ABS, MBS or CDS. Tranche $10 million in car loans into ABS you can’t give away and tell me what you just did to the value of those car loans.
And the reason they aren’t worth anything is you can’t properly value one. There are formulas called Gaussian Copulas they use, but at the bottom of these things are loans taken out by human beings—whose behavior more correctly is described by Brownian Motion than Gaussian Copula.
Now…here’s the fix.
First, ban naked CDS. Very easy to do; simply apply insurance laws requiring coverable risk to the CDS market. The naked CDS that are currently outstanding are going to be hard to deal with, but eventually we’ll get a handle on them.
Second, ban re-tranching CDOs into other CDOs. Any CDO that can’t be sold will have to be either held by the brokerage or written off. The threat of having to write off a large asset like a CDO should be enough to tighten credit standards. The Republicans will scream that we’re limiting access to the credit markets. They figured that out quick, but it’s totally necessary to do this: loaning money almost without regard to the debtor’s ability to pay killed the economy. This has to end.
You may be wondering about the famous financial reform bill. It’s a decent start, but it didn’t fix some of the worst things. I have gone over Title VII, the derivatives legislation, repeatedly and, while it’s one of the president’s favorite parts, it’s actually one of the weakest. First, it only regulates swaps. The legislation specifically excludes “securities based on a security” which is the textbook definition of an ABS, MBS or CDO. In other words, the most abusive derivative, the CDO, isn’t regulated. Second, it doesn’t stop or regulate over-the-counter swaps, synthetic CDOs, retranching, or any of the really bad abuses. And the law doesn’t reinstate Glass-Steagall, nor does it solve the problem of banks that are “too big to fail” by stopping them from getting too big to fail.
America has a choice. It can do what the liberals want to do, which will work, or it can continue to let the conservatives and the banks do what they want and have an even worse crash in just a few years. Any question which side I’m on?
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