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How to Save the U.S. Economy

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I read a lot of blogs, news, policy papers, etc. I also have thoughts as to what is broken with the US economy, and what needs to happen for the world to recover.
The underlying issue - US consumers consumed...and consumed...and then borrowed a lot more and consumed that. China built its whole manufacturing capacity around this phenomena. China runs narrow trade deficits/surpluses w/ most nations, but a HUGE trade surplus w/ the US. All to feed US consumer demand.
This is broken, and now the US is faced with persistent >15% unemployment, and China owns $2trn in US IOUs. Further, the US is facing a liability shortfall that amounts to US$53trn in current dollars. The majority of this >80% is entitlements - healthcare and Social Security.
So what to do? The obvious answer is to roll up our shirt sleeves, and work. But how should the playing field be altered (if at all) by policy makers to ensure binges such as the one from which the US is recovering do not occur again? I have a few suggestions which I modestly title, "5 Steps to Save the US Economy":

1.Mortgage Interest Deductions - eliminate this. It encourages home flipping rather than home ownership. The Mortgage Banker lobby pushes hard to keep this on the books, and for good reason - every time you sign a 30yr mortgage, they earn a fee every year of the mortgage. But, the mortgage banker - as of 2003 - is now allowed to book all 30yrs of fees as income in the first year. So what is in their interests? Volume of mortgages. If everybody bought and sat on their home, the mortgage industry would look terrible from an earnings perspective, but great from a cashflow perspective (the opposite holds true now).

2.Corporate Interest Tax Deduction - eliminate this. It provides an incentive to borrow and repurchase shares. To what end? This merely encourages more debt, at the expense of existing creditors. Average credit ratings have been sliding for 30 years, and the marginal returns on incremental debt was reduced to almost negligible levels.
The best way to exemplify this is to compare ROE – Return on Equity to ROI – Return on Investment. ROE can be calculated simply by taking Earnings, and dividing them by Shareholder Equity. More debt would normally mean more earnings (no matter how small) so ROE would go up. ROI is Earnings/Assets. As debt goes up, ROI normally declines. I have not conducted a broader examination of this disparity, but should. The difference of ROE-ROI, divided by total leverage (Assets/Equity), gives a rough approximation of return incremental unit of leverage. In the case of Morgan Stanley's 2006 financial statement, this return figure was 0.30%. For Goldman Sachs it was 1.07%. i.e. for every 100% increase in leverage, and additional 0.3%/1.07% was earned. These are hardly inspiring numbers that would hearten shareholders, and instill confidence. These sorts of debt levels, and the miserly returns associated with them, were “normal”. Individuals would not risk a trade by mortgaging their house to make 1% extra on the notional value. Why would a corporation? Common sense had gone on holiday and failed to ring in to see how things were going. This is directly related to regulations.

3.Executive Compensation - Currently execs are paid in equity. Lots of upside, limited downside. So why not bet the ranch? This compensation could be changed to Junior Subordinated debt. The last bondholder to be paid off in the event of bankruptcy - lots of downside, limited upside. This unfortunately is the way most of the world works, and executive compensation should be no different. Just as old Wall Street partnerships had the partners own capital on the line (which bred conservatism), so to would senior execs think twice about CDOs squared as a product when their retirement gets paid off AFTER this teenager bond trader gets his bonus.
Should equity compensation be eliminated? No way. But to create "ownership", the stewards of the firm need to feel that churning lurch in their stomach at the thought of the company going under.
4.Bank Tier 1 Capital- This should be Junior Subordinated debt. Bill Poole (ex Fed Governor) has been pushing this idea for over a year. A bank must have 10% of its capital in Junior Subordinated debt - the riskiest kind. 10% of this matures every year, so that once a year, 1% of total capital is "voted on" by the marketplace. If this market vote takes place at times of market anxiety (e.g. 10/'08), then the bank either pays up, or decides not to roll over this debt, and reduces assets by 10%. If all banks were subject to this regime, there would be far fewer paroxysms as the market attempts to value the solvency of the firm at 5:30pm Friday night.

It is interesting to note that after the securitised market collapsed in 8/'07, most of Wall Street funded itself through the overnight repo market. While they still strongly deny this, it is widely known that all firms met their overnight funding shortfalls by a "voting" process of other Wall Street firms lending to one another. If a rumor of insolvency was going around, it tended to occur. No overnight repo trader wants his book locked up in bankruptcy court for years.

5.Retain and Promote Progressive Income Taxes - In various economic "games", with all players starting with equal betting pots, one player will eventually win all the chips, and the game ends. Anybody playing monopoly has experienced this. The player with the most assets tends to accumulate more, and can weather runs of bad luck better. What players also notice is that the level of activity declines as one player becomes wealthier, and the game ceases to be interesting.
The real world is no different. Left to their own devices, market "players" will sort themselves in various ways, and if things are allowed to process, there is a winner, and the level of economic activity declines as this level of wealth builds.
Progressive taxation has been shown to be the best "solution" to this phenomena i.e. it does not penalize the winner to the point of dissuading further play, and it keeps the other players in the game through transfer payments. In addition, it increases the relative total level of economic activity, and so generates increased revenues for investment in public goods (infrastructure, human capital, etc).

This is by no means exhaustive - We will continue to ruminate as to how to save the world. Your thoughts on the subject are always appreciated!

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Guest Monday, 25 May 2020