Monday, June 08, 2009

Three Perverse Incentives That Sank the U.S. Economy

Three perverse incentives created windfalls of low-risk speculative fraud which have gutted the U.S. economy and led to massive distortions in investment and risk.

This may be a bit extreme, but a law passed in 1997 may well go down in history as the legislation that triggered the collapse of the U.S. economy.

Like all such catastrophic triggers, this law was passed with much hoopla about the great good it would accomplish. Fully 90% of Congressmen/women voted for it. Like all such laws, it had unintended consequences. The law?

The Taxpayer Relief Act of 1997 which raised the estate tax exemption and lowered the capital gains tax rate from 28% to 20%.

The law also created a windfall of $250,000 tax-free profits for each homeowner ($500,000 for a married couple) and did away with the old statute which required the profits to be protected must be reinvested in a new home. Even better (from the industry's point of view), an owner could "flip" their primary residence every two years (as long as it was their primary residence for two out of the last five years).

This law, deeply cherished by the real estate industry, unleashed a tidal wave of perverse incentives which have now mortally wounded the U.S. economy.

The other two incentives were super-low interest rates and lax regulation of the mortgage and mortgage securities markets.

This is not an original thesis; it has been covered elsewhere, such as Tax Break May Have Helped Cause Housing Bubble.

What such analyses fail to grasp is the enormous consequences of favoring housing so overwhelmingly as an investment. As discussed here on Friday inBooms, Manias, Windfalls and Die-Offs (June 5, 2009), "windfall exploitation" is built into all organisms via being selected for as a beneficial trait.

A $500,000 tax shelter available to 60% of the population who owned real estate made it very broad-based, and its enormous size--a half million dwarfed every other tax break or tax shelter available to all but the very wealthy--made it an irresistible magnet for investment money.

Why invest in a risky biotech company when you could reap $500,000 tax-free in just two years-- and then repeat the shelter again and again?

The key problem with this stupendous incentive is that housing is ultimately a form of consumption, not productivity. Rather than incentivize hundreds of billions of dollars to flow into the technologies which undergird real growth, this 100% tax-free shelter on "shelter" perversely insured that trillions of dollars would pour into a rathole of unproductive assets: housing.

Once you assemble the lumber, granite countertops, copper wiring, etc., the house is an unproductive capital trap unless it generates rental income. The jobs it creates after assembly are minimal, as it requires modest maintenance and only occasional repair.

The only way housing generates profits after the assembly is if it is churned via frequent sales transactions, a.k.a. "flipping." Magically, the Greenspan era's super-low interest rates and the Clinton/Bush era's hands-off approach to regulations (tear down important limitations on greed and fraud and gut the staff of the remaining watchdog agencies) added gasoline to the perverse incentives to invest in housing.

Here's the other point which has been under-reported: housing is not just an industry, it is the bedrock of middle-class wealth. So by incentivizing investment in housing to the exclusion of other investment options, the law not only funneled funds away from productive investments but it enabled a stupendous bubble in housing which in turn created a "windfall" of equity appreciation which homeowners could not resist.

Exploiting the windfall was easy: just re-fi and/or HELOC the "crib" until the equity was drained. Your friendly neighborhood mortgage broker (23, just "graduated" from the car wash down the boulevard) was able to massage your income higher, or dispense with any documentation entirely, while arranging for his pal the appraiser to "juice" the value of your home.

And don't worry--the increase in housing prices next year would replenish the "spring" of equity to be tapped.

The penalty for getting caught in such fraud? None! Zero! Not only was nobody looking, but nothing happened to those who did (perversely) manage to get caught or noticed. So with no disincentive (punishment) in place and every incentive to run the fraud as fast and hard as possible (churn, baby, churn), then what else could possibly happen but what did happen?

An unprecedented frenzy of fraud was unleashed.

The third point which remain under-appreciated is that the securities industry/investment bankers noticed that this ballooning asset was "rock-solid safe" and basically zero-risk; after all, housing never went down, it only hiccuped a bit before re-starting its inevitable rise. They're not making any more land, the population is growing, etc.

Compared to riskier securities based on corporate income or currency swaps, mortgage-backed securities and derivatives based on them were a security-writer's dream: here was an asset class which was so low-risk, any amount of risk could be loaded on it and sold as safe.

Thus the perverse incentives of the land-rush into housing as a "safe" tax-sheltered investment haven quickly spread to the global securities market.Say you're a pension0-fund manager in Europe or Asia; interest rates are so low that traditional "safe investments" like bonds are providing abysmal returns. So the sales guys present you with a high-yielding derivative based on a pool of mortgages from California.

Hey, what's not to like? Hollywood, Silicon Valley--these were rock-solid winners. Housing was rising like a hot-air balloon, and this yield was much better than any other--and so low-risk! If you could beat the standard low-risk return even by a point, you'd be a star. So you go for it with virtually no reservations--after all, the issue was rated triple-A by a U.S. ratings agency.

Thus the three perverse incentives distorted not just the U.S. housing market but the entire global economy. With housing down 40% and a bottom nowhere in sight (unless you're being paid to pump out propaganda for the Treasury or real estate industry), the middle class is reeling from an unprecedented destruction of wealth: some $13 trillion has been lost in housing and its dependent cousin, the stock market.

With corporate profits ultimately dependent on a free-spending consumer funded by the extraction of home equity (the same also true in Ireland, Spain, et al.), the stock market's collapse was inevitable. Despite the manic 24/7 propaganda about "green shoots," it is easy to predict that consumption is crippled for a generation: utterly reliant on easy cheap credit and housing appreciation, the U.S. consumer is now hobbled with high debt, falling appreciation and the destruction of his/her wealth and confidence in future wealth.

With the "low-risk" housing market destroyed, the securities markets have also been destroyed.

Unfortunately, the mis-investment of trillions of dollars has already occurred. Trillions that might have funded productive assets and research-development have been squandered, and now a massively indebted U.S. citizen and government are facing the unenviable prospect of actually having to save up the trillions needed for productive investment.

The feckless, irresponsible leaders of the U.S. government are attempting to paper over this reality with an unprecedented orgy of new debt. (Let's borrow $2 trillion a year until things get better--but wait--how can they get better when interest rates are rising due to our stupendous borrowing, and as a result we're paying $1 trillion a year in interest?) This effort to replace housing-bubble fueled consumer spending with government spending will fail, especially since much of the "stimulus" went to protect the financial Plutocracy from it's own self-inflicted losses.

The way out of the hole is obvious: eliminate perverse incentives and incentivize savings and investment in productive assets. Get rid of the housing tax shelter entirely and the mortgage interest deduction above $50,000 a year. Eliminate the perverse incentives to dump trillions in unproductive capital traps, incentivize saving over debt-based consumption, and maybe the U.S. economy can heal itself before the final implosion becomes unstoppable.

A few titles worth borrowing from your local library:

The first chapter of The Future of Life is the best short piece written on China in the past decade. Academic studies loaded with statistics on China's GDP, etc. miss the point: China is facing environmental collapse, sooner rather than later. Quantitative financial data cannot possibly capture this as the environmental data points are lacking/massaged for political purposes. The economy is not some free-floating entity disengaged from the rivers running dry.

On Peak Oil:

Beyond Oil: The View from Hubbert's Peak

The Party's Over: Oil, War and the Fate of Industrial Societies

The End of Oil: On the Edge of a Perilous New World

Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy

On chemical/toxins overload:

Our Stolen Future: How We Are Threatening Our Fertility, Intelligence and Survival

On the demographic time bomb about to explode:

Fewer: How the New Demography of Depopulation Will Shape Our Future

The Coming Generational Storm: What You Need to Know about America's Economic Future

On collapse of advanced civilization:

Collapse: How Societies Choose to Fail or Succeed (Jared Diamond)

The Collapse of Complex Societies

A realistic appraisal of alternative energy:

Sustainable Energy - Without the Hot Air

Our previous lists of hot reading and viewing can be found at Books and Films.

Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle

Of Two Minds reader forum (hosted offsite, reader moderated)

Thank you, Peter J. ($25), for your extremely generous contribution to this site. I am greatly honored by your support and readership.

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