When the course of civilization takes an unexpected turn -- when, instead of the continuous progress which we have come to expect, we find ourselves threatened by evils associated by us with past ages of barbarism -- we naturally blame anything but ourselves. Have we not all striven according to our best light, and have not many of our finest minds incessantly worked to make this a better world? Have not all our efforts and hopes been directed toward greater freedom, justice, and prosperity? If the outcome is so different from our aims -- if instead of freedom and prosperity, bondage and misery stare us in the face -- is it not clear that sinister forces must have foiled our intentions, that we are the victims of some evil power which must be conquered before we can resume the road to better things? However much we may differ when we name the culprit -- whether it is the wicked capitalist or the vicious spirit of a particular nation, the stupidity of our elders, or a social system not yet, although we have struggled against it for half a century, overthrown -- we all are, or at last were until recently, certain of one thing: that the leading ideas which during the last generation have become common to most people of good will and have determined the major changes in our social life cannot have been wrong. We are ready to accept almost any explanation of the present crisis of our civilization except one: that the present state of the world may be the result of genuine error on our own part and that the pursuit of some of our most cherished ideals has apparently produced results utterly different from those which we expected. -- F.A. Hayek, The Road to Serfdom
I had originally set out to write on the whole
complaint, which although it sounds titillating and salacious I believe has very little merit, but instead started thinking about this rush to find a culprit for the whole financial crisis. Shouldn't we be thinking a little more broadly?
So we have a 1,300-page piece of legislation that is supposed to cure all our ills (and don't get me wrong, I argued over a year ago that what we needed was not necessarily more regulation, but certainly more thoughtful regulation), but will it be any different if we fail to acknowledge the real elephant in the room?
I use the following quote from Hayek's
The Road to Serfdom
, not as a comment in defense of individual liberty (although I am sure it can be interpreted as such), but because of the point it makes with regards to looking within some of our most cherished ideals to truly get a better understanding as to how we got here.
It feels good to pin the blame on someone for all our problems, but the fact is we all share some culpability. I have long argued that Wall Street was one link in a very long chain -- from real estate agents to mortgage brokers to appraisers to nonbank financials to rating agencies to ABS buyers who needed yield to the home buyer who bit off a little more than he or she could chew. But rather than focusing on a single link, maybe we need to stop and ask: How did this chain come into existence in the first place?
The answer is that we not only have a culture that embraces leverage, but we have a tax and accounting regime that further incentivizes leverage. This isn't a particularly inventive thought on my part, for example, my good friend Michael Lewitt at HCM has spoken about this for ages, but maybe it's time has finally come. We have created a monster that shapes all of our lives. Corporations deduct interest payments, but dividends are double taxed. We have the mortgage interest deduction to promote the "American Dream" (nightmare?) of home ownership.
Everywhere you look, debt is favored over equity. Is the most recent crisis not simply the natural outcome of this ongoing policy (or should I say, "policy error")? Leverage leads to volatility, and volatility to instability. And you don't need to just look at the housing crisis, take a look at the various cycles of LBO booms and busts. Would these have reached the same magnitude if we didn't tax-favor debt?
It is a little disingenuous to rail against the obscene leverage that the banks had while turning a blind eye to policies that helped create the incentive societywide. As any economist will tell you, incentives matter. So shouldn't we look at the incentives we have put in place?
I am not suggesting going cold turkey on these tax matters, but maybe it is worthwhile to think of phasing out perverse debt-vs.-equity inducements. We could gradually step down the mortgage interest deduction over a 15- to 20-year period so as not to create a shock to housing. I know people will scream that this would wreck home affordability (not to say the debt bubble and subsequent burst didn't already), but this isn't as horrible as it sounds on the surface: If fewer people on the margin decide to take out mortgages, supply/demand means rates should be lower for those who do. And if you phase the deduction out over 15 to 20 years, that should not adversely effect mortgages currently being originated, given interest as a percentage of payment is much heavier in the first half of a level payment system.
I could make a similar argument for corporate leverage as well. Maybe it is a cap, rather than a complete repeal of interest deduction, but the principle is the same. Less levered companies could lead to more stability in the economy. And shareholders aren't particularly well served by all of a company's free cash flow going to debt service anyway.
Such a sweeping change also should have the side benefit of radically simplifying our tax code -- which helps eliminate excessive lobbying interests, closes loopholes, etc. And with fewer deductions, tax rates will come down. Right now the leveraged company (or individual) gets a tax subsidy at the expense of the less-levered company (or individual). It always cracks me up when people argue the tax benefits as a reason to take on debt. We are subsidizing those who take on more financial risk -- not just in the banking system but societywide! You want a tax break? Give to charity. (In my perfect world, the only deduction would be for charitable contributions.)
M&A should be determined by business synergies and thoughtful business plans, not a tax-incented capital structure.
This isn't the end of leverage. People and companies will still employ leverage when it is sensible; we just don't need to incentivize the use of debt for nonsensical purposes. Folks can always find a way to hang themselves, we just don't need to hand them the noose.
The most brilliant analysis I have yet heard of this current crisis took place more than 20 years ago. The speaker was Arnold Weinstein, a professor of comparative literature at Brown University, in his course on "The City and the Arts." He was talking about the evolution of cities from trading outposts to industrialization to the modern corporate city that largely processes information. He made the analogy to technology: the steam engine to the combustion engine to nuclear power. He furthered the analogy socially -- which is really the stroke of genius here: "We have moved from barter to money to credit ... or at its most base level from being to having to appearing."
We have the appearance of doing something with this financial reform, or with trying Goldman in the court of public opinion. Maybe it will do something helpful; maybe it will be a waste of time. Rather than the appearance of getting things done fast, we should really think of getting things done right. That starts with introspection.
Author's Note: I know some will feel this is a political writing and may use this to champion their cause, whatever that may be. Truth be told, I am a bemused independent -- bemused because I currently have my choice between two parties. We have one party that champions economic liberty but turns its back to social liberty, and the other party is just the opposite. This is why I believe the outcome of the 2012 presidential election will be determined by an independent candidate who will force a sense of reality onto the two main parties. (Hey, maybe I could run. Oh wait, I used to work at Goldman.)
At the time of publication, Oberg was long Goldman Sachs
Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.