Donnerstag, Dezember 03, 2009

A Modest Proposal...

Niall Ferguson and Laurence Kotlikoff in todays FT make a modest proposal that I'd like to expand on.

Their thinking is quite clear and robust: banks are financial intermediaries, first and foremost. In fact, if you look at how they are described in the industrial classification systems, that is where you will find them, next to insurance companies, stockbrokers and financial advisers.

Their job, first and foremost, is to bring people with money together with people who need money. They earn their money by charging fees for this and by determining risk for those with money when they lend to those who need money, which is then reflected in interest rate differentials between those who borrow money and those who lend money.

And that is all. Nothing more, nothing less: Ferguson and Kotlikoff call it Limited Purpose Banking or LPB for short.

Under LPB, all limited-liability financial institutes - which right now have transferred all liabilities to the general public in an absolutely horrific example of moral hazard gone dramatically, perversely and criminally wrong - become mutual funds: LPB may process securities and sell them to mutual funds, but would be limited to that and no more. First and foremost: LPBs may not borrow to invest themselves, guaranteeing that if investments go horribly wrong, they do not take down the financial infrastructure with them. Which is exactly what came close to happening last year.

These mutual funds aren't quite what we now understand mutual funds to be, but are nonetheless quite close. They would be small banks with 100% capital requirements, no ifs, ands or buts. That is exactly what the current mutual funds are, albeit they are not called banks.

The goal is to create numerous, small, flexible investment instruments that also carry all risks associated with each and every of their activities. This is the key solution to the monumental screw-up of the financial industry in 2008 and 2009, and allows for consumers to choose their risk portfolios easily: high returns, high risks, a modern God of the Copybook Headings if I ever saw one, but one that was grievously ignored (and is ignored in any bubble, indeed forms the bubble itself).

The mechanism for creating instruments would be straight-forward: create the "FFA" or Federal Financial Authority, which would be charged with verifying prospectii, as well as the credit histories, income statements and third-party custodies of fund securities, hiring external rating companies the rate the securities and value their collateral. Hence a bank when processing a loan or stock issue would send it to the FAA for verification, disclosure and independent rating, and then auction it off to buyers, who would be organized as mutual funds. Mutual funds could be aligned with the LPBs in order to offer financial services using cash mutual funds, and insurance mutual funds would permit diversification of individual risks and the sharing of aggregate risks.

This is the point that Ferguson and Kotlikoff end their analysis, and I'd like to extend it.

A number of years ago Germany abandoned one of the most useful tools it had for industrial and investment policies, largely due to a failure in the government to properly work out how to allocate capital effectively. Failure to allocate capital effectively is a cardinal sin of economic policy, and unfortunately the German government threw the baby here out with the bath water.

What had worked brilliantly for many years was tax credits for closed investment funds. Basically, for any investment there is an investment period where an instrument is developed before that instrument generates a cash flow. By allowing large tax write-offs during this period, sometimes in excess of the sum actually invested, the German government had an elegant method of directing private investments in areas that they deemed useful in terms of industrial investment, largely real estate investments. Why was this abandoned?

Basically, they overdid it in Eastern Germany after unification, with much too much money flowing there to be sensibly invested, resulting in misallocation of capital (remember, a deadly sin) as multiple projects were started up that ended up flooding the market with high-cost real estate investments in a low-wage environment, resulting in the loss of equity for many investors.

But not necessarily financial ruin: the investment phase brought very large tax write-offs for current income, resulting in an almost immediate payback due to tax reductions on current income.

How did this work? Simplified, like this: say an investor had a cash flow (income) of $500k/year. Taxed at an average of 30%, that meant paying taxes worth $150k/year. If the investor invested $100k in a closed fund - i.e. a fund where an investor may first exit after a set number of years - he could write off, in the first year, say, 80% of that in tax breaks during the investment phase of the project. That gives him a tax break of $80k, reducing his taxes to $70k, leaving him with $430k in the first year of his investment instead of $350k otherwise. The investment then proceeds normally, with any income earned taxed at the normal rate. Let's stipulate a closed-end fund with a clear exit 10 years after the initial subscription, with an average 6% return on equity after the investment starts producing income.

The nominal return on a $100k investment would be $54k over 10 years (1 investment year, 9 years of disbursement at 6% of equity for $6k*9=$54k). At the end of 10 years the investment object would be liquidated for $90k (for the $100k initial investment), resulting in taxable income of $44k ($100k-$90k = $10k loss in equity). While this is in and of itself a modestly attractive investment, the real key is the tax write-off in the first year: that nominal $44k profit, which would then itself be taxed, really is a $114k profit: there was, after all, that $70k tax reduction windfall. Again, this is highly simplified, but is how the system basically worked.

That makes such an investment instrument highly desirable for high-income, long-term investors.

This can be used by government to direct publicly useful but highly risky investments using private equity to meet industrial and investment policy needs: if the US, for instance, were to decide that it wants a watch industry once again, it would simply change the tax code to reflect this, directing high-income investors into those fields. Such funds could also be set up as cooperatives to allow corporations directly involved to participate in order to acquire productive assets after a set time period. Risk is carried by the investor, who can lose every penny of their investment.

Join the ideas of Ferguson/Kalikoff and the use of tax credits for directing investment activities for industrial and investment policy, and you have an enormously efficient method for governments to achieve policy goals with little or no direct outlays.

The downside?

Of course: governments making mistakes that lead to misallocation of capital. This was the biggest problem with the system, but if the FFA were also able to veto such tax policies to refute the ability of politicians to exploit and corrupt the system, then this can be defused (but not totally eliminated).

Again; a modest proposal. Which would give government enormous leverage on directing private investment to achieve policy goals without having to issue bonds or spend taxpayer monies to do so.

The cost? Foregone tax income. Cheap at the price, I say.

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