fee would be paid by large bank holding companies that engage in risky activities beyond traditional banking

TO BE NOTED: From the NY Times:

‘Too Big to Fail’ Policy Must End, F.D.I.C. Chief Says

Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation, is adding to the debate over what may be the largest overhaul of the nation’s financial rules in decades.

In an interview on CNBC Friday morning, Ms. Bair said a main priority was ending the “too-big-to-fail doctrine” — the idea that a financial institution can become so large and interconnected that it must be propped up at all costs — and called the Obama administration’s proposed regulatory changes an “opening in the process” toward that goal.

She said she wanted a seat at the table in redrafting banking rules and reiterated her support for higher insurance fees for large banks that take big risks, an issue that has been a sore spot between her and John C. Dugan, the comptroller of the currency.

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As the insurer of $6 trillion in bank deposits, the F.D.I.C. should be included in the decision-making process, Ms. Bair said Friday, especially when it comes to dealing with risks to the entire financial system.

“We would obviously like a seat at the table in decision making on systemic risk,” she said. “The F.D.I.C. has tremendous exposure to the system.”

Ms. Bair is seeking to create a separate insurance pool, similar to, but separate from, the deposit insurance premiums the F.D.I.C. currently collects from banks, which would be designed to curb systemic risk. The fee would be paid by large bank holding companies that engage in risky activities beyond traditional banking. Ms. Bair mentioned proprietary trading and over-the-counter derivative trading as two examples of activities that could warrant the payment of the new insurance fee.

Ms. Bair said the fees would create economic disincentives for banks to take on more risk and grow to a size that would make them too big to fail, thereby posing a risk to the whole financial system.

She also said that she is not likely to continue in her role at the F.D.I.C. past her five-year term, which ends in 2011.

“I am very much looking forward to getting back to more sane hours and more time with my family,” Ms. Bair.

– Cyrus Sanati"

"a tax break for homeowners, enacted in 1997, may have contributed to the housing bubble"

An interesting post from Start Making Sense about the power of incentives:

"Perverse satisfaction?

Today's New York Times notes that a tax break for homeowners, enacted in 1997, may have contributed to the housing bubble that (coupled with pathological defects in our financial markets) did so much to bring us to our grim current economic situation.

Specifically, Congress in 1997, acting at the behest of President Clinton, provided that up to $500,000 of home appreciation would be tax-free on sale. Clinton was practicing silly but no doubt poll-tested populism, boasting that, due to the rule, middle class Americans would never again face capital gains tax on their homes. ( WHY SHOULD IT BE TAXED? )

Now let's roll the tape forward 11 years. According to the Times:

"[M]any economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law. ( WHY DO WE WANT A DISINCENTIVE TO SELL? )

"Vernon L. Smith, a Nobel laureate and economics professor at George Mason University, has said the tax law change was responsible for 'fueling the mother of all housing bubbles.' ( HOW SO? )

"By favoring real estate, the tax code pushed many Americans to begin thinking of their houses more as an investment than as a place to live. It helped change the national conversation about housing. Not only did real estate look like a can’t-miss investment for much of the last decade, it was also a tax-free one. ( HOMES ARE AN INVESTMENT. THAT'S WHY I BOUGHT MINE, PRIOR TO THIS CHANGE IN THE TAX CODE )

"Together with the other housing subsidies that had already been in the tax code — the mortgage-interest deduction chief among them — the law gave people a motive to buy more and more real estate. Lax lending standards ( THIS IS THE CAUSE. THE OTHERS ARE SILLY ) and low interest rates then gave people the means to do so ( IF THEY COULD HAVE AFFORDED THE HOUSES, WHO WOULD CARE? ).

"Referring to the special treatment for capital gains on homes, Charles O. Rossotti, the Internal Revenue Service commissioner from 1997 to 2002, said: 'Why insist in effect that they put it in housing to get that benefit? Why not let them invest in other things that might be more productive, like stocks and bonds?'” ( WHY SHOULD ANY INVESTMENT BE TAXED? HELLO! )

I happen to know a couple of people who got into the business of buying fixer-uppers, doing renovation work, and then selling for tax-free capital gain, thus achieving exemption for their labor income. There, at least, there was productive activity - but still distortion of economic choice by the tax incentive. ( THE TAX INCENTIVE WASN'T AN INCENTIVE. THE TAX WAS A DISINCENTIVE THAT WAS TERMINATED )

One further idiotic incentive effect was that, as soon as your home begins to approach $500,000 of appreciation, you have an incentive to sell it immediately and buy a new home for the current market price, so that you can run the exemption from zero all over again. Happily (?), however, that is no longer a problem in today's market.

Whenever something like this comes out about special tax breaks that don't merely create perverse incentives ( WHAT'S PERVERSE ABOUT IT? ) but seriously aggravate major economic problems, I have to admit to feeling a twinge of, well, perverse satisfaction that the rules I spend some of my time studying are at least important. Plus I duly note that the problems come from failure to heed the recommendations (e.g., for a relatively broad-based and neutral tax ( WHAT DOES NEUTRAL MEAN?) ) that nearly 100 percent of the experts in my field would make. An unworthy sentiment, to be sure, but I'm only human.

Another big example is the role of the tax system in overly entrenching employer-provided health insurance as the dominant mode of provision ( THAT IS BAD ), to the degree that, while few would advocate building on employer-provided insurance if we were starting fresh, many believe that at this point we need to just accept it as an entrenched feature. Thus, for example, one of the big criticisms of Senator McCain's healthcare plan was that it would have undermined employer-provided insurance without sufficiently putting something else in its place.

The home exemption story is admittedly a bit more complicated than just being a case of stupid Clinton-era populism. Prior to the 1997 enactment, people could generally roll over gain when they sold one home and bought a new one (for at least as much money) within a two-year period. Plus, gains on home sale were otherwise taxable ( WHY? ) while losses were nondeductible ( WHY? ), creating apparent (and some actual) tax bias. The underlying problem is that a "correct" approach would have treated gains and losses symmetrically (leaving aside the issue of taxpayer choice whether or not to sell) when they resulted from market swings, while disallowing recovery only for declines in home value that resulted from home use. Richard Epstein, before he became a libertarian icon, actually wrote an article on this, suggesting that the basis of homes be reduced by depreciation (which would not, however, be deductible since it reflected personal rather than business use), with gain or loss relative to the adjusted basis being equally recognized. That is actually a pretty logical approach, within a standard income tax accounting framework, and the failure to do it, meaning that in some cases properly deductible investment losses were being disallowed, may have helped contribute to the 1997 silliness.

Still, the predominant message here remains: stupid tax breaks interact with other defects in our economic system to help create the current horrific circumstances we face. It's happened before, and it will happen again."

How did it do so? There is no connection between tax breaks and fraudulent or ill-advised loans. None. Why was the sale of the house taxed in the first place? It's a terrible idea that causes a disincentive to buying and selling. Why? The idea that it lead to the current crisis assumes a mechanical view of human behavior, which is clearly false. Under a Human Agency Explanation, it is the committing of fraud, negligence, fiduciary mismanagement, and collusion, along with idiotic loan terms that caused the crisis, not any incentives.

"If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes."

Brendan Brown in the FT confronts this buying of basically interest free bonds:

"A conundrum has long been known to monetary economists, but only comes into the open during the once in a quarter-of-a-century type of recession apparently plaguing the global economy.

The quandary is how, in a conventional monetary economy, to bring interest rates down to the negative levels essential to speedy recovery during periods when there is a sharp decline in spending propensities.

If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes.

The interest rate under discussion is the risk-free nominal rate as quoted on short-maturity government bonds, most obviously US T-bills or short-dated German government bonds.

Over the course of decades, particularly during the Japanese “lost decade” of asset deflation, suggestions have emerged as to how to solve the conundrum."

So, you want interest rates to decline so that businesses, say, can borrow more cheaply, and hire workers, etc., in order to increase buying, and come out of a recession. But what happens when no one is buying and yet interest rates are as low as they can get.

Well, are there any incentives or disincentives to combat this problem, largely associated with the fear of risk and flight into safe investments, such as US Treasuries, that are guaranteed by the government? Now, it's important to understand that this is also an incentive.

One thing you can use are disincentives. Here's one:

"These include the periodic stamping (for a small fee) of banknotes (without the stamp they would not be valid). The idea is that by imposing a running tax on banknote hoarding, nominal risk-free rates could fall to negative levels."

So, this a purchase fee added onto the bond. How about taxes?

"In the age of the information technology revolution, surely the authorities could devise a simple and practical method of effective taxation of banknote hoards?

There are two cues to a practical method of taxing notes. The first comes from what happened during US financial crises in the 19th century.

Banks under stress of cash drains (depositors withdrawing funds) suspended temporarily the 1:1 link between cash and deposits, so their notes sold at varying discounts. The second comes from the launch of the euro; a conversion of old banknotes into new.

These cues lead to the solution."

Basically, change their price after being purchased.

"The relevant government would announce that existing banknotes were to be converted into new notes at a fixed date, say three years from now, at a discount (for example 100 old dollar banknotes would be converted into 90 new).

In the interim, 1:1 conversion of banknotes into deposits would be suspended. Instead, a crawling peg would be established. At the start, the exchange rate between deposits and banknotes would be virtually 1:1. At the end it would be 0.9 banknotes/deposit.

As the discount grew, retailers would quote different prices for cash or cheque/card settlement. And as to the note switch-over costs, the “experiment” of Europe’s economic and monetary union demonstrates the feasibility.

The looming conversion would provide an essential degree of freedom for monetary policy. In terms of our illustrative arithmetic, the risk-free interest rate could fall to a negative 3.33 per cent a year without triggering cash withdrawals from the banking system."

As time goes on, the bond becomes worth less, making it a less desirable product.

"Is the exercise worth it?

The main reason for believing it is stems from an appreciation of how the bursting of a global credit bubble influences the equilibrium level of risk-free interest rates relative to risky rates of return and in absolute terms.

Most of us would agree that the bursting process ushers in a period during which soberly-measured risk premiums increase sharply.

This means that the risk-free rate must plunge to be consistent with an average overall cost of capital which reflects the new glut of savings.

So, in terms of our illustrative arithmetic, it is plausible that the neutral risk-free nominal rate of interest in the US and Europe, especially taking account of a likely near-term drop of the price level, is significantly negative.

The central bank and government, by devising a system in which such negativity can express itself, can give a big fillip to the recovery process.

The most direct channel for this fillip most likely passes through the equity market.

Pervasive negative risk-free rates across the advanced economies would underpin equity market levels.

Investors faced with certain substantial nominal loss on risk-free holdings would bid up the price of equity which could offer rich risk premiums even at a presently feebly level of prospective earnings.

And it is equity market developments which hold the key to the economic recovery."

As these looming losses approach, investors will shift from the bonds to stocks, spurring investment and new business and job growth, and I suppose there will be a kind of wealth effect as well.

"As consumers across the globe retrench, the forces of equilibrium should (if not thwarted by zero rate traps) bring about a redistribution of economic output, away from the production of consumer goods and towards capital goods (including technological know-how).

A higher rate of business investment matched by lower consumption now will have a counterpart in higher-than-otherwise consumption in the far-off future.

A resilient equity market with its counterpart in a low cost of equity capital is the key motor behind that transformation.

Firms across much of the global economy would respond to the combination of squeezed profit margins, low equity capital costs and continuing technological progress by “capital deepening” (increasing the ratio of capital to labour).

That would mean a challenging increase in frictional unemployment and pressure for increased social insurance of the losers.

Losses and losers are an inevitable consequence of the big credit bubble which is bursting. In the equity markets these losses reflect swathes of now obsolescent capital stock in the wrong place at the wrong time.

The key to rapid progress towards re-building wealth is to nurture the golden egg of the equity market, in which the coming capital spending upturn will be financed and to minimize monetary disequilibrium in the meantime.

The scheme proposed here for sharply negative interest rates promises much on both objectives."

So, basically, if investors do shift from bonds to stocks ( Or buy corporate bonds, I suppose )

1) Businesses will borrow ( Spending on capital goods, building things )

2) Creating jobs

3) People will spend more

4) The economy will grow

What's with the Golden Egg? It's been used now by McTeer, Becker, and Brown.

Will this work? I have to admit to liking it, because it involves using incentives to refocus the look of risk to the investor. And I believe that combating fear and aversion to risk is the main problem facing us.