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Financial System Safety and Resilience Policy

2010/10/13

Our aim at the CAS this October is to increase the diffusion and dissemination of whole-system wicked problem assessment and action across safety-reliability-resilience in varying settings.  The first post tackled taking risks to improve the safety culture in high-consequence industries.  The next post examined safety, quality, and productivity as parallel processes in the chemical industry.

[Edit note:  copyedited post for clarity—see policy 4 at “Rebalancing” and at its two bullets]

My blog post today aims at growing the economic safety of the US by addressing key steps to take to achieve and sustain system-wide safety and resilience in US financial system operations as a resource reliably able to benefit the US economy in its global context.  The resulting better basic framework of laws and cultural norms grounded in economic safety and resilience will yield a more effective and sustainable US economic and financial system.

The premise of today’s post is that a smaller number of basic framework laws and rules can yield a more effective, safe, and resilient economic and banking system.  Piling on rules to “do this” and “don’t do that” absent a safety and resilience framework is counterproductive.  A myriad of banking rules taken apart from an intentional economic safety context does not make the overall banking system more resilient or productive in mobilizing financial resources to benefit the US economy.  A friend who set up a bank in California some 10 years ago discovered his monthly all-day board meetings ran to 4pm on regulatory matters.  The regulatory workload limited the time available for business issues such as bank management, operations review, and growth strategy.

The work place vignette for management reality in a small bank provides context for the major changes taking place in finance, banking, and the economy.   As background, see a recap of recent contributions to long-term trends across several decades leading to the fiscal policy profiles now in effect.

Context for this post

This post is not intended to assess Federal Reserve efforts to run monetary policy.  First, the Fed does not control the fiscal policy made by Congress and the President.  Second, it cannot control corporate self-interest, to which the Supreme Court recently gave leverage for a new corporatist hegemony funded by business and (to the extent it has money and members) by labor.

This post looks at the ability of the current banking system safely to apply the cash flowing into the financial sector.  A key problem is that a banking culture grounded in absolutely maximizing leverage from massive cash flows is distorting banking system safety and resilience.   The rampant and self-referent leverage culture will not adjust until financial sector profitability is reduced and until fiscal policy restores more balanced US personal income flows grounded in a US economy that is both more labor-intensive and more manufacturing intensive.  The goal is to dampen the financial sector’s ability to nurture an unsafe leverage culture.

The last several decades tell the story.  In the mid-1980s, finance earned some 15% of corporate profits, but by the 2000s it reached 40%.  Financial sector pay rocketed from the US midpoint in the 1970s to 80% above the US midpoint by 2007.  The outsized profit and pay have redrawn financial and corporate culture as a winner-take-all gaming scenario.  The bank sector’s appetite for gaming increases systemic risk without adding to economic safety, quality, or resilience.

What’s the reality?

The valid assertion that global trade adds value has been sucked dry for the middle class and the working public by the financial market imperative for companies to report higher earnings, no matter how achieved.  In the face of US labor laws regarding child labor, minimum wages, work week hours, work place safety, retirement safety nets, and legal labor unions, the fastest way to maximize short-term dollar global value seemed two-fold…

  • Employ comparatively low-wage workers elsewhere (rather than make stuff here and then sell in US and global markets), and
  • Fund US imports and government debt by leveraging our reserve currency status to sell our trade and government debt to the overseas nations now housing the bulk of the world’s workers.

The export of jobs initially affected manufacturers.  In recent years, with the web and good global communications, both prosaic services and highly value-added services are rapidly shifting offshore.  The high earners then convinced the public that if all taxpayers including the top payers got tax cuts, there would be more money at the top to create new firms and to hire more US workers.  That canard is savagely self-serving baloney.  Ever since deregulation from the late 1970s and early 1980s, when labor unions, progressive taxes, and financial regulation fell out of favor and the global shift to offshore manufacturing hit high gear to boost corporate earnings, the inflation-adjusted “real” wages for most US workers has flatlined, except for the top earners.

Does this affect me?

There is financial pressure to cut costs due to global competition impacting profits. As a result, a major part of productivity gains (output per person per unit of time) has not been shared with labor’s take-home earnings.  Flatlined wages mean that the increase in productivity has accrued primarily to capital and, for complex reasons, to health care.  Thus the ability of workers to sustain consumer spending by borrowing has been underwritten by – yep – the financial sector, which was happy to lend money on the value of consumer assets, such as for their homes, or for payday cash by lenders who willingly treat low income payday cash as an asset.  Meanwhile, unsustainable debt-supported consumer demand in the 2000s drove a rising import flood fed by the move overseas by the manufacturing response to financial market calls for ever-rising profits.

Financial sector behavior may sound slick, but it’s not really a grand plan

The last several decades simply reflect widespread efforts to grab more and more.  As costs rose while income growth slowed for many, the need to make and seek more and more loans has increasingly deeply affected firms, bankers, and consumers alike (note the quadruple role— consumers are also borrowers, taxpayers, and workers).  Bankers led the charge, called the tune, and played the fiddle, but they weren’t alone.  Everybody was happy to ignore unintended impacts (negative externalities) from the cultural and policy choice to do more and more with less and less, always right now.

Seeking more with less on a continuing basis without considering side effects has affected banking and business behavior.  Today long run externalities from a constant short run focus (climate change, economic blight, infrastructure collapse, fisheries collapse, less healthy eating habits, water pollution, farmland exhaustion, etc) are coming home to roost, even as the Baby Boom population bulge begins to hit retirement age.  The resulting current spending on Social Security, Medicare, Medicaid, Food Stamps, and unemployment support is not a plot by a wildly out-of-control government to accumulate national debt in a bid for power and influence.

It will not repair the economy to reduce consumer buying power by slicing Social Security, Medicare, Medicaid, and unemployment support on the premise that US debt is too high and government is too big.  Asking more folks to live under bridges is not positive policy.  That’s the stampede mentality since the late 1970s that brought us 35 years of deregulation and the “Morning in America” program – it sounded so easy – we just release ourselves from taxes, and also from systemic responsibility.

The more recent idea that a rebound in housing construction will save us also sounded good – but wait – if consumers have low wage jobs, they can’t sustain mortgages, pay taxes, or retire the rollover credit and dubious mortgages that banks extended until the later 2000s by giving away high-interest credit cards and making quickie home loans.  The US economy can’t underwrite corrected mortgages and necessary bankruptcies absent reliable cash flows.  We need fiscal-financial policies grounded in systemic safety-resilience operations.  Let’s take a look…

1. Break up financial oligopolies

Reduce financial sector profitability by separating commercial and investment banking.  The goal is to blunt the incentive for combined commercial-investment banks to engage in systemically dangerous leverage strategies.  Banks sought and got Congressional approval in 1999 to combine commercial (lending) and investment (securities) banking.  The overextended leverage strategy has two parts.

First, money center and retail banks carry out the legitimate commercial banking role of creating circulating money from fractional reserves based on customer deposits.  This is the positive benefit of a commercial and retail banking system.

Then, investment banking activity kicks in to fund transactions and take positions in the securities and money markets.  The problem comes when too-large-to-fail banks use funds including balance sheet borrowing to make insurance bets on price movements in derivatives and insurance vehicles aimed at debt instruments, futures, and financial indices.

Reasonably leveraged bets on price movements can help stabilize financial markets.  But when leverage is pushed to the point that covering bad large bets drains bank system cash and critically reduces public confidence in financial institution stability, the lure of investment insurance jackpots has three critical effects—

  • Jackpot thinking distorts the investment banking focus on funding long-term financial and securities markets and the retail banking focus on transparent and fair credit and interest practices.
  • Jackpot thinking creates uncertainty among borrowers as to bank relationship reliability and stability that induces a reduction in borrower and bank-to-bank confidence in ongoing access to reliable short-term credit and working capital.
  • Jackpot thinking generates complex instruments that confuse banks themselves as well as borrowers and issuers, making markets less safely transparent and destabilizing US growth.

The resulting loss in financial and economic confidence reduces the demand for commercial banks to make business and commercial loans.  Cash stops moving.  The underlying issue is the gun slinger mentality of winner-take-all in the untethered investment bank cadre dominating the service mechanics of commercial and retail banking.  A financial sector operational connection story is here.

2. Break up energy oligopolies

Energy becomes a money issue if energy can shift away from high-cost carbon-based impacts.  The necessary policy is to drop the oil depletion allowance, tax all forms of carbon energy, and rebate the carbon tax monthly to human persons (not to legal fiction corporations).  Rebalanced relative energy prices will reduce demand for carbon-based fuels.

The more realistic pricing framework also will accelerate non-carbon energy at lower subsidy levels than have been needed absent rebalanced energy prices.  The targeted rebate will cushion consumers through their energy transition.  Carbon tax efficiency is noted here by EXXON CEO Tillerson, and a working example is noted here.

3. Create countervailing policy voices for income and health strategies

Empower union membership formation to bring more explicit and effective voices into a systemic income distribution dialogue between capital and labor.   As a related matter, connect the health care dialogue with the realization that a healthy population and work force are strategic keys to improve comparative advantages in labor productivity (see here and here) and the wages enabling the consumer demand leading to job growth.

Health as an economic safety and resilience asset requires systemic community voices focused on health care changes outside the insurance sector to improve the overall health care safety and resilience delivered to the US population.  Systemic health care action around safety and resilience can influence patient and provider behaviors by enabling risk assessments, healthy behavior credits, an active medical safety culture, and regional experience-based “cost-outcome path” payment strategies.

At the hands-on level, drop emerging requirements for Nurse Practitioners to have PhDs, specify and enforce national data standards for interoperable health records (i.e., only publically fund health record efforts that meet strong US interoperability data standards to be defined for medicine), enable direct sharing of hands-on skills and knowledge by local and remote expertise centers and medication management, and reduce health practitioner costs by modifying tort law and by funding health training for primary care doctors, dentists, nurses, and for critical specialists.  The results include growth in regional and US comparative advantages in health, health cost, and labor productivity, enabling jobs and wages.

4. Address significant US income inequality

Addressing systemic US income inequality is not class war – it’s a necessary fiscal policy to rebuild the sustainable (wage-based) buying power of the middle class and working public.  Sustainable consumer buying of foods, commodities, and durables represents the stable US mass market for non-luxury goods and services.

The consumer process depends on widely shared and stable household earnings.  However, today the top 1 percent of households captures over 20 percent of all US pre-tax household income, and its income grew 10 times faster than the bottom 90 percent of households during 2002-2007.  The policy argument for fairness, equity, and economic stability depends on having a significantly broad-based society in order to deal with widely shared challenges such as infrastructure, domestic production, pollution, education, health, retirement, defense, land use, agriculture, urban sprawl, transportation, energy, and basic research.  The current income distribution is not broad-based.

Dealing with shared issues at a US scale requires at least restoring the 2001 marginal tax rates for $250,000 and up, while continuing the 2001 and 2003 tax cuts for incomes below that point.  Protecting the middle class from tax hikes while taxing the truly well off on a more meaningful incremental basis (such as incomes over $1 million, and additional brackets above that) is good policy for any time, including our times.

Rebalancing sales taxes as well as income taxes will add to the economic system’s safety— reduced sales taxes and middle and low income taxes (funded by higher upper income taxes and luxury taxes) will help average consumers pay slightly higher prices for US-produced goods and services.  Why is that important?  US output drives US jobs.  Toward that end, adding several high-end marginal brackets to the Federal income tax code, continuing the low taxes below $250,000, and increasing low income tax credits, combined with increasing Federal transfers to states, will help offset highly regressive state sales and property taxes.

As a complementary strategy to rebalancing sales and income taxes, the widespread safety and resilience culture discussed in the first two posts this month was shown to reduce costs in US manufacturing and services while growing sustainable domestic productivity and thus work force (consumer) wages.  Sustainable consumer credit and buying, resulting in business investment spending and government infrastructure spending, drives the retail, wholesale, transportation, manufacturing, construction, service, and financial sectors and their overall jobs and wages.

Resolving significant income inequality also addresses a systemic core of US economic safety and resilience.  High incomes don’t exist in a vacuum.  The whole US workforce and US infrastructure combine to create an overall US economic framework.  The entire US framework enables the cash flow for any incomes, including top incomes, to exist in the first instance.  Therefore the system must accommodate two factors that operate in tension together—

5. Income inequality continued—tax unearned income

As an important step to address income inequality, include “unearned” income with earned income (wages, salaries, tips, bonuses) in determining overall income subject to US income taxes.  Modify tax brackets and expand income averaging safeguards below $250,000 for the more complete taxable income definition in order not to increase middle and low income tax bills, and also not to impact middle and low income seniors living off the interest from their savings.  To ensure safe and reliable state and local government operations, continue to support state and local government bonds with favorable tax treatment.

Interestingly, taxing interest and similar income is not a survival problem for most high-income people.  If a household is pulling in $250,000 or more each year, especially if the interest income portion is calculated on a rolling three-year basis (to avoid harming households with one-time lifetime windfalls), that level of annual income will enable the household to pay higher taxes on that part of its income over $250,000.

6. Fund college tuition

As a practical step, use some of the incremental US tax revenue from rebalanced taxes to fund college and vocational tuition, the same as is recommended for health training in item 3, Create Policy Voices.  Tuition funding handles a key expense for households with college-age children or grandchildren.  By funding college and vocational tuition, the taxing of interest income as well as earned income for high income households will help increase the likelihood that the economy can benefit from access to college and vocational education.  That’s a generational idea that supports long term economic safety and resilience.

Next up: Clarissa Sawyer will provide a summary and synthesis for the safety-reliability-resilience confluence across the October posts, including her spin on framing safety as networks of caring social relationships and treating the Earth as a living bio-social system.

6 Comments leave one →
  1. 2010/11/16 7:50 pm

    Hi David,

    I saw your posting at Juliet Schor’s Plenitude and came over to have a look. All of your proposed reforms are well taken but I think there is a prior reform that is even more urgent and that is re-establishing the purported measure of national income, GDP, on an appropriate social accounting framework. The GDP is by definition a social accounting indicator but in practice it deviates from that function due to what Dutch economist Roefie Hueting calls “asymmetric entering”. What that means is that environmental deficits caused by industrial activity are NOT counted in GDP but the remedies are counted as “value added”. So if you have an oil spill, the cost of cleaning it up is good news for the economy. Italian economist Stefano Bartolini takes this argument a step further and points out that negative social and environmental externalities have become engines of economic growth. It becomes a vicious cycle. I’ve also written about this perverse connection between nominal economic growth and real social and environmental depredation in the unpublished manuscript linked to my name.

  2. 2010/12/10 8:10 pm

    Tom Walker (I like your Sandwichman tag), regrets for my long lag time in responding to your interesting comment. Thanks for pointing out the value of a social accounting matrix (SAM) view of economic activity for addressing negative externalities. A good friend of mine, Tom Tanner, now deceased, created an excellent new variation on a working SAM model that applied a rigorous perspective to a truly circular make-and-use system. He treated all entities (public and private) as users and creators of commodities, where labor and capital and transfer payments are just commodities that are made and used like any other. The fixed entity is land so that the system does not collapse in a general equilibrium multi-regional dynamic context subject to distance impedance by commodity by transport mode for commodity access, and gravity-driven regional attraction by commodity for commodity trade flow. Distance impedance, gravity gradients, and baseline delivered prices are defined by commodity for all county pairs or any specified regional aggregations. The design breakthrough is the commodity production function linkage between the trade flow process and the economy’s entity-based data structure, where the rest-of-US always is present in any regional analysis. In the case of negative externalities, an industry could include in its output array (typically one or two primary outputs, statistically minor outputs, and scrap) one or more other commodities representing one or more externalities with negative signs. All that is needed is a production function aligning inputs with outputs in the make-and-use framework for the negative externalities being modeled. So as you suggest, it should be possible to specify and model a more complete view of economic activity impacts. See more at http://www.redyn.com/Documentation/regionaldynamics_howitworks.pdf. Again, thanks very much for bringing the subject into focus for capturing negative externalities as something other than positive economic activity.

  3. Kim Coffman permalink
    2010/12/22 3:24 pm

    The REDYN web site does not seem to work anymore (nor does http://www.regionaldynamics.com). Is anyone maintaining the model?

  4. 2010/12/23 5:17 am

    Kim, thanks for your question. The http://www.redyn.com site and model are active. Both the link in your comment, and the direct PDF link in the comment to Tom Walker that caught your attention, were active when I clicked on them at 3:30am 12/23/2010 (EST). There are intermittent times when the site is down for upgrades and maintenance. Yeah, this is a late-night reply, but sometimes late night is the best quiet time for sorting out next steps. BTW, http://www.redyn.com is a convenient short-name link to REDYN.

  5. Kim Coffman permalink
    2010/12/23 9:56 am

    Thanks. I was able to reach Tre Huchison, who said that the server was down for maintenance. I was able to reach the site from home last night.

  6. 2010/12/23 12:22 pm

    Kim, I’m glad you reached Tre. Good models are hard to find, so I hope REDYN ends up being useful in your work assessing offshore oil impacts. For a discussion of the context within which economic activity interacts with frameworks for individual, social, and policy actions, you might find interesting my post at http://aneconomyofmeaning.wordpress.com/2010/12/14/economic-ecology-makes-or-breaks-financial-systems/. Best regards, David

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