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Blood Money

September 23rd, 2008

The past couple of weeks have been a real eye-opener for ardent believers in the infallibility of market investment. It’s not that stocks of actual companies are in trouble, it’s that the so called financial sector appears to be in the state of some sort of meltdown. I’m no economist, and I don’t follow the market like I follow other things, but I certainly can’t say I’m surprised at the situation. For me this goes back to human nature and the basic concepts on which capitalism is based.

Capitalism, as opposed to say, socialism, seems based on the notion that humans are self-interest maximizers. Given the option we will always do what’s in our own best interest. Which is a really positive way of saying we are all selfish bastards. In my limited travel of the world, I think that’s fairly accurate. But capitalism had the brilliant idea of saying that so long as everyone is acting in their own self-interest, the outcome will be beneficial for everyone. Again, put more brutally by famed economist John Maynard Keynes, “[c]apitalism is the astounding belief that the most wickedest of men, will do the most wickedest of things for the greatest good of everyone.”

Underlying all of the market economy is the notion of risk, and in it’s purist form, the individual who takes on the most risk has the greatest potential for profit. I borrow $50,000 to start a business, I’ve now taken a risk, but if it pays off I’ll be much better for it. Of course, if it fails, I’m out $50K. This concept supposedly scales all the way up to the Fortune 500 companies who routinely borrow billions of dollars in the name of investment. At that high level of play it’s called leveraging. A company may have $5 billion in fixed assets, but only 10 million excess cash with which to invest. But, it can borrow against those fixed assets and leverage the company millions more. As long as the return on investment is higher than the interest rate on the loan, then it’s a profitable deal for the company.

What the past few weeks have demonstrated rather clearly is that the above concept of risk is simply not operative. When a bank buys securities backed by junk mortgages, on the hope that the risk will pay off, the bank is not the the only actor taking on risk, they are just the only one doing so voluntarily. Turns out that the entire financial system takes on risk, from the lowest bank depositor, up to the federal government, all the way back down to the lowest taxpayer.

The result is that risk takers are not, in fact, risk takers… they are risk distributors, with the added bonus that all of the benefits of the risk flow to just to them, while the negative fall out will be distributed. This creates a perverse incentive for risk takers to assume more risk than the profit margins would suggest, because the full weight of the risk is not theirs to shoulder. Suddenly the idea of buying complex securities with shoddy accounting backed by junk mortgages doesn’t sound so bad. Suddenly the idea of over-leveraging your company begins to make market sense. Suddenly approving mortgages to risky borrowers in order to cash in on the soaring housing market is the best way to meet quarterly earning projections. The next thing you know we’ve got a system stuffed full of so much unwise risk that it simply cannot hold under its own weight… and that brings us to today.

I entitled this post Blood Money not in reference to the funds these risk takers extract from us as depositors, pensioners, and tax payers, but rather as a proposal for the reverse. We often hear pure market advocates say taxes on the rich–though, generally in this context they are referred to as “risk takers”–should be cut to encourage investment. The thought goes that these rich folks won’t be sufficiently self-interested if they know the government is going to tax their income. I’ve never really been convinced by this argument, seeing as how if I have the opportunity to make $100, and in one universe the government is going to take $40 and in the other the government is going to take $45, I will still go for the $100, because in both universes the residual earnings is still greater than zero. The only situation where I wouldn’t act is one where the risk of failing is so great that the $5 profit margin is actually determinative. But I digress :)

The point is that lowering taxes on the highest tax bracket has always been justified because these folks are the so called wealth creators, through their clever risk taking strategies, and that if we tax them, we will destroy their ingenuity. But now we find ourselves in a situation where the rich are asking for a $700 billion bailout, financed by taxes, because they assumed too much risk… and we, as tax payers, are probably going to give them an amount in that neighborhood because the risk takers figured out a away to ensure that we already bear the risk, even though we were never in line for any of the profits.

Students of history will note a bit of a cycle here… whether with the Savings & Loan bailout, or the auto industry bailout, risk takers are always figuring out ways to trap us regular Joes with the risk, while pocketing the profits during good times. My suggestion then, is that it’s time for us to claim our share of the profits. Here are a few ideas just off the top of my head: we could go back to treating profits from investment just like normal income, ending the preferential tax treatment of those whose entire earnings come from their own existing wealth; we could enact windfall taxes on industry in boom cycles (I’m looking at you, oil sector) which has the added bonus of cooling off those boom industries so they don’t overextend and then crash out, leaving us holding the bag; we could even revisit the assumed knowledge that lower taxes on the high income bracket somehow benefits us all. That way, when times are good and the risk takers are rolling in the dough, so are we… and when times are tough and the risk takers come groveling for a bailout, there won’t have to be a discussion about Wall Street vs. Main Street, because we will have the money on hand and know that by helping the risk takers out today, we will be getting all that money back from them tomorrow.

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