Reason Foundation - Authors > Michael Flynn

Is America Following the Policies that Caused Japan's "Lost Decade"?

Wed, 10 Jun 2009 00:00:00 EDT

The scenario was eerily familiar. A long real estate bubble that had expanded extra rapidly for the previous five years suddenly burst, and asset prices came crashing back down to earth. Banks and financial institutions were left holding piles of worthless paper, and the economy soon headed south. The national government responded to the crisis by encouraging more lending and spending previously unfathomable amounts of money on public works projects in an effort to stimulate consumer spending and restart growth.

But that stimulus did not save the Japanese economy in the 1990s; far from it. The ensuing period came to be known as the Lost Decade, characterized by multiple recessions, an annual average growth rate of less than 1 percent, and a two-decade decline in stock prices and corporate profits.

The Japanese government’s easing of credit rates, instead of spurring real demand, created artificial demand. Federal loans and stimulus spending were not economically productive, and they vastly increased the nation’s debt and prolonged the economic malaise. Worse, businesses spent critical time on the sidelines, waiting for government bailouts and other centralized actions, instead of speedily consolidating their losses, clearing their balance sheets of bad investments, and reorganizing.

The United States in 2008–09, unfortunately, has started down the same path. Federal intervention and the expectation of additional government action are removing firms’ incentive to clean up their balance sheets by selling “toxic” assets. Why accept pennies on the dollar if a deep-pocketed new bidder (i.e., the state) looms large on the scene? The Japanese experience shows that when the government is an active participant in the market, many firms would rather accept state support than initiate the inevitable financial reckoning. Such a status quo does not provide a sustainable foundation for the economy. Instead, it restricts economic growth and creates a cycle of stagnation.

How Bubbles Form—and Burst

The Japanese asset bubble grew out of a long postwar economic boom that accelerated in the latter half of the 1980s, spurred in part by the central bank’s loosening of monetary policy. With access to easy credit, businesses sped up the country’s transformation into an economy based on technology, most prominently in the consumer electronics, telecommunications, and finance sectors.

The ensuing demand for new and better technology products, combined with increased living standards, fed an asset investment craze referred to as the Heisei boom, after the emperor who took the Japanese throne in 1989. The value of the yen increased during this time, due primarily to the 1985 Plaza Accord, an agreement reached at an international conference in New York that depreciated the dollar against the yen, and Tokyo became a major financial services center. The Japanese Stock Market grew enormously, with the Nikkei 225 (an index similar to the Dow Jones Industrial Average) more than tripling between 1985 and the end of 1989.

Times looked so good that U.S. bestseller lists were sprinkled with anxious tracts about Japan eclipsing the country that had defeated it militarily less than half a century before. But a more real threat was hiding in plain sight: Japanese asset prices, after rising precipitously, were about to come crashing down to earth.

The late-’80s Japanese bubble and the mid-’00s American bubble had similar causes that are worth pondering:

Overaggressive financial institutions and poor risk management that ignored traditional economic fundamentals. In both Japan and the U.S., excessively optimistic expectations led to bad investment decisions from Wall Street to Main Street and a pervasive culture of denial that there was any bubble at all.

Japanese asset inflation was fueled by a 51 percent average growth rate in housing prices and an 80 percent increase in average commercial property values between 1985 and 1991. This spike created an overconfident climate in which investors failed to adequately prepare for a correction. Since that peak, asset values in Japan have fallen by more than 40 percent as of 2008.

Japan was flush with capital in the 1980s, in part due to an export boom that started the decade before. The country was becoming an increasingly important player in the world financial system, and international investors came looking for a stake. In the preceding years, Japanese individuals and firms had built up a large pool of savings and begun investing those resources in real property. This rapid rate of investment pushed the value of land, buildings, and other capital investments higher, encouraging even more investment, and in turn speculation, based on the belief that values and returns would keep rising.

Riding this asset appreciation, Japanese banks borrowed nearly ¥200 trillion ($3.4 trillion in today’s dollars) from foreign markets. This sum sloshed throughout the Japanese economy. The lending was further fueled by tiny debt-to-equity requirements, a relatively recent development that encouraged financial institutions to heavily leverage their bets. By 1991 Japanese banks held reserves of only ¥3 trillion to cover the ¥450 trillion they had lent. Normally, such a lopsided portfolio would have triggered widespread concern. But the economic climate in Japan back then was often described as “euphoric.” Prudence was not in vogue.

The American housing bubble was bigger, although values have yet to fall as much as those of Japanese real estate. Between 2000 and 2006, average home prices in the U.S. grew by 90 percent, and commercial property values rose at the same rate. Since the peak in July 2006, home prices nationwide have declined more than 30 percent, and certain regions have experienced even sharper drops. Prices were still falling as of press time.

After the twin shocks of the dot-com bubble bursting and the September 11 attacks, the Federal Reserve repeatedly slashed interest rates. And like Japan in the 1980s, the U.S. was seen as an attractive destination for international investment. With more investors using more money to chase high returns, Wall Street began aggressively “securitizing” home mortgages by bundling and reselling bits of loans and doing likewise with the insurance contracts underwriting them. New subprime mortgages became increasingly available to home buyers with spotty credit histories. Because of the risk, subprime loans brought a higher rate of return. But since they were bundled with safer loans, the entire packages received ratings from credit agencies that were higher than warranted.

Investment patterns suggest that most Americans thought rising stock values and AAA ratings on securitized mortgages were safe financial bets. This overconfidence led most major Wall Street firms to decrease their capital ratios, taking on more debt and decreasing the amount of cash on their balance sheets. By 2007 the investment bank Lehman Brothers was leveraged 30 to 1, meaning just a 3.3 percent decline in asset values would wipe out its capital—which is in fact what happened.

Stock market bubbles. In both the U.S. and Japan, the rapid rise in property values fueled gains in the stock markets. The Japanese stock index Nikkei 225 rose from 13,000 in 1986 to an intraday high of 38,975 by the end of 1989. But the implosion of the property market sent the index crashing. It had dropped to 15,025 by July 1992, and it continued a steady decline throughout the Lost Decade. By April 2003, the Nikkei had fallen to 7,603, less than 20 percent of its peak.

Similarly, the Dow Jones Industrial Average went from 7,489 in July 2002 to an intraday high of 14,115 in October 2007. After that high point, the market began a modest decline, reaching 10,850 on September 30, 2008, then plummeting to 7,552 by November 20. The Dow continued to fall over the ensuing months and closed at 6,547 on March 9. (It has since rallied to just over 8,000.) In the U.S. as in Japan, the quick run-up in stock valuations lured people to invest money they did not have. The result was inadequate risk management, over-leveraged investments, and fragile capital reserves. Investors did not adequately plan for any contingency other than continued high growth and largely ignored those who warned that such growth was not sustainable.

Monetary policy errors. Although private financial institutions played a key role in the booms and busts of both Japan and the U.S., monetary policy was a critical root cause. In both cases, the central bank helped set off a boom in asset prices by expanding credit and driving interest rates to artificially low levels. This encouraged individuals and businesses to take on debt they otherwise would not have accepted and make investments they otherwise would not have considered.

When a central bank inflates the money supply and drives interest rates below those that would exist in a free marketplace, it sends a false signal to businesses to borrow and invest more in capital projects and goods than they otherwise might. Similarly, consumers respond to the signal by taking on higher mortgage and/or credit card debt, saving less, and spending more. Credit binges cannot last forever; when interest rates increase again, the bad investments are revealed, and it becomes painfully clear that much of the outstanding credit cannot be paid back.

Between January 1986 and February 1987, the Bank of Japan cut its discount rate—the interest rate charged by the central bank on loans to its member banks—from 5 percent to 2.5 percent, leading to an increase in real estate and stock market prices. Realizing a bubble was forming, the central bank then raised rates five times in 1989 and 1990, to a high of 6 percent. This increase revealed that many investments were built on extensive, unsustainable debt. Stocks began their long and painful slide.

When a recession began to set in after the 1990 stock market crash, Japan responded by reversing its tight money policy, cutting rates to 4.5 percent in 1991, 3.25 percent in 1992, 1.75 percent from 1993 to 1994, 0.5 percent from 1995 to 2000, and as low as 0.1 percent in September 2001.

A similar pattern took place in the United States. From 2000 to 2002, the Federal Reserve slashed the target discount rate from 6 percent to 0.75 percent. Fearing irrational exuberance, to borrow Alan Greenspan’s famous phrase, the Fed then raised the rate as high as 6.25 percent in June 2006. But now that the bubble has burst and the economy contracted, the Fed has cut the discount rate 12 times, lowering it to the current 0.5 percent. Federal Reserve Chairman Ben Bernanke has repeatedly stated that he sees interest rate cuts as a way to “support growth and to provide adequate insurance against downside risks.”

In both the Japanese and the American cases, post-bubble policy makers believed that lowering interest rates would make credit easier to obtain, thus recreating the environment that had spurred economic growth to begin with. But this meant that the supposed cure for a bubble created by easy credit was to extend even more easy credit.

These rate cuts only perpetuated the distortion of economic decisions and prevented savings, investment, and consumption from realigning with true preferences, as opposed to the illusory ones created by easy credit and artificially low interest rates. The lesson is that when monetary policy is used to “smooth” or “tweak” the market, it inevitably causes unintended consequences that in some cases can be very damaging to long-term economic growth.

Regulatory Responsibility

The current American debate often falls into broad-brush discussions about whether the nation had “too much” or “too little” regulation. The real issue is how the existing regulatory order helped spawn the financial crisis. We see it doing so in at least a couple of areas:

Capital reserve requirements. In 1988 the Basel I Accord between the Group of 10—which then included the U.S., Switzerland, Japan, Germany, France, and the U.K., among others—set new capital requirements for banks around the world. But the requirements were focused on loan amounts and did not factor in a debt’s underlying risk. In other words, a loan to a sound borrower required the same percentage of capital to be set aside as an equal amount lent to a high-risk borrower. There was already a developing atmosphere of heavy lending and insensitivity to risk, but the Basel requirements rewarded firms for making loans to shaky borrowers because they could earn higher interest rates that way without having to set aside any more capital than they would for loans to safe borrowers.

The chief problem was not that the requirements were too low. It was that the rules created a false sense of security for investors and lenders. Banks were meeting their legal requirements, although it was never clear what kind of debt they were holding capital to cover. Without a standard or competing standards for transparently measuring the value and risks of portfolios, Basel I proved ineffective at preventing systemic rot.

In the United States, when firms calculated their reserve requirements, they were required until recently to mark many assets “to market,” i.e., value them at the price they could be sold for immediately. When asset values started falling, and categories of assets stopped trading, firms scrambled to find capital to shore up their shoddy-looking reserves. The collapse of the government-created mortgage behemoths Fannie Mae and Freddie Mac suddenly devalued mortgage-backed securities, and that meant banks holding large swaths of these assets had to come up with millions in cash overnight to meet their capital ratios. Many of the worst or most toxic mortgage-backed securities could not be sold immediately because their values were hard to determine. Under “mark to market” accounting rules, they were in effect worth nothing for the time being.

The market needed time to reassess the mortgage market, given the new information it was facing from the Fannie and Freddie debacle. In the meantime, banks watched the numbers on their balance sheets go from millions to zero. Unable to find sufficient capital to meet the requirements demanded by mark-to-market accounting, institutions such as Lehman Brothers, Washington Mutual, and Citigroup fell prey to their debt. Easing the mark-to-market rules at the onset of the crisis, instead of a year later, would have bought firms precious time to recapitalize their balance sheets in a more stable manner. The banks still would have lost money, but they might not have gone bankrupt and caused a negative ripple effect throughout the economy.

Government housing policy. Both Japan and the United States had explicit government policies that encouraged an unhealthy appreciation in land and housing prices. A 2003 report from the Bank of Japan blamed tax and regulatory policies for an unnatural rise in asset values. In America the Federal Housing Administration has for years encouraged the expansion of mortgage lending, including subprime lending, particularly through Fannie Mae and Freddie Mac. This was done to expand homeownership by low-income families. Such policies span administrations of both political parties, from the Community Reinvestment Act passed during the Carter administration in 1977 to George W. Bush’s efforts to create an “ownership society.”

The push to expand homeownership had two big effects. First, it greatly increased the number of buyers, driving up housing prices. Second, it provided mortgages to a large number of people who had a high risk of default.

Recession Responses

By early 1992, realizing that the economy was not going to rebound quickly, the Japanese government hurriedly enacted its first recession-fighting stimulus package. Government spending and loans during the next several years propped up failing Japanese financial firms, but the companies’ lack of vitality and perpetual operating losses earned them the moniker “zombie businesses.”

Given the similar source of the U.S. bubble, American officials should take a careful look at Japan’s ineffectual and massively expensive response to ensure that the United States does not duplicate the following mistakes:

Government lending to poorly managed firms. The Bank of Japan tried to ease economic pain by loaning large amounts to businesses. But the attempts to recapitalize the market ignored underlying management problems in the dying firms. It was a costly mistake. Intense lobbying from special-interest groups representing various sectors of the Japanese economy perpetuated the ill-fated loans and funneled government money to zombie businesses.

The United States has already begun to copy this policy, lending billions of dollars to financial institutions and auto companies and buying up billions more in bank equity in an effort to recapitalize the marketplace. The effect has been to keep poorly managed firms alive with taxpayer money.

Just months after a $25 billion investment in Citigroup, the government had to step in with a second bailout of $20 billion. Despite the infusions, Citigroup is now breaking up its holdings, a process that could have been started months earlier if the authorities had not used tax dollars to feed the zombie firm. Instead of letting the Big Three automakers go bankrupt, the administration has kept them on life support with tens of billions in loans to buy enough time for...likely bankruptcy.

Conflicts of interests. With all those loans, the Japanese government found itself deeply entwined in the market, skewing its policy incentives. Daniel I. Okimoto, former director of the Shorenstein Asia-Pacific Research Center at Stanford University, points out that Japan’s banking industry and economic bureaucracies were too interdependent. Studies from Okimoto’s center and the Bank of Japan concluded that data revealing the scope of the economic malaise were suppressed and that regulations were developed with governmental interests in mind. At the height of financial industry bailouts, there was little transparency or public accountability.

The United States has ventured into the same dangerous waters. In an attempt to recapitalize the banking industry, the Treasury Department forced the major banks to take bailout funds from the Troubled Asset Relief Program, in exchange for which the government took equity stakes. The federal government now owns a majority of the American International Group insurance company, as well as major chunks of General Motors and Chrysler. The dangers of interconnectedness have already become apparent.

With taxpayer money on the line, elected officials feel emboldened to prescribe the marketing, compensation, travel, and other business policies of companies taking government money. Members of Congress and White House staff have criticized specific spending decisions by participating firms. Concern over bonuses to AIG employees led the House to pass an arbitrary tax on a standard business practice that lost public favor. President Obama himself has delved into such business minutiae as whether General Motors should be focusing more on brand consolidation. And a bill now in the Senate would give the Treasury Secretary power to set the salary of all employees, not just executives, at any firm with bailout money burning in its pockets.

Lawmakers’ incentives are to serve their constituencies or their own political careers. This can put them at odds with the businesses they are suddenly attempting to manage. The more the government is involved in directing business activity, the less likely those firms will succeed in maintaining long-term growth, and the more likely they will turn into Japanese-style zombies.

Short-term, static political vision. You can blame the length of Japan’s asset deflation, recession, and liquidity struggles on an unwillingness to choose hard but necessary policies, such as allowing banks to fail and the market to reset itself. Politicians bent on retaining their power and showing the public they were doing something took actions without regard to their long-term effects.

There was little effort to clean up the banking system or get rid of harmful regulations. The government refused to acknowledge the breadth of Japan’s economic troubles, and the Ministry of Finance went so far as to order banks to hide their toxic loans to create the appearance of success. This approach was largely due to fear of the keiretsus, the powerful alliance of Japanese businesses that propped each other up with cross-shareholding and loans. Taking swift action would have upset the traditional way of business and forced the government to admit mistakes.

The principle of creative destruction—the economic mutation that continuously breaks down old forms and creates newer, more productive and efficient ones—was ignored in the hope that legacy corporations could somehow save Japan. From Wall Street to Detroit, under both George W. Bush and Barack Obama, the American government has been equally unwilling to let once-formidable companies fail.

Bad tax policy. In different periods, Japan tried to climb out of its economic mess by both cutting and raising taxes. There were two major tax cuts during the Lost Decade: a ¥5.8 trillion ($69 billion in today’s dollars) income tax cut in 1994 that lasted for one year, and a ¥4 trillion ($46 billion) income tax cut in 1998 spread over two years. The problem was that these tax cuts were not permanent and thus did not increase long-term aggregate consumption.

From 1994 to 1995, the Japanese economy began experiencing modest growth, partially due to the first tax cut. But deflation in 1995 reduced government revenues. In an effort to stem surging national debt, the consumption tax was increased from 3 percent to 5 percent in 1997, which slowed the economy again.

President Obama and Republicans in Congress have proposed various tax cuts and tax credits to stimulate the American economy. The American Recovery and Reinvestment Act (the “stimulus” bill) included the president’s signature “Making Work Pay” $400-per-taxpayer ($800-per-family) tax credit that eliminates all federal income taxes for up to 18 million Americans. The legislation also increased the amount of losses that businesses may write off on their taxes while providing tax credits to new homeowners, students, and efficient energy developers.

Other ideas, such as the GOP push for reductions in capital gains taxes, have been tossed aside.

As welcome as tax cuts are, without a decrease in spending they will require an increase in taxes later to cover the lost revenue and pay off the debt incurred.

Japan found that temporary tax rate cuts combined with increased spending did not spur economic growth. Neither did an attempt to increase government revenues through tax increases. Reducing taxes for businesses—permanently, not until the next shortfall—allows firms to keep more revenue, which in turn lets them reinvest that money to innovate and expand their business, hire new workers, pay out dividends, or just be inspired to continue their hard work. Tax rate cuts for individuals—all individuals, including those with income over the arbitrary $250,000 threshold—give people more control over their income, allowing them to pay down debt, save, invest, or increase consumption. Those tax policies are the quickest way to stem a recession.

Government infrastructure “investment.” In an attempt to encourage growth, the Japanese embarked on a massive, multi-billion-yen infrastructure program. They built roads, bridges, and airports, all with the goal of creating jobs and reviving the economy. This didn’t work either.

During the 1990s, Japan passed 10 fiscal stimulus packages, focused largely on public works, totaling more than ¥120 trillion ($1.4 trillion in today’s dollars). When one construction plan failed to stimulate economic growth, another was tried. Those plans did not succeed in reviving the economy, but they did saddle the nation with a mountain of IOUs that helped postpone recovery for years. Including “off-budget” borrowing, Japan’s debt was estimated to exceed 200 percent of GDP in 2001.

Construction plans often set job growth targets but rarely focused on project prices. From 1992 to 1999, the Japanese government spent more than $500 billion (in today’s dollars) on public works projects. Yet the construction jobs were not long-term and did not lead to sustained economic growth. Public debt sky-rocketed, unemployment actually doubled from 2.3 percent to 5 percent, and the economy remained stagnant. As Gavan McCormack, a historian at Australian National University, noted in his 1996 book The Emptiness of Japanese Affluence, “The construction state is in some respects akin to the military-industrial complex in Cold War America (or the Soviet Union), sucking in the country’s wealth, consuming it inefficiently, growing like a cancer and bequeathing both fiscal crisis and environmental devastation.” The government failed to properly identify which projects should be pursued, ignoring demand signals that the private sector is better at recognizing and responding to.

The United States has started down a similar path. In February, Congress passed nearly $100 billion in transportation and public works spending. Naturally, political interests, not economic viability, are determining how this money is being spent.

An American Lost Decade

The Japanese government’s monetary expansion and poor regulation, coupled with the risky behavior and ineptitude it encouraged in the financial sector, led to distortions in private investment instead of economic recovery. Recessions are the unavoidable costs of unsustainable booms fostered by government policy. While politicians would like to stave off the negative effects they create—business failures, unemployment, falling housing prices—bankruptcies and corrections are necessary steps in realigning consumer preferences and the structure of production.

The U.S. government is repeating many of the same mistakes that created Japan’s Lost Decade, becoming entangled with the business community through bailout equity purchases and trillions of dollars in loans and guarantees to keep failing American firms alive. This policy is making the recession worse, extending it further than it would otherwise last.

Any attempts to artificially spur a credit expansion through either low interest rates or “fiscal stimulus” will only add to the economic distortions and make the market correction longer and more severe. Spending hundreds of billions of dollars on infrastructure, broadband Internet, and the like may provide some short-term benefits for some Americans, but as Japan discovered the hard way, it won’t rescue the economy. The history lessons from Japan are plentiful and clear. If the American government continues its pattern of intervention, the United States may soon be trapped in a zombie business economy and a lost decade of our own, ensuring economic stagnation for a long time to come.

Anthony Randazzo is a policy analyst at the Reason Foundation. Michael Flynn is president of Marengo Strategies. Adam B. Summers is a policy analyst at the Reason Foundation. This column first appeared in Reason magazine.

State Governments Face Deficits and Fiscal Trouble Because of Spending

adam.summers@reason.org (Adam Summers) mike.flynn@reason.org (Michael Flynn) — Thu, 09 Apr 2009 11:32:00 EDT

Reason magazine

Of the $787 billion in “stimulus” money President Barack Obama authorized with his pen on February 17, at least $144 billion was earmarked for a particularly unstimulating purpose: covering the budget deficits of state governments. The 12-digit sum, touted as “state and local fiscal relief” on the administration’s glass-half-full website recovery.gov, quickly exposed a fault line between the nation’s governors. On one side were a handful of fiscal conservatives, led by Republicans Bobby Jindal of Louisiana and Mark Sanford of South Carolina, arguing that bailouts and federal mandates create moral hazards and unfunded liabilities requiring future tax hikes. The other, more powerful side was represented by moderate Republican Arnold Schwarzenegger of California.

“Gov. Sanford says that he does not want to take the money, the federal stimulus package money,” Schwarzenegger told ABC’s This Week on February 21. “And I want to say to him: I’ll take it. I take it because we in California…need it.”

But does California, or any other state, really “need” federal money during this economic downturn? Only if you accept the premise that state budgets should roughly double every decade.

When Gray Davis, a Democrat, became California’s governor in 1999, the state’s budget was $75 billion. Tempted by dot-com windfalls and beholden to public-sector unions, Davis bumped that number to $104 billion in four short years of boom and bust, after which he was bounced out of office for his fiscal irresponsibility and replaced by a Milton Friedman–quoting action hero who promised to bring “fiscal sanity” back to Sacramento. Five years later, after facing another boom, another bust, and a series of bruising political defeats at the hands of public-sector unions, Schwarzenegger had hiked the budget to an astonishing $145 billion. In 10 years, state spending in nominal terms increased 92 percent.

One good way to measure fiscal stewardship is to see whether state spending growth exceeds the rate of population growth plus inflation. Under Davis, budgets rose an average of 6.7 percent a year, as opposed to a population/California price index growth rate of 4.8 percent. Under Schwarzenegger, spending has increased 6.8 percent annually, compared to a population/inflation rate of just under 5 percent. A governor who was swept into office by damning Davis’ $38 billion budget deficit, vowing not to raise taxes, and mocking his predecessor’s vehicle license fee hikes announced on February 20 that he would address his own $42 billion budget deficit by raising taxes and doubling those same fees.

Asked to explain the contradictions on This Week, Schwarzenegger praised the federal stimulus (“a terrific package”), urged Republicans to be “team players” for Obama (who, he said, was doing a “great job”), and unleashed a spectacular metaphor in favor of abandoning a limited-government philosophy. “You’ve got to go beyond just the principles,” he said. “You’ve got to go and say, ‘What is right for the country right now?’ I mean, I see that as kind of like, you go to a doctor, the doctor’s office, and say, ‘Look, can you examine me?’ The doctor says, ‘You have cancer.’ What you want to do at that point is you want to see this team of doctors around you have their act together, be very clear, and say, ‘This is what we need to do,’ rather than see a bunch of doctors fighting in front of you and arguing about the treatment. I mean, that is the worst thing. It creates insecurity in the patient. The same is with the people in America.”

But if the people in America have fiscal cancer, it’s just the latest in a long series of relapses.

There They Go Again

In 2002 the National Governors Association issued a press release saying the “states face the most dire fiscal situation since World War II.” In 1990 The New York Times reported that states and cities faced a “fiscal calamity.” Fire up Google, pick almost any year, and you’ll find plenty of stories about a “fiscal crisis” around the nation.

For decades statehouses have followed a predictable schedule. In good economic times, they collect a lot more tax revenue than they really need. But instead of giving the money back to taxpayers or putting it in a rainy day fund, they pretend the good times will never end. When the good times do inevitably come to a close, governors plead poverty and either ask the federal government for help or raise taxes on their beleaguered citizens. Eventually, the economy rebounds and the vicious cycle starts again.

In the 2009 version, the liberal Center on Budget and Policy Priorities warned in February that governors faced a combined funding shortfall of $350 billion, causing “at least 40 states to propose or enact reduced services to their residents, including some of their most vulnerable families and individuals.” That same month, Corina Eckl, fiscal program director for the bipartisan National Conference of State Legislatures, described the budget figures as “absolutely alarming, both in their magnitude and the painful decisions they present to state lawmakers.” Across the country, newspapers have been filled with stories of closed parks, furloughed state workers, cigarette tax increases, and even, in California, IOUs instead of tax refund checks. “The easy budget fixes are long gone,” Eckl said. “Only hard and unpopular options remain.”

Is that true? Consider the boom cycle preceding this latest recession. In the five years between 2002 and 2007, combined state general-fund revenue increased twice as fast as the rate of inflation, producing an excess $600 billion. If legislatures had chosen to be responsible, they could have maintained all current state services, increased spending to compensate for inflation and population growth, and still enacted a $500 billion tax cut.

Instead, lawmakers spent the windfall. From 2002 to 2007, overall spending rose 50 percent faster than inflation. Education spending increased almost 70 percent faster than inflation, even though the relative school-age population was falling. Medicaid and salaries for state workers rose almost twice as fast as inflation.

Recessions exert a great deal of pressure on state budgets. As economic activity declines, governments collect less tax revenue. As people lose their jobs or suffer drops in income, there is more demand for services such as job training, health care support, welfare, and unemployment compensation. The combination, it is often argued, throws state budgets out of balance and, because states are generally required to enact balanced budgets, often leads to tax increases, dramatic cuts in services, or both. These actions, it is argued, further dampen consumer demand and worsen the economic situation. The chief rationale for federal support of state budgets is to counter this cycle.

By studying the period from 2002 to 2007—that is, the period that began as the economy came out of the mild 2001 recession—we can judge how states spent money when times were better and their services weren’t as desperately needed. In this period, unemployment dipped to around 4 percent, a historic low in modern times; gross domestic product posted steady gains; and most economic measures pointed upward. Meanwhile, the states indulged in fiscal irresponsibility from which no taxpayer should feel eager to bail them out.

Total Revenue

The top-line figure for state funding is total revenue. It encompasses every dollar available to state governments: tax revenue, money from the federal government, income from trust funds, earnings from investments, even state employee contributions to pension systems. In 2002 total combined state revenue was $1.097 trillion (see Figure 1). In 2007 this figure had risen to almost $2 trillion. That’s an 81 percent increase, at a time when prices plus population increased 19 percent. So total revenue increased more than four times faster than inflation and population growth.

Here’s a hypothetical that puts this trend in a more understandable context. In 2002 you and your friend (call him “Mr. State Government”) come out of the recession with jobs paying $50,000 a year. During the next five years you receive cost-of-living adjustments from your employer, so by 2007 your salary is $59,500. Your pal, on the other hand, has jacked his annual earnings up to $90,500.

But the 81 percent increase over five years only tells part of the story. Since 2002 total revenue collections have been well above the levels needed to maintain services each year. This windfall has a cumulative impact. In just five years, taking inflation into account, the states collected $2.2 trillion more than they would have needed to maintain revenues at 2002 levels.

Let’s put this another way. After 2007 we were clearly experiencing an economic downturn. If the states had merely maintained their existing programs between economic downturns, they would have been able to deliver a $2 trillion tax cut at the end of 2007. Imagine the impact that might have had.

General Fund Revenue

Some will argue that total revenue isn’t the appropriate focus. Since a portion of that money is out of the direct control of elected officials, the argument goes, it doesn’t truly reflect the choices they have faced or the decisions they have made.

The general fund better reflects the day-to-day activities of state government. It includes all the programs we traditionally associate with states: education, Medicaid, road building, departments of motor vehicles, etc. Money in the general fund comes mainly from tax revenue and federal funds.

In 2002 states’ general fund collections were $1.062 trillion (see Figure 2). By 2007 general fund revenue had risen to almost $1.5 trillion, an increase of 37 percent, or almost twice the national growth rate of inflation plus population. Of the 50 states, only one (Wisconsin) saw its general fund expand at a rate below the state’s population growth plus inflation. Alaska and Wyoming led the charge with 91 percent and 74 percent, respectively, compared to rates of population growth/inflation of 20 percent and 18 percent. Even in Mark Sanford’s South Carolina, the general fund grew by 45 percent, compared to a 21 percent rate of population growth plus inflation.

Intergovernmental Funds

About 30 percent of state general fund money comes from the federal government. These funds support federal initiatives in education, road building, and Medicaid, among other uses. Given the well-publicized increase in federal spending during George W. Bush’s administration, it is worth examining whether states shared in the windfall.

Interestingly, this is one area where federal spending rose relatively modestly, at least in comparison with other priorities. In 2002 states received $335 billion in revenue from the federal government (see Figure 3). In 2007 they received $430 billion, a 28 percent increase. It is noteworthy that in examining government financing, a 28 percent increase over five years now seems modest. It is worth remembering that this increase is still 50 percent faster than the rate of inflation and population growth.

Taxes

About half of state general fund revenues come from taxes. In 2002 states collected $535 billion in taxes; by 2007 that had grown to $749 billion, an increase of 40 percent, or more than twice the rate of inflation and population growth (see Figure 4).

The robust growth in state tax revenue during this five-year period is only part of the story. The pace of this growth is notable: rising slowly out of the recession, increasing rapidly, and then beginning to taper off in advance of the general economic slowdown. In 2002–03, the rate was 2.4 percent. By 2004–05, it had leaped to 10 percent. In 2006–07 it was down to 5.4 percent—a more moderate level, but still far ahead of inflation.

The decline in the rate of tax revenue growth ought to have sent a signal to state budget drafters. Instead, they seem to have looked beyond the data and assumed continuing strong revenue growth. State budgets for fiscal year 2008, which were drafted toward the end of the period analyzed here, called for more than an 8 percent annual spending increase on average. Small wonder states had to make mid-year adjustments to their budgets in the middle of 2008 as the economy began to cool.

Golden Failure

In fiscal year 1990–91, California took in more than $38 billion in general fund revenues. In 2008–09 revenues are $102 billion. If the state had simply limited spending increases to the 4.4 percent annual average growth in consumer price index plus population, the state would be sitting on a $15 billion surplus this year instead of a $42 billion deficit.

A significant portion of California’s spending increase stems from the growth in state employees. Today there are more than 356,000 workers on California’s payroll, or 9.3 state employees for every 1,000 residents. The biggest hiring binges came during Gray Davis’ dot-com exuberance, and then again during the pre-recession Schwarzenegger administration (see Figure 5).

This increase in personnel is important because so much of the budget is devoted to employees’ wages and benefits, and because their pension benefits, which are locked into place for all current employees, are both colossal and precarious. The California Public Employees’ Retirement Security System, which until last year was the largest public pension fund in the United States, lost a staggering 20 percent of its value in just three months of 2008 (see “The Next Catastrophe,” February).

By chance, the National Governors Association held its annual meeting in Washington, D.C., the weekend after both the stimulus and California’s new budget were passed into law. Mark Sanford and Bobby Jindal, both considered possible future leaders of the GOP, drew early headlines with their Hamlet-like deliberations on whether they would accept stimulus money. (In the end, they narrowed their considerations to the unemployment insurance component of the federal mandate, a comparatively trivial sum.) Schwarzenegger, always a media darling, regained the initiative with his Obama praise and Sanford baiting on This Week. Pundits speculated hopefully that perhaps the new president would give Arnold a job once his term expires in 2010.

Martin O’Malley, Maryland’s Democratic governor, dismissed Sanford as “fringe.” Sanford shot back in The National Journal. “There is a larger problem if we get so Balkanized with ‘you-don’t-want-yours-give-it-to-me,’ ” he told the magazine. “That means nobody is minding the store.” On Fox News on February 22, Sanford described the stimulus as sounding “like the Soviet grain quotas of Stalin’s time—X number of jobs will be created because Washington says so.” He added that “one of the real issues here is we have $52 trillion in accumulated debt in Washington, D.C. And we don’t have a giant piggy bank that we can now raid now that times are tough. All this money is going to be borrowed from the future—from future generations, from Social Security. So in essence, we’re digging yet another hole for ourselves with regard to unsustainable spending.”

For more than two centuries, the states have been the laboratories of democracy. Whether they become laboratories of sound economics depends largely on whether Sanford’s words become real-world deeds.

Adam B. Summers is a policy analyst at Reason Foundation. Michael Flynn is director of government affairs at Reason Foundation. This column first appeared in Reason magazine.

Avoiding an American Lost Decade

Fri, 20 Feb 2009 00:00:00 EST

The current economic uncertainty in the United States, and the government’s response to it, is eerily similar to that of Japan’s “Lost Decade” according to a new Reason Foundation report.

The study finds that Japan’s housing prices rose by 51 percent and commercial real estate values rose 80 percent between 1985 and 1991. In the U.S., commercial real estate and housing prices both skyrocketed 90 percent from 2000 to 2006.

The Nikkei, Japan's stock index, fell from 38,975 in 1989 to just 18,934 by the end of 1999. During the continuing economic malaise, it dropped even further to 7,603 in 2003. The Dow Jones Industrial Average hit 14,115 in October 2007. On February 19, 2009, the Dow closed at 7,465, its lowest finish since 2002.

President Barack Obama recently signed a $787 stimulus package that includes over $60 billion for infrastructure and transportation projects. Japan passed 10 stimulus packages in the 1990s that would equal $1.4 trillion in today’s dollars. From 1992 to 1999, Japan spent over $500 billion (in today’s dollars) on public works projects. Despite this infrastructure spending, Japan’s unemployment rate more than doubled and the economy remained stagnant.

State Budget Crises Arrive Like Clockwork

mike.flynn@reason.org (Michael Flynn) — Wed, 11 Feb 2009 20:07:00 EST

Three weeks ago President Barack Obama entered the history books and the White House, riding a promise to change the way Washington works and to inject new ideas into stale policy debates. It is too soon to tell whether he'll succeed in changing DC, but here's hoping this mandate for change gets heard in the nation's state capitals.

From Albany to Sacramento, America's governors and state legislators are showing that there's nothing like that "old-time religion." Change may be in vogue among voters, but their elected representatives in state government are like that old vaudeville troop that can't let go of its old laugh lines.

The skit this year, of course, is another "budget crisis." In states across the country, the public is being told that parks will close, workers will be furloughed and, in California, IOUs instead of tax refunds will be mailed to taxpayers. The Center for Budget Policies and Priorities warns that "at least 39 states have made or proposed budget cuts that threaten vital services" and face total deficits of $350 billion over the next couple years. Other research organizations report deficits less than a third of that, but are still quite concerned.

The bipartisan National Conference of State Legislatures says state budget figures are "absolutely alarming, both in their magnitude and the painful decisions they present to state lawmakers."

Do these sky-is-falling state budget forecasts sound familiar? They should.

In 2002, the National Governors Association issued a press release saying that "states face the most dire fiscal situation since World War II." In 1990, The New York Times reported that states and cities faced a "fiscal calamity." Fire up Google, pick almost any year and you'll find lots of stories about a "fiscal crisis" in the states.

For decades states have been on a predictable schedule. In good economic times, they collect a lot more tax revenue than they really need. But instead of giving the money back to taxpayers or putting it into a rainy-day fund, they pretend the good times will never end and they spend it. When the good times do end, they plead poverty and either ask the federal government for help or raise taxes on their beleaguered citizens. Eventually, the economy rebounds and the vicious cycle starts again.

Look at the boom years preceding this recession. State general fund revenue increased twice as fast as inflation. In the five years between 2002 and 2007, revenues grew so much that state governments collected almost $600 billion more than if revenues had just kept pace with inflation. Had they been responsible, they could have maintained all state services, increased spending to compensate for inflation and population growth, and enacted a half-trillion dollar tax cut.

Instead, lawmakers ploughed the windfall into new spending. From 2002 to 2007, overall spending rose 50 percent faster than inflation. Education spending increased almost 70 percent faster than inflation, even though the relative school-age population was falling. Medicaid and salaries for state workers rose almost twice as fast as inflation.

Unfortunately for taxpayers, this money is gone or is now built into ever-expanding baseline spending. So, state lawmakers are once again sounding the alarm about a budget crisis that they ‘just couldn't have seen coming.' And, they've again reached into their old bag of tricks and warned about closing parks, cutting back on services and laying off teacher, firefighters and other state workers. It's as if the last dollar the government spends each year is to keep a park open.

Desperate for an infusion of cash, politicians have turned to their oldest stand-by; cigarette taxes. Even after decades of steady increases in tobacco taxes, state lawmakers in at least a dozen states are looking to raise cigarette taxes.

Right now, government makes more off the sale of a pack of cigarettes than tobacco companies. In some states, two-thirds of the price of a pack already goes to government. This will get worse because Congress just hiked the federal cigarette tax 61 cents a pack to help pay for the expanded State Children's Health Insurance Program.

The overwhelming majority of cigarette taxes are paid by low-income households. In a recession, you'd think lawmakers would want to give these folks a break. But, lawmakers' habits are hard to break even when it is clear that tax increases don't raise any new revenue.

In 2006, New Jersey raised its already high cigarette tax, thinking it would bring in an extra $30 million a year. It didn't. Worse, it caused their actual collections to drop by more than $20 million. The tax increase threw the state's budget off by $50 million, money that had to be made up by other taxpayers. This isn't unique to the Garden State. Since 2003, there have been 57 cigarette tax increases across the country. In 37 (68 percent) of those cases revenues failed to meet projections.

Isn't it time we retired this skit? We're almost one decade through the 21st century and our esteemed lawmakers in state capitals are still using a decades-old recipe: Boom and bust budgets; cigarette taxes when times get tough. Stir.

It seems our state lawmakers have reached their "sell-by" date.

Christmas in October

mike.flynn@reason.org (Michael Flynn) — Thu, 02 Oct 2008 13:47:00 EDT

The Senate is overly fond of referring to itself as the “world’s greatest deliberative body.” Barely 48 hours after the House rejected the Treasury’s bailout plan, the august body took a previously passed House bill mandating that insurance companies cover mental health benefits, added in the core $700 billion bailout, laced in money for rural school districts and disaster relief, expanded FDIC deposit insurance coverage, and topped it off with over $150 billion in old and new tax breaks for businesses, individuals in high-income states, individuals living in states without an income tax, and various interests such as wooden-arrow makers and film production crews. GOP Leader Mitch McConnell, almost choking back tears after the Chamber passed the 451-page monster, said it was the Senate “at its finest.” The Age of Pericles this ain’t.

I’ll leave it to others to comment on this mother-of-all-Christmas tree bills. The bulk of the Senate legislation is essentially the same as that rejected by the House. It authorizes the Treasury Department to use $700 billion to buy up bad loans. Certain banks get cleaner balance sheets immediately and the feds supposedly will minimize the risk to taxpayers by selling the bad loans when the market “stabilizes” and the prices of the loans have improved.

To paraphrase Mencken, this solution is neat, plausible, and wrong. The first failing is something that is only now being openly stated: Treasury expects to pay some unknown premium above any current market price for mortgage-backed securities (MBS). We don’t know what the premium will be nor how it will be determined. Well, in a sense we do. It will mostly be determined by politics, not economics. This is the foundational flaw in the Treasury plan.

Once signed into law, Treasury would begin a process to determine the assets it will buy and the manner it will set a price. Like everything in government, this is a moment that is lobby-able. Expect swarms of financial services lobbyists, investor groups, housing advocates, and others to try to game the system for their individual clients or members. The further away from economics these decisions are made, the more risk there is for taxpayers. The higher the premium over any current market price, the longer the government will have to hold the assets.

The risk here is particularly high given the complicated and rather opaque nature of the financial instruments involved. Few on Wall Street, let alone in Washington, understand these products. I have strong reservations about whether federal bureaucrats have the capacity to appropriately price and manage these instruments. Apparently, I’m not the only one with these doubts. The bailout would authorize Treasury to bypass normal contracting rules and hire outside private firms to handle the purchases and manage the toxic assets. That these private firms have ongoing relationships with the banks selling the bad assets creates one hell of a conflict of interest.

Some commentators have drawn parallels to the Savings & Loan bailout in the 1980s, when the government established the Resolution Trust Corporation to dispose of the assets of failed thrifts. They mean the comparison favorably. But, that is of a piece different than the proposal at hand. The RTC took possession of a host of assets as thrifts went bankrupt. They received whatever assets the failed thrift possessed. Under this plan, however, federal bureaucrats and their outside contractors would decide which assets to buy. They would ostensibly go from institution to institution, review the books, and say, “We’ll buy this and that; you hang on to those.” The government will be actively investing taxpayer funds in individual securities and then managing the portfolio until such time as it decides to sell.

One doesn’t have to be paranoid to envision the political dynamics that will shape these decisions. Will Fidelity out of Boston have a special edge because Rep. Barney Frank (D-Mass.) chairs the Financial Services Committee? Will Nutmeg State-based hedge funds have an advantage because of their close ties to “Friend of Angelo” Sen. Christopher Dodd (D-Conn.)? That we don’t even fully know who will be making these decisions, as a new administration takes office in just four months, warrants no further comment.

Neither do we need to say much about the moral hazard raised by taking bad debt off the books of private companies. While the government, unfortunately, has in the past taken steps to shore up individual companies or even certain sectors, I don’t think it has ever before proposed to take such an active role in the markets. Secretary Paulson is proposing our very own sovereign wealth fund. Once government has dipped its toe into this water, it is hard to see it leaving the pool, especially if the government is able to earn a “profit” when it sells the assets in a rebounding market.

It is hard to imagine the government resisting calls to take the “toxic” pension costs off of automakers’ books. Or some of the “toxic’ legacy costs of the big airlines. Let’s remember, this is one of those rare cases where the “victims,” the bankers and investment bankers, are the very people who made the mistakes. It is possible that, absent government intervention, we can get through this upheaval with no one else actually getting hurt. This isn’t like the former Enron employees who lost their life savings through no fault of their own. This is financial institutions failing because of the very specific mistakes they made.

Probably the most troubling is the proposal to give the government equity stakes in the companies participating in the bailout. It’s bad enough for the government to purchase these companies’ bad debt. The bailout, however, would make the government an owner in the companies themselves. This is unchartered territory, and raises lots of troubling questions. Would the government get seats on the board of directors? How would the government dispose of the equity? When? Will there be firewalls to prevent government, or government officials, from using the equity stake to influence the business decisions of the company?

The bailout passed by the Senate also contains provisions to limit executive compensation for participating companies. It is entirely unclear how this would work. The populist appeal is easy to understand, but if the restriction is too draconian, companies may decline to participate. Beyond practicality, however, it is another dangerous precedent. We are perhaps too far removed from the wage-and-price-control days of Nixon to remember how destabilizing they were.

These are the things we know. Certainly, there will be a host of new regulations that will only emerge in the days, weeks, even months after final passage. And, unfortunately, these will likely be with us long after the government has sold off the last of the bad debt. We could be entering an era where the financial services sector evolves into a kind of regulated utility. Not only would this stifle future innovations in finance, it would also probably jeopardize the U.S.’s status as the global leader in capital markets.

It is hard to see a systemic regulatory failing that allowed the current situation to arise. There does seem to have been a comprehensive failure by the ratings agencies to appropriately analyze the MBS, but torts are a better way than new regulations to correct this. Besides, regulations are usually backward looking. Regulators rarely identify problems before they arise. Chiefly they sort out what happened and who’s responsible after the fact.

Remember, wrongdoing at Enron wasn't uncovered by regulators. It was uncovered by the market, as analysts realized that much of the company’s story was fiction. Markets with free flows of information are the best guard against meltdowns. The slightly less free market we are entering will make them more common.

Also, while I have no real reason to question Hank Paulson’s motives in his rampant cheerleading for a bank bailout, I would feel a whole lot better if he weren’t sitting on a few hundred thousand options to buy shares in Goldman Sachs.

This is something like a 50,000 mile wide Rubicon. Once we’ve crossed into this unchartered, constitutionally suspect territory, it is hard to see us ever going back. We will never again have free-flowing, free-wheeling or free capital markets.

Mike Flynn is director of government affairs at the Reason Foundation. This column first appeared at Reason.com.

The Roots of the Crisis

mike.flynn@reason.org (Michael Flynn) — Wed, 01 Oct 2008 13:34:00 EDT

The unexpected 228-205 defeat of the housing bailout in Congress Monday threw a curveball across Wall Street. It contributed to a large sell-off on Wall Street, where the bailout had already been "priced" into the market. The Dow shed just over 6 percent, the 18th largest drop in its history. But given the dire warnings about financial chaos that would result unless there were a bailout, this seems fairly modest.

Let's be clear: This is a Wall Street crisis, not a national economic crisis. The overall economy, while a bit weak, is still growing. Some politicians are comparing the current environment to the Great Depression. But in 1932, when the federal government last moved to bail out the banking sector, economic output had fallen 45 percent and unemployment was a staggering 24 percent. Today, economic output is actually up and unemployment is a historically modest 6.1 percent.

The overall economy doesn't even face a liquidity crisis in the current turmoil. Consumer, commercial/industrial, and real estate loans are all up over last year. Main Street is doing fine. The liquidity crisis is confined to Wall Street, between and among investment banks, insurance and securities firms, and hedge funds. There is the possibility that the contagion could spread, but in a global capital market, this is hardly certain.

It is the intersection of several underlying trends that have brought us to this point, not a breakdown in any specific part of the financial sector. The fundamental flaw with the bailout approach is that it ignores these trends and simply seeks to shore up the finances of certain Wall Street institutions.

Mortgage-backed securities (MBSes) are the principal source of pain in the current environment. Investment houses would bundle individual mortgages from several banks together into a bond-like product that would be sold to individual investors. Mortgages have historically been seen as among the safest investments. In an era of rising house values, "safe" became "guaranteed returns."

One of the major factors pushing investors into these securities was the Federal Reserve's weak money policy. Immediately after the terrorist attacks of 2001, the Fed began a sustained period of easing interest rates. Its efforts went so far that, at one point in 2003, we had effectively negative interest rates. Institutional investments needed a place to park money and earn some kind of return. Mortgage-backed securities became a favorite investment vehicle. Under traditional models, they were very safe and, because of Fed policy, even the most conservative fund could earn better returns than they could on treasury notes.

In the early years of this century, mortgage-backed securities exploded. Their growth provided unprecedented levels of capital in the mortgage market. There was a lot more money available to underwrite mortgages. At the same time, investment houses were looking to replace the healthy fees earned during the dot com bubble. MBSes had fat margins, so everyone jumped into the game.

The additional capital to underwrite mortgages was a good thing...up to a point. Homeownership expanded throughout the decade. Over the last few decades, the American homeownership rate has been around 60 to 62 percent. At the height of the bubble, homeownership was around 70 percent. It is clear now that many people who got mortgages at the height of the bubble should not have. But Wall Street needed to feed the MBS stream.

At the same time, Fannie Mae and Freddie Mac were going through a crisis. In 2003 and 2004, an accounting scandal was revealed. The two public-private partnerships were cooking the books to show phantom profits. The Bush administration and its allies on the Hill pushed a strong bill to reform how these institutions operated. The measure came very close to passing, but Fannie and Freddie cut a deal. They would refocus on expanding mortgages for low-income borrowers if the feds kept out of their operations. The bargain worked. Virtually all the Democrats and a few Republicans backed the two companies and the reform effort failed.

Fannie and Freddie then went on a subprime bender. They made it clear that they wanted to buy all the subprime or Alt-A mortgages that they could find, eventually acquiring around $1 trillion of the paper. The market responded. In 2003 subprime mortgages made up less than 8 percent of all mortgages. By 2006, they were over 20 percent. Banks knew they could sell subprime products to Fannie and Freddie. Investments banks realized that if they laced ever increasing amounts of subprime mortgages into the MBSes, they could juice the returns and so earn bigger fees. The rating agencies, thinking they were simply dealing with traditional mortgages, didn't look under the hood.

Unfortunately, after several years of a housing boom, the available pool of households who could responsibly use the more exotic financing products had dried up. In short, there were no more people who traditionally qualified for even a subprime mortgage. However, Fannie and Freddie were still signaling that they wanted to buy these products. At the same time, activist groups were agitating for more lending to low-income families. Banks realized they could make even more exotic loan products (e.g., interest-only loans), get the activists off their backs, and immediately diffuse their risk by selling the mortgages into MBSes. After all, Fannie and Freddie would buy anything.

Everything worked as long as housing prices continued to rise. The most pessimistic scenarios on Wall Street showed a leveling off of housing prices; no one foresaw an actual decline in prices. Suddenly, though, there weren't enough buyers. In hot real estate markets, builders raced to bring inventory to market that they thought was inexhaustible. But at this point everyone (essentially) who could possibly qualify for a mortgage had received one. At the same time, the first wave of the more exotic mortgages began to falter. Interest rates on adjustable rate mortgages moved higher—the Fed was finally tightening the money flow—and mortgages that were initially interest-only were close to resetting, with monthly payments jumping to include principal. A not insignificant number of these mortgages moved into default and foreclosure.

The overall numbers moving into foreclosure were small. Someone simply looking at housing stats could be forgiven for wondering what all the fuss is about. Nationally, the number of mortgages moving into foreclosure is just around 1 to 2 percent, suggesting that 98 to 99 percent of mortgages are sound. But the foreclosed mortgages punched way above their weight class; they were laced throughout the MBS market.

Then the MBS market collapsed. The complexity of these financial products cannot be overstated. They usually had two or three "tranches," different baskets of mortgages that paid out in different ways. Worse, as they moved through the system—being bought and sold by different firms—they were sliced and diced in varying ways. A MBS owned by one firm could be very different when it was sold to another.

No one fully understood how exposed the MBS were to the rising foreclosures. The market for them dried up. No one traded them. The market became effectively "illiquid." American accounting standards, however, required firms to use "mark-to-market" to value their assets. This means that you value your assets based on what you could sell them for today. Because no one would trade MBSes, most had to be "marked" at something close to zero.

This threw off banks' capital requirements. Under U.S. regulations, banks have to have a certain percentage of assets to back up the loans they make. Lots of banks and financial institutions had MBS assets on their books. With these moving to zero, they didn't have enough capital on hand for the loans that were outstanding. They rushed to raise capital, which raised fears about their solvency and compounded into a self-fulfilling prophecy.

We should pause here to note that two simple regulatory tweaks could have prevented much of the carnage. Suspending mark-to-market accounting rules (you could use a 5-year rolling average instead, for example) would have shored up the balance sheets. And a temporary easing of capital requirements would have provided banks breathing room to sort out the MBS mess. Although it is hard to fix an exact price for these in this market, they aren't worth zero.

Alas, the Fed and the Treasury decided simply to provide the capital to meet the regulatory requirements. They moved into crisis mode, making a series of tactical moves to deal with specific, present challenges. The first misstep, in March, was to force a hostile takeover of Bear Stearns. The Fed put up $30-40 billion to back JP Morgan's takeover of the investment bank. In the long term, it probably would have been better to let the bank fail and go into bankruptcy. That would have set in motion legal proceedings that would have established a baseline price for MBSes. From this established price, banks could sort out their balance sheets.

It is worth noting that immediately after the collapse of Bears Stearns, rumors quickly circulated on the Street of trouble at Lehman Brothers. Lehman went on a PR offensive to beat back those rumors. The company was successful, but then did nothing over the next several months to shore up its balance sheet. Their recent demise was largely their own doing.

The collapse of the MBS market now started to pollute other financial products. (The Fed moves did nothing to deal with the MBS market, but simply provided temporary means to cope with it.) Credit default swaps and derivatives, both of which amount to hedges against the risk of bonds defaulting, came due. Suddenly, stable firms like AIG were overexposed. Insurance companies regularly sell these swaps, as an insurance policy against bonds defaulting. Traditionally they are fairly conservative investment products. These developments threw off the accounting in one division of AIG, threatening the rest of the firm. Given a few days, AIG could have sold enough assets to cover the spread, but iron-clad accounting regulations precluded this. So the government stepped in.

The one-two punch of Lehman's failure and the government's $85 billion bailout of AIG on September 16 seriously spooked the Street and the Bush administration. With Fannie Mae and Freddie Mac already in government receivership, there were fears that the MBS weakness would spread through the entire financial system. There was a big sell-off on the Dow. The next day, the government announced there would be a bold rescue plan. The market rebounded. Details emerged over the weekend. On Monday, the Dow had another sell-off. But, the most important signal was the rise of oil. The spot price for October delivery of oil jumped $25 a barrel. Some of this was covering trades, but a sizable amount of this appreciation was probably a "flight to quality," a place to park money while everything was sorted out. It was also a signal that the government's plan might not work.

The original plan crafted by Treasury would authorize the department to spend up to $700 billion to buy MBSes and other "toxic" debt and thereby remove them from banks' balance sheets. With the "bad loans" off the books, the banks would become sound. Because it was assumed that the MBS market was "illiquid," the government would become the buyer of last resort for these products. There is a certain simple elegance to the plan.

Except that no market is truly illiquid. It just isn't liquid at the price you want to sell. This summer, Merrill Lynch unloaded a bunch of bad debt at 22 cents on the dollar. There are likely plenty of buyers for the banks' bad debt, just not at the price the banks would prefer. Enter the government, which clearly intends to purchase MBSes at some premium above the market price. That was the nature of the bailout that failed on Monday.

Congressional leaders have vowed to bring a new proposal for a vote, possibly as soon as Thursday, proving yet again that Washington is fertile ground for really bad ideas. But with the market rebounding—as of this writing the Dow was up almost 300 points—and public opposition hardening, signs are emerging that banks are starting to clean house. The crisis may have already peaked. Of course, Congress' ability to further screw this up can't be overstated.

Mike Flynn is director of government affairs at the Reason Foundation. This column first appeared at Reason.com.

California General Election: Voter Guide

adrian.moore@reason.org (Adrian Moore) mike.flynn@reason.org (Michael Flynn) — Wed, 01 Oct 2008 00:00:00 EDT

Executive Summary

It is election season and that means Californians once again face a daunting package of ballot questions on difficult public policy issues. This year’s initiatives cover a wide range of topics including transportation, gay marriage, criminal justice, hospital construction, the treatment of farm animals and much more. As has been the case in years past, the ballot measures are not always as straightforward as they first appear. Some are premised on questionable assumptions and value judgments. Others, despite admirable motivations, would nevertheless lead to unintended or unforeseeable adverse consequences. Some of these initiatives would empower the government to restrict individual freedom and choice in the name of uncertain benefits. And several would further burden California taxpayers by dramatically expanding the size and scope of state government, most notably by borrowing heavily against the future through bonds.

California’s latest budget deferred a nearly $15 billion shortfall to next year, so voters are going to have to be hardnosed about facing the tough choices these initiatives represent. The amount of general obligation bonds authorized in California has nearly tripled, from $42.1 billion in 2002 to a staggering $120.1 billion this year. If the four bond measures on the ballot this November are approved by voters, an additional $16.8 billion of bond debt would be authorized. Given that the state is already spending well beyond its means with an annual deficit of $15 billion, increased commitments would be financially irresponsible and an unjust hardship for future generations of taxpayers.

The nonprofit and nonpartisan Reason Foundation has evaluated the 12 initiatives on this year’s ballot.

(Note: The budget figures cited in this voter’s guide are the official estimates of the California Legislative Analyst’s Office.)

Private Prison Information Act of 2007

mike.flynn@reason.org (Michael Flynn) — Thu, 26 Jun 2008 00:00:00 EDT

Chairman Scott, Ranking Member Gohmert and members of the Subcommittee, thank you for the opportunity to speak to you today. My name is Michael Flynn and I am Director of Government Affairs for the Reason Foundation. Reason is a non-profit, non-partisan think tank that, for four decades, has researched the consequences of government policy and worked to advance liberty and develop ways the market can be used to improve the quality of life for all Americans.

I'm especially grateful to provide testimony today, as the issue before you touches on several aspects of Reason's work. For decades, we have produced leading research showing how the market and competition can improve the delivery of government services. We have also long advocated reforms in the criminal justice system, such as reducing or eliminating jail-time for non-violent drug offenders, to reduce our nation's high rates of incarceration and recidivism. In addition, Reason Foundation publishes Reason, the magazine of "Free Minds and Free Markets."

The Freedom of Information Act (FOIA) process is a powerful tool we have used to expose government corruption and failure, including, most recently, prosecutorial misconduct in Mississippi. Expanding the reach of FOIA throughout the halls of government will find no greater champion than Reason Foundation.

That said, extending FOIA to private companies, including private correctional companies, is at best misguided and at worst a dangerous precedent that would undermine several important principles. It would also stifle competition and, in this specific case, tie us forever to a correctional system that is failing both inmates and the public at large.

I. Extending FOIA to private companies is unnecessary

Currently, federal agencies contract with private companies to manage correctional facilities and immigration detention centers. The government agencies often have their own employees on-site to monitor the facilities and contracts. They also provide regular oversight and audits to determine whether the terms of the contracts are being met. The contractors are also required to file regular reports with the agency on their management and operations. All such documents are currently available from the federal agencies through the existing FOIA process. We know of no case where a legitimate FOIA request was turned down by a federal agency. In other words, most of the relevant information is already available by filing FOIA requests with the federal agency that administers the private contract.

Proponents argue that these documents don't detail the private company's staffing levels, compensation, or training requirements. If these issues are a concern, the answer is simple: The federal agency can - and should - make disclosure of this information a requirement in the contract. There is no prohibition on requiring the disclosure of this, or any other, information as part of the contract. Imagination is the only limit on what federal agencies can require companies partnering with the government to disclose.

Agencies can very specifically and precisely mandate certain staffing levels, rates of compensation, or even specific training courses that must be completed by workers as a condition of their contracts. Indeed, the onus must be on government officials who negotiate and administer such contracts to represent the public interest and require disclosure of information relevant to oversee the contract. They should not defer to the application of FOIA, which was neither intended nor designed for this purpose.

We already have the tools to obtain everything proponents say they want. And we can get it without an unprecedented extension of FOIA into private companies.

Indeed, through contracting, agencies can essentially require the disclosure of more information than would typically be obtainable from a government agency through FOIA.

II. Extending FOIA to private companies is a dangerous precedent

It is important to note that this proposal would have serious negative consequences. Extending FOIA to private companies and, by extension, private individuals is an unwarranted invasion of their privacy.

Governments have sovereign powers to tax, regulate and prosecute. Because of this, Congress wisely enacted FOIA to ensure the public could "peek behind the curtain" to ensure government agencies and officials were acting openly, honestly and fairly. FOIA is a protection against the abuse of government power.

Private companies have no such powers.

There is no argument for private correctional companies to be subjected to FOIA that wouldn't also apply to other government contractors and suppliers, and even down the line to their contractors and suppliers. Thousands of individuals, and small and large companies, provide important products and services to taxpayers and the government through competitive sourcing and managed competition.

Subjecting them to FOIA would open all aspects of their business to any prying eye. Competitors could use it to learn trade secrets. They could use information on compensation to try to poach staff. They could use it to obtain a company's proprietary software code. Curious individuals could even use FOIA requests to find out how much money their neighbor earns. That is not what the FOIA was designed or intended for.

The costs to private companies to comply with a potential avalanche of paperwork and FOIA requests about individual salaries or training courses would be passed along, ultimately to taxpayers.

The end result is that many companies would likely pull out of the contracting market altogether. Not only would this increase costs for taxpayers, it would shut federal agencies out of the innovations and efficiencies that come from market-based competition. We would end up with inferior services at higher costs.

III. Extending FOIA will stifle innovation, eliminate flexibility

It bears noting that the leading proponents of this legislation are organizations that oppose contracting out the operation of correctional facilities. They want to dramatically alter the purpose of the FOIA in order to protect the status quo of mostly government-operated prisons.

Private prisons are delivering significant cost savings and equal or higher levels of quality when compared to government-run correctional facilities, according to a Reason Foundation study. Reason examined data from 18 quality comparison studies conducted since 1989 and found that private prisons outperformed, or were equal to, their government counterparts in 16 of 18 studies. In studies comparing costs, private prisons demonstrated significant savings in 22 of 28 studies.

But, this issue is larger than saving taxpayer money. The correctional system in this country is dysfunctional. Its costs are rising far faster than the rate of inflation. We have one of the highest rates of incarceration and recidivism in the world. We lock up non-violent offenders at alarming rates and provide few opportunities to enhance their skills or to further their educations in ways that would break a cycle of criminal behavior. We are simply housing people, rather than rehabilitating people for a productive life. We need to move away from operating the correctional system and start managing its outcomes.

Competitive contracting gives the government the means to do this. We can build positive performance requirements into the outsourced contract and make compensation contingent on meeting these goals. Today, we could craft contracts that stipulate that private prisons must meet requirements regarding the number of inmates taking GED courses, or getting substance abuse treatment, or taking part in job training programs. We could structure contract payments or even incentive bonuses on a whole range of goals that would benefit society. Private companies would compete and innovate to meet these goals.

Our current public correctional system does not and cannot do this. Government agencies are monopoly providers who can never be "fired" nor incentivized through performance payments based on outcomes. Private providers can be made far more accountable to the public through a rigorous contracting process than the current bureaucracies that run most prisons.

We have a choice. We can continue to fund our existing - and failing - correctional system or we can use the competitive contracting process to achieve correctional outcomes that are accountable, deliver a higher quality of service, and successfully rehabilitate prisoners while reducing the number of Americans behind bars. Again, imagination is the only thing that limits building these positive outcomes into a contract. Without this tool, we will forever have the existing status quo.

IV. Conclusion

The current proposal before you fails three critical policy tests:

It is unnecessary. Most of the relevant information is already available through the normal FOIA process. Any information that isn't already available could very easily be included in the terms of a contract.
It has serious, negative consequences. It exposes a private company's internal trade secrets and operations, not to mention individual salary information, to any curious outsider, imposing costs that will be passed along to the public, potentially reducing the government's contracting pool, and jeopardizing the right to privacy.
It locks us into a system that is failing. Contracting correctional management is a tool to improve our prison system. Eliminating competition and strengthening the public monopoly provider will prevent us from focusing on positive outcomes. It is neither in the interests of the general public nor incarcerated individuals.

Thank you again for the opportunity to provide testimony on this important issue. I'm happy to take any questions.

Legislative Proposals on GSE Reforms

mike.flynn@reason.org (Michael Flynn) — Thu, 15 Mar 2007 14:35:00 EDT

Chairman Frank, Ranking Member Bachus, and members of the Committee. Thank you for the opportunity to speak to you today. My name is Michael Flynn and I am Director of Government Affairs for the Reason Foundation. Reason is a non-profit, non-partisan think tank that, for almost 4 decades, has researched the consequences of government policy and worked to advance liberty and develop ways the market can be leveraged to improve the quality of life for all Americans.

The legislation before you today is a massive undertaking. Over 300 pages long, it could have a significant impact on America’s housing sector, as well as the aspirations of millions of families. At a time when segments of the housing market are showing wear and even vulnerability, I know you do not take the task before you lightly.

My remarks will concentrate on the Affordable Housing Fund that would be established by the legislation. Reason has published several studies on the issue of affordable housing, focusing especially on the housing market in California. As a matter of policy, we have significant concerns about this proposed new federal fund.

With housing prices at record highs in many parts of the country, it is understandable that you would be interested in examining ways to make housing more affordable. In many parts of the country, the unavailability of affordable housing is a serious concern. In California, where Reason is headquartered, the demand for housing outstrips the supply by 500,000 to 1 million units. In many parts of the state, the most commonly used ‘index of affordability’ is about half that in the nation as a whole. Nationally, about 50-60% of families earning the median income can afford a home in their community, but in many parts of California, only about 25-30% can.

Unfortunately, a new federal Affordable Housing Fund will not fix this situation. In the end, we believe it will fail. It will not fail because of a lack of resources, although there will be many who clamor for more funds. If the Fund were doubled or tripled—as many groups will request—it would still fail. It will fail because it doesn’t address the fundamental problem: too few housing units are being built to meet the demand.

Simply put, this proposal fails three tests:

It ignores the real problem;
It creates a veneer of action, which will stymie more substantive efforts for meaningful reform; and,
It creates a host of unintended consequences, ranging from distortions in the housing market which may exacerbate the problem to wasting resources on activities that have nothing to do with improving the affordability of housing.

I will discuss these briefly.

In many parts of the country, there is a severe shortage of housing. This, combined with monetary policy that has effectively increased the demand for housing, has dramatically increased the cost of housing in many areas. While in recent years the nation has experienced a burst of homebuilding, new construction has not met the robust demand.

It is not for lack of capital. I do not need to tell the members that unprecedented resources have been devoted to construction over the last decade. These figures are well-known. It is also not due to any inherent economic flaw in the housing market, per se. There is nothing in the fundamental economics of housing that would skew building towards any particular segment of the market. Entire industries have sprung up catering to the demands of low and moderate income consumers in virtually every other sector of the economy. Housing would be no different, but for one factor: government policy.

No matter how much money from the federal treasury is devoted to housing, it will ultimately run into the chief architects of housing policy in this country, which are state and local governments.

It is no small irony that while this committee deliberates over measures to increase the stock of affordable housing, governmental bodies elsewhere are meeting to consider new growth limits or boundaries, increased impact fees, more stringent zoning requirements, prevailing wage laws, new environmental regulations, open space requirements, or building standards.

While some of these may seem individually reasonable, taken together, they have a cumulative effect that makes homes less affordable for more and more Americans. Moreover, these, as well as other land use restrictions, have exploded over the last decade. Today, it is increasingly expensive, cumbersome, and time consuming to build a single dwelling. Researchers from the University of California at Berkeley found that prevailing wage mandates on affordable housing projects alone drive up the cost of construction by anywhere from 9 to 37 percent. Reason Foundation’s study of housing price trends in Washington State and Florida found that 20 to 25 percent of the housing price increases in these states could be attributed to their statewide growth management laws. In Florida, the impact was significant enough to reverse trends toward more housing affordability in urban counties.

Growth management and land-use restrictions artificially limit the supply of housing that can be built. These restrictions work in two ways. First, housing units are explicitly limited through large lot zoning, housing permit caps, or urban growth boundaries (or limit lines). Second, regulatory burdens increase the uncertainty of the permitting process and dramatically increase the upfront costs needed to apply for and receive approval. Reason Foundation studies have empirically investigated both these effects. The result of this higher level of regulation is to make building lower and middle-income housing, which already involves very tight profit margins, economically risky and less viable. In light of this, it is no surprise that builders often focus at the upper-end of the market. If you are pressured to build fewer units than you otherwise would, you will focus on higher margin products, to achieve the necessary return on capital.

This causes a ripple effect that is felt all the way down the housing ladder. Middle income or young professional families who might otherwise move to larger, newer homes are priced out of that market. As a result, they seek out older, smaller homes and push these prices up beyond the means of low-income and blue-collar families.

A 2005 study by the Harvard Institute for Economic Research found that, over the last several decades, there have been a growing number of metro area housing markets in which housing prices have risen substantially higher relative to the costs of physical construction. The authors concluded that these changes do not appear to be the result of a dwindling supply of land; rather, they reflect the increasing difficulty of obtaining local regulatory approval for building new homes, making large-scale development increasingly difficult. This problem has been most acute in coastal regions like the Bay Area, Southern California, Seattle, and Boston, but it is increasingly spreading to interior regions like Austin, Denver, and Raleigh-Durham. In other words, regulation is artificially constraining the supply of housing, so we’re left with higher prices and fewer new homes being built.

It is the total stock of housing that dictates the relative affordability of homes. There is a general misconception that affordable housing is lacking because no one is building it. But, affordable housing is not generally new housing. It is housing that is made available as families move into newer, more expensive housing. Any artificial falloff in new construction creates bottlenecks throughout the system.

Unless we deal with this bottleneck, which again is mostly the result of regulations and restrictions that limit growth and construction, we’re simply applying a band-aid to a gaping chest wound. Special subsidies, loan guarantees, credits, or even blanket changes in the measure of affordability can’t alter this equation, as the recent meltdown in the sub-prime market shows.

Now, even the smallest band-aid will stop some bleeding. If the federal government decides to pump billions of dollars into affordable housing initiatives, no doubt some new units will be built. Some number of families will be lucky enough to benefit from this. But, a great opportunity will be lost. We will have lost the opportunity to review the range of regulations and restrictions that impact the housing market. State and local officials, content to see millions of dollars flowing into their community, will never consider the consequences of the restrictions they enact. The fundamental factors that artificially limit the supply of housing will remain in place; the crisis will simply be put off until another day.

Of course, a lot of that money will be wasted. First, there are state and local elected officials, who often treat new money from Washington as a lotto jackpot and view the stipulations for their use as suggestions. It may be redirected to uses only tangential to housing or it may simply replace resources that were being spent, resulting in fewer new resources than would be expected. Or, even if spent as directed, it may exacerbate distortions in the housing market that will further reduce the overall supply of affordable housing. Several Reason studies examining particular programs in California are cited at the end of my testimony.

Housing policy has often created distortions which can be gamed by many of the players. There are of course some developers and landlords who have manipulated the system. In many places, inclusionary zoning restrictions, which mandate that a certain percentage of a development be set-aside for low-income groups, have sparked a cottage industry in the selling and buying of these set-asides. While lucrative for some, they fail to improve the lives of families searching for housing.

Moreover, statistical analyses of these programs by economists at San Jose State University found that cities that adopted inclusionary housing programs experienced dramatic declines in private market housing construction. The number of units created through these programs were minor compared to the measured need in these communities and could not come close to compensating for the lower level of housing construction in these communities. In Los Angeles and Orange Counties, for example, 17,296 fewer homes were produced in the eight cities with inclusionary zoning ordinances while just 770 “affordable” units were produced. Because housing supply was reduced but lower rate housing was subsidized through the private market, the effect of the inclusionary housing ordinances was to increase housing prices by $33,000 to $66,000 per unit.

I would be remiss if I didn’t mention one particular organization that has carved itself a lucrative niche from housing programs. The Association of Community Organizations for Reform Now (ACORN) is a multi-national conglomerate that acts as the umbrella for more than 70 organizations. Among these are a number of state housing associations or corporations, as well as the ACORN Housing Corporation, which operates nationally. In the mid-1990s, the ACORN Housing Corporation received a $1.1 million grant from the AmeriCorp program to train AmeriCorp workers to assist low-income families trying to purchase a home. According to evidence uncovered by the program’s Inspector General in 1994, these workers were directed to inform these families that they had to become dues-paying ACORN members in order to receive the assistance. Because they effectively were using the grant to increase the membership of ACORN, which engages in political advocacy, AmeriCorp terminated the grant.

This commingling of government grants between affiliated organizations and the ACORN political organization continues. According to tax records, between 1997 and 2003, ACORN Housing Corporation received more than $11 million in government grants. Almost half, over $5 million, was paid out to other ACORN entities as either fees, rent, or grants.

The examples of ACORN’s misuse of government grants, especially housing grants, are too many to cover in this single hearing. I would be happy to provide the Committee with other instances, but suffice it to say that it stretches back for thirty years. In almost all cases, the misuse of funds has been tied to political advocacy. The prospect that such an organization –rather than low and middle income Americans—could benefit from a new infusion of federal housing resources is troubling.

Even if Congress were able to construct a Housing Fund in such a way that such waste and abuse were eliminated and it were certain that every single dollar went to affordable housing initiatives, it couldn’t achieve its intended goal. There isn’t a lack of resources to build housing; there is an overabundance of regulation limiting the construction of any housing. This causes a bottleneck that is felt through every segment of the housing market.

Thank you. I would be happy to take any questions you have.