Where Will the Money Go?

by Kevin D. Williamson
As Europe founders, we should be moving forward with these seven steps.

A few weeks ago, it looked like bank depositors in Cyprus might lose 10 percent of their deposits in excess of 100,000 euros. As of this morning, that is looking more like 60 percent. That the European economic-integration project is an unmitigated disaster is obvious to everybody except those who are professionally obligated to remain immune to the truth. But Europe is not the only large economy operating on dodgy premises: While there is no reason to believe that China is headed for a European-style meltdown in the near future, its oligopolistic banking system is rife with bad loans, many of which have been packed into off-balance-sheet instruments, and the country’s bank deposits represent an unusually large share of GDP. Russia has been riding high on a petro boom, but it is one petro bust away from crisis. And if we have learned anything from events such as the 1997 Asian currency crisis or the 2008–09 credit crunch, the sources of economic instability are not always obvious.

Global capital wants to go where there are returns, but it will settle for safety if it has to. For years, that safety was found in the banks of stable, well-governed countries such as Switzerland and the United Kingdom. But the problems suffered in recent years by Iceland and Cyprus, among others, point to a problem for such finance-friendly countries as Ireland, Malta, Singapore, and even Switzerland: Having a banking sector larger than your entire economy can be an enormous problem. (Swiss bank deposits are some six times GDP.)

If you are looking for an economically and politically stable country with reasonable growth prospects in which to park your capital, consider the world’s ten largest economies by GDP, in reverse order: Russia, India, Italy, the United Kingdom, Brazil, France, Germany, Japan, China . . . and the United States, with an economy roughly twice the size of second-place China’s. What else is on the list? A few hostages of the euro nightmare, a couple of autocratic police states overdue for another bloody revolution or three, an up-and-coming democracy in which 68 percent of the people live on less than $2 a day, a poor country not 30 years removed from its last military dictatorship, a rapidly aging country that has been in recession for much of those same 30 years . . . and jolly old England. And us.

The United States should get ready to hang out the welcome mat for the huddled masses of capital yearning to breathe free. But being the world’s investment destination is not always an unmitigated good. Gushers of foreign capital helped inflate the housing bubble and contributed to the ensuing financial crisis. Our asinine tax-and-regulatory regime does not always encourage investors to put capital to its best and most productive uses. And our financial sector, allegedly reformed by Frank-Dodd and by the brilliant people of Massachusetts’s elevation of Senator Elizabeth Warren to Mount Olympus-by-the-Potomac to hurl lightning bolts and invective upon the pinstriped hordes below, is in reality still weak and unstable. If we want to make the most of the rest of the world’s current economic troubles — and I see no reason why we should not — there are a few things we should do to get started.

1. Get rid of the corporate-income tax. As readers of Exchequer will know, I am not a big tax-cutter. But our tax on business incomes is, famously, the highest in the developed world, except that a great many large and politically connected businesses do not pay it. Our corporate tax is so rife with favoritism, carve-outs, and boneheaded “incentives” to do Washington’s bidding that firms such as General Electric and Honeywell pay little or no corporate tax in many years, and all corporate taxes combined add up to about 10 percent of federal revenue, even though the top rate is nearly 40 percent. What this means is that companies spend a great deal of money figuring out creative ways to minimize their taxes. And the corporate-income tax, when it is paid, constitutes double taxation in some instances, such as when after-tax profits are paid out to investors as dividends, which are taxed again. Ideally, we would tax all income (salaries, bonuses, dividends, capital gains, inheritances, blackjack winnings) the same way (when it hits somebody’s bank account) and we’d tax it once, and everybody’s taxes would take four minutes to do. But while deep and far-reaching reform of the rest of the tax code probably is not on the near-term horizon, even if Barack Obama and Harry Reid were replaced by conservative Republicans, we could get rid of the corporate-income tax at a cost of only 10 percent of federal revenue, which could easily be distributed across the rest of the tax base. Overnight, businesses that spend millions of dollars and man hours every year on figuring out what’s expensable, what qualifies for what deduction or exemption, and how to route all the rest to the Caymans would be able to put those resources to actual productive uses. And there would be much more incentive to invest in long-term productive activities in the United States.

2. Raise banks’ capital requirements. Doing so will undoubtedly raise the cost of lending, but that is a reasonable price to pay in exchange for greater stability throughout the banking system. It is the simplest single reform that we can undertake to make the system more reliable — and to ensure that no bank is too big to fail. Even with higher capital requirements, U.S. banks are going to look pretty good compared with their European counterparts. A few more basis points on your loan looks a heck of a lot better than a 60 percent haircut on your deposits.

3. Make sure the FDIC gets paid. In the depths of the 2008–09 financial crisis, the FDIC had to go begging for money and impose a special fee on banks in order to replenish its emergency fund. This happened in no small part because the FDIC neglected to collect premiums between 1996 and 2006. It didn’t need the money then, and it figured it wouldn’t need it in the foreseeable future. Which goes to show what federal regulators can foresee. The FDIC is one of the few federal regulatory agencies we have that works reasonably well, and it is a source of confidence for millions of bank depositors. Make sure it is fully funded and that it does as little as possible beyond its core mission. While it is impossible to insulate the agency from politics, making sure that it owns its own revenue stream is the best we can do, short of relocating the agency to Bonners Ferry.

4. Fix the money markets before they become a problem again. There is about $2.7 trillion floating around in money-market funds, which were bailed out by the Fed in 2008. As Tyler Cowen notes, they are an underappreciated source of systemic risk. The rule requiring them to keep 10 percent of their holdings in liquid assets to cover runs on funds probably is not adequate. A small capital requirement should probably be imposed on them, even though the industry is howling that this will kill profits. Other reform proposals may or may not have merit, but, again, a simple reserve cushion seems the easiest and most straightforward measure.

5. Start hanging state pension-fund managers. The SEC was right to charge the entire state of Illinois with securities fraud for lying about its pension obligations; it erred only in failing to put anybody behind bars. I’ve reported before that state pension funds are some $3 trillion short of their obligations; Steve Malanga reported in the Wall Street Journal over the weekend that state and local taxpayers are on the hook for some $7.3 trillion in obligations they never approved. Bailing out Citi was painful; bailing out California would be somewhere between the works of Dante and those of the Marquis de Sade. Washington needs to be on this before it is a full-blown meltdown.

6. Establish a BRAC-style committee on regulation and corporate welfare. Most Republicans and a few Democrats want regulatory reform. Most Democrats and a few Republicans would like to see less corporate welfare. The two are not really separate issues: Narrowly targeted regulatory measures (and regulatory carve-outs) are one common form of corporate welfare. Put the two together into a single package to be approved or rejected in its entirety, as we did with the military bases during the BRAC process. If we can deal away some special-interest tax breaks in favor of broad regulatory reform, that’s a win-win.

7. Let the next troubled bank fail. Nobody will ever believe that we have solved the too-big-to-fail problem until we let a major institution fail. If we do Nos. 1 through 6, then we have a better chance of being able to do No. 7.

The foregoing list is not a comprehensive solution to everything that ails the U.S. economy. It is, rather, a to-do list that will make the United States more attractive as a haven for capital in a troubled world while helping to ensure that our financial system and other institutions are better equipped to handle it. We want our businesses and investors to put more resources into building goods and delivering services, and less into navigating the tax code and engaging in regulatory arbitrage. We are in an interesting position at the moment: Stocks are at or near record highs, while the cost of Treasury borrowing is near historic lows. That is largely the result of the Fed’s keeping the taps wide open, but, as the Wall Street Journal argues, that is not going to last forever, and “one of these two contrary markets will eventually have to give.” What is needed now is sensible, sustained, long-term investment, driven by productivity and stable financial institutions. We have a window of opportunity to do a great number of things right while most of the rest of the world is suffering from self-inflicted injuries. We are past the crisis, and past the short-term fix. While Europe is trying to figure out what to do in the next 20 minutes, we should be thinking about the next 20 years.

Kevin D. Williamson is National Review’s roving correspondent.