Archive for January, 2010

To Stimulate Job Creation, Try Helping People Who Actually Create Jobs

Tuesday, January 26th, 2010

First, a simple fact: according to the Small Business Administration firms with less than 500 employees created 64 percent of all new jobs in the U.S. during the fifteen years up to 2008, and employ over half of all private sector employees in the country. So, naturally, when Washington looks to allocate bailout and stimulus funding, the largess goes straight to bloated, uncompetitive layoff champs like General Motors.

So here’s a crazy thought: how about a little help for folks who actually have some idea how to employ people and make a profit doing it? The potential bang for the buck would be considerably higher in aiding small, innovative firms, or at least in getting out of their way. To do so, however, one has to craft solutions that acknowledge the special problems small firms have in this economy. Here are three approaches:

1) Cut small business payroll taxes. Tax cuts are part of the answer, but recognize that the recent downturn has sharply reduced or eliminated profits for many small businesses, and that early-stage firms usually operate at a loss or “burn rate” even in the best of economic conditions. (Note this last point is also true for older small firms reinventing themselves – a critical ability in an era of both innovation and financial stress – which is why focusing only on new firms would be a mistake). What this means is that while an income tax break for small business is certainly advisable, it will be of limited short term help to firms with little or no current taxable income. This is even more true for the administration’s proposed capital gains cuts for small companies, since such firms rarely have earnings in this form. If we want to help small business, a reduction or moratorium on the payroll taxes small business must pay regardless of profitability is probably the surest way to quickly aid struggling yet promising firms. Because the first priority should be to prevent layoffs and allow retention of the people needed to expand the enterprise and set the stage for future hiring, this cut should apply to the current payroll, not just the new employees the Senate jobs bill targets for tax credits.

2) Provide seed grants for small business in hard-hit urban centers. Cities are natural incubators for small business, providing extensive infrastructure and facilitating networking with an energy efficiency far higher than most suburban or rural locations. But these also tend to be high local tax and cost of living environments, partly because of their disproportionate role in addressing national social issues. In an anemic economy this higher cost structure can drive struggling firms out of town or out of business before they get strong enough to help sustain the city – for example, consider the demise of New York’s Silicon Alley. Federal “urban angel grants” could be used to counterbalance this effect, especially in formerly expanding new business districts that have recently fallen into decline.

3) Encourage venture capital. Access to capital is also critical for small business, and especially for start-ups. Surveys have shown that lack of bank loan availability, while an issue for such firms, is not at the top of their list of current problems. This is partly due to the fact that, with demand for their products and services having fallen so sharply, funding expansion is less of a priority. However, for early stage companies, debt is not the dominant means of financing. In fact, most early stage venture capital is provided in the form of equity, especially convertible preferred (this is a point a few of my economist friends will recall I demonstrated in a paper attributing the phenomenon to problems with debt’s foreclosure option under high probability of “asymmetric information” i.e when entrepreneurs are more likely to know more about the condition of their start-up than venture capitalists). Because this type of funding plays so key a role in backing new and innovative firms, venture capital financing needs to be encouraged right now, and care must be taken to make sure any new taxes and rules do nothing to harm venture capital formation. This means exempting venture capital investments from any coming increases in long term capital gains rates (indeed, cutting this rate would help) as well as from costly regulation contemplated for other financial activities (VC firms had nothing to do with the current crisis and what limited hedging they may do in the securities markets constitutes little systemic risk).

One might reasonably and even urgently ask where the money to do any of this would come from. The answer is from reallocation of some of the funds in the stimulus plan, much of which is slated to be spent sub-optimally. Alternatively, some of the unexpectedly high returns on TARP funds paid back by large banks might be used. Of course, there would be some merit in using these funds to simply reduce the deficit, but if the political winds cannot be prevented from blowing money off Capital Hill, at least let those gusts help fill the sails of a vessel of hope for real job creation. The name of that ship is small business.

If Washington Won’t Regulate Like Capitalists, How About Like Chinese Communists?

Friday, January 22nd, 2010

The recent spasm of White House and Congressional initiatives to limit bank risk taking flies in the face of demands for more loan origination, and for good reason: lending is all about taking risk. This point may be lost inside the Beltway, but not in Beijing.

For example, the Obama Administration’s proposal to eliminate bank’s proprietary trading would sharply reduce the ability to take positions offsetting exposure created by a variety of customer financings, potentially increasing the riskiness of banks. Further, driving banks out of trading deprives them of a revenue stream which may have low or even negative correlation with returns on lending, removing a stabilizing counterbalance. Case in point: Phibro, the commodity trading firm formerly owned by Citigroup, produced earnings that lowered the funds Citi required from the TARP by hundreds of millions of dollars (regulators pushed the bank into selling Phibro to Occidental Petroleum for less than one year’s earnings, so we as Citi’s taxpayer-shareholders no longer have the benefit of that diversification – see “Taxpayers Saved from Morally Corrosive Profits As Citi Sells Phibro”). Private equity and hedge funds, two other businesses from which Obama would bar banks, also played no significant role in banks’ losses in the crisis, in some cases offsetting hits to loan portfolios.

Meanwhile, the White House plans to tax banks assets less Tier 1 capital and FDIC-insured deposits, which in plain English means a levy on the banks’ lending risk. The President claims his aim is to recover TARP funds. Leaving aside the fact that the big banks have already repaid those funds with interest, why would you tax lending at a tine when you are trying to increase it? As I’ve noted before, there’s a strong rationale for taxing banks to fund deposit insurance (see “You Don’t Want To Pay Deposit Insurance Premiums A Year In Advance? Fine – Then Pay Three Years Worth! You Wanna Try For Six?”). But both experience and academic research (including my own) demonstrate the time to increase that tax is when the economy is strong and lending risk is high, since it’s during a boom that a downturn is most likely. Increasing levies a period of economic weakness and low risk-taking delays and attenuates recovery. This crisis demonstrated a need to insure banks against runs on short-term liabilities beyond deposits, meaning a broader financial stabilization fund is in order, but the time to tax remains the same: during expansions, reigning in risk when banks are not undercapitalized, as they are now. Of course, the President’s tax would be used not for systemic insurance but to fuel federal spending, drawing capital out of banks just when more of it is needed to fund the lending required for recovery.

Then of course there’s the Congressional proposal to force lenders to retain a piece of every mortgage they originate. The idea is that they’ll be more careful in their lending if they have to keep some of every loan they make. But as demonstrated in a study I co-authored, the effect of restricting loan sales is ambiguous: origination may be more cautious, but when a downturn inevitably does come, those loans the banks were forced to retain will still go south, meaning a bigger bailout than if those assets had been sold. Restricting sales can thus actually lead to riskier banks.

How should bank risk-taking be regulated? The key is to recognize control is achieved not by eliminating risk taking but by making sure institutions are in a position to manage the risk they take on, and that means properly using tools like trading and secutization now under attack from Washington. It also means being responsive to economic conditions. For a more constructive approach, one might look across the Pacific, where China’s central bank waited until that nation’s recovery was in full swing (growth hit 10.7% last month according to Beijing) before increasing bank reserve requirements and tightening lending standards so as to dial down risk and deflate nascent bubbles.

Perhaps it’s unrealistic to expect this Administration and Congress to listen to council from capitalists (even the liberal-leaning Warren Buffet criticized Obama’s bank tax); populist bank-bashing is just too tempting, especially in the wake of a rebuke like that the President received in Massachusetts this week/ All I’m really asking for is regulatory policy less wrong-headed than that of the Communist Party of the People’s Republic of China.