More of the Same! Won't Fix it This Time!

When I am advising someone whose efforts are not producing the results they seek, there are several expressions I've picked up along the way that come to mind immediately. The first one goes something like this: "If you want more of what you have, do more of what you are doing". If that doesn't work, the second one is a little sharper, and more to the the point: "Doing the same thing over and over, and expecting different results is the definition of insanity". If they aren't with me after that, this last one is self evident, unless you work in Washington: "When you find yourself in a hole, first stop digging".

Based on what I read and hear today, I've come to some conclusions. Our political class has gone insane. They'd rather enjoy the power that accrues to them in troubled economic times, and they are going to make things much worse on the way to trying to make things better. How else do you explain the way they are acting?

The new administration is putting together the mother of all stimulus plans in order to get our economy back on track again. The big problem with this kind of thinking is that it was this type of thinking that got us into this jam in the first place. The housing fiasco that set off the economic troubles we now enjoy is the result of a huge misallocation of capital brought about by a number of policy decisions, some of them misguided, and there unintended consequences. There are lessons to be learned from the housing debacle , but they are not the ones that seem to be getting all the attention. The lessons are 1.) Misallocating capital always ends badly, which also means that misallocating huge amounts of capital ends even worse. 2.)Eliminating the capital gains tax is a powerful incentive that draws investors to seek the higher profits it affords.

Providing tax relief to homeowners, by eliminating the capital gains tax on the first $500k in profit on the sale of a residence, was probably pretty good tax policy. You shouldn't follow it up with an easy money stance ( the Fed Funds Rate was held below 2% from December of 2001 until November of 2004) as the Fed did, providing artificially low mortgage interest rates and putting pressure on the value of the dollar, that invariably lead to an surge in inflation and a preference for real assets. If you do, you are you are walking down a very dangerous path. On top of that, you push banks to make loans to folks who can't pay them back, and it turns into an all out sprint, sending home prices soaring. The Fed reacted by tightening monetary policy, which started the downward spiral in home prices as the SEC dug in it's heels defending it's mark to market accounting rules that have help to gut the capital base of the banking industry.

The culmination of the unintended consequences of what many people considered to be good public policy has turned into the economic ilk we see all around us today.The question I have for our sages on the hill is this: Where did you get the idea that our economy would be better off if we invested more capital in our homes at the direct expense of investing less capital to make our businesses more productive? In others words, only crazy people say things like, "I might be unemployed but at least I have a big house I can't afford". My followup question is: Why are these same pols now insisting that the government pursue the same bad advice again on an even grander scale?

The lesson was: tax cuts provide powerful incentives to investors. What also should have been apparent is that tilting the playing field has consequences. It leads investors to favor one asset class over another. I propose that we once again level the playing field, by eliminating the tax on all capital gains. This would unlock significant capital from non productive assets, and provide a powerful incentive to the risk takers whose capital facilitates the business productivity increases that drive employment growth and higher wages.

The lesson that wasn't learned is that politicians are incapable of making policies guided only by sound economics. They are too busy providing favors for their political supporters in order to be able to count on them to fund their next run for office. Should I believe that the political class will do things differently this time? I don't think so. They never do. Instead, there will be a massive never ending orgy of pork to pay off the friends of the party in power. In other words, a misallocation of capital on a scale we've never seen before, the same thing that got us here, only several magnitudes larger.

The millions of entrepreneurial minds that together make up the free market are a much better bet to move us forward than the proven record of those whose failed policies have landed us in the soup. They just need a little incentive to get going again. So let's "Ax This Tax" and get on with the economic recovery.