Bravo. Reprinted from the WSJ:
With only two balance-sheet crises in the U.S. in the past 80 years, 1929-33 and 2007-09, we have little experience against which to test alternative policies and economic responses. Japan and Sweden are examples of economies that followed distinct pathways after crises in the early 1990s. In Japan the economy floundered in slow growth for over two decades; Sweden recovered much more quickly. The difference can be attributed to following different policies in the treatment of severe bank distress.
Japan’s real-estate market suffered a major decline in the early 1990s. Home prices peaked in the fall of 1990 and fell by 25% in two years. By 2004 they had fallen 65%. Meanwhile, nonperforming loans continued to escalate throughout this 14-year period.
Japanese policy permitted banks to carry mortgage loans at book value regardless of their accumulating loss. Loans were expanded to existing borrowers to enable them to continue to meet their mortgage payments. This response could be rationalized as “smoothing out the bump.” Bank investors were protected from failure by stretching out any ultimate return on their investment, relying on a presumed recovery from new growth that never materialized. This accounting cover-up was coupled with government deficit spending—tax revenues declined and expenditures rose—as a means of stimulating economic growth that was delayed into the future.
From the beginning Japan was caught in the black hole of too much negative equity. The banks, burdened with large inventories of bad loans, geared down into debt reduction mode, reluctant to incur more debt, much as their household mortgage customers were mired in underwater mortgages and reluctant to spend. The result was a decade of lost growth that stretched into and absorbed a second decade of dismal performance. The policy cure—save the banks and their incumbent investors—created the sink that exceeded the pull of recovery forces.
Sweden’s response to deep recession in the early 1990s was the opposite of Japan’s: Bank shareholders were required to absorb loan losses, although the government financed enough of the bank losses on bad assets to protect bank bondholders from default. This was a mistake: Bondholders assumed the risk of default, and a bank’s failure should have required bondholder “haircuts” if needed. Nevertheless, the result was recovery from a severe downturn. By 1994 Sweden’s loan losses had bottomed out and lending began a slow recovery that accelerated after 1999.
The political process will always favor prominent incumbent investors. They are visible; they contribute to election campaigns; they assist in the choice of secretaries of Treasury and advisers and they suffer badly from balance-sheet crises like the Great Recession and the Great Depression. Invisible are the investors whose capital will flow into the new economic activity that constitutes the recovery.
Growth in both employment and output depends vitally on new and young companies. Unfortunately, U.S. firms face exceptionally high corporate income-tax rates, the highest in the developed world at 35%, which hobbles growth and investment. Now the Obama administration is going after firms that reincorporate overseas for tax purposes. Last week Treasury Secretary Jack Lew wrote a letter to the chairman of the House Ways and Means Committee urging Congress to “enact legislation immediately . . . to shut down this abuse of our tax system.”
This is precisely the opposite of what U.S. policy makers should be doing. To encourage investment, the U.S. needs to lower its corporate rates by at least 10 percentage points and reduce the incentive to escape the out-of-line and unreasonably high corporate tax rate. Ideally, since young firms generally reinvest their profits in production and jobs, such taxes should fall only on business income after it is paid out to individuals. As long as business income is being reinvested it is growing new income for all.
There are no quick fixes. What we can do is reduce bureaucratic and tax barriers to the emergence and growth of new economic enterprises, which hold the keys to a real economic recovery.
Mr. Smith, a recipient of the 2002 Nobel Prize in economics, is a professor at Chapman University and the author, along with Steven D. Gjerstad, of the new book “Rethinking Housing Bubbles” (Cambridge University Press).