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How to Grow Employment and the Economy

Executive Summary

On the basis of the arguments and evidence in the macroeconomics and finance literature, we suggest the following ideas, which, if implemented, will grow employment and the economy in the short and long-run.

Cut spending and entitlements: Congress would need to enact significant spending cuts on both discretionary and non-discretionary (including Medicare, Medicaid, and Social Security) items. These spending cuts should provide 85% to 90% of the funds for any deficit reduction plan.

Lower taxes: Congress would need to lower personal tax rates, and the corporate tax rate. Simplification of the tax code would provide additional revenues.

Focus on education: This includes the quality of the primary science and math education, and the lack of native-born Americans’ interest in pursuing graduate science and technology education. The education challenge can be addressed without investment of additional financial resources.

Burst the real-estate bubble: Stop using current and future taxpayer dollars to continue propping-up/bailing-out the U.S. real estate market. In particular, privatize Fannie Mae and Freddie Mac.

Address the banking crisis: Corporate board members and institutional investors in large financial institutions should implement executive incentive compensation plans and capital structure strategies focused on creating and sustaining long-term shareholder value. And, if a bank fails, let it fail – no matter how large it is.

Related to the issue of growth in employment and the economy is the following important policy question: Is a reduction in government expenditures, or an increase in government revenues the more effective policy for successfully reducing the federal deficit and national debt? Academic research findings strongly suggest that reduction in government expenditures are much more effective in successfully reducing the federal deficit and national debt.

Sanjai Bhagat

Professor of Finance, University of Colorado at Boulder

January 2011

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1. Introduction

Perhaps the only consensus regarding the massive $814 billion fiscal stimulus initiated

in February 2009, also known as the American Recovery and Reinvestment Act (AARA), is

that it has not had the desired effect on employment or the economy. The current

unemployment rate is at 9.4%. The unemployment rate for the past year has fluctuated between

9.5% and 10.0%; see figure 1.1

So how do we grow employment and the economy? There is not and cannot be a silver

bullet solution, else it would already have been tried by now. Briefly, the solution consists of

the following steps noted in the order of importance:

1 A Federal Reserve Bank economist, after a comprehensive and thorough analysis of the employment impacts of ARRA, concludes, “…ARRA spending created or saved about 2.0 million jobs…in the total nonfarm sector by early 2010. However, the results indicate that many of these ARRA-generated jobs were short-lived, as the estimated employment impact fell to just 0.8 million… by June 2010 and to essentially zero by August 2010.” Wilson (2010).

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Step 1: Cut spending and entitlements: Congress would need to enact significant spending

cuts on both discretionary (including Government wage expenditures) and non-

discretionary (including Medicare, Medicaid, and Social Security) items. To be fair to the

current and near-term recipients of Medicare, Medicaid, and Social Security, these non-

discretionary spending cuts would have to be gradually implemented over ten or fifteen

years. These spending cuts should provide 85% to 90% of the funds for any deficit

reduction plan.

Step 2: Lower taxes: Congress would need to significantly lower the personal tax rates,

and the corporate tax rate. Simplification of the tax code would be a step in the right

direction and would provide additional revenues.

Step 3: Focus on education: This includes the quality of the primary science and math

education (rather the learning of science and math by primary school students), and the

lack of native-born Americans’ interest in pursuing graduate science and technology

education. The education challenge can be addressed without investment of additional

financial resources. However, it will require investment of political and bully-pulpit

capital of our national leaders, and the parental-energy capital of our families.

Step 4: Burst the real-estate bubble: Stop using current and future taxpayer dollars to

continue propping-up/bailing-out the U.S. real estate market. In particular, privatize

Fannie Mae and Freddie Mac. Ensure that FHA enforces prudent lending standards and

minimum equity down-payments of 15%.

Step 5: Address the banking crisis: Corporate board members and institutional investors in

large financial institutions (including large commercial and investment banks, and

insurance companies) should implement executive incentive compensation plan and

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capital structure strategies focused on creating and sustaining long-term shareholder value.

In particular, incentive compensation should include only restricted stock and restricted

stock options, restricted in the sense that the stock cannot be sold or the option exercised

for at least two years after the executive’s last day in office. Large financial institutions

should move towards significantly greater equity capitalization – in the order of 25% to

30% of their total capital. Finally, if a bank fails, let it fail – no matter how large it is.

Rather, let the bankruptcy courts address the bankruptcies of these banks. For that matter,

if an industrial company fails (think, GM and Chrysler), let the bankruptcy courts address

the situation using their own processes.

2. The Problems and Solutions are Inter-related

Figure 2 provides a stylized pictorial depiction of the financial relationships among U.S.

and international households, the U.S. government, large financial institutions, and the

mortgage market.2 The U.S. households are at the center of the figure for two reasons. First, it

is the savings of U.S. households that ultimately funds all U.S. government expenditures.

Second, employment of U.S. households is a central focus of this paper.

2 This is a modified and extended version of Figure 1 in Jagannathan, Kapoor and Schaumburg (2009).

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Figure 2: Stylized depiction of the financial relationships among U.S. and international households, the

U.S. government, large financial institutions, and the mortgage market. Div, P+I: Dividends, Principal and Interest. IC: Intellectual capital.

The federal deficit and debt essentially is a problem of imbalance between government

expenditures (Services) and revenue (Taxes). The heavy Services arrow emphasizes the

problem of imbalance between government expenditures (Services) and revenue (Taxes). The

bailout of the banks and the continuing bailout of Fannie Mae and Freddie Mac is of secondary

importance, but is noted to highlight the link between deficits and bailouts.

The interaction between U.S. households, U.S. corporations and “Developing Country”

(China) has important implications for the employment of U.S. households. This highlights the

competition that U.S. employees face with international employees. American workers can be

competitive internationally on a compensation-and-productivity-adjusted basis if they are better

educated and better trained. The U.S. trade deficit is related to both U.S. employment and the

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productivity of U.S. workers. The trade deficit has led to increased earnings in developing

countries. Developing countries have shown a strong preference for saving their earnings and

investing it in U.S. Treasury bonds. This has enabled the U.S. Treasury to borrow at historical

low interest rates; these funds have been used to finance U.S. government expenditures in

excess of government revenue (leading to federal deficit and debt).

The recent housing market bubble was facilitated by easy availability of funds made

available from purchasers of U.S. government bonds. Large banks, Fannie Mae and Freddie

Mac invested in high-risk mortgages. As the housing bubble burst, these mortgages defaulted;

and the U.S. government bailed out these financial institutions.

3. Annual Federal Deficits, Debt and Its Negative Impact on the Economy

The annual federal deficits leading to the current and large federal debt is the single

most important reason for our current bleak national economic outlook. Persistent deficits and a

growing national debt have a significant negative impact on our economic growth and well-

being. A dollar spent by the government ultimately comes from the savings of a private U.S.

household.3 4 Hence, the question of whether or not government spending is better for

economic growth is a question about whether the government’s spending of the dollar or the

private U.S. household’s decision to invest the saved dollar will lead to greater economic

growth. The private household can invest the saved dollar in the stocks and bonds of private

corporations. These private corporations use these funds to invest in their business projects to

3 The government can print the dollar which, ultimately, leads to inflation.

4 Some have noted that governments of developing countries, notably China, purchase significant amounts of U.S. government debt. However, these foreign debt-holders have to be paid interest and principal in the future. It is the future savings of a private U.S. household that is ultimately used to pay this interest and principal to foreign debt-holders.

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hire employees, buy inputs, and produce goods and services. With the exception of public

goods (like national defense) it is difficult to point at examples where the government has been

more efficient, in terms of price and quality, in providing goods or services compared to the

private sector. As the ratio of national debt to GDP grows, perverse incentives start creeping

into the national economic debate; recall the behavior of some Latin American countries in the

1980s - these countries were reluctant to invest in their own economies given the concern that

payoffs from their investments would go to foreign debtors.5 Additionally, a large government

debt has a negative impact on economic growth because the funds used to pay interest on the

debt would otherwise have (ultimately) gone to new and ongoing investments of private

businesses; see figures in the Appendix.6

Deficit and debt reduction programs have two components: reduction in government

expenditures, and increase in government revenues. Reduction in government expenditures

would include cuts in Medicare, Medicaid, Social Security, and government wage expenses.

Increases in government revenues would include increases in personal and corporate taxes.

Is a reduction in government expenditures, or an increase in government revenues

the more effective policy for successfully reducing the federal deficit and national debt?

This is probably the pre-eminent national policy question of the day. Related to the above

question is another relevant question: What are the characteristics of successful debt reduction

programs that include a mix of reduction in government expenditures and increase in

5 International economists refer to this as the debt overhang problem; see, for example, Bulow and Rogoff (1991) and Boot and Kanatas (1995). In corporate finance this problem is referred to as the Myers (1977) underinvestment problem: with risky debt outstanding, shareholders have incentives to pass up on good, positive net present value projects.

6 Reinhart and Rogoff (2010) document that levels of debt above 90% of annual GDP have a dampening effect on real economic growth in advanced economies.

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government revenues? Several recent papers have provided empirical evidence on the above

questions.

Alesina and Ardagna (2009) study the effects of fiscal stimuli and adjustments for

OECD countries during the period 1970-2007. They define a period of fiscal adjustment

(stimulus) as a year in which the country’s budget balance improves (deteriorates) by at least

1.5% of GDP. They consider a fiscal adjustment to be successful if the cumulative reduction of

the debt to GDP ratio three years after the beginning of the fiscal adjustment is greater than

4.5%. They find “…that fiscal stimuli more heavily based on increases in current spending

items (government wage and non-wage components, subsidies) are associated with lower

growth,” and “…fiscal stimulus packages based on cuts in income, business and indirect taxes

are…associated with higher GDP growth.”

Building on the work of Alesina and Ardagna (2009), Biggs, Hassett and Jensen (2010)

also study the effects of fiscal consolidations for OECD countries during the period 1970-2007.

They find that successful “…fiscal consolidations that reduce ratios of debt to GDP tend to be

based upon reduced government outlays rather than increased tax revenues.” Regarding the

policy question pertaining to the mix of reduction in government expenditures and increase in

government revenues, they recommend, “…steps that consist of approximately 85 percent

reductions in expenditures and 15 percent increases in revenues…are consistent with

historically successful fiscal consolidations.” Biggs, Hassett and Jensen (2010) provide another

important insight regarding the mix of reduction in government expenditures and increase in

government revenues for successful debt reduction programs. President Obama’s National

Commission on Fiscal Responsibility and Reform (2010) and the Bipartisan Policy Center

(2010) both suggest a mix of approximately 50% (of the funds for debt reduction) from

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reduction in government expenditures and 50% from increase in government revenues. Recent

experience of OECD countries suggests that a mix of 50-50 is unsuccessful in reducing the debt

to GDP; see figure 3 which is from Biggs, Hassett and Jensen (2010) Figure 3.

Figure 3: Revenue and Expenditure Shares in Successful and Unsuccessful Consolidations Source: Biggs, Hassett and Jensen (2010), Figure 3

Table 1 summarizes the findings of three recent prominent studies that evaluate the

effects of a government spending increase and tax cuts on GDP. Their findings are consistent

with the above two studies. In particular, these authors find that a tax cut of $1 increases GDP

by about $3, whereas an increase in government expenditure of $1 increases the GDP by

significantly less than a dollar – some of the estimates suggest an increase in government

expenditure decreases the GDP.

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Table 1: Mutiplier Effects of Fiscal Stimulus

Paper Sample Stimulus Mutilplier Authors’ conclusions

Barro and Redlick (2010)

U.S., 1914-2006

Increase in defense spending

0.7 to 0.8 a “…the full effect from greater defense spending and correspondingly higher taxes is to reduce GDP; that is, the estimated balanced-budget multiplier is negative.”

Barro and Redlick (2010)

U.S., 1950-2006

Decrease in income-tax rates

-1.1b

Mountford and Uhlig (2008)

U.S., 1955-2000

Deficit financed spending increase

0.91 Max; -2.88 Min

“Comparing these three scenarios, we find that a surprise deficit-financed tax cut is the best fiscal policy to stimulate the economy, giving rise to a maximal present value multiplier of five dollars of total additional GDP per each dollar of the total cut in government revenue five years after the shock. “

Mountford and Uhlig (2008)

U.S., 1955-2000

Balanced budget spending increase (financed with higher taxes)

0.47 Max; -5.84 Min

Mountford and Uhlig (2008)

U.S., 1955-2000

Deficit financed tax cut

-3.81 Max; -0.19 Min

Romer and Romer (2007)

U.S., 1950-2006

Tax increase -3.0 “…our results indicate that tax changes have very large effects on output. Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.”

Note: a A multiplier of 0.7 implies a $1 million increase in government expenditure increases GDP by $0.7 million. b A multiplier of -1.1 implies a $1 million decrease in tax revenue increases GDP by $1.1 million.

4. How Jobs Are Created

Jobs that are sustainable and grow the economy are created by private businesses.

Businesses will invest in a new project if the revenues from the project are greater than the

costs.7 Businesses will hire employees for these projects if an employee’s contribution to

revenues is greater than his/her wages and benefits. It is this cost-benefit calculus of hiring

employees that makes job-creation by private businesses sustainable. Furthermore, employee

wages and business help grow the economy with a multiplier effect.

The paradigm for growing the economy and creating jobs is well-accepted in corporate

finance. Hence, it is especially surprising that so little attention was paid to the role of private

businesses in the policy debate leading to the February 2009 $814 billion fiscal stimulus

(AARA). If a government agency were given $1 million with the stated objective of creating as 7 More precisely, if the net present value of the project is positive. This is covered in the first few classes of any basic corporate finance course.

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many jobs as possible, certainly it would take little acumen, business or otherwise, to create 20

jobs that paid $50,000 each. Of course, these 20 jobs would last only a year. More important,

the question that needs to be raised: Where did this $1 million come from? As discussed earlier,

this $1 million ultimately comes from the current and future savings of private U.S.

households. Would these private households (via their investment decisions) or a government

bureaucrat be more focused on running a business efficiently? Efficient running of businesses

grows the economy and creates/sustains jobs. Inefficient running of businesses (or investments

in projects that are not viable from a business perspective) hampers economic and employment

growth, and ultimately squanders the savings of private U.S. households.

Private businesses will invest in a new project if the expected revenues from the project

are greater than the expected costs. As expected revenues increase and expected costs decrease,

businesses are more likely to invest and grow their business and employment. Equally

important, as the uncertainty of these future revenues and costs increases, businesses are less

likely to invest or hire/retain employees. Government policies that increase expected revenues,

decrease expected costs, and decreases the uncertainty of future revenues and costs (of

businesses) will help grow the economy and create jobs.

In spite of the stated laudable goals of the February 2009 $814 billion fiscal stimulus

(AARA), it has been unsuccessful in growing the economy or creating jobs. There is much

controversy on ARRA’s impact on the economy and employment. However, the current high

unemployment numbers by historical U.S. standards are undisputed; see figure 1. So why are

private businesses not investing in new projects (or growing their existing projects)?

There are two related reasons why private businesses are holding back from investing in

new projects or growing existing ones. First, the proposed and enacted policies of the Obama

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Administration have increased the uncertainty of future revenues and costs for businesses.8

How and when the health care law would be implemented, how and when corporate and

personal tax rates would be changed, and how and when EPA would enforce its own

regulations – these are just a few examples of the policies that have increased the uncertainty of

future revenues and costs for businesses. Second, expected revenues have decreased and

expected costs increased for businesses. Decreases in expected revenues originate from the

concern that the U.S. economy may not be growing at the same pace as it has in the recent

decades. A related concern is that U.S. workers on a compensation-and-productivity-adjusted

basis are less competitive internationally.

Andy Grove, CEO of Intel 1987-2005, makes some thoughtful observations about the

demise of our manufacturing base, our “industrial commons.” On the basis of his experience in

the semiconductor industry in California’s Silicon valley, he suggests, “A new industry needs

an effective ecosystem in which technology knowhow accumulates, experience builds on

experience, and close relationships develop between supplier and customer.” As the number of

firms and employees with appropriate intellectual capital in a technology-based industry reach

critical mass in a geographic neighborhood, it is easier for these companies to learn from each

other, innovate and aid the birth of other companies in that technological space. The

implications for job growth and wealth creation are obvious. The above positive externality can

be realized only if the companies are in the same geographic area. Given the existence of an

externality, it would be appropriate for the government to provide incentives to companies in

appropriate technologies to locate themselves (including their manufacturing) in similar

8 There is some relevant empirical evidence, for example, see Kahle and Stulz (2010), “Although firm financial policies were affected by a credit contraction during the recent financial crisis, the impact of increased uncertainty and decreased growth opportunities was stronger than that of the credit contraction per se.”

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geographic neighborhoods. This said, we hasten to add that lower corporate tax rates and a

better technically-educated U.S. workforce will provide strong (perhaps, stronger) incentives

for corporations to locate themselves (including their manufacturing) in the U.S.

To summarize, we make the following suggestions which, if implemented, will stimulate

jobs growth in the short-term and long-term:

First, address the uncertainty of future revenues and costs for businesses. For

example, businesses need to know how and when the health care law would be

implemented, how and when corporate and personal tax rates would be changed,

and how and when EPA would enforce its regulations.

Businesses will invest more and hire more employees if their expected costs are

lowered. To the extent repeal of the health care law, lowering of corporate and

personal tax rates, and rationalization of EPA regulations lower costs on

businesses – these businesses will invest more and hire more.

Businesses will invest more and hire more employees if their expected revenues

are higher. A smaller federal deficit with a realistic intermediate-term plan to

address the national debt will stimulate the economy via its implications for lower

future corporate and personal tax rates, and lower interest rates in the future. A

rapidly growing U.S. economy is a very potent source of increased revenues for

businesses.

In the longer term, creation and sustenance of well-paying jobs is critically

dependent on a workforce that is focused on its productivity – it is in this context

that a priority on improvements in math and science high-school education and

science and engineering higher-education is critical.

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5. The Education Challenge

The education challenge is the most serious long-term challenge that U.S. is currently

facing, even more than the government deficit and debt problem. The education challenge has

two components. First, the quality of the primary science and math education – rather the

learning of science and math by primary school students. Second, the lack of native-born

Americans’ interest in pursuing graduate science and technology education. Unlike the federal

debt, real estate bubble, and the banking-crisis challenges, the education challenge can be

addressed without investment of additional financial resources. However, it will require

investment of political and bully-pulpit capital of our national leaders, and the parental-energy

capital of our families.

At least since World War II, the U.S. has been the predominant technical and scientific

power in the world; this has had direct impact on our economic well-being (and military

strength) via employee productivity and technical innovation. While U.S. is still the dominant

technical and scientific power in the world, other nations are fast closing in. The erosion of our

relative dominance in technical and scientific arenas has negative implications for our long-

term economic well-being and national security.

In the 1950s the Russians challenged U.S.; the “Sputnik moment” crystallized the

challenge. Some years later, President Kennedy responded with a call to the country’s

scientists, engineers and technocrats to address the challenge. The historical record on the

subsequent U.S. technological victory is well-documented. An anecdote here might be relevant.

A colleague who was in high-school at the time of President Kennedy’s challenge, heard and

responded to the challenge. I remember him saying, “Every self-respecting American high-

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school student at that time wanted to become a scientist or engineer.” My colleague went on to

an engineering school after graduating from high school.

American high school students are not competitive in science and math with their

counterparts from many of the developed and developing countries including Finland, Canada,

Japan, Netherlands, Poland, Korea, and China (Shanghai); see Figure 4. The usual U.S. solution

of throwing more money at the problem will not work since the U.S. is already spending

significantly more per-pupil than every other country, and, sometimes several times more. A

review of some of the leading U.S. high school textbooks (and other instructional material

including interactive websites) in math, physics and chemistry indicates the extremely rigorous

but student-friendly strengths of these textbooks. However, even the best textbook in the world

needs to be opened and studied! It is here that we need the bully-pulpit of the national leaders,

and the commitment of our parents to do whatever it takes to get our high-school students to

increase their commitment to and focus on academics, in general, and math and science, in

particular.

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SOURCE: Organization for Economic Cooperation and Development (OECD), Program for International Student Assessment (PISA), 2006, PISA 2006: Science Competencies for Tomorrow's World.http://nces.ed.gov/programs/digest/d09/tables/dt09_402.asp

Figure 4: Average mathematics literacy and science literacy scores of 15-year-old students, by country.

A secondary reason why American high school students are not competitive in science

and math with their counterparts from many of the developed and developing countries is the

quality of instruction. While many of our high schools are populated with well-motivated and

conscientious teachers doing an outstanding job under, sometimes, rather challenging

circumstances, this is the exception. The rule is many (most) teachers are not well-motivated

for doing their very best. The teachers union that has steadfastly opposed merit-only pay

increases, is more concerned with teacher welfare and tenure, rather than student learning. This

is where we need the willingness of our national leaders to spend their political capital to

encourage primary school districts across the country to do away with tenure for primary

school teachers, and institute a merit-only pay increase system.

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Better science and math educated and motivated high school students would provide a

larger and more talented pool of native-born American students having both the interest and

academic background to pursue science and engineering in college and graduate school. These

science and engineering graduates and PhDs form the core of our country’s future technical

human capital.9 Both today’s and tomorrow’s better-paying jobs are in technical areas. Equally

important, fast-growing entrepreneurial companies almost always have a significant

technological component to them. It is worth noting that fast-growing entrepreneurial

companies contribute significantly to job and wealth creation in our country; for example, see

Lowery (2010).

A primary cause of our large and growing international trade deficit is that U.S. workers

on a compensation-and-productivity-adjusted basis are less competitive internationally. This

growing international trade deficit has negative repercussions on our long-term economic

growth and well-being. Besides putting a downward pressure on the value of the dollar, this

deficit ships our manufacturing and non- manufacturing jobs overseas. Imposing import

barriers are likely to be counter-productive, since our trading partners will respond in kind

leading to loss of American jobs. To address the trade deficit in an effective manner, we have

to focus on getting the American worker to be competitive internationally on a compensation-

and-productivity-adjusted basis. While there has been some downward pressure on wages

during the current recession, this is not an attractive long-term policy alternative. The more

preferred alternative, also consistent with free-trade principles, is to focus on increasing the

9 While this proposal focuses on math and science in high school; a serious emphasis on communication skills including foreign languages, and a critical understanding of U.S. history is important for high-school curriculum. Similarly, a strong liberal arts background is critical for a well-rounded college education.

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productivity of American workers. A workforce better-trained in science and technology tends

to be more productive.

An increased focus on math and science in high school and science and engineering in

higher-education are intermediate to long-term solutions to our employment and productivity

issues. However, there is one higher-education related policy proposal relevant that will help

with jobs creation in the immediate future. Currently, about 55% of the number of PhDs in

engineering and 42% of the number of PhDs in physical sciences are granted to temporary visa

holders by U.S. universities; see figure 5. Many of them prefer to stay and work in the U.S.,

and most do. However, a growing number of these highly-trained individuals are going back to

their country of origin – partly because of difficulties in getting work visas in the U.S. A policy

favoring work visas for such highly-trained individuals will benefit many of our technology

companies with resulting long-term growth in jobs and productivity.

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SOURCE: NSF/NIH/USED/USDA/NEH/NASA, 2009 Survey of Earned Doctorateshttp://www.nsf.gov/statistics/nsf11306/data_table.cfm#16

Figure 5, Panel A: Doctorate recipients in engineering, by citizenship.

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SOURCE: NSF/NIH/USED/USDA/NEH/NASA, 2009 Survey of Earned Doctorateshttp://www.nsf.gov/statistics/nsf11306/data_table.cfm#16

Figure 5, Panel B: Doctorate recipients in physical sciences, by citizenship.

6. The Real Estate Bubble and the Banking Crisis

At least for the past half-century, national leaders have promoted policies to increase

home-ownership by Americans. These policies have been well-meaning, for example, it has

been suggested that home-ownership leads to stable neighborhoods and strong families.

Recently, researchers have suggested that given the dynamic nature of advanced economies

where employment and economic opportunities are constantly changing across different

geographic regions - the loss of mobility associated with home-ownership can lead to negative

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impact on wages and employment for the home-owning family.10 Regardless of the pros and

cons of home-ownership, the U.S. taxpayers have paid dearly and are continuing to pay dearly

for this. In the 1980s, saving and loans institutions invested in very high-risk real estate projects

– most of these projects failed. Since deposits at the saving and loans institutions were federally

insured, the U.S. taxpayer ultimately paid for these unwise and high-risk real estate investments

to the tune of $150 billion.

During the past decade, policy makers continued their emphasis on home-ownership.

Government sponsored entities like Freddie Mac, Fannie Mae, and more recently Federal

Housing Administration (FHA), poured massive amounts of U.S. taxpayer dollars to fund

mortgages for low-risk and high-risk home-buyers. Underwriting standards were repeatedly

lowered to the point that some individuals could obtain mortgages without any down payment

or income verification. This is the primary cause of the recent housing bubble. A lax monetary

policy by the Federal Reserve fueled this bubble. During this same period, foreign countries,

notably China, had excess savings that they wished to invest in the safest of financial assets,

namely, U.S. government bonds. This allowed the U.S. Treasury to borrow at historical low

rates; these funds were ultimately channeled to the U.S. housing market. With the collapse of

the housing bubble, Fannie Mae and Freddie Mac have incurred massive losses and are

continuing to incur losses; Wallison (2010) has suggested a figure of $400 billion. It is

important to point out that ultimately Fannie Mae’s and Freddie Mac’s losses are covered not

by the Federal Reserve, not by foreign governments investing in U.S. government bonds, but

by the (current and future) U.S. taxpayers. Solutions to this problem would include immediate

privatization of Fannie Mae and Freddie Mac. Going forward, government agencies providing

10 For example, see Fisher and Gervais (2009), Munch, Rosholm and Svarer (2006), and Diaz-Serrano (2004).

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mortgage funds should be required to insist on prudent underwriting standards including

minimum equity down-payment of 15 % to 20%, and income and credit verification. Even if

home ownership is a good idea, with zero equity down, where is the “ownership”?

What have the U.S. taxpayers gained from their $400 billion (and counting) bailout of

Fannie Mae and Freddie Mac? Some have suggested that we, as a nation, have lost more than

the $400 billion in bailing out Fannie Mae, Freddie Mac and their ultimate customers – those

individuals that behaved irresponsibly in buying homes they could not afford hoping to

refinance their homes as the real estate bubble kept expanding. We have lost our financial

responsibility values; our sense of moral indignation at financial irresponsibility has been

eroded. The vast majority of American homebuyers have either completely paid off their

mortgages or are making their mortgage payments as they contractually agreed to when they

took out the mortgage; see figure 6. Policy makers need to understand that when they use U.S.

taxpayer dollars to bail out Fannie Mae, Freddie Mac and more direct bailouts of homeowners

who are unable to make their mortgage payments (mortgages they would not have undertaken

if they were acting in a financially responsible manner), essentially they are punishing citizens

who have acted responsibly, and rewarding citizens who have acted irresponsibly. This

undermines our sense of fair-play and the moral fabric of our nation.

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Mortgage Paid Of f Completely

32%

Mortgage Current61%

Past Due Less Than 90

Days3%

Past Due More Than 90 Days

3%

In Foreclosure1%

Figure 6: 93% of mortgages in the U.S. have been paid off completely or are current; 7% of mortgages are delinquent or in foreclosure. Source: HUD, American Community Survey.

A secondary though related cause of the current financial and economic crisis is

the melt-down of the large financial institutions (including some of the largest investment

banks and commercial banks) in September 2008. These large financial institutions had

invested heavily in the bubble-inflated U.S. real estate market via their investments in mortgage

backed securities. There are two narratives that explain the investment behavior of these banks

in the earlier part of the past decade and their dramatic collapse in 2008. The first narrative

suggests that incentives generated by executive compensation programs led to excessive risk-

taking by banks; the excessive risk-taking would benefit bank executives at the expense of the

long-term shareholders and the U.S. taxpayers (via the bailout funds). The second narrative

holds that bank executives were faithfully working in the interests of their long-term

shareholders; the poor performance of their banks during the crisis was the result of unforeseen

risk of the bank’s investment and trading strategy. Bebchuk and Cohen (2010) and Bhagat and

Bolton (2010) find evidence supporting the first narrative, that is, incentives generated by

executive compensation programs led to excessive risk-taking by banks.

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Bhagat and Bolton (2010) recommend the following compensation structure for senior

bank executives: Executive incentive compensation should only consist of restricted stock and

restricted stock options – restricted in the sense that the executive cannot sell the shares or

exercise the options for two to four years after their last day in office. However, managers

should be permitted to annually liquidate about 5% to 15% of their ownership positions, but

these ownership position annual liquidations should be restricted to an amount of $5 million to

$10 million. This compensation structure will provide the managers stronger incentives to work

in the interests of long-term shareholders, and avoid excessive risk-taking.

Currently, large U.S. banks have thin equity capitalizations in the order of 5%. In times

of financial distress, equity value of these banks can rapidly vaporize (as they did in fall of

2008). As equity value approaches zero, the equity-based incentives of the above compensation

plans would become ineffective. This can be addressed by requiring banks to have significantly

more equity in their capital structure – to the tune of 25% to 30%. This recommendation is

consistent with that of Admati, DeMarzo, Hellwig, and Pfleiderer (2010), and Fama (2010).

Additionally, greater equity capitalization will allow banks to better weather times of economic

crisis.

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7. Summary and Conclusions

We suggest the following ideas (noted in the order of importance), which, if

implemented, will grow employment and the economy in the short and long-run:

Step 1: Cut spending and entitlements: Congress would need to enact significant spending

cuts on both discretionary (including Government wage expenditures) and non-

discretionary (including Medicare, Medicaid, and Social Security) items. To be fair to the

current and near-term recipients of Medicare, Medicaid, and Social Security, these non-

discretionary spending cuts would have to be gradually implemented over about ten years.

These spending cuts should provide 85% to 90% of the funds for any deficit reduction

plan.

Step 2: Lower taxes: Congress would need to significantly lower the personal tax rates,

and the corporate tax rate. Simplification of the tax code would be a step in the right

direction and would provide additional revenues.

Step 3: Focus on education: This includes the quality of the primary science and math

education (rather the learning of science and math by primary school students), and the

lack of native-born Americans’ interest in pursuing graduate science and technology

education. The education challenge can be addressed without investment of additional

financial resources. However, it will require investment of political and bully-pulpit

capital of our national leaders, and the parental-energy capital of our families. Well-

educated and well-trained U.S. workers will be competitive internationally on a wage-and-

productivity-adjusted basis leading to increased employment of U.S. workers.

Step 4: Burst the real-estate bubble: Stop using current and future taxpayer dollars to

continue propping-up/bailing-out the U.S. real estate market. In particular, privatize

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Fannie Mae and Freddie Mac. Ensure that FHA enforces prudent lending standards and

minimum equity down-payments of 15%.

Step 5: Address the banking crisis: Corporate board members and institutional investors in

large financial institutions (including large commercial and investment banks, and

insurance companies) should implement executive incentive compensation plan and

capital structure strategies focused on creating and sustaining long-term shareholder value.

In particular, incentive compensation should include only restricted stock and restricted

stock options, restricted in the sense that the stock cannot be sold or the option exercised

for at least two years after the executive’s last day in office. Large financial institutions

should move towards significantly greater equity capitalization – in the order of 25% to

30% of their total capital. Finally, if a bank fails, let it fail – no matter how large it is.

Rather, let the bankruptcy courts address the bankruptcies of these banks. For that matter,

if an industrial company fails (think, GM and Chrysler), let the bankruptcy courts address

the situation using their own processes.

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Appendix: Figures from U.S. Department of Treasury (2010).