The One Sure Way to Stabilize
our Financial System

Edward J. Dodson

[Comments submitted to the Public Broadcasting Service program Talk of the Nation,
18 March, 2009. No acknowledgment or response was received]

The measures being proposed and implemented to stabilize our financial system and the economy reflect the sad state of policy analysis on substantive economic and societal challenges. Conventional wisdoms that conflict with reality continue to exert great power over the decision-making of our elected officials and those who serve as policy advisers. This circumstance is not new. Back in 1955, economics professor Harry Gunnison Brown expressed his frustration with many of his professional colleagues:

"Economics is concerned with the problem of 'getting a living'. It deals, therefore, with an important phase of the 'struggle for existence'. Unfortunately, this fact operates to prevent unprejudiced investigation of its laws and of the effects of various economic policies. An examination that would show the effects of various policies from which a part of the public was benefiting, to be injurious to the remainder, might not be an examination which those who were profiting by the policies in question would desire to have made. And if such an examination were made, acceptance of its inevitable logical conclusions would probably be vigorously opposed."

Over time, the search for solutions to the periodic tendencies of our economic system to implode have given way to systemic acceptance and policies of mitigation by modest technical interventions using defined fiscal and monetary tools. These have never worked well and have proven to be counter-productive in the face of institutional and structural flaws left uncorrected in our systems of law and taxation.

Our very understanding of the health of our economy is obscured by the meaningless language of mainstream economics that is repeated regularly by journalists and news reporters. Let me begin with one prime example: the use of Gross Domestic Product (GDP) as a commonly-accepted measurement of economic health and growth. I doubt that any of the media commentators know that GDP includes (with minor exceptions) every dollar spent by government for any purpose, whether obtained by taxation or borrowed. GDP is calculated as follows: consumption + gross investment + government spending + (exports ? imports). Thus, a rising GDP is hardly an indicator that the economy is expanding. Goods production can be falling, unemployment rising, crime rising, environmental disasters occurring with increasing frequency, with escalating government spending on the military and the servicing of debt -- all combining to cause GDP to be reported as increasing. The public interest organization Redefining Progress has offered an alternative measurement -- the Genuine Progress Indicator -- that indicates real advances in widespread wellbeing peaked around 1978.

Another fundamental problem with how economics has evolved as a discipline is the extent to which theorists have embraced the notion that markets for locations in our cities and towns, for agricultural land, for natural resource laden lands, for the broadcast spectrum and all of nature, generally, respond to changes in price and demand in the same manner as goods we produce from nature. Generations of political economists who preceded economists treated nature (i.e., what they termed "land") as the first factor of production; that is, as the source of "wealth" but not as wealth itself. Nature was (and still is) the passive factor of production, acted on by labor with and without the use of capital goods.

A vital lesson confirmed in the real world is that the "price mechanism" does not work for "land". Price effectively clears markets for for labor, for capital goods and (to a great extent) for credit. However, as we have seen during this last property (i.e., land) market cycle, as prices are rising speculation intensifies. Land is acquired to be held off the market for speculative gain rather than for development. This occurs even when locations are improved by various types of structures. Investors ignore vacancy rates and even negative cash flows on the gamble that rising land prices will allow them to flip the property to someone else within a few short years. The same mentality spills over into the residential property markets, exacerbated by low- and no-down payment mortgage financing that allowed for interest-only payments or even negative amortization. Moreover, appraisers dependent upon mortgage originators for their livelihood, provide appraised values required to support desired mortgage loan amounts, even when actual market data would indicate otherwise.

What caused the current land market crash to spread so deeply and broadly around the world was readily-available credit, allowing land speculators to pass on most of the risk to financial institutions (and to investors under various types of collateralized mortgage obligations). The absence of effective regulation and law enforcement also deepened the crash by overloading the credit markets with poorly underwritten subprime mortgage loans, hundreds of billions of dollars in predatory loans made to low income, elderly and otherwise marginal borrowers, and outright fraud (e.g., the sale of nonexistent or extensively falsified loans by mortgage brokers).

One immediate measure that ought to be passed into law is to prohibit any financial entity that accepts government insured deposits from financing or refinancing land values. This would remove a good deal of the accelerant from the next upsurge in land and property speculation. Speculators would have to commit their own funds or find other investors willing to share the downside risk that always occurs when such speculations are made near or at the top of the land market cycle. Consistently imprudent bankers would be protected from their own inclination to book nominally high-yielding assets without an objective assessment of the default risks involved.

There is nothing governments can really do at this point to bring us out of the economic depression. Government spending on infrastructure will stimulate a degree of private job creation and (combined with extended unemployment benefits and other social welfare measures) prevent widespread homelessness and social unrest.

The time is long past for continued reliance on fine-tuning of the economy. When we suffered thru stagflation in the 1970s, critics on the right called for business deregulation and "supply-side" stimulation of investment based on dramatically lower marginal rates of taxation on so-called "capital gains" and ordinary income. These measures largely provided the atmosphere for an economy driven by speculation rather than goods production or the development of new technologies and services. I believe there are four main shifts in public policy required to start the dominoes falling in the right direction (i.e., in the direction of full employment without inflation):

First, make the individual income tax system truly progressive and at the same remove its complexity. Wages and salaries are, for most people, the largest portion of their incomes, and are "earned" producing goods and services. This level of income should be exempted from taxation, or taxed at very low rates. We should begin by exempting all individual incomes up to a far higher amount than is now the case (eliminating all other exemptions and deductions). The national median could be a good starting point. Above the national median, increasing rates of taxation would be applied to higher ranges of individual income (which, as incomes increase, are derived from what economists describe as "rent-seeking" and essentially passive investment activities).

Second, establish the mechanism for gradual repayment of the national debt by issuing fully amortizing bonds to replace existing government bonds as they mature. The amount required to service the debt (both interest and principal being retired) would be incorporated as an integral expense of the government budgeting process. The tax rates on individual incomes at the highest ranges would be set to raise sufficient revenue to achieve a balanced budget.

Third, we need to replace the business profits tax with a graduated tax on gross revenue, exempting small businesses (which create the overwhelming number of jobs in the economy). Some analysis is required to determine what the exemption level should be, but the idea is to benefit those companies most that have a stake in their communities and where profits are circulated locally rather than routed to a distant (or overseas) corporate headquarters and senior executives rewarded by compliant boards of directors for implementing "efficiencies" that actually reduce the number of employees in pursuit of maximizing shareholder value. This measure would also end the practice of companies being able to expense the huge compensation packages to executives and thereby reduce taxable income.

And, finally, the federal and state governments must urge every community across the nation to restructure the long-destructive ways they have raised revenue for public goods and services. What communities create by investment in infrastructure and public amenities is land value. Thus, this community-created value ought to be the primary source of public revenue. Every parcel of land in a community has a potential annual rental value. This rental value is the amount that ought to be paid to the community in return for the services brought to a location. This means exempting property improvements (i.e., buildings of all types) from the property tax base. Moving to a land-only tax base will not only stimulate new construction and rehabilitation of existing structures, landowners will find it far more profitable to bring the land they hold to "highest, best use" as dictated by market forces (or sell to someone who will) than to hold onto land for speculation. Sufficient revenue might be generated by the taxation of location rental values to lower or eliminate taxes on wages and commerce.

In closing, I realize that what I have described in this message challenges much of conventional thinking. I decided to write to Talk of the Nation because your audience is both thoughtful and open to asking the hard questions.

I am not an economist, although I teach political economy and have written extensively on the subject. For 20 years (until retiring in 2005) I worked for Fannie Mae in its regional office based in Philadelphia. For ten years I managed a team of review credit underwriters, which gave me a unique insight into how mortgage loans were being originated and packaged for sale into the secondary market. Then, in 1995 I began working as a market analyst and business manager in the company's Housing & Community Development group. This put me in the midst of virtually all of the industry changes that have brought us to this point.

If Talk of the Nation is interested in a perspective from someone who worked "in the trenches," so to speak, I would be pleased to offer my services.