Tax ‘Reform’ Sent Nation Down Road to Recession

If, half a dozen years ago, we had set out to deliberately end an economic expansion, put the kibosh on such big-ticket purchases as new houses and cars, depress the real estate market for the first time since the 1930s, deal a body blow to the financial system by eroding confidence in banks, reduce the effectiveness of monetary policy and widen Washington’s budget deficit while causing states and local governments to run red ink of their own, we could not have done a better job than we actually did.

I am referring, of course, to the passage of the Tax “Reform” Act of 1986, the unprecedented tightening of money by the Federal Reserve in 1988-89, as well as to a number of actions, such as requiring higher capital-to-loan ratios and forcing some banks to declare certain loans “non-performing,” even though interest and principal were being paid on schedule.

These developments are what led to our ninth postwar recession--not the invasion of Kuwait by Iraq. And although business downturns are nothing new--we’ve experienced at least 30 since records were first kept 140 years ago--this one is somewhat different.

For one thing, it has affected occupations that in the past were barely touched. People working in such white-collar positions as lawyers, accountants, commercial and investment bankers, stockbrokers and real estate personnel including architects, interior designers, brokers and construction workers, and those in the media, have not only lost jobs en masse-- they have also had significant difficulty finding new jobs in their fields.

Second, real estate values have been plummeting in most parts of the country. This in turn has depressed consumer confidence in a way that the stock market crashes of 1987 and 1989 could not, because it has undermined the value of the average family’s biggest asset: its home.

Third, it was precipitated, and is still being accompanied by, a credit crunch. This is a situation in which many would-be borrowers find it increasingly difficult to obtain a loan from their bank. Needless to say, such apparent unwillingness of the banks to lend money could deepen the current downturn--not to mention delay the beginning of the next recovery.

The Tax Act of 1986 started the ball rolling by suddenly changing the rules for investing in real estate. Thanks in part to the 1981 tax law, real estate had been a sought-after investment, pushing up values considerably. Soaring stock prices from 1982 to 1987 gave real estate a further upward shove.

But changes made in 1986 in the interest of tax equality served to stifle economic growth by reducing incentives to invest, especially in real estate. For example, passive investors were deprived of such normal tax deductions as mortgage interest, taxes and depreciation. This effectively made it more costly to invest. Then capital gains taxes were raised from 20% to 28%.

The net result was that real estate suddenly became uneconomic. As investors sold their holdings, real estate values contracted, hurting a number of parties, including those institutions that had financed these holdings.

Weak to begin with, the savings and loans began collapsing first. To make up for their inability to spot this ahead of time, the regulators proceeded to require that some commercial banks--also large lenders to real estate--write down the value of their real estate loans. This, of course, led to big increases in loan losses, impaired profitability and lower prices for many bank stocks.

Meanwhile, the Fed and its central bank counterparts in many other countries were raising the amount of capital that banks had to have behind loans. With the sudden deterioration in their loan portfolios, not to mention the steep decline in prices of their shares, the only way the banks could comply was to cut back on new lending. Therein lies the origin of today’s credit crunch.

If this were not enough, the fall in confidence caused by the drop in the value of people’s homes caused them to reduce their purchases of a wide variety of goods, ranging from autos to new homes to household furnishings. Needless to say, this depressed the goods-producing sector of our economy, sending it down long before Hussein crossed the border into Kuwait.

Spending also fell because effective buying power was decimated by two other provisions of the 1986 tax act: the elimination of the deductions for sales taxes and for interest on most consumer loans. Subsequent sharp increases in Social Security taxes, as well as those on alcohol and tobacco, gasoline and luxuries, ensured that consumer spending, which represents two-thirds of the gross national product, would tumble, and with it the rest of the economy.

On top of this, the Fed decided to tighten monetary policy to a degree not seen since the 1930s. Bank reserves in 1989 fell by about the largest percentage in the postwar era, while money growth since then has been almost non-existent. The yield curve went negative, too.

And, in a case of extremely poor timing, Washington has begun to talk about reducing deposit insurance coverage as part of restructuring the banking system. Once again, with seemingly laudable interests at heart--in this case, avoiding another taxpayer financial industry bailout--politicians are effectively choking the economy.

It has been reported in the financial press that a number of large corporate and individual depositors have begun to withdraw all but FDIC-insured funds from some banks. Indeed, there have been a few instances of smaller, “country” banks refusing to lend their excess funds to some bigger money-center banks. Instead, these funds are being kept idle or invested in Treasury instruments.

This has not only worsened the credit crunch by impairing the banks’ ability to lend, it has also weakened materially the effectiveness of monetary policy as the Fed tries to jump-start the economy.

And it boggles the mind that, in today’s environment, some people would want the banks to “mark to market”--in other words, to carry long-term loans at current market prices. You can see where a temporary decline in asset values could have a deleterious effect on loan “quality,” thus on provisions for bad loans, profits and bank capital.

Here’s what we need to do to end this vicious cycle:

* The Fed should ease more aggressively, pushing interest rates down further, while injecting additional reserves into the banking system.

* Increased capital ratios should be postponed in the United States and elsewhere.

* The examiners should modify their standards regarding what constitutes a non-performing loan.

* “Marking to market” should be consigned to the circular file, where it belongs.

* Federal deposit insurance coverage should be broadened--not narrowed--to help restore confidence in the banking system.

* The Tax Act of 1986 should be repealed. Capital gains tax rates should be lowered.

* Social Security taxes should be cut to put buying power back in the hands of the average family.

* Banks should be allowed to diversify geographically and by product line. This will strengthen them, while the increase in competition will result in more services to consumers at a lower cost.