When I review tax programs, whether they are for local, state, or federal governments, there are two critical criteria:
– Effectiveness – does the tax program raise the revenue in a manner that is cost-effective and have the lowest level of harm and distortion to the overall economy?
– Incentives – if the tax program is designed to promote a certain type of activity or “deter” a different type of activity, do the incentives actually drive the behavior that the law is intended to achieve?
I thought about the “incentives” element of the program as my parents rushed out to take advantage of the “cash for clunkers” program which provides a credit (on the spot, to the dealer) for turning in cars that basically get less than 18 mpg and purchasing a new car off the dealer lot. This program has their own website (where they unhelpfully refer to the program as “Cars” or “Car Allowance Rebate System” rather than the far more effective “cash for clunkers”). My father’s car barely made the cut because it was right around 18 mpg and they have been clarifying the program and making him sign form after form (to prove that he has owned it for several years, that he had it scrapped, etc…) but generally this program was a “shining star” of an incentive because 1) the government wanted him to go out and buy a new car off a dealer’s lot right now 2) they wanted to make sure that his old 18 mpg car was taken off the road 3) they wanted to make sure that he actually owned the car and didn’t just swap it with someone else to get the $4500 in trade in when the car was only worth maybe $1000. All of these criteria were met, in this case.
While the FDIC isn’t a tax program, the agency that guarantees deposits at insured banks (with your tax dollars) also provides incentives. I was involved in the early 1990’s when the Resolution Trust Corporation was created by our Federal government in order to take control of insolvent banks (basically banks that made dud loans, generally for property) and pay back depositors. I was on one of the teams that would go into banks right at the time they were being shut down and secure the cash and assets as a lowly auditor. We weren’t exactly the CIA – we sat in cars outside the bank and everyone knew it was coming and the staff were generally very polite – but that was where I frequently heard the phrase
Heads – I win, Tails – the FDIC loses
By this phrase they exactly summed up the banking game at the time – make a lot of big and risky loans with “guaranteed” customer deposits, and if it goes well and the loans are repaid, you make a bunch of money. If the loans go sour, oh well, you just walk away and leave the FDIC holding the bag.
I have a CD (way below the insured minimum) with the Mutual Bank of Harvey, Illinois. Or I did, until recently, when the FDIC took over the bank (press release here) and named the United Central Bank of Garland, Texas as the receiver (they get the deposits and the “good” assets, the FDIC gets all the “bum” assets to work through).
When I purchased this CD I followed the incentives that the government has given me like bread crumbs – Mutual Bank of Harvey offered amongst the highest CD interest rates and since purchasing any FDIC insured CD was pretty much as good as any other (you wouldn’t want to put all of your money in failed banks because it may take some paperwork to get it all straightened out if you needed the funds right away, but an occasional failure shouldn’t dent you very much), I bought from Harvey.
Why was Harvey offering higher rates? Probably because they were in trouble (verified by the fact that they were just taken over) and raising money through CD’s can then be used to prop up the bank (and continue paying executive salaries) that much longer. The FDIC was reviewing whether to limit the amount of “excess” interest that banks could offer above the average if they were thinly capitalized here but I don’t know if this was actually put into practice or not.
With the fact that CD’s can be purchased electronically, the government is in effect using this program to bring in US taxpayer savings to prop up banks. In the old days, when you had to physically visit a branch, this wasn’t very viable, but today it is easy through your brokerage account to purchase CD’s from any institution with just a click of your mouse (check here if you are interested in learning more).
As far as Harvey was concerned, if I had any stake in the outcome of their eventual failure, would I buy a CD from them? Hell to the no. Harvey is located in a relatively impoverished area (I would not have been excited to drive there back in the days before you could do this all electronically) which unfortunately is the type of area most likely to be hit hard in the current wave of foreclosures. If you think your little suburb or town is in the middle of the foreclosure wave, take a tour of anyplace in the inner city where complex loan products like interest only mortgages were peddled by the ton, and where the recipients of the loan proceeds were not likely to use those proceeds for income producing ends. These areas are just demolished.
Even though I guessed (correctly) that the Harvey bank was in trouble, I did just what the Federal government “wanted” me to do based on their incentives – to put more money in that bank which likely flowed right into losses and salaries of bank officers that should have been shut down months or years ago. The government allowed Harvey to offer more for my CD, and so now the government has to find another bank to pick up that CD, and presumably the government gets less back “net” on the total portfolio as a result.
In these cases the incentives both worked as designed – but what are the consequences of each?
Your government at work.
Cross posted at LITGM