Thinking about Wall Street Jude Wanniski January 17, 1989

There's certainly little question by now that the restructuring of the U.S. economy in the current era is directly tied to the Reagan Revolution in economic policy. Conglomeration accompanied the rampant inflation and bracket-creep tax increases of the 1970s, and deconglomeration naturally followed the deflation and tax reforms of the 1980s. If the economic, tax and monetary environment was largely back to where it was in the 1960s, we might expect the architecture of the business and financial community to look like it did back then, once the dust settled. But too many other things have changed.

We really can't tell, for example, what would have been the full effect of financial deregulation over the course of the last 15 years if it had occurred in an atmosphere of fiscal and monetary stability. It seemed likely at the time that Wall Street would, after a few years observing the law of the jungle, be smaller as well as more efficient. And to a degree it is smaller — a smaller number of bigger firms. Wall Street has had to do a lot more work as a result of the monetary and tax convulsions. More brainpower, at least, has to be expended in a period of financial turbulence than in a period of currency and price tranquility.

Cutting against this demand for services, though, was the dramatic surge in computing and communicating technology. Other things being equal, these great increases in the ability of Wall Street to do its work offset some of the demands imposed by the economic convulsions of the period. Another way of putting it is this: Once economic equilibrium is restored, the total effect of financial deregulation in a vastly more efficient marketplace should require a smaller workforce, or the same size workforce with smaller brainpower.

To a supply-sider, this is a good thing. We can recall one of our early supply-side heroes, Caesar Augustus, liberating much of the Empire's human capital by minting a gold coin as the currency of the realm, thus unemploying many thousands of the money changers of Rome, Alexandria, etc., required in the previous era of floating exchange rates within the empire. It is unambiguously a good thing to have fewer people working as financial intermediaries at a given level of GNP. It's also more efficient to get along with fewer lawyers, accountants, politicians, police and military, if an economy can manage it.

Yet the streamlining of Wall Street is not entirely driven by efficiency, but instead partly reflects a new tax distortion favoring debt over equity. This element required that the Street would have to experience a relative shift to bankers from brokers: In 1988, for the first time in several decades, the tax on capital gains was the same as the tax on ordinary income (even though capital gains are more vulnerable to inflation). For most of the 1960s, the marginal tax on investment income was three times the tax rate on capital gains. For most of the 1980s it was twice the capital gains rate. Now, it's the same. That portion of a common share that represents the bonus yielded by growth — a capital gain taxed at a low rate — has been clipped from the equity coupon. When Shearson Lehman Hutton last month split a common share into its "component" parts, unbundled stock units, on the theory that the dividend segment and the interest segment would be more attractive separate than tied, the idea flopped because nothing was done to retrieve the growth segment.

There is an illuminating parallel with Germany in the 1930s. The tax rates on personal and corporate incomes were extraordinarily high and the capital gains rate low, a combination not especially attractive. Hitler's finance minister, Hjalmar Schacht, added a twist that made it all work. There was no tax on all corporate earnings reinvested above a sizeable level — perhaps the equivalent of $5 million today. This meant the virtual elimination of the corporate income tax from established industry, whose leaders became lap dogs to the Fuehrer. The capitalist class cashed the capital-gain coupons instead of paying out high-taxed dividends. It was admittedly an awkward system, partly designed to prevent small companies from competing with big companies. On the theory of the day that small enterprises were inefficient, the tax structure was designed to produce dinosaurs with economies of scale. It did at least permit growth in a grotesque way, however.

The adjustments the U.S. economy is making to the new architecture of the tax and monetary system are not quite so grotesque, but the business community has been forced to twist into awkward positions to capitalize on some of the efficiencies available. Michael Milken's junk bonds did not flourish until they were needed to capitalize the new efficiencies of debt instruments over equity, equity having lost its capital gains coupon. The equity markets must shrink, as they have, fixed-income markets expanding until a new equilibrium is reached. (Imagine if dividends were now taxed at a flat rate of 100%. The Wall Street Journal would have blank pages where the NYSE, AMEX and NASDAQ tables are now listed.)

The Savings & Loan crisis is tied into all this perestroika. S&L were never meant for a world of floating currencies. Borrowing short and lending long requires a gold standard, or some reasonable facsimile. The S&L crisis was born with the closing of the gold window in 1971, ripening with the official dollar float on 1973. History will send the $100 billion taxpayer bill to Milton Friedman and his monetarists, James Tobin and his Keynesians, for this wicked experiment in demand-side economics.

The crisis could not have reached this costly state without FDR's government deposit insurance schemes, the barns erected after all the horses had fled in the 1929 Crash and ensuing banking collapse. The inflation of the 1970s pushed the S&Ls into riskier loans, as it did the banks as well. But where most of the banks could lend into sectors that would soon produce the big returns of the current expansion, the S&Ls are still chasing their tails as a result of bum deals in their narrow real-estate sector, "due diligence" out the window as long as Uncle Sam guaranteed depositors their principal plus interest, up to $100K. Their problems would have surfaced even earlier if not for the high yields from junk bonds, which S&Ls have gobbled, also without due diligence, Uncle Sam's FSLIC backing the deposits behind these as well. Credit unions, in turn, bought the CDs of many different thrifts, safe in the arms of FSLIC insurance. If high-yield bonds were not around, presumably the S&Ls would simply cart deposits to Las Vegas to bet the hard-eight, which pays 10-to-1.

As with Schacht's jerry-rigged financial structure of the 1930s, what we have today is working okay on average, although the average is composed of folks being squeezed on the one hand and Henry Kravis and the junk-bond takeover artists bloating on the other. Indirectly, the taxpayer bailout of the S&Ls is partly going into this bloat, if one ponders the scene for a moment. None of the respectable firms on the street can resist the fee bonanza from the S&L bailout through the junk-bond spigot.

The policymakers in Washington are now eyeing this tangled mess, trying to figure what array of regulations and controls and bailouts will neaten things up. A debate is underway between the White House and Fed on one hand and Treasury and Congress on the other, about how to interrupt the zany perpetual motion machine of the S&Ls: Government backed depositors financing ever riskier LBOs. The White House/Fed free-marketeers want to limit government insurance to one $100,000 worth of deposits per person. Treasury and Congress see this as the death knell of the S&Ls and resist the idea, but it's hard to imagine Congress watching the hemorrhaging continue without eventually applying a tourniquet. Some combination of public and private insurance and re-insurance will have to result.

At the same time there are powerful interests trying to slow, through SEC regs, the junk financing of LBOs, perhaps limiting arrangements whereby sellers pay fees to buyers to buy, which undermines the very concept of due diligence. But there is little doubt that restructuring will continue for several years, with LBOs part of the furniture.

The most salubrious policy change that could be made at the moment, though, is a cut in the capital gains tax to restore the 2-to-l ratio of ordinary income over gains. If RJR Nabisco had its growth coupon reattached to its common shares, it would have climbed in value by restoring equity attractiveness relative to debt without the help of Henry Kravis, now chairman of the third largest company in America. It might still be worth more in pieces than as a unit, but this would only be the result of inappropriate structure and management, not the tax laws.

As it happens, George Bush has in his hip pocket a mandate to cut the capital gains tax to 15%. He and his campaign manager, Jim Baker, correctly trumpeted the many advantages of such a cut during the campaign, never flinching in the face of Dukakis arguments that this was a rich man's giveaway. In the past, JBIII has been especially wary of getting tangled up in that argument, but in the campaign he aggressively made the case that its primary benefits flow to entrepreneurs who are starting the new companies that provide most of the new jobs. His feet may have chilled in the weeks after November 8, when the Beltway rose up to claim a mandate of tax increases, not more tax cuts. The water is getting warmer, though, as we get closer to the inaugural, when the real mandate will be claimed.

A cut in the capital gains tax, after all, will do more than simply fuel economic growth and add to the revenue pool. It would straighten out the leaning tower of Pisa in the fundamental financial structure's tilt to debt from equity. The same could be accomplished by ending the double-taxing of dividends, which would be fine with us, an idea Jimmy Carter actually discussed in his 1976 campaign in positive fashion (along with never giving up the Panama Canal). The political environment, though, is more likely to accept a capital gains cut as part of an overall package aimed at solving several problems at once, incidentally reviving trading on the stock exchanges.

Monetary reform in 1973 from gold to paper brought on the problems of the banks and S&Ls. Monetary reform, back to some form of commodity standard, would ameliorate the problem, not only the Home Loan Bank's, but the Third World's. Even the average congressman now understands the correlation between interest rates and the amount of money it will take for the S&L bailout. A 7% long bond puts a host of troubled institutions back onto dry ground, 11% puts most of them under water.
Movements in these directions will ease pressures everywhere, including the business of Wall Street, erected to handle high volume and forced to contract. KKR will still be on the prowl, but the prey will no longer be fish in a barrel.