By now we're familiar with the usual suspects behind this financial crisis: rates were held too low for too long; banks loaned to anyone who had a pulse; JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), Bank of America (NYSE:BAC), and the like created "derivatives of mass destruction;" regulation was non-existent, and so forth.
But Robert Frank, economist, author of The Economic Naturalist: Why Economics Explains Almost Everything, and Cornell University professor, offered an unconventional theory behind the crisis during a recent visit to Motley Fool headquarters.
Frank used the quest for status and rank to explain what has happened in the economy, implying that the lust for societal status and rank was furthered by the easy availability of credit -- which caused this crisis. Frank maintains that the quest for status can actually hurt others.
His theory goes like this: As the affluent become wealthier and spend more, the "frame of reference" shifts, causing a cascading effect down the income ladder. The wealthy start building bigger houses, and then the group below them builds bigger, too -- not necessarily because they can afford to, but because the standard has increased.
If you don't match others' spending on housing, Frank said, then it's your kids who go to the inferior school, because the quality of school districts tracks neighborhood prices very closely. "If everyone is spending more on housing, so must you -- unless you want to endure sending your kids to an inferior school," he said. According to Frank, the average U.S. house is now 50% larger than its counterpart in the 1970s.
The aftermath
Certainly, "wealth" grew at a breakneck pace over the past five years as people chased status, made possible by an overdose of credit that was unsustainable. Homebuilders like Lennar (NYSE:LEN), Pulte Homes (NYSE:PHM), and Toll Brothers (NYSE:TOL) did well for themselves building larger homes. Now, they're suffering the consequences.
Now the economy's rip cord has broken. To pull it back up, the federal government has committed to spending billions of dollars to jump-start the economy.
Of course, the magnitude of the stimulus brings with it inevitable deficits. But Frank says we shouldn't be overly concerned about deficits in the short run. "Deficits in short term aren't a problem, as spending levels are low right now," he said.
However, Frank said that in the long run, deficits can be very costly. You can minimize the long-term impact of deficits by spending on useful investments; Frank points to this simple example:
There are a couple bottlenecks on the northeast rail corridor -- you can't get double-decker rail containers under the overpasses and through the Baltimore tunnel. If you cleared those bottlenecks out it would cost you about $6 billion; but the immediate benefits would be $12 billion. So if you do that project with borrowed money you're ahead $6 billion.
How to minimize the impact of deficits
Frank has come up with a solution to the "status problem" that would alleviate debt burdens for future generations: redesign the tax system.
He has proposed that the U.S. scrap the income tax and in its place adopt a steeper progressive consumption tax -- or in its catchier name, "the unlimited savings allowance tax." The theory starts with the basic assumption that consumption plus savings equals your income.
Individuals would report their income to the Internal Revenue Service the same as they do now, but would also report savings the way they would for a 401(k) plan. Then you'd take income minus savings to get how much you consumed for the year. From there, you'd take off a large standard deduction ($30,000, for example) to get the tax base.
The tax rates start out low, but the tax rate increases the more people spend. There's no logical limit to the top marginal tax rates on consumption, according to Frank; it could even be 200%.
Rationale for the consumption tax
Frank said we've been reluctant to raise the tax rate too high because we fear that people will start saving and investing less. However, he argues that under the progressive consumption tax, you actually encourage greater savings with higher marginal tax rates, while providing incentives for people to pursue slightly less glamorous materialistic things, and keep their accounts growing where they are sheltered from tax. "I think that's the easiest way we have to change our incentives -- and it wouldn't be a painful adjustment for the rich," said Frank.
Implementing this
The key to implementing Frank's plan is taxing consumption after we emerge from the downturn. "Tell people today that there's a consumption tax coming so they all go out and spend," he said. "I better buy the car now and not wait. You get immediate stimulus."
As for the long run, Frank said that if you phase the tax in gradually, you would shift money from consumption to investing, which means faster growth in the long run. "It's a proposal that says we'll have faster growth, and we won't consume as high a percentage of our national income as we do now," he said. "The challenge is to make a transition from our unsustainable 'borrowing-consuming economy' to a 'save-and-invest economy.' We can do that."
What do you think, Fools? Chime in below with a comment, or click these links for related Foolishness:
