Entrepreneurs Want Capital, But Not Bank Capital

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Just as many failed to see the Crash of '29 as the byproduct of a fiscal policy and regulatory blunder - the Smoot-Hawley Tariff Act - and not a monetary event (the Federal Reserve providing too much liquidity), there exists similar confusion over the solution to reversing the Great Recession. The Great Recession was an economic contraction caused by a monetary policy blunder (the dollar de-linking from gold) which led to a distortion in market activity. As more and more capital funneled toward hedging the risks of inflation and deflation, as opposed to the production of goods and services, a vast derivatives market emerged birthing the extreme form of securitization we saw in the lead up to the crash.

I've explained the 3 stages of mortgage securitization elsewhere but it begins in 1970 when the Government National Mortgage Association (GNMA), "Ginnie Mae," created the model for a pass-through mortgage-backed security. This of course was just one year before President Nixon executed the final cut in the tie between the dollar and gold, hurling us all into a universe without Polaris, a clearly defined dollar. These two events made for the perfect storm that hit in 2007.

All of this matters because the heart of last decade's breakdown took place within the commercial banking sector - the only true market where all of us ‘trade' goods and services with one another. As Jude Wanniski recalled telling Treasury Secretary Paul O'Neil. in April of 2001, "As I explained it to O'Neill: If he is a producer of bread and I am a producer of wine, and we are planning to exchange our surplus output with each other over a period of time, in a modern economy, this is done through the intermediation of banks and financial markets, not barter."

What most across the political spectrum have failed to realize is that when the banking system fails, it is the trade of goods and services which automatically becomes inefficient and uneconomic.

Pouring more money into the system - from the top down (i.e. T.A.R.P., TALF or ‘QE') or bottom up (providing more securitized loans via the Small Business Administration) doesn't solve the problem, because the electorate has lost trust in its primary market and has decided to intermediate capital through other means. When trade becomes uneconomic, other entities (i.e. the entrepreneurial firm) become more efficient at allocating capital than the market. People don't just invest because of the supply of liquidity, but by their calibration of risk relative to reward in the future and their determination of where capital is most efficiently allocated and where it first concentrates - professional earnings and family savings. When the system of financial intermediation that we rely upon breaks down, people turn to the ‘tribe,' the ‘crowd,' or the trusted individual for capital. This is why ethnic solidarity, populism, genius innovators and charismatic leadership resonate in these periods.

Here, the late Ronald Coase was decades ahead of others, arguing persuasively that a firm originates as an alternative to a market transaction-based system which requires more cost and effort than when resources are arranged by an ‘Entrepreneur-Coordinator.' Coase understood that companies are like centrally planned economies, as David Henderson has pointed out.

So, the solution to the Great Recession is not as hard as most think. Simply increase the flow of capital where it is most economically allocated, into the hands of entrepreneurs.

Doing so through the banking system won't work because the best and brightest entrepreneurs are quite often uncollateralized (banks invest in property and income streams not ideas and talent), and because debt is unattractive to lenders when they expect to be paid back with less valuable dollars.

The solution is to unleash capital from the bottom-up and where it first accumulates - outside of the distorted debt-based commercial banking system, among family and friends. The J.O.B.S. Act. Already signed into law, would do this as I've written previously. Yet, it remains mired in a regulatory hesitancy to allow persons who make less than one million dollars invest to in an entrepreneurial public offering.

John Berlau of the Competitive Enterprise Institute (CEI) has made the right call, here, seeking to decrease the "accredited investor" net worth exemption from $1 million down to $500,000, or preferably lower. I believe the magic number is $250,000 or lower - the same level President Obama spied for tax cuts and the exact range Republican Mitt Romney sought in 2012 for an exemption of interest, dividend and capital gains income. Eventually, the limit should be the bottom income tax bracket - if you earn enough to pay taxes you earn enough to invest.

Those who mix up ‘contractions' and ‘deflations', and insist that Federal Reserve monetary policy be blamed for all things have my sympathy. While he exempted the Fed of responsibility for 1929, Jude Wanniski told Secretary O'Neill he blamed it for both a deflation and a contraction during the Greenspans era, adding, "The contraction part can be overcome by lowering short-term interest rates or cutting marginal income-tax rates and capital-gains taxation."

With the Fed likely to raise short-term rates next year, the time to focus on taxation is now. The complete unwinding of the Great Recession depends upon it.


Cedric Muhammad is a Contributor to RealClearMarkets, a former congressional campaign strategist, and author of The Entrepreneurial Spirit.  His Twitter handle is https://twitter.com/cedricmuhammad.  

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