Schwalb: Dealing with the hangover

The stock market has a hangover. It stayed out late with friends. They met some trashy mortgages at Toad’s and some CEOs did a few things they’re not proud of.

It was a fun night — until the Nasdaq wound up in DUH.

As unpopular as Wall Street is right now with the American public or your socialist roommate, we need capital markets to keep the economy working. Every share in the market represents money that a company is using to grow and provide society with products and services. On top of that, as ordinary Americans buy stocks, they get a piece of ownership in those companies.

The big question is whether the problem is systematic. Is Wall Street an alcoholic? If we let the big banks go back out on their own, will they make healthier decisions, or will we have to pump their stomachs again?

For the answer, check the incentives.

Corporate executives and fund-managers currently are incentivized to take extra risks. Many funds pay their managers a base fee, plus a percentage of the profits he produces. So if the fund performs very well, the manager earns very well. And if the fund performs poorly, the manager earns just fine. So, even managers of “conservative” funds are incentivized to take on more risk.

Pay structure for top corporate positions is even worse. The issuance of stock options means executives profit wildly if the stock goes up in the short term, and “golden parachutes” mean their pay isn’t at risk if their companies eventually tank. One particularly intelligent proposal suggests deferring executive pay over an extended period. If an executive’s firm continues to perform well, he can collect his earnings.

But if history shows that his decisions were worth nothing, then his paycheck, too, will be worth nothing.

The check on run-amuck agents should be the owners, who have long-term stakes in the health of the company. Rational shareholders and fund-investors should pressure executives to keep risk under control. But many investors now have a short-term view. They look for dazzling quarterly reports, and executives are under lots of pressure to provide them. The outlook is often season-to-season, rather than year-to-year.

Truly fixing this problem calls for a change of both rules and boardroom culture. But even without new regulation, the federal government can help just by changing the tax code. The current tax structure encourages short-term investing. Profits from stock held for less than one year gets taxed as income, while profits from stock held for more than one year are taxed at reduced rates. Why should a time period as short as one year be considered a good dropoff point?

What we need is a capital gains tax that decreases progressively over time. Shorter holds will translate to higher taxes. The longer investors hold onto their stocks and the more they push executives to think of the long term, the more of their earnings they should get to keep. Investors who stay with their company for decades and encourage healthy decisions will be rewarded with lower taxes. Additionally, such a tax change will encourage investors to trade less, spending fewer resources on brokers and financial services and allowing them to commit more capital to growing the real economy.

A comprehensive solution to these types of crises will not just entail buying into banks or regulating their behavior. It will involve bringing the incentive of CEOs and fund managers back in line with the long-term interests of the firms they run. We should be encouraging Americans to save rather than speculate. In doing so, we might just get the markets sober.

Nate Schwalb is a freshman in Ezra Stiles College.

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