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Good Government

From the January/February 2007 Issue

The federal government sometimes takes obscure actions that actually help the economy, big-time. Matthew Rees selects five of the best ever.

Ask a Washington policy wonk to identify the best thing the federal government has done to stimulate the U.S. economy in the past generation and you’re likely to get one of two answers. Republicans will cite the Reagan tax cuts. Democrats will cite the Clinton deficit reduction. There’s no denying the impor­tance of both, but what about the impact of the Depository Institutions Deregulation and Monetary Control Act of 1980?

The what?

That measure, which deregulated the interest rates that banks could offer and helped the U.S. economy to move from sluggishness into overdrive, is today long forgotten by all but a few aging bankers, economists, and aca­demics. Yet it is just one of many federal initiatives beneficial to the economy in the long term now mostly consigned to the historical equivalent of books in Barnes & Noble’s remainder piles—forgotten, but not gone.

To remind policymakers that eco­nomic growth is not entirely about tax cuts or deficit reduction, we offer five mostly overlooked instances of govern­ment doing the right thing. You’ll notice that in three of the five cases, doing the right thing meant undoing the wrong thing government had previously done.

1. Amendment to ERISA’s prudence standards (1979)

Google. YouTube. eBay. Federal Express. Intel. Cisco. The common denominator? All got started thanks, in part, to venture capital. For the past 25 years, large sums invested in early-stage companies have provided valuable fuel for the engine of economic growth. In 1980, only $570 million in venture cap­ital was invested in U.S. companies; by 2000, the figure was $104 billion—a nearly 200-fold increase in 20 years.

But what enabled venture capital to become the behemoth it is today? Rewind to 1977. Pension funds had accumulated billions in assets, but because of the prudence standards set by the 1974 Employment Retirement Income Security Act—better known as ERISA—that money was being invested, over­whelmingly, in conservative, blue-chip stocks.

Venture capital investments went from $570 million in 1980 to $22 billion in 2005, and Pozen and Lanoff were right to believe that the change in ERISA would not put pension funds at risk.

Ian Lanoff, then the administrator of ERISA, knew he had a problem. He called in a respected 30-year-old law professor from New York University, Robert Pozen, and together they rewrote the pru­dence standards. The key passage reads, “Although securities issued by a small or new company may be a riskier investment than securities issued by a ‘blue chip’ company, the investment in the former company may be entirely proper under the [ERISA] act’s prudence rule.” The new standards were issued as a forthcoming regulation in 1977, and they took effect on July 23, 1979.

The press took little note of the moment. There was a brief Associated Press story, and The Washington Post buried its article in the Business section. Yet the standards would prove to be the spark that ignited the venture-capital industry, says Mark Heesen of the National Venture Capital Association. Between 1990 and 2002, pension funds provided 44 percent of all the money raised by venture-capital firms.

While venture investment has declined from the years of the high-tech boom, it still totaled $22 bil­lion in 2005. And Pozen and Lanoff were right to believe that venture investment would not put pen­sion funds at risk. After all, total pension assets exceed $7 trillion. Even in 2000, venture repre­sented less than 2 percent of pension investments.

In addition to helping launch countless high-growth companies, venture capital has spurred innovation. Harvard Business School pro­fessor Josh Lerner has found that as the amount of venture capital increases in an industry, so does the rate of patented innovation. More broadly, the rule change gave pension funds—and the investors in these funds—an opportunity to realize what are sometimes enormous gains from venture capital investments. How enormous? Benchmark Capital’s $5 million stake in what was a fledgling online auc­tion company—eBay—became a cool $4 billion.

2. Creation of the 401(k) (1981)

In making their argument for tax cuts, supply-siders sometimes cite Genesis, pointing out that the “seven fat years” ended because Joseph per­suaded Pharaoh to confiscate money and goods in preparation for the lean years that the confiscation actually caused. Those on the left scoff, but one of the most effective tools for promoting consumer saving, and wealth accumulation, did come about through divine inspiration.

In 1979, a Pennsylvania-based benefits consul­tant named Theodore Benna was helping a bank to figure out how it could convert a cash bonus plan to a deferred profit-sharing plan. After turn­ing to prayer, he realized that a section of the tax code added the previous year would do the trick. This section—401(k)—would become a catalyst for extraordinary growth in U.S. equity markets.

The (k) portion of Section 401 had been inserted by New York Republican Representative Barber Conable, but it had received little attention until Benna’s revelation. And when Benna presented his idea to the bank, it declined, fearing IRS rejection. Benna responded by asking the tax authorities for a clarification, which arrived—in the form of reg­ulatory approval—on November 10, 1981. Michael Clowes, author of The Money Flood: How Pension Funds Revolutionized Investing, writes that the 401(k) idea proved so popular so quickly that by 1984 the Treasury Department—which projected that it would lose $4.6 billion in revenue from 1986 to 1989—raised the prospect of killing off the 401(k), though wisely dropped the idea a few months later.

Since then, the 401(k) has undergone a num­ber of tweaks from the IRS, but its underpin­nings have remained the same. It allows employees to move part of their pay into tax-deferred stock and bond accounts and lets employers contribute as well. Today, two in five families have a 401(k).

From 1990 to 2005, assets under management in 401(k) plans grew from $385 billion to $2.4 trillion. The injection of so much new money into the equity markets helped to reduce the cost of capital, boost the stock market, and generate wealth-creating opportunities for millions and millions of investors, who learned the benefits of long-term investing.

3. Signing of the Information Technology Agreement (1996)

Information technology has driven American economic growth for more than a decade. Kevin Stiroh of the New York Federal Reserve has pointed out that all of the U.S. produc­tivity gains from 1995 to 2001 came from the sectors of the economy that either produced information technology (IT) or made extensive use of it.

The (k) portion of Section 401 had been inserted by New York Republican Representative Barber Conable, but it had received little attention until a Pennsylvania consultant, after turning to prayer, discovered it for a client.

It’s often assumed that the development of the Internet as a tool for commerce and communica­tions is what drove all of these productivity gains. But frequently overlooked is an action taken at a 1996 meeting of the World Trade Organization in Singapore. That’s where the U.S. government signed the Information Technology Agreement, a pact as bold and comprehensive as you’ll find in international affairs. It committed signatory coun­tries—which accounted for more than 90 percent of the $500 billion IT trade—to eliminate, within four years, all tariffs on 180 products in the sector.

A tariff-free world has, not surprisingly, enabled American IT companies to sell more of their goods internationally and enabled American purchas­ers of IT, wherever it is produced, to benefit from lower prices. U.S. high-tech exports—a category that largely overlaps with IT—increased from $18 bil­lion in 1999 to $211 billion in 2005, according to the Census Bureau. At Dell, for example, overseas sales now account for 40 percent of total revenues, and its market share in the world’s 13 biggest IT mar­kets increased from 3 percent in 1994 to 21 percent in 2005. The number of people employed in the U.S. IT industry has increased to 3.76 million, according to Robert Atkinson of the Information Technology and Innovation Foundation.

4. End of fixed commissions (1975)

Business journalist Joseph Nocera calls it “the seminal event in the his­tory of modern Wall Street.” The rise and fall of Michael Milken? Electronic stock trading? The creation of the NASDAQ? Nope. It’s something much more mundane: the end of fixed commissions on stock trades, which took full effect on May 1, 1975, known thereafter as “May Day.”

Until that date, brokers had no control over how much they could charge their clients to place a trade. The price-fixing began in 1792 with the signing of the Buttonwood Agreement, which created the market that would become the New York Stock Exchange. Fixed commissions suited the NYSE’s owners—the firms that did the trading—just fine. They preferred not to have competitors driving down their fees. And with government backing, the NYSE got its way.

But pressure gradually built for change, mainly from institutional investors who came to see the arrangement as little more than “the most endur­ing and successful cartel in American history” (as one writer characterized it). The NYSE resisted, and its president threatened to sue the Securities and Exchange Commission if it voted to deregu­late commissions, but in September 1973 the SEC went ahead.

The effect of the deregulation was felt almost immediately. Within three weeks of May Day, trad­ing commission fees for institutional investors had fallen by about half. And transaction volume on the NYSE roughly doubled between 1975 and 1980, according to the American Enterprise Institute’s Peter Wallison, who served in the Treasury and the White House under Ronald Reagan.

May Day also gave rise to discount brokerages. One CEO, Charles Schwab, described the end of price-fixing as “a watershed moment for individual investors and for the markets.” The arrival of cut-rate stock trades, said Schwab, eliminated a major barrier to investing for the average American.

The price-fixing began in 1792 with the signing of the Buttonwood Agreement, which created the market that would become the New York Stock Exchange. It ended in 1975.

Reduced commissions—they’ve fallen from as high as 82 cents per share to an all-time low of just 3.9 cents last year—put more money in the pockets of investors, increased the amount of trading, and thus fostered liquidity. In 1975, for example, indi­vidual investors held approximately $1.75 trillion of investable assets. Of that, less than 45 percent was invested in equities, and just 2 percent was in mutual funds. Thirty years later, investable assets were $17 trillion, with 73 percent in equities and about 25 percent in mutual funds. Reduced com­missions helped many more Americans join the ownership society. About 15 percent of households had exposure to the stock market in 1975; today the figure is 50 percent.

5. Repeal of Regulation Q (1980)

In March 1980, Jimmy Carter signed the Depository Institutions Deregula­tion and Monetary Control Act. While the mouthful of a measure didn’t attract much attention at the time—The Washington Post didn’t bother to mention the bill signing—its impact prob­ably exceeds that of other, better-known Carter-era deregulation efforts (for example, airlines) because it helped shed the economy of its New Deal shack­les and unleashed the banking sector to provide the credit needed to finance corporate growth and job creation.

The 1980 law was an effort to repeal a bank­ing measure enacted in the first year of FDR’s presidency. One provision in the original law—Regulation Q—capped at 5.25 percent the interest rate banks could offer depositors. The goal was to reduce vola­tility in the banking sector, and so scarred was the nation by the bank failures of the Depression that Reg Q, despite its anticom­petitive nature and the danger that it would restrict banks’ ability to raise needed cash, attracted little opposition for decades.

That changed when market interest rates soared above the Reg Q ceiling. In 1979, for exam­ple, market interest rates on short-term money hovered around 16 percent and inflation exceeded 11 percent. Depositors were taking a double hit—they couldn’t realize the higher interest rate, and the value of their bank assets was eroding. (This is the origin of the now-comical practice of banks seeking to retain depositors’ money by offering toasters.) Reg Q cre­ated a credit crunch as depositors shifted their funds out of banks and into new free-floating invest­ment vehicles such as money-market funds—a process known as disintermediation. That left the banks without the funds they needed to make loans, and mortgage and commercial lend­ing dried up.

In 1980, Congress approved the repeal of Reg Q, saying that its effect had been to “discourage persons from saving money, create inequities for depositors, [and] impede the ability of depository institutions to compete for funds.” The repeal, which was phased in over the next six years, had a salutary effect. At the most basic level, depositors could get paid a higher interest rate. And, says George Kaufman of Chicago’s Loyola University, “there has been far less volatility in bank and thrift credit and little, if any, disintermediation from depository institutions.”

While tax cuts and deficit reduction certainly contributed to the strength of today’s economy, the long-term benefits of deregulation—often achieved by a Congress of one party and a president of the other—have been powerful. That’s a lesson for poli­cymakers—of both parties—to remember.


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