A Financial Sector Small Enough to Drown in a Bathtub
As the tale of greed and stupidity that gave us the housing bubble and subsequent crash continues to unfold, it is becoming increasingly clear that the problem was not simply that the regulators were out to lunch. Some regulators saw the problems and wanted to take steps to rein in abuses but were prevented from doing so by the political power of the financial industry.
The best example of politics thwarting effective regulation was when Alan Greenspan, Robert Rubin, and Larry Summers prevented Brooksley Born, the head of the Commodity Futures Trading Commission, from regulating credit default swaps in 1998. However, there are many other instances coming to light in which political interference obstructed efforts to stem questionable practices by the financial industry.
We must come to grips with the power of the financial industry in any effort at regulatory reform. The issue is not just producing the right set of regulations to prevent the sort of abusive practices, over-leverage, and excessive risk-taking that fed the growth of the housing bubble. It is also necessary to ensure that regulators have the power to restrain industry abuses.
In order for the regulators to get the upper hand, it will be necessary to shrink the financial sector to a size where it can be effectively controlled. The sector had experienced explosive growth over the last three decades. At its peak in 2004, it accounted for almost 30 percent of all corporate profits.
This figure by itself should have raised alarm bells. Finance is an intermediate good. We need the sector to be able to borrow money to buy a home or start a business, but it is not an end in itself. While spending more on health and housing may make us better off, spending more on finance is evidence of an inefficient financial system. An efficient financial system is a small financial system.
The financial industry constantly develops new and more complex financial instruments as a way to siphon away wealth created elsewhere in the economy. The system of regulation must be designed to prevent this from happening. While we need specific and detailed rules to ensure that the industry runs properly, keeping it small and manageable will also be crucial.
The best way to restrict the size of the financial industry is through a system of modest financial transactions taxes (FTT). A tax of 0.25 percent on a stock trade, or 0.02 percent tax on the purchase of an option or future, will have almost no impact on those looking to invest in the stock market or hedge their wheat crop. However, it will impose a heavy cost on short-term traders, and therefore will substantially reduce the volume of trading.
Such a tax is also likely to make complex derivative instruments less practical, since they could involves several taxed transactions. An FTT can also raise a huge amount of revenue, more than $100 billion a year (0.6 percent of GDP) according to calculations that I did in a paper with Robert Pollin.
FTTs have been widely used in financial markets around the world. The United States had a stamp tax on stock trades until 1964 and continued to have a very small tax to finance the Securities and Exchange Commission. The United Kingdom still imposes a tax of 0.25 percent on stock trades. Adjusted for this size of its economy, this tax raises the equivalent of almost $30 billion a year in the UK.
While the UK experience shows that an FTT is enforceable, we can adopt stronger provisions to limit evasion on a more extensive set of transactions taxes. The most obvious enforcement tool would be to give workers a percentage of any unpaid tax and penalties if they report their bosses. They are few workers that would not enjoy getting a million dollar payday at their boss's expense.
An FTT can play a crucial role in keeping the financial sector at a controllable size. If we let the industry return to its former strength, even the best-designed regulation is doomed to fail.
At a meeting of central bankers in 2002, Lawrence Meyer, a former Federal Reserve Board governor, argued that it would not have been politically acceptable for the Fed to have deliberately burst the stock bubble, destroying trillions of dollars of bubble wealth. If we get the regulation right, then it will not be politically acceptable for the Fed to let a bubble grow unchecked as Alan Greenspan did twice in the last decade. This shift in politics will require permanently reining in the financial sector.
Ken Rogoff has said in a number of interviews that the "banking" sector is too large. Not sure whether he means commercial banking or investment banking.
December 8, 2008 6:46 AM | Reply | Permalink
Politics thwarting regulation -- The Born incident shows no such thing, and Baker provides no evidence to support the notion compared to say: http://news.yahoo.com/s/ap/20081207/ap_on_go_co/the_influence_game_freddie_mac -- and the main component of the crisis was of course the anti-regulatory stance of Cox re leverage in search of optimized risks which turned downturns into cliffs. Cox had the power but abdicated responsibility. What this means is that there is already regulatory power, but there must also be the will to use the power well.
In my view, Born's heavy handed approach scared people off, resulting in a rejection of the sensible parts. There is no question that Born saw the potential for trouble. So if you want to say that Born was "politically" not up to the job in 1998 of defusing that potential, I don't object. That doesn't finger the financial so-called "industry" nor does it establish that "politics" thwarted anything.
Shrink the financial sector?? What in the world does that really mean? Hasn't it already done that to itself?
That said, I consider financial sector profits to be mere churning of the economy, so limitations on leverage and churning may well be worthwhile, whether as a transaction tax or by some other means.
December 8, 2008 7:01 AM | Reply | Permalink
Shrink the financial sector?? What in the world does that really mean? Hasn't it already done that to itself?
Shrink it some more. The basic principles have to be that nothing can be too big to fail, and nothing can be big enough to gain decisive political influence over its regulators.
December 8, 2008 11:31 AM | Reply | Permalink
I don't know. I mean, I agree that "too big to fail" is something to avoid. And getting big while hiding corruption IS clearly a problem.
But I still don't see that the sector needs to be shrunk a whole lot more. Damped, maybe. And if damping suppresses the urge to gamble wildly, and that leads naturally to moderate shrinkage, that's okay with me.
December 8, 2008 5:21 PM | Reply | Permalink
The chicks are never politically up to the job. We're always too strident (if only she hadn't been so strident, we wouldn't have kept doing what we were doing and crashed the financial system) or shrill. What women who do anything learn is that we have to be willing to be called strident or shrill to have any chance of being heard. If we aren't strident or shrill, we sit quietly until we're asked to get the coffee.
And read: http://www.wowowow.com/post/four-financial-horsewomen-who-tried-stop-crisis-born-bair-whitney-tanta-152160
December 8, 2008 4:02 PM | Reply | Permalink
Baker used the Born story wrongly, I pointed this out. Your link doesn't seem to apply at all, either way.
December 8, 2008 5:04 PM | Reply | Permalink
The best example of politics thwarting effective regulation was when Alan Greenspan, Robert Rubin, and Larry Summers prevented Brooksley Born, the head of the Commodity Futures Trading Commission, from regulating credit default swaps in 1998. Dean Baker
"[Born's] focus was the arcane class of derivatives linked to fluctuations in currency and interest rates." Washington Post 10/14/08
The award of undeserved encomia*, here, reminds me of the self-congratulation common among those who noticed a bubble in home prices and now, without having explained how air coming out of the bubble would affect the health of financial institutions, seek to take credit for predicting the current crisis.
* The failure to regulate the swaps Born appears to have been concerned about -- currency and interest rate -- would, as far as we know, have had no effect on the problems experienced by Bear Stearns, Lehman Brothers, or AIG, and no one, least of all Born, called for the CFTC to regulate the trading of or rating of asset backed securities.
December 8, 2008 8:33 AM | Reply | Permalink
Though Dean may have misstated his case by referring to CDSs, his main point is valid. In 1998 if one was interested in regulating the kinds of games being played by the funds now known as hedge funds, the target of regulation would be speculation on interest rate and currency spreads. These the bets that blew up TPCM that year. If Born had won, it would have been easy to extend those regulations to the CDS market that was relatively tiny in 1998. In fact if you think about it for a few minutes, you will see that gaming CDSs is betting on interest rate and risk spreads.
December 8, 2008 8:14 PM | Reply | Permalink
There's no way that the problems of excessive leverage on Wall Street would be solved by taxing me every two weeks as I dollar cost average into the mutual funds in my 401(k). And... how is the tax assessed? Do I pay when I buy fund shares? Does the fund pay as it trades shares? Doesn't that just add costs to the mutual fund that is supposed to be a cheap way for a small investor like me to get diversification?
If you want to regukate leverage on Wall Street, regulate leverage on Wall Street. Don't tax me and say the problem is solved.
December 8, 2008 9:26 AM | Reply | Permalink
Destor,
We aren't that much stupider than the folks in England. It is taxed at the point where the trade is made. They been doing it for many decades. It's simple enough for a Wall Street boy to understand.
The key to paying little taxes is to avoid frequent trading. That would be very simple for almost everyone. (I assume your daily re-balancing doesn't require selling the whole portfolio.) Since there has been a sharp decline in transactions costs over the last three decades, this tax would just bring costs back to their mid-80s levels.
December 8, 2008 9:36 AM | Reply | Permalink
But Dean... this kind of undoes the one good thing that Wall Street has brought us since the 1980s which is that transaction fees are down.
Trades that used to cost a nickel or more now cost a fraction of a cent. The problem for people like me is high fees and no disclosure. Anything that adds to transaction fees winds up hurting me in the end. Remember, my mutual fund returns are net of trading costs. This tax effectively reduces my return. Don't expect Fidelity not to pass it on.
It's true, it's not a huge tax and of course I don't sell my entire portfolio daily. But transaction costs are pretty much always bad for the retail investor.
Surely there's a way for you to to regulate the credit worthiness of Bear Stearns' balance sheet without dragging little old me into it?
December 8, 2008 9:49 AM | Reply | Permalink
I say the "retail investor" needs to pay a proportional share of the cost of regulation, too. How that works out isn't crucial at this point. Trades used to cost dollars in fees, so adding in/back pennies of tax won't hurt that much.
But I'm open to non-tax methods of damping markets, as suggested in my reply to the OP.
December 8, 2008 5:00 PM | Reply | Permalink
Wait - you're suggesting treating regulation as a public good, and taxing everyone who benefits from the stability it purports to provide?
What an intriguing idea!
It must be incredibly costly to the average little guy investor, like myself as I contribute to my 401(k).
Much more costly, than say, a loss in value(even if inflated) caused by a lack of confidence in the markets.
Wait.
December 8, 2008 8:10 PM | Reply | Permalink
We aren't that much stupider than the folks in England. It is taxed at the point where the trade is made. They been doing it for many decades.
And it helped them how?
December 8, 2008 10:45 AM | Reply | Permalink
I'm sure you good people know exactly what should be done to get us out of this financial mess, at the least you could come to a consensus.
However, at the risk of sounding like a broken record, you aren't addressing the one thing that is central to implementing your plans;
In order to implement your plans, how are you going to get Congress, especially the Corporate friendly Democrats (the Republicans are hopeless) who helped get us into this crap, to divorce themselves from their allies on Wall street and in the corporate boardrooms?
Can you trust Chris Dodd to turn on these benefactors? Schumer? Biden? Feinstein? Hoyer?
I see nobody addressing this stumbling block.
December 8, 2008 10:14 AM | Reply | Permalink
Because we just all stumbled over it, and broke our ankle.
December 8, 2008 12:10 PM | Reply | Permalink
JohnW, your point is well taken, and I believe the answer lies in getting corporate money out of politics. Easy to say; very hard to do. But essential, in my opinion.
The influence of corporate money is perhaps the only true existential threat to our democracy. Our founders would be alarmed by the current state of affairs, and especially by the notion of corporate personhood and the idea that money equals speech.
We must find ways to reverse these currently accepted conditions. Then we can reduce the influence of the financial sector, as well as big pharma, the health insurance biz, et cetera ad nauseum.
-- ARG
December 8, 2008 1:10 PM | Reply | Permalink
ARG,
You're right, and to take a page from the immigrant issue when they say "Control the border first, then get control of the illegals".
Find a way to make corporate money radioactive, then you get more control over the politicians.
You can also "OUT" the Democrats who went along with the sharks on Wall street; all that Congressional gang that signed on with Gramm's bill and other nefarious legislation needs to be singled out and made to answer for their actions.
December 8, 2008 2:16 PM | Reply | Permalink
If Fidelity wants to keep its reputation for decent returns, it will develop trading strategies that minimize churn.
The first paragraph here, meanwhile, demonstrates a common economic misunderstanding, namely the notion that cheaper is always better. If things are priced below their true (internal and external) cost, then people will tend to buy more of those things than they should, be the things stock transactions, barrels of oil or high-fructose corn syrup, or politicians. As a result, assets will be misallocated, and the people doing the misallocating will suffer along with the result of the economy.
December 8, 2008 1:44 PM | Reply | Permalink
Excellent point. It's like the sale table. You don't need another purse, but oh, it is soooooo cheap. This is why I am spending my time hauling purses to the Salvation Army.
Women understand that cheap fuels the urge to splurge. Maybe that's why uppity women like Born and Bair were some of the first to try to put on the brakes.
December 9, 2008 10:14 AM | Reply | Permalink
This is not the first time lately that I have heard of this stock transaction tax.
The CEOs and Fed regulators that caused this mess continue to go unpunished?
"The power of the financial industry". The power of the wealthy will always remain. Where is the power of the individual? Am I expected to pay for all this out of my retirement? Moving from job to job, broker to broker, 401k plan to another will cost the average individual a much larger percent than the 0.25 percent, before a profit is even seen. What's tens of thousands of dollars over a lifetime anyway to the average person? That would be all they have at the end of their ability to work for a living!
There is too much nonsense being written. The best way to shrink the number of words being written is to impose a $0.25 tax on every word written on the net. It will have almost no impact on wealthy individuals, but will shrink the number of poor individuals that think they have something to say for tax free.
December 8, 2008 2:03 PM | Reply | Permalink
Ok, so the Brits have an FTT. What's the benefit to them? The public revenue gain I see but what else? It doesnt't seem to a lay person that their financial industry works any differently than ours, or is in any better shape than ours right now. Can you quantify the benefit versus the costs?
December 9, 2008 2:48 AM | Reply | Permalink
Deeeelightful that we should use one of Grover Norquist's favorite old saws. Funny, it doesn't seem to matter who uses the bathtub line, the effect is the same revoltion.
Seven competitive markets agree: let's shrink US financial markets. Dubai thinks trade taxes are a great idea. Hong Kong is keen on draconian regulation (preferrably drafted by gifted academics, like Dr. Baker, big on ideas and short on experience in the marketplace). Singapore is ready to write the check to Dean's thinktank. Even Johannesburg wants in on the action!
In a global market, comparing US financial sector results to any single domestic measure is beyond ignorant of how GLOBAL financial markets work. But be my guest, Dr. Baker, and be the Andrea Yates of financial re-engineering. We may even feel sorry for you once the bathtub is drained (well, the liberals will at any rate; the conservatives will want to strap you to the gurney and start the drip).
December 9, 2008 9:00 PM | Reply | Permalink