WSJ Editorial Page Favors “Bailout Tax” on Large Financial Institutions

I had a post criticizing John Carney on the topic of bankslaughter. However, I must say I agree with him when it comes to Goldman Sachs. Even more surprising, I largely agree with the Wall Street Journal editorial that Carney links to.

Here’s what the Journal has to say:

We like profits as much as the next capitalist. But when those profits are supported by government guarantees or insured deposits, taxpayers have a special interest in how the companies conduct their business. Ideally we would shed those implicit guarantees altogether, along with the very notion of too big to fail. But that is all but impossible now and for the foreseeable future. Even if the Obama Administration and Fed were to declare with one voice that banks such as Goldman were on their own, no one would believe it.

. . . Banks that want to be successful will also want to be more like Goldman Sachs, creating an incentive for both larger size and more risk-taking on the taxpayer’s dime.

One policy response to the incentives created by last fall’s bailout is simply to restrict the proprietary trading done by the subsidiaries of bank holding companies that enjoy both FDIC deposit insurance and an implicit government subsidy on their cost of capital. This is what Paul Volcker proposed, only to be overruled by Tim Geithner and Larry Summers. Another answer would be an FDIC-style bailout tax, perhaps tied to leverage ratios, for those in the too-big-to-fail camp. Developing a template to facilitate the seizure and orderly winding down of failing financial giants is also an essential element of whatever reform Congress cooks up.

Did I read that right? The WSJ proposing a new tax?

And here’s Carney’s conclusion:

What’s worse, letting CIT fail might not help this situation at all. Rather than clearing the way for market discipline to reassert itself, CIT’s failure might only reify the policy of Too Big To Fail.

Financial firms that are deemed too small to be rescued will find credit hard to come by and expensive, which will incent them to grow or sell themselves to a systemically important firm. In short, we’re increasing the concentration of financial power and hence systemic risk in the largest Wall Street firms that led us into this mess.

To use traditional labels for a moment, the right-wing criticism is that the implicit government guarantees created by Too Big to Fail distort the market. The left-wing criticism is that bailing out large banks enriches capitalists at the expense of ordinary people, and the benefits don’t trickle down into the economy at large (see the number of foreclosures, for example).

The Obama Administration’s defense is that only by enriching those banks can we keep the economy from sinking further and hurting everybody. It’s not an implausible position to defend, but it can’t be fun, especially for people who always thought they were progressives.

By James Kwak

24 responses to “WSJ Editorial Page Favors “Bailout Tax” on Large Financial Institutions

  1. The implications of your last paragraph are appalling. It implies at least that we face the stark choice between fiancial chaos and a near open-ended commitment to financial institutions, now extended from the ‘too big to fail’ to the ‘not so big but cannot be discriminated against.” This is unacceptable. It is first a matter of social ethics. Since we generally agree that attitudes and behavior (linked to market and structural innovations) have been at the heart of the cisis, it seems to make little sense to lock them in.
    Second, there do seem to be alternatives, e.g. the Volcker proposal you reference. There are several others that have been debated here and elsewhere. Finally, this is a formula for endless recession as the deformation of the economy’s capital markets remains in place to a large extent, and as large chunks of national wealth continue to flow upwards rather than gradually redirected to can make better use of it. Goldman Sachs in this sense is exemplary of a major flaw in our economy rather a cause for optimism. To be in this state of mind a year into this historic meltdown is a sad commentary on the inadequacy of the country’s collective response – intellectual and in terms of public policy.

    cheers,
    Michael Brenner

  2. GRAMMATICAL CORRCTION, SORRY

    The implications of your last paragraph are appalling. It implies at least that we face the stark choice between fiancial chaos and a near open-ended commitment to financial institutions, now extended from the ‘too big to fail’ to the ‘not so big but cannot be discriminated against.” This is unacceptable. First there is the matter of social ethics. Since we generally agree that attitudes and behavior (linked to market and structural innovations) have been at the heart of the crisis, it seems to make little sense to lock them in by keeping open the Treasury spigot. Second, there do seem to be alternatives, e.g. the Volcker proposal you reference is one. There are several others that have been debated here and elsewhere which could be knit together into a coherent program. Finally, this is a formula for endless recession as the deformation of the economy’s capital markets remains in place to a large extent, and as large chunks of national wealth continue to flow upwards rather than gradually redirected to those who can make better use of it. Goldman Sachs in this sense is exemplary of a major flaw in our economy rather a cause for optimism. To be in this state of mind a year into this historic meltdown is a sad commentary on the inadequacy of the country’s collective response – intellectual and in terms of public policy.

    cheers,
    Michael Brenner
    Michael Brenner

    July 15, 2009 at 5:56 pm
    MATICAL CORRECTION. SORRY

  3. Too-big-to-fail has to go! We need to break up these companies. I keep reading from the experts that this is not possible. Why? We need an anti-trust-like law for financial institutions that disallow aggregation based on the common good, i.e. a healthy economic/financial system. The CIT discussion and this blog point our clearly that on this playing field the only “rational” goal is to aggregate in order to become “too-big-to-fail”. I’ve read it before: too-big-to-fail is too-big-to-exist. We need limits on capitalism, both size and consumer protection.

  4. The incentive to merge could be countered to some degree by making any financial institution excise tax steeply progressive.

    In the ordinary course of business, smaller firms would have a meaningful cost advantage over larger firms, and would essentially be more profitable. On the other hand, they would be liable to fail. The larger firms – which the government doesn’t seem to have the nerve to allow to fail anyway – would pay for the privilege.

  5. I think Paul Volcker is an incredibly intelligent person with so much experience and wisdom. And when I think about how he has been in essence “put out to pasture” by the Obama Administration it makes me extremely extremely angry. Like RAGE angry. How can you muffle a sage like Volcker in favor of a jackass like Larry Summers?? Unbelievable.

    I think the idea of the FDIC charging a bailout tax on banks with high debt ratios and/or low % of capital reserves is a great idea.

    Other than that I don’t want to say anymore or I’m just gonna start cursing, dropping F bombs, and James is gonna delete my post.

  6. Lavrenti Beria

    “The Obama Administration’s defense is that only by enriching those banks can we keep the economy from sinking further and hurting everybody. It’s not an implausible position to defend, but it can’t be fun, especially for people who always thought they were progressives.”

    And its particularly not implausible to defend if you disguise your state capitalist, National Socialism as “hope”. Lets see, we encourage the developement of a corporative state employing enormous taxpayer bailouts of the largest political contributors, we torture, we launch aggressive war after aggressive war and rationalize each with the Big Lie, we support ethnic cleansing and the unconstitutional violation of privacy rights, we even support the destruction of the very weakest and most vulnerable among us with much the same rationale as that used by Josef Mengele at Auschwitz. This is “progressive”? Not quite, its simply dictatorship with a patina of an elitist morality. And it will never go away using the franchise.

  7. I remain unconvinced that ‘too big to fail’ exists. But if it does (or what amounts to the same thing, if the Treasury and Fed can be counted on to behave as if it did), then it must be regulated out of existence. The current situation is ridiculous. It is not just the problem of bailing out shareholders of the highly-levered companies, the bigger problem is that to do this, the debt holders and other counterparties must be made whole. This is simply unaffordable with asset misalignments as great as the present.
    Instead of wasting government funds making lenders whole (wealth support), the money should be spent to keep up employment, such as more transfers to keep up state services.

  8. Reading these Baseline blogs I’m struck by the general lack of thinking outside the box. Essentially everything I’ve read suggests that we are stuck with the current paradigm for the existing economic/financial sector. The suggestions that have been offered, which are really quite few, only apply to the existing model. I’ve seen nothing about non-profit banking for both commercial and investment banking. My suggestion here is that the profit motive, totally uncontrolled, without any limits, is at the root of this problem, which has been with us for decades, if not centuries. This business of lending, how difficult is it? In its simplest form is it not matching borrowers to lenders? How has it become so complex? Is this complexity intentional? Is it possible that non-profit banking corporations could give this nation the fair and competent banking system we all would like to have? We have had successful non-profit credit unions in the U.S. since the 1930s. Could these serve as a model for non-profit banking? Is it possible that a financial/economic system could/should function somewhat like a public utility? Some have suggested that banking should become “boring” again. The financial sector has been known lately for devising “innovative” products. Is it finally time that a truly innovative financial system that benefits ALL of the be people proposed?

  9. I found that editorial to be one of the most intriguing stories on the collapse – dangling the suggestion that the bailout has institutionalized “too-big-to-fail” into our financial foundation. (And asked about this notion over on Simon’s CIT post from today.)

    Seems as if you have the full support of the government only if you’re TBTF. And should a crisis arise, your income/bonus revenue stream remains essentially intact (giving you the opportunity to recruit even more smart people) because the feds feel compelled to assume your losses.

    Everyone else – take a hike.

    Don’t see how this will encourage people to invest in the smaller firms or ones known to be out of favor with whoever is writing the checks over at the Fed.

  10. In reference to this issue below is a small piece of what I as an Executive Director of the World Bank told some hundred regulators at a Risk Management Workshop for Regulator at the World Bank in May 2003… and they never invited me to speak again on the issue again.

    “Old agricultural traditions hold that burning a little each year, thereby getting rid of some of the combustible materials, are much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

    Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.

    Knowing that “the larger they are, the harder they fall” if I were regulator, I would be thinking about a progressive tax on size.

  11. James lists the reasons why both the Right and the Left would support this tax. While the reasons are different, there should still be support. While both sides love to tax and spend (exhibit A is the past ~20 years) both sides rarely agree on what to tax. Let’s take advantage of this unusual situation!

    This tax also looks like one of the few new ones that I’d support these days. The trick is making the tax also a disincentive. Maybe a 25% tax on the bonus and compensation of the top 75% of employees? The company would pay the tax, not the employees. But somehow I think that those employees are benefiting more from the implicit guarantee than shareholders are.

  12. Hey, you sound like a reasonable version of me.

  13. Lavrenti Beria

    “Reading these Baseline blogs I’m struck by the general lack of thinking outside the box. Essentially everything I’ve read suggests that we are stuck with the current paradigm ….”

    All of which serves to reinforce the notion that you are clear of any learning disfunction or perceptual malady. :-)

    Now on to the deeper reason for this poverty of thought you describe: That the sense we are stuck with the current economic paradigm is the direct consequence of an inability to think outside the box politically, not economically! Its not that the paralysis here comes about as the result of a paucity of economic imagination. There are truly many well educated and intelligent folks here. It just that many of them have as yet to discern that the political order must be changed utterly before any meaningful approach to the economy can be formulated. A Congress and a President that does no more than whore to AIPAC and the financial, arms and drug interests is no government at all. They are employees, no more and no less. And the idea of there being an alternative provided by the existence of an opposition party is a fantasy that simply serves to funnel popular outrage into a black hole. All of the self-serving bacteria that run and manage this very corrupt system – every single one of them – must go if “ALL” are ever to benefit. And no election is apt to bring that kind of change about, you can be sure of that.

  14. Ted K: “I think Paul Volcker is an incredibly intelligent person with so much experience and wisdom. And when I think about how he has been in essence “put out to pasture” by the Obama Administration it makes me extremely extremely angry. Like RAGE angry. How can you muffle a sage like Volcker in favor of a jackass like Larry Summers?? Unbelievable.”

    My guess for a long time has been behind the scenes politicking by Summers, possibly aided by Geithner.

  15. don: “I remain unconvinced that ‘too big to fail’ exists.”

    In 1984 Continental Illinois was explicitly deemed Too Big to Fail by the U. S. gov’t. The practice of bailing out banks that are too big or too connected to fail goes back at least to early 19th century England. The devastations of Tulip Mania and earlier bubbles were still painful memories back then.

  16. William: “Reading these Baseline blogs I’m struck by the general lack of thinking outside the box.”

    Yes, there is a lot of “we can’t do this” or “we can’t do that” or “smart people can always get around the system”. I am old enough to remember when the Federal gov’t actually worked. If the current regulatory regime is ineffective, that can be changed. But not by simply tweaking here and there.

  17. Per Kurowski: “Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.”

    Hear, hear!

  18. Bill S.: “But somehow I think that those employees are benefiting more from the implicit guarantee than shareholders are.”

    Yes. Having to accept bailouts or guarantees should be hard on the managers. The CEO and CFO should be required to work for $1/year. (Iacocca did that voluntarily, remember?) Others should take a haircut or be fired. Boards should be sacked or packed.

    “Oh, we’ll lose our top talent!” Yeah, like you really need the people who got you into this mess.

  19. For quite some time now, I have thought that the concept of TBTF is inconsistent with the foundations of capitalism. If there is no ultimate risk of insolvency, the manamgement teams will make poor long-term decisions. Until or unless we get rid of the TBTF companies, we’ll face these same issues again and again. And I do like the concept of the “controlled burn” view. This does avoid the major fires.

  20. Forcing the industry to self-insure via a tax seems like a good concept; it would be peace of mind at the expense of a slither of economic growth.

    The financial firms would pass any tax on to consumers and businesses, so while it would serve to sequester funds in advance of any financial meltdown, those funds will still be coming from, basically, taxpayers in the form of consumers. Your overdraft fee will move to $50 from $35 and Joe’s Gas Exploration Company will pay more for the hedge on gas prices.

    The simplest action should be to create several clearly labeled tiers of banks, and with those liberated to use leverage and derivatives in a tier that will have slowly declining government guarantee, but heightened government and regulatory disclosure.

    (The heightened publicity forcing firms to advertise, in effect, their own risky practices, which, if too obvious, will cause their trading partners to flee).

    Consumers will evolve in the direction of those retail firms with full FDIC support, and those in need of more complex financial firms will drift towards the reclassified “uncovered” firms.

    But human nature being what it is, firms will seek to grow large no matter, and you would likely still end up with a liquidity crunch that will impact everyone.

  21. There is something odd about the underlying logic of the various tax schemes proposed to cover the costs of bank failures that could be caused by a combination of size and related modes of operation. If we applied this line of thinking elsewhere, we might consider taxing potential arsonists based on their proclivity to start fires of a certain magnitude and their aptitude for doing so. The accumulated funds would be available to rebuilt devastated real estate. The inconvenience to the inhabitants and community? Well, an unavoidable ‘externality’ of finding ‘solutions’ that go with the grain of the (deformed) market. Of course,part of the deal would be a tacit agreement to let the arsonists resume their activities after a less than decent interval and for them to keep earnings from ‘shorting’ the businesses they have destroyed.

    cheers,
    Michael Brenner

  22. Your discription of “…we encourage the developement of a corporative state employing enormous taxpayer bailouts of the largest political contributors, we torture, we launch aggressive war after aggressive war and rationalize each with the Big Lie, we support ethnic cleansing and the unconstitutional violation of privacy rights, we even support the destruction of the very weakest and most vulnerable among us with much the same rationale as that used by Josef Mengele at Auschwitz.” These are the works of the previous administration, the George W. Bush Administration. Don’t be so foolish to think, that any one can correct this Economic devastation in 6-7 months, progressive or not. These consitutional violations, are the reason why true conservatives who value every letter of the constitution, turned there backs on the Bush Admin. Our country suffers from ADD or Alzheimers, I am sure of it.

  23. Absolutely! If the Basel authorities licensed and regulated the arsonists I would find it quite acceptable they tax them for their wrongdoings.

  24. I was at Bank of New England in the late 80s — also TBTF (next biggest commercial bank failure after Continental). So I agree that the notion of TBTF has been around for a while. There are some big differences, though.

    Back then — saner days, in my view — TBTF meant receivership, restructuring, orderly sale of assets and/or wind-down. BNE wasn’t given a sack of taxpayer $ to do with as it would — instead the government oversaw a process of separating the good from the bad, and, eventually, finding new owners for all the assets. Same kind of things that happened later to the S&Ls that failed.

    In my opinion, what’s nonsensical now is not so much the idea that the government might want to prevent the calamitous meltdown of a large financial institution. It’s the current approach to doing so. How can you hand cash over to the management that is stymied by their situation, beholden to shareholders, etc., etc., and expect behavior that is in the interest of the public/government/taxpayers?

    Another key difference is the amplifying effect of combining government insured deposit institutions (quasi public institutions, really) with risk-reward driven financial organizations. Government subsidy of high-risk financial businesses was never intended … but, allowing these kinds of organizations to combine has allowed it to happen. Glass Steagall should never have been repealed. Why can’t this be undone?