The Obama Financial Tax Is A Start, Not The End

The flurry of interest this week around ways to tax Big Banks is important, because officials in the US are – for the first time – recognizing that reckless risk-taking in our banking system is dangerous and undesirable.

But the possibility of a tax on bonuses or on “excess profits” that are large relative to the financial system should not distract us from the more fundamental issues.

Mr. Bernanke and Mr. Geithner need to admit that the Federal Reserve and New York Fed played a key role in creating this problem through misguided policies.  They were part of the regulatory failure, not independent of it.  When you keep interest rates very low and let balance sheets explode under your watch, we’ve seen how things fall apart.

As long as Bernanke and Geithner do not concede this point, they send a clear message to banks throughout the US and around the world that they can load up on risk again, and hope to profit – personally and professionally – from Mr. Bernanke’s next great credit cycle. 

Yes, a new tax on these profits will raise money.  But it will not prevent a major collapse in the future.  There is no use discussing tough regulation when the previous regulators are still in charge, and they refuse to admit they were part of a system which egregiously failed. Mr. Bernanke’s speech at the American Economic Association 10 days ago was a big step backwards for those – such as Tom Hoenig, head of the Kansas City Fed – who want to send a message that there is a new regime in place to stop future crises.

One view of regulation is that you can adjust the rules and make it better – with each crisis we learn more, so eventually we can make it perfect.  This appears to be the current White House position – there is even mention of the US becoming “more like Canada”, in the (mythical) sense that we’ll just have four large banks and a quite life.

Another view is that the current complicated rules obfuscate and make it easier for the financial sector (sometimes with collusion of regulators) to game and hide risk.  Successive failures of regulators at large cost over the last three decades make it clear that fine tuning the system is not likely to work; every time you hear the “Basel Committee [of bank standard setters] is meeting today to discuss the details”, you should wince.

The ingredients for regulatory reform need to be simple and harsh.

  1. Capital requirements at banks need to be tripled from the current levels so that core capital is 15-25% of assets.
  2. Simple rules need to be in place to restrict leverage – the amount that banks, firms, and individuals can borrow (including in the form of mortgages).
  3. Complex derivatives where risk is hard to measure need to have very high capital requirements behind them. It is not the regulators’ job to work out the complex implications of derivatives, and we can’t rely on banks or ratings agencies to do the job, so just keep it simple (and less profitable than today).
  4. And, as the ultimate fail-safe, we need a hard size cap on major banks.  All financial institutions have to be small enough so they can fail without causing major damage to the economy.

By all means, implement a sensible tax system that creates a punitive disincentive to size in the banking system – if you can figure out how to make this work.  Most likely, the big banks will game this, like they have gamed everything else over the past 30 years.

But don’t think taxes are the answer.  We need to go back to simple, transparent regulation, and much smaller banks.

By Peter Boone and Simon Johnson

An edited version of this post appeared this morning on the NYT’s Economix; it is used here with permission.  If you would like to reproduce the entire text, please contact the New York Times for permission.

29 responses to “The Obama Financial Tax Is A Start, Not The End

  1. Terrific column, Terrific 4 ingredients for regulatory reform. Go Tom Hoenig!!!

  2. You know, here is what it is like. It’s like you’ve got the swine flu, you’re running an extremely high fever, and someone says “Ok, let’s stock up on orange juice and chicken soup”. That’s what the tax is–it’s orange juice in the refrigerator and chicken soup in the cupboards after you got swine flu and your about to lose consciousness.

    How about this: F#*K the tax, and use the 4 ingredients for regulatory reform Professor Johnson and Peter Boone mention above. That’s the freaking swine flu VACCINE.

    If Larry Summers doesn’t have his head up his rear, maybe Obama will stump for these things in the near future.

  3. This is spot on and simple. The regulators have toied themselves in knots about what is glaringly simple. The remarks about Basel II are particularly apposite. Basel I was a crude tool to distinguish between inter bank lending or Sovereign lending(low capital weighting) and the private sector ( high capital weighting) it was so crude that lending to a multinational was not essentially distinguished from the credit risk of Joe Six Pack. If that was bad, it soon detriorted into a major consultithon trying to assign capital weightings to all major categories on the balance sheet. Utterly bogged down in often abstruse detail it came into force “dead on arrival”. The 10 years of consultation allowed just about everyone to work out how to game the system. In short this was useless. What is needed is principles based. This is the amount of capital that we think appropriate to your activities. If you deviate in your balance of risks underwritten, then the market as well as the regulators will act in defense of the system. Why cannot the G20 simply adopt this and stick to it. That is all that is asked of them.

  4. Another (infrequent) post from “Alan One-Note”!

    Mr Johnson is working on a theory of bank regulation:
    how, in an ideal world, should banks be regulated.

    This is a good start. But we should go further:
    we should have a discussion about what a proper
    Financial Sector should look like. Do we have a
    vision of what a human-serving financial sector
    ideally should consist of? I haven’t seen it
    here, nor elsewhere.

    Two clarifying points:
    1. I’m not calling for a new Thomas More’s Utopia,
    or for a Bellamy’s “Looking Backward”. I’m asking:
    in the framework of standard capitalism, what should
    stock markets, banks, and insurance companies be
    doing, and what should they Not be doing.
    2. I don’t hope that we’ll get what is desirable
    in a financial system this time around; the forces
    arrayed against us are much too powerful. But we
    are at the moment fixated on reacting; chipping
    away with our own private chisels at the monstrosity
    which exists. Cannot we work to construct our
    own edifice, so that we can say: “Here’s the way
    things _should_ be”?

    I have suggested to Mr Kwak that he find a sequence
    of intelligent, non-bought experts to give their
    ideas of what a sociey-serving system would be like.
    One expert could talk about banks, another about
    insurance, another about government. Maybe others
    here could join my call . . .

    Best wishes,

    Alan McConnell, in Silver Spring MD

  5. Tax will only be passed on to the consumers and lower the value of the stock.
    The government created the initial catalist for the housing/credit bubble and the regulators didn’t even notice.
    TARP already has a provision for full repayment of all costs by 2013.
    Why do Fanny, Freddy or Insurance Cos. not have this tax?
    This is just another Obamanation.

  6. I agree with Alan’s “one note.” Our economy and indeed our society have become horribly distorted by excessive financialization. I noted how Mr. Blankfein from Goldman Sachs insisted that all the investors who bought the mortgaged based securities were professional investors. I don’t care how professional you are, if you do not receive accurate and honest information you cannnot make good decisions. This basic failure in disclosure is a basic failure in human relations. It is predatory and puts Goldman Sachs at the same moral level as a con-artist.

  7. By the way, I agree taxation is the way to go as a way of inhibiting excessive growth.

  8. Hoenig is a deflationist disaster, and a poor central banker. Plosser is the same. The two, taken together, have nearly brought the economy to its knees. Their views are appealing to many people because of their ideological purity, even if that ideology leads down a doomed path.

    Plosser’s job is to balance inflation and unemployment using monetary instruments, but as a “real business cycle” theorist, he’s on record as disputing that an “output gap” exists – in other words, all unemployment is at the “natural rate”. Hoenig is close behind.

    It is important to recognize something crucial:

    Any attempt by the Fed or other agencies to use administrative mechanisms to limit risk (that is, to regulate) is going to effectively decrease credit supply (and thus, higher order money supply). This is going to mean the economy takes a huge hit.

    And I am in favor of this.

    But to demand that the Fed aggressively cut monetary stimulus (as Hoenig and Plosser have repeatedly done even while the markets projected deflation) while AT THE SAME TIME imposing strict administrative rules on banks would plunge the country into a repeat of Japan (declining nominal gdp growth and increasing debt burden) – and the political reaction would be to extend/increase unemployment support and transfer taxes until the US federal government was crushed under debt.

    So, is Baseline now officially endorsing a Great Depression? This is in stark contrast to Baseline’s previous baseline scenarios (in which it called for monetary coordination among major central banks and stronger stimulus), and indeed contradicts certain guest posts from individuals.

    I would note the absolutely vicious comments received by Joe Gagnon when he endorsed a view opposed by Hoenig/Plosser (that we need a bit more inflation/devaluation).

    http://baselinescenario.com/2009/11/14/whos-afraid-of-a-falling-dollar/

    So, which is it? Does Baseline endorse Gagnon’s view, or Hoenig/Plosser?

  9. While reading “The American Presidency, an Intelelctual History”, I ran across a reference to the Panic of 1907, the ensuing recession and the subsequent findings of the Pujo Committee of a highly concentrated “money trust”.

    These findings were popularized in a 1914 book titled ” Other People’s Money and How the Bankers Use It.” The author is Louis D. Brandeis.

    The volume is still in (re)print and available on Amazon. Even reading just the online excerpts is well beyond spooky with 100 year-old deja vu writ large.

    The question is, will our current leaders have the spine and perseverance of Woodrow Wilson, Brandeis and others to take on the “money trust”?

  10. Well said Alan. Rocks my boat.

  11. Follow up –

    In general, there appears to be a growing inconsistency in Baseline’s arguments as it shifts tone to match the Populist agenda. I understand the strategy, but would note a few things –

    Baseline has a habit of utterly dismissing technical arguments out of hand. Baseline’s increasing obsession with channeling populist anger has caused it to endorse policies that have very poor consequences.

    For example, back at the beginning of 2009 Baseline spent a lot of attention focusing on how Banks were trying to screw the taxpayer by refusing to IMMEDIATELY recognize losses on assets based on Mark-To-Market rules in the MIDDLE OF A LIQUIDITY and DEMAND CRISIS.

    http://baselinescenario.com/2009/04/02/the-mark-to-market-myth/

    Here is a quote: “The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets. This makes no sense, for three reasons.”

    The implication is that if bankers wanted the change, then it must bad for everyone else. Subsequent lines of argument were deeply flawed. Plese reread the rest of that post, and consider how much of it Baseline still agrees with.

    In retrospect, if we had forced banks into insolvency based on prices in an illiquid market, we would have ended up intensifying that crisis and forcing banks to sell assets at EVEN LOWER fire sale prices. This would have further crippled the housing market and rebounded against all other banks as each struggled to clear out assets in a market with sharply downward momentum in order to comply with short-term-minded administrative valuation rules?

    Looking back, the sharks who were circling made out pretty well on their investments in distressed assets, and that was WITHOUT forcing those prices even lower.

    Reread that old pro-MtM post. Now think, very seriously, about the impact of administrative actions on money supply, asset valuations, and by extension nominal gdp and unemployment.

    If you truly endorse the Hoenig/Plosser view, you are looking for a repeat of 1931.

    Tighter administrative actions MUST be accompanied by looser monetary actions, and coordinated carefully, or the resulting depression will destroy all political momentum.

    So, thank you for registering your voice against Bernanke’s appointment.

    But if Baseline is seriously suggesting the likes of Hoenig (or Plosser), then I would rather have Bernanke, thank you very much.

    BTW, I would love to see more guest posts from folks like Joe Gagnon or others, but cannot blame them for being frightened away by the angry response of the commenters.

  12. This still doesn’t address one of the primary causes of the meltdown: the threat of a penalty for the malfeasance did not outweigh the rewards for doing such; or more simply put, individuals did not face the same threat of financial ruin that their companies did for their actions. Sure Stanley O’Neil nearly destroyed Merrill Lynch, but he still received somewhere around $250-300 million over the course of his tenure as CEO of ML.

    So what’s the fix? (a) Require all financial institutions to sign on an FDIC of sort for all financial institutions to protect against failure. (b) Require that if a bailout is required, the personal assets AND compensation over the prior five years of the top X percent of earners at the bailed out institution must be forfeited first to pay for the bailout. (c) Institute tracking rules and regulations to prevent gaming and off-shoring of assets.

    The problem wasn’t that the banks didn’t have ‘skin in the game,’ it was that the bank management had no threat of the same kind of financial ruin that they put on their companies (and the worldwide economy).

  13. RT

    RT
    a digression from the topic but good points

    Now, how to ensure the regulators actually regulate especially when said regulator hopes to land a mega paying consulting job after leaving the gov job with pension, of course, compliments of the taxpayer.

    Instinct not to “bite the hand that will feed you” particularly to the tune of millions in the future.

  14. Big Bonus Bankers are also gaming the entire economy. It is in their interest to make it as lousy as possible.

    It works this way: first Big Bonus bankers observe they will not make huge would-be profits in the normal economy, but they can claim to have made them in the derivative world(even if it is not true, they can hide behind the smokescreen of complexity).

    Second, they observe that if they send all the money the state has given them the opportunity to create towards the real economy, they would have none for the derivative illusion.

    Thus, third, they send none to the real economy: this makes the real economy lousy, with no profits possible, so then the Big Bonus Bankers can turn to the political leaders and say: “Well, see, we can’t make any profits in the real economy, so our only hope, to save the banks is to send all the money the state has allowed us to create towards the derivative world. QED.”

    And then the political leaders and the plutocratic political economists (Bernanke, etc…) offer to help by keeping interest rates as low as possible, etc.

    Patrice Ayme
    http://patriceayme.wordpress.com/

  15. It would be helpful to identify those things that are expected of an economy/financial system. At the point there is agreement on that, then ideas about how to achieve those goals can be tested/validated and tuned.

  16. Hear, hear!

    I agree completely. I just hope that more people with power realize that this is what we should be doing.

  17. Federal Reserve makes record $52.1bn profit

    Fed chief Ben Bernanke has made money for the US taxpayer
    The Federal Reserve made a profit of $52.1bn (£32.2bn) in 2009, a rise of 47% over the previous year.
    The sum allowed the central bank to pay a record $46.1bn to the US Treasury last year.
    That was the largest amount ever paid by the central bank since its creation in 1914.
    The record figure was largely thanks to its attempts to support the financial system throughout the ongoing financial crisis.
    The Fed funds itself from its own operations and returns any profits to the Treasury department.

    Can I get in on this as my returns were not near this good!!!
    Big government is more of a problem and more tax when they make such a profit on the bailout.

  18. I work for one of those “bad” banks and I relish my compensation this year. For those of you who think you’re taking our money back, forget it. We’re more emboldened now than ever.

    You can’t regulate effort and drive.

    No matter what happens, successful people find ways to win in the end.

    This isn’t socialism – it’s called freedom.

  19. If we can just move out Summers, Geithner and Bernanke, and replace them with Hoenig and Volcker, we’ll all breathe a sigh of relief, and feel safe in the knowledge that very soon (if we can expose the Congressional bias and how it has been created) REAL REFORM is actually probable. Amen to everything you said, amen, amen.

  20. Hear, hear. Baselinescenario has become much too shrill and angry of late. The informed commentary and debate that characterized it early on is now much harder to find amongst the hardened positions. Perhaps this means its usefulness has run its course…

  21. Let me guess: You’re a stand-up comedian trying out a bit from his new routine.

  22. Arbeit Macht frei.

  23. Stats Guy:

    Can You Please stick to one topic at a time, instead of wrapping everything – monetary policy, regulation/deregulation, Hoening/Plosser etc etc etc etc…., in “The American Flag of Patriotism.”

  24. “t would be helpful to identify those things that are expected of an economy/financial system.” ! ! !

    Yes, indeed. It is pleasant to have agreement so
    succinctly and elegantly expressed

    And I would like to add to my original post the
    thought: Until we have done what “oldgal” prescribes,
    talk about “regulation” is way premature.

    Again, a call to Messre Johnson and Kwak: can
    you pick experts to talk about what a Socially
    Useful Financial Sector should look like?
    At the least we need guest posts about:
    1. Banking
    2. Insurance
    3. International Finance
    4. What the Public needs to know about the above.

    Best wishes,

    Alan McConnell, in Silver Spring MD

  25. Surprising to me that serious commentators see the “Big Bank” tax proposal as anything more than a political ploy appealing to public anger against Wall Street and the prospect of another round of big Wall Street bonuses. Since the only criterion to qualify for the tax is being a “big” financial institution it punishes both responsible and irresponsible players. Case in point: presumably Berkshire Hathaway through its sizable insurance operations would be subject to the tax. Does anyone believe that Warren Buffett’s financial recklessness contributed to the financial meltdown of 2008?

    I think a more telling question is why has the Administration taken so long to move its financial reform bill through Congress? We were on the cusp of financial disaster of untold proportions in September 2009. Nearly a year after the new Administration took office, we have yet to see financial reform legislation passed to assure we don’t face such a risk again. (Compare the time and energy put into the health care “reform” legislation).

    I think the essentials of financial reform need to be strict and sensible. The objective is to assure that never again will the financial system be threatened with total destruction due to an irresponsible aggregation of loans and their derivatives that violate all sensible credit standards. Here are the priorities I see:

    1. Higher capital requirements at banks, securities firms, finance and insurance companies that engage in lending, equity investing or broker-dealer transactions. Federal regulators should set the capital standards based on a simple risk weighting of asset classes and the standards should be uniform.

    2. Full disclosure of an institution’s derivatives exposure, both in terms of net profit and loss, and in terms of its counterparties’ credit standing. Failure to comply with this “full transparency” requirement would result in significantly higher capital requirements for this part of their business.

    3. Regulators would have authority to impose regulatory agreements on financial institutions whose credit standards fall below the regulator’s “safety and soundness” standards. A higher “safety and soundness” standard would be applied to institutions above a certain size whose failure could pose a threat to the financial system as a whole.

    4. Resolution authority permitting the regulators to take over a failing institution and settle its liabilities. This would avoid the panic and chaos that could ensue from a bankruptcy filing (recall Lehman Brothers) and send a message that no one is “too big to fail.”

  26. Surprising to me that serious commentators see the “Big Bank” tax proposal as anything more than a political ploy appealing to public anger against Wall Street and the prospect of another round of big Wall Street bonuses. Since the only criterion to qualify for the tax is being a “big” financial institution it punishes both responsible and irresponsible players. Case in point: presumably Berkshire Hathaway through its sizable insurance operations would be subject to the tax. Does anyone believe that Warren Buffett’s financial recklessness contributed to the financial meltdown of 2008?

    I think a more telling question is why has the Administration taken so long to move its financial reform bill through Congress? We were on the cusp of financial disaster of untold proportions in September 2008. Nearly a year after the new Administration took office, we have yet to see financial reform legislation passed to assure we don’t face such a risk again. (Compare the time and energy put into the health care “reform” legislation).

    I think the essentials of financial reform need to be strict and sensible. The objective is to assure that never again will the financial system be threatened with total destruction due to an irresponsible aggregation of loans and their derivatives that violate all sensible credit standards. Here are the priorities I see:

    1. Higher capital requirements at banks, securities firms, finance and insurance companies that engage in lending, equity investing or broker-dealer transactions. Federal regulators should set the capital standards based on a simple risk weighting of asset classes and the standards should be uniform.

    2. Full disclosure of an institution’s derivatives exposure, both in terms of net profit and loss, and in terms of its counterparties’ credit standing. Failure to comply with this “full transparency” requirement would result in significantly higher capital requirements for this part of their business.

    3. Regulators would have authority to impose regulatory agreements on financial institutions whose credit standards fall below the regulator’s “safety and soundness” standards. A higher “safety and soundness” standard would be applied to institutions above a certain size whose failure could pose a threat to the financial system as a whole.

    4. Resolution authority permitting the regulators to take over a failing institution and settle its liabilities. This would avoid the panic and chaos that could ensue from a bankruptcy filing (recall Lehman Brothers) and send a message that no one is “too big to fail.”

  27. My apologies for covering too much in one comment, but I’m not sure how I wrapped anything in a flag of patriotism… ?

  28. The IRS e-flie system is now open, most W-2s and 1099s will be in mail in the next couple of weeks. Is everybody ready for tax time?

  29. Greetings all. I have what I think is a slightly different perspective on the investment banks. Doesn’t the exceptional level of “profitability” that they are able to show say something about the fundamental competitiveness of their industry? I understand that when these guys are speculating, this is not about providing a service in a competitive environment. This is basically just gambling. But the fees that the I-banks charge in many aspects of their business seem to be egregious, which would be impossible in a truly competitive landscape. It seems that the rest of the economy is dealing with something of a cartel here, and this cartel structure allows for truly extraordinary profits. Can’t this be addressed directly to put the excess profit back into the economy?

    And a related point: how is it that Morgan-Chase can set aside $29B for bonuses out of the $40B in gross profit for the year? What about the shareholders? This seems like nothing much more that legal embezzlement to me. What stops John Chambers at Cisco from doing the same thing? Who do these guys think they are? If they want to run a partnership, they should take the company private, and keep their hands out of the pockets of the stockholders!