Taxation and Prohibition

By James Kwak

Andrew Haldane (of “doom loop” fame) has another provocative paper, “The $100 Billion Question,” delivered in Hong Kong last week. A central theme of the paper is what Haldane sets up as a debate between taxation and prohibition as approaches to solving the problem of “banking pollution” — the systemic risk externality created by the banking industry. Taxation is higher capital and liquidity requirements; prohibition is structural reforms that limit the size or scope of financial institutions. Drawing on work by Weitzman and Merton, Haldane discusses when one approach would be superior to the other.

The advantages of prohibition include modularity (ability of a system to withstand a collapse of one component), robustness (likelihood that regulations will work when needed), and better incentives (since tail risk is a function of banker behavior — not weather patterns — the risk-seeking nature of banking means that no capital level will necessarily be high enough).

Here’s Haldane on robustness:

“There is a literature on how best to regulate systems in the face of such Knightian uncertainty.
It suggests some guideposts for regulation of financial systems.  First, keep it simple.  Complex
control of a complex system is a recipe for confusion at best, catastrophe at worst.  . . .

“Second, faced with uncertainty, the best approach is often to choose a strategy which avoids the
extreme tails of the distribution.  Technically, economists call this a “minimax” strategy –
minimising the likelihood of the worst outcome.  Paranoia can sometimes be an optimal strategy.

“Third, simple, loss-minimising strategies are often best achieved through what economists call
‘mechanism design’ and what non-economists call ‘structural reform’.  . . .  In the words of economist John Kay, it is about regulating structure not
behaviour.

“Taken together, these three features define a ‘robust’ regulatory regime – robust to uncertainties
from within and outside the system.  Using these robustness criteria, it is possible to assess
whether restrictions might be preferable to taxation in tackling banking pollution.”

The disadvantages include lost economies of scale and scope — but, as Haldane discusses, these don’t exist in banking beyond a moderate size threshold.

In the United States, it seems pretty certain that the administration and Congress have chosen the taxation route. But Haldane thinks the debate is not over in the long term:

“We are at the start of a great debate on the future structure of finance, not the end.  Some fear that
momentum for radical financial reform will be lost.  But financial crises leave a scar.  This time’s
sovereign scar should act as a lasting reminder of the criticality of reform.  . . .

“The history of banking is that risk expands to exhaust available resources.  Tail risk is bigger in
banking because it is created, not endowed.  For that reason, it is possible that no amount of
capital or liquidity may ever be quite enough.  Profit incentives may place risk one step beyond
regulation.  That means banking reform may need to look beyond regulation to the underlying
structure of finance if we are not to risk another sparrow toppling the dominos.

“Today’s financial structure is dense and complex, like a tropical rainforest.  Like the rainforests,
when it works well it is a source of richness.  Yet it is, as events have shown, at the same time
fragile.  Simpler financial eco-systems offer the promise of greater robustness, at some cost in
richness.  In the light of a costly financial crisis, both eco-systems should be explored in seeking
answers to the $100 billion question.”

It’s pretty clear which side he’s on.

33 responses to “Taxation and Prohibition

  1. Its kinda frustrating following this debate. Better regulation? Activity taxes on banks? Seriously? The bankers are smart people and in an anglo-saxon law system they’ll find a legal way around leverage limits, regulators, taxes on activities etc. Yeah, it might take time but they’ll do it, and by then the regulators will be asleep again and unaware of new ways to hide risk-taking from public eye (via new but perfectly legal ways).

    In my view the only solution is to strike at the heart of the problem. Bankers want to earn a lot now. They couldn’t care less about what will happen to their banks if just in few years they can earn more than enough for a decent retirement even if the noone will ever hire them again.

    There are only a handful of ways to decrease the incentives to try to earn a lot quickly and run:
    1) Criminal punishment for past reckless risky behavior. But a) adding those to new laws will be hard, b) good lawyer with a couple of experts could probably make any reckless decision look reasonable and defendable.
    2) High marginal taxes in the top brackets. Penalty for tax evasion is already there, proving those is much easier than recklessness in business decisions

    So basically I think the only long-term solution is high (like 60-90% marginal tax on incomes). This does not have to kick-in at anything below $1mln or even higher, has to be world-wide (so some caps in tax treaties are needed). I don’t think it will cost us too much growth.

  2. That’s a decent heuristic, though we need a better term than “prohibition”. I don’t know how it is in England, but that term’s in some disrepute in America (however prohibitionistic Americans tend to be in action wherever it involves activities of the non-rich which don’t generate rents for the rich).

    We’re not talking about banning an innocuous pursuit, but doing the same thing as incapacitating a murderer. Strangely, outside of criminology we don’t seem to have a good term to describe the policy criminalizing murder. We don’t generally call it “prohibition”.

    (I’d like to figure out a way to render wealth concentration taboo.)

    In the United States, it seems pretty certain that the administration and Congress have chosen the taxation route.

    At any rate, the sham pretense of it.

  3. Just some thoughts (it’s all your fault, you triggered them! :^)

    In the manufacturing operations I’ve worked in, I’ve noted two types of work flow, the “pull” system, where a worker goes and takes a new batch of work when he/she is ready for it, and the “push” system, where the work is dumped on his/her bench regardless of whether it can be worked on at once or not.

    I’ve a feeling that your concerns are less a problem for the economy as a whole than you think. As I describe above, perhaps the simplest way to protect banking is to define what we want them to be (a push) rather than prohibit every action we don’t want then to take (some kind of pull – reactive at any rate). It may be simplest to just lay out what banks can do, and make it plain they can engage in no other kinds of transactions, regardless of complex formulae concerning capital levels, risk estimations, etc, while at the same time specifying the exact ways banks could behave in certain other ways (in what uses of SPV’s are permitted, for instance). This would aim to remove banking from the riskier practices of financial markets, and hopefully, the predatory practices of traders. Plain vanilla banking should then be somewhat better protected. Ultimately, this is a return to some form of Glass-Steagall.

    The growth continues to be financed by the shadow bankers and the traders, who take the biggest risks and enjoy the bigger profits. Other than forcing draconian capital controls, I don’t see how one can successfully regulate financial markets behavior. Maybe nothing else will suffice. Certainly, the free market has been giving societies all over the world plenty of headaches these past 40 years. Stringent capital controls might be the way to go. Certainly we don’t want depositor’s money going to operations of the in-house hedge fund, like Citi did with its (Philcom? What was its name?) hedge subsidiary.

    Ineffcient? Yes. The real questions then become: Are the extra costs worth it? What are the societal side effects, and are they worth it? On the other hand, is the free marketer’s insistence on lower taxes, employing deposits (and the Social Security trust fund) anything more than rent seeking? How efficient are financial markets anyways, when they make up such a huge portion of GDP, and put the control of assets worth 60% of the US GDP into a handful of bankers? Might a redistribution of wealth even be stimulative to other markets given these conditions?

    My two cents. I’d really love to see more posts addressing proposals and concerns on this level.

  4. OMG I discovered an economist named — Michael Hudson — today. He is at the University of Kansas at Missouri … where William Black is tenured. It must be a hot bed of lefties :)

  5. That’s a relatively small University, but they seem to have a excellent faculty and making some noise. Wish people like Krugman and Blinder would be willing to stick their necks out more, but I guess they don’t consider that “professorly” or academic type behavior. I wish they would give the matter a second thought as they watch large investment banks destroy our society.

  6. Yeah, Hudson’s great. He’s written many of the best pieces on the great crime. (He’s been writing good stuff on this going back many decades. Krugman recently felt called upon to attack a piece Hudson wrote in the early 70s critical of K’s hero Samuelson. Smugman couldn’t even bring himself to mention the filthy peasant’s name, Hudson. I thought that was funny.)

    Here’s the Kansas City website:

    http://neweconomicperspectives.blogspot.com/

    Hudson, Black, Wray, Auerbeck, others – it’s a hotbed of something, all right. :)

  7. Completely agree. The New Economics Perspective website is fantastic; I wish the contributing authors would put up more than one blog post per day. I would also like to add that many of the commentators there are writing from a “Chartalist,” perspective. Chartalism, also called “Modern Monetary Theory,” also sometimes referred to as “post-Keynesianism,” is derived from the writings of Marx, Keynes, Abba Lerner, and Michael Kalecki. Modern proponents include Warren Mosler, Bill Mitchell, someone who calls himself/herself Winterspeak, and several of the authors mentioned above by Russ who write for the New Economics Perspective blog, most notably Randall Wray:

    http://moslereconomics.com/

    http://bilbo.economicoutlook.net/blog/

    http://www.winterspeak.com/

    If you like the New Economics Perspective blog Tippy, I would highly recommend giving any of these other blogs a shot too.

  8. I’m still waiting for Krugman’s column on accounting control fraud (to use Bill Black’s term of art). I guess the limits of acceptable discourse just don’t include the possibility of criminal behavior by our elites. Too bad Krugman’s reinforcing those limits, rather than trying to break them. Not what I would have expected, given his heroic behavior during the Bush administration, which is sad.

  9. Thanks for your replies. At a first gloss, these post-Keynesians resonate with me.

    I have never been attracted to free-market and libertarian theory. Inclined to feel it is glorified materialism that has lead to American “culture-heroes” like the guys at Magnetar. Although some might consider them rats. I mean how would you feel if you were a citizen of Latvia, Estonia, Iceland, Greece, Portugal, Spain, Ireland and who knows what country next.

    Black humour indeed when Hudson (?) calls this free-market exercise the Road to Serfdom and 21st century feudalism. IE ordinary people saddled with 50+ taxation over a generation to keep TBTF solvent.

    Maybe the world needs more post-Keynesians :)

  10. Kansas seems like a very interesting state. These are new names for me. But Kansas has give us Thomas Frank, Thomas Hoenig, William Black, Michael Hudson … Kansas is a hotbed of brilliant, independent thinkers?

  11. Thanks for the link. It was very refreshing to listen to Moyer’s interview of Bill Black. Black represents the best of the best in Federal regulation that has frankly been driven out of government sine the advent of the Reagan administration.

    What has really interested me all these years is the manner in which public accounting adapted to institutionalized fraud. This adaptation was very innocuous and not overtly intentional contrary to populist views. Auditors attest to the basic soundness of financial statements on a going concern basis. First and foremost , financial statements must comport to the state of the law applied to the business whose financial statements are being attested to by audit certification. The complexity of basic business arrangements since the use of electronic software came to dominate business practices while the law is generations behind the effects of software is a major contributor. The auditor is hopelessly stuck in the middle here and the profession is too constrained by similar ideologies to extricate itself, even if it could. An audit opinion cannot be based on Supreme Court like interpretations of what the law interpretation should be as compared to what the average interpretation of the law is. To me, this fact alone renders auditing and financial statement assurance ineffective. Some one else’s financial statements are independently attested to. Too much input converts the financial statements to the product of the auditor thus invalidating the audit. Complexity renders opinion difficult on an account by account or asset by asset basis.

    The combining of commercial banking , investment banking and securitization have made valid attestation of very large financial institution financial statements nearly impossible in my view.
    The commercial bank as a going concern lends long to term while borrowing short from depositors. Investment banking is merchandising of the same types of assets on a going concern basis. Herein lies the problem for fraud, that is engaging in deceit. It does not help that accounting professionals are of the same beliefs as the managers of the company being audited. It is also obvious that accounting firms can never charge enough money to cover the risk of a bad audit. Over the years, every accounting firm of size has come to understand that auditing is something to be de-emphasized while engaging in consulting to generate the profits they need to even engage in the risky business of auditing.

    Complexity has finally defeated even the concept of an independent audit, even at the high fees involved today. But, that is how the auditor earns his or her living as a partner.

    The solution to the audit problem would be reversion to unlimited liability partnership status for auditors. If that happened, they would be far better off going out of business. What an intractable mess.

  12. Generally I actually like Krugman. I think he sympathizes with the lost soul out there looking for employment. Krugman is basically a good guy. But he gets a tad arrogant at times. “Smugman”–did you make that up on your own?? pretty good (no sarcasm). Arrogant is more like it. He’s very arrogant, but not snobbish, and there is a difference between arrogant and snobbish

  13. Just to add a little fire to all this. The 2007 audit for every major bank and investment bank was obviously a gross failure. The first attestation of an audit is that the audited company will be a going concern for the next year under ordinary circumstances. Since these financial institutions need rescue by the state the firms failed going concern reliance at the end of their preceding accounting year. First and foremost, the audit must establish that practices and conditions of the audited company can be expected to survive until the end of the next accounting period even including foreseeable adverse results in the ensuing year.

    The TBTF’s were brought down by a silent run outside the purview of their audited statements. That possiblity was not adequately conveyed in the financial statements.

    At the least, some accounting reserves were required for liabilities arising from derivative losses. Yet, there was nmo prior experience on which to accrue the costs and establishing a reserve for losses. AIG in particular had failed audits here. Yet, no provision existed to establish a reserve because there were no facts at the time enable a loss reserve to be established.

  14. Steve Randy Waldman had an interesting article up on his website last week about the impossibility of independent auditors accurately assessing the capital positions of large, complex institutions, stating quote:

    “For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.”

    The whole essay is here:

    http://www.interfluidity.com/v2/716.html

    Steve’s solution is less complex financial institutions. Seems to mesh well with what JerryJ writes here. If for nothing else besides the sake of the accounting profession the world needs less complex financial institutions =)

  15. It came to me spontaneously when I recalled that blog post where he argued with Hudson without naming him. Just some guy, basically.

  16. Thanks JerryJ for your answers to my question at a previous post. We are lucky here to have you share your professional knowledge in accounting.

  17. University of MIssouri at Kansas City, to be specific. Seems to have the hottest econ department in the US at the moment.

    A lot of their professional work and that of others like them can be found as working papers (free access) at The Levy Institute and the Center for Full Employment and Price Stability if you don’t have a subscription to the journals.

  18. Add Scott Fulwiller and Marshall Auerback to that list. Scott blogs at New Perspectives and Marshall at New Deal 2.0. They are both knowledgeable about MMT and banking/finance.

  19. Mr. Kwak wrote:

    “…. approaches to solving the problem of “banking pollution” — the systemic risk externality created by the banking industry. ”

    Matthew Richardson & Nouriel Roubini wrote:

    How to reduce risk on Wall Street? Make the banks pay

    Sunday, April 11, 2010 – Washington Post – excerpts

    “It will not be so easy to put this genie back in the bottle, but we believe that our proposed fee would propel firms to become smaller, alter their risk-taking behavior and reduce their leverage. There is some hope. Several governments are already moving in this direction — as the United Kingdom prepares for next month’s elections, both major parties agree on the need for a bank tax, while Germany and France have signed on as well.

    Unfortunately, these proposals, along with those in Congress, still focus on the firms themselves, rather than the costs their risk-taking behavior imposes on the rest of society. Unless the banks face the prospect of paying up front for the damage they could inflict, they will continue to pollute the financial system with unnecessary risk — and increase the chances of another crisis.”

    http://tinyurl.com/y8ap6gl

  20. There are many avenues of controlling financial firm risk. One avenue might take a page out of the big banks own book of tricks. Require banks to deposit offsetting collateral with the central bank ( or others) for holding risky paper or contracts like CDS’s as merchandise. The same principle as is used for collateral deposits to cover possibly triggering credit default swaps. A second set of similar rules would apply to paper held to maturity.

    Do a Saul Alinsky and use their own cherished methodologies as a police tool.

    Firms that go into risk cover risk as they go.

  21. Yes, absolutely, keeping it simple so that everyone can follow it is the trick (hi, hi hi!)
    http://bit.ly/bXMi9I

  22. I’m geography-challenged on American states. Yes it is the University of Missouri at Kansas City. So — Kansas City — distinguished for its brilliant, independent thinkers.

  23. “The history of banking is that risk expands to exhaust available resources.”

    In this sentence, I believe Haldane crystalizes THE issue I have been blogging about. We have an economic ecosystem. It only works if there is proper balance. Otherwise it gets far out of kilter. Karl Marx (much maligned, but never saw himself as a communist or even a radical socialist) saw what is happening as a natural dialectic process of capitalism. I believe him, even if I don’t necessarily subscribe to his solutions. (By the way, Lenin and friends totally corrupted his work to suit their purposes.) He saw the vast imbalances coming a hundred and fifty years ago. We have seen them many times before. If we look at our banking oligarchy and see it as having the current leadership role in a vast plutocracy, we are right on the money, so to speak. Banking, not just here, but globally, has become the dangerous algae in our economic pond. It is gradually, but insistantly squeezing out other economic life forms, or at least subjugating them to its power.

    The clearest sign is that, although the public says it hates Wall Street, very, very few of our political leaders are speaking clearly to the economic peril created by the big finance interests, EVEN IF THEY DON’T FAIL AND NEED A BAILOUT. They are a force of suppression in our economy and that of the greater global community. This will continue until we have the courage to clearly and convincingly curb this economic (and political) dominence. I am NOT anti-banking, but I am in favor of a real recovery, and, until finance is tamed, it won’t happen.

  24. Valerie Gagnon

    Don’t forget that Krugman uses Canada as an example where a few super-size large banks maintained under stark regulation, managed to completely avoid the financial crisis.
    He argues that size doesn’t matter so much as constraints and control.

  25. Capital requirements in Canada were indeed much stricter than what was allowed by Basel II

  26. Bayard, it’s not just banking or even FIRE that has become parasitic on the system. It’s also the energy industry, the food industry, the pharma industry, and the many others that have lobbied successfully for privilege and corporate welfare. Until there is adequate campaign finance reform, an amendment that corrects the recent SCOTUS decision allowing unlimited corporate political financing, and lobbying reform, as well as closing the revolving door, the US will be controlled by a plutocratic oligarchy and crony capitalism. The problem can be summed up in one word — corruption.

  27. Keep in mind that the Government of Paul Martin was voted out of power following the Sponsorship Scandal which was about $100 million dollars being mis-directed to, yes, curry political favour, but mostly to fund an “unfair” propaganda campaign against Quebec separatists…

    No amount is too small in Canada to launch an enquiry and bring Government to its knees…

    People here generally have faith in the goodness of their governmental institutions and come down hard on them when that faith has been breached.

    $100 million ?? How many billions in bonues has Wall Street paid out over the past 15 years that have ultimately been transferred from the taxpayers’ coffer? The fact that Wall Street has not been burned to the ground by pitchfork wielding citizens is, quite frankly, beyond me.

  28. It’s all just one big collective action problem. All hail the Free Riders! In the end the Meek shall inherit the Earth. There just won’t be much left of it to enjoy!

  29. Bartenders and boozers:

    My bent is generally against prohibition and in favor of moderation. Yet I have been leaning towards prohibition, because of regulatory capture. Prohibition is clearer and, to a degree, more immune to capture. However, during alcohol prohibition there was plenty of regulatory capture. I have even heard of a sheriff who gave confiscated whisky as Christmas presents. ;)

    With alcohol legal, bartenders act as informal regulators. They limit the amount of alcohol they sell people, and sometimes have people thrown out of their bars.

    Yet there is not much regulatory capture. Why not? Because the bartenders are legally liable for their regulatory failure.

    Did the regulatory failure of the Fed help lead to a worldwide financial crisis? Send Greenspan, Bernanke, Geithner, et al., to Lompoc for a year. That should have a bracing effect. ;)

  30. And what about all other “experts” that should have spoken out and kept mum?

  31. I am afraid the bankers and the elites learned their lessons from the First Great Depression so that this time things won’t change for the better of society. Last time, they let unions grow, they let a middle class develope that gave minorities rights and fought very hard to avoid involvement in the Vietnam War. They let regulations restrict their banking activities very heavily for 40 years. We are going to experience this oppression for a long while.

  32. They can’t put the Internet genie back in the bottle. The landscape has changed.