ataxingmatter

Wasn't Hedging Supposed to Prevent, not Cause, Market Failures?

As some of you may know, I'm not an economist by trade (B.S. in Chemistry, PhD in Linguistics, JD, and LLM in Taxation).  I'm married to one, however, who holds a PhD in Economics from Chicago, no less, having studied with Milt Friedman and F. Hayek.  (He thinks Hayek is misread quite frequently....)  So we've been talking about this economic crisis and the behavior of the big banks.  They supposedly have proprietary computer models for assessing risk, and use these models to hedge their risks on a daily basis.  They mark to market their assets, so that any time they know whether they are doing good or their assets are turning sour.  Yet the subprime/mortgage-backed security crisis has hit them like an iceberg slicing the Titanic.  Why?

Mark Thoma has collected a couple of interesting explanations (including Greenspan's), at this link.  I suspect it has a lot to do with the fact that the future can't be predicted from the past, no matter how sophisticated the computer programming that attempts to extract trends from points or how successful it may appear to be at times.  Here's what Avinash Persaud, linked on Thoma's blog, has to say about risk.

.....When a market participant’s risk model detects a rise in risk in his portfolio, perhaps because of some random rise in volatility, and he tries to reduce his exposure, many others are trying to do the same thing at the same time with the same assets. A vicious cycle ensues of vertical price falls prompting further selling. Liquidity vanishes down a black hole. The degree to which this occurs is less to do with the precise financial instruments, but more with the depth of diversity of investor behaviour. Paradoxically, the observation of areas of safety in risk models, creates risks and the observation of risk, creates safety......

If the purpose of regulation is to avoid market failures, we cannot use as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator....

Meanwhile, Paulson at Treasury is trying to preempt congressional action to regulate the huge investment banks that are "too big to fail", leading the Fed to come to their rescue. Here's the text of his remarks, the Blueprint for a Modernized Financial Regulatory Structure , a fact sheet and news release. But the Bush administration plan for revamping the regulation of financial institutions seems too little, too late, and maybe even intended to eviscerate the ability of the states to regulate banks.  In other words, like most things coming out of this administration, it is done more with the eye of aiding and abetting the mighty than with the eye of curbing their appetite for risk in favor of supporting a more sustainable economy that lifts all boats. As Floyd Norris writes for the New York Times--Market Plunges, Fed Acts --appearing to give Wall Street whatever it wants.

And here's what Nelson Schwartz and Floyd Norris, In Treasury Plan, a Reluctant Eye on Wall Street, New York Times had to say about Paulson's plan for revamping the financial system yesterday (3/30/08).

Although the proposal would impose the first regulation of hedge funds and private equity funds, that oversight would have a light touch, enabling the government to do little beyond collecting information — except in times of crisis.

The regulatory umbrella created in the 1930s would grow wider, with power concentrated in fewer agencies. But that authority would be limited, doing virtually nothing to regulate the many new financial products whose unwise use has been a culprit in the current financial crisis.

*  *  *

Mr. Paulson is clearly taking a stand against critics who support even stricter regulations, while rejecting any notion that the crisis in financial markets or the collapse of Bear Stearns can be laid at the administration’s doorstep.

I'm not convinced that a plan hatched in the desire to help banks be "competitive" (Bush administration jargon for "make money without sharing any of it with the Federal government") has any place in the reforms we need to develop.  I wonder if we don't need to rebuild the Glass-Steagal wall, or at least some part of it.  When you let banks get too big to fail, that means that there will come a time when you really can't prevent it after all.  Now is not the time to go "light" so banks can continue their reckless and risky run for the money.  It's time to be reasonable and thoughtful-- to move with all due deliberation towards a revamped system of bank oversight that subjects investment banks to real supervision and takes a very hard look at their exotic derivatives, especially the credit default swap speculation and the collateralized debt obligations.

More on McCain and Economics/Taxes

Yesterday, I thought it would be interesting to look at what people were saying about Candidate McCain's professed economic and tax policies, given the Center for American Progress study that shows him to be a fervent believer in the laughable Laffer "throwing away revenues to the rich makes more money for everybody, even for the government that gave it away" and despicable Norquist  "tax everybody but the rich" campaigns to return our tax and economic policies to the good ol' days pre FDR.

Remember that McCain admitted that he knows almost nothing about economics.  The vacuity of his campaign website's verbiage on fiscal and tax policy issues provides a fairly clear demonstration that he was, at least on this, speaking truth. 

This little snippet from Dani Rodrick's Weblog may explain what's going on.

Kevin Hassett, economics advisor to John McCain, is quoted today as saying:

What really happens is that the economy grows more vigorously when you lower tax rates. It is beyond the reach of economic science to explain precisely why that happens, but it does.

Now you can be excused for thinking that the first of these statements is true, if you have an economically sound reason for it. But if you don't, you shouldn't. 

Let's call it no longer supply-side economics. It is faith-based economics.

Maybe that's why economics has so often been called "the dismal science"--because for too many purported economists, like Kevin Hassett, there is so often so little science there. 

The comments on Rodrik's posting are also unusually interesting.  Robert Feinman, for example, offers the following:

Henry George had interesting ideas, but nobody reads him any more because the one organization devoted to promoting his work runs on a shoestring.

Compare this with the funding behind Heritage, Hoover, Cato, George Mason U, and a score of others. If you dig deep enough you will find the same core group of people funding all these propaganda factories: Coors, Scaife, Mars, Waltons, Koch, Olin, etc.

Liberals think that the "truth" will come out if there is an open debate of ideas. The plutocrats prefer to fund their version of the truth to guarantee that their viewpoint becomes widespread. They have been remarkably successful over the past 40 years.

This, of course, part of the concept I have espoused in this blog of "democratic egalitariansm."  Where elite families with extraordinary wealth retain that wealth and use it to influence the governing institutions, not only is "truth" hard to come by, but any efforts to undo the machinery that feeds the power that grows from the wealth are akin to scaling Mount Everest.  And that, of course, is what Jim Repetti is talking about when he says we need to consider the role of taxes in a democracy even in defining the underlying justice principles that decide how we set our tax base and rates.  See my earlier posting on Repetti's articles.

Center for American Progress: McCain and Taxes

The Center for American Progress Action Fund has put together a study of candidate John McCain and the likely impact of his tax policies, as he has expressed them as a candidate, if he is elected president.  Robert Gordon and James Kvaal conclude, in Five Easy Pieces and Two Trillion Dollars (March 2008), that McCain's professed tax agenda would:

• cost over $2 trillion;
• deliver 58% of its benefits to the superwealthy in the top 1% who have been the beneficiaries of the weak economic growth over the last 7 years;
• continue the shift of the tax burden to wage income from investment income;
• lead to increased use of tax shelters to avoid taxes;
• be paid for (if not by borrowing) by massive cuts in Social Security, Medicare and other programs that benefit the majority of Americans.

Here are some relevant links:

Krugman, Loans and Leadership (March 28, 2008) (assessing Obama, Clinton and McCain):

"Mr. McCain more or less came out against aid for troubled homeowners: government assistance “should be based solely on preventing systemic risk,” which means that big investment banks qualify but ordinary citizens don’t."

"But I was even more struck by Mr. McCain’s declaration that “our financial market approach should include encouraging increased capital in financial institutions by removing regulatory, accounting and tax impediments to raising capital.” "

"These days, even free-market enthusiasts are talking about increased regulation of securities firms now that the Fed has shown that it will rush to their rescue if they get into trouble. But Mr. McCain is selling the same old snake oil..."

Douglas Holz-Eakin, McCain's Economy Fix

This link is to an op-ed by candidate McCain's primary economic adviser, advising that he will support tax cuts for corporations to "ease" companies' burdens so they can create jobs. Problem with those kinds of tax cuts is that they don't often lead to jobs.  The companies that got the  2004 tax cut in the "American jobs creation act" bill which permitted them to bring funds back from overseas at a ridiculously low 5% tax rate ended up cutting jobs instead of creating them.

He also says candidate McCain will support a "tax credit for research and development".  That's something else the big corporations have been trying to get Congress to give them for years.  It simply isn't justifiable under an income tax.

FactCheck.org, Supply-Side Spin (2007): 

Republican presidential candidate Sen. John McCain has said that the major tax cuts passed in 2001 and 2003 have "increased revenues." He also said that tax cuts in general increase revenues. That’s highly misleading.  In fact, the last half-dozen years have shown us that we can't have both lower taxes and fatter government coffers. The Congressional Budget Office, the Treasury Department, the Joint Committee on Taxation, the White House’s Council of Economic Advisers and a former Bush administration economist all say that tax cuts lead to revenues that are lower than they otherwise would have been – even if they spur some economic growth.

Jeff Frankel, Does McCain Suscribe to the Laffer Hypothesis (Mar. 27, 2008)

Almost all serious economists – let us say Ph.D. economists teaching at real universities – disagree with this [Laffer Curve--tax cuts generate revenues] proposition, with only a microscopic handful of exceptions like Laffer.   Indeed some of the advisers who defend the Reagan and Bush economic policies claim that this formulation of supply side economics is a caricature, and was not the true rationale of the tax cuts.   This wishful thinking is directly at odds with quotes from the presidents themselves and their Treasury secretaries and other economic officials, to the effect that tax cuts stimulate income so much as to produce more tax revenue.  Laffer is not a straw man.

Economist's View (March 29, 2008), Let Them Eat Their Losses, linking to Paul Krugman, on the Gramm Connection, and Daniel Gross of Slate, Staying on Bush's Course--Here's Some Straight Talk, who has this to say:

"Reading McCain's economic agenda and listening to his speech, it appears that the problem with the last eight years is that we haven't seen enough tax breaks for the wealthy, that economic royalism hasn't been pursued with sufficient vigor, and that the middle and working classes haven't been stiffed sufficiently."  Dan Gloss, Slate.com.

Citizens for Tax Justice (March 28, 2008), Center for American Progress Finds McCain Tax Plan a Continuation of George W. Bush/Grover Norquist Tax Agenda.  CTJ concludes its review of the study with the following:

John McCain's views on taxes are either extremely mysterious or just totally unprincipled. As we have discussed before at length, he swung from a conservative position in the 1980s and 1990s to opposing tax cuts for the rich in the early part of George W. Bush's administration and now has swung back to the right with a plan that his own advisers admit would cause the deficit to grow.

Jim Repetti's work on wealth, taxes, and Democracy

One of the truly great advantages of serving as a visiting professor at another institution is the chance to become better acquainted with tax colleagues.  I'm blessed here at Boston College with a wonderful group of colleagues, not least of which is Jim Repetti.

Jim wrote an important article in 2001 about the negative impact of wealth concentration.  He concluded that a reasonable estate tax is an important institution to sustain democracy.  The article, titled "Democracies, Taxes and Wealth" is available at this link on SSRN.  Here's the abstract. 

This article demonstrates why wealth concentration matters and why the tax system should be used to help control wealth concentration. It shows that wealth concentration appears to be related to slow economic growth because of the lack of opportunities. It also shows that wealth concentration adversely affects the democratic process. It argues that because inheritances represent approximately fifty percent of wealth, wealth transfers should be taxed so long as the tax provides benefits that outweigh any assoiated harms. Using the current estate tax as a case study, the article concludes that a wealth transfer tax raises significant revenues and helps curb upward spiralling wealth concentration. Moreover, contrary to what has commonly been asserted, empirical studies generally show that the tax does not discourage savings.

Readers will no doubt recognize a good bit of similarity with this blogger's thoughts on this issue.  I wish we could get Senator Baucus and the other members of Congress who are so intent on eviscerating the estate tax in favor of the ultra-wealthy (who are the only ones who bear it at this point anyway) to read this and pay attention.

This year, Jim has developed his theory about the importance of proper tax theory to democracy even further, in Democracy and Opportunity: A New Paradigm in Tax Equity, 61 Vanderbilt L. Rev. (forthcoming 2008). This is a wonderful article that reconsiders much of prior thinking about fairness in tax (and does not slight efficiency, either).  What it accomplishes is a clear grounding of tax fairness in the democratic institution that our tax system is intended to support.  Here's how Jim describes his approach.

Tax policy has ignored the necessity of first identifying equity goals appropriate for a just government and then designing a tax system to help achieve those goals. This article proposes that the principal equity goal underlying a just government is the creation of equal opportunities for all citizens to achieve self realization, i.e. to maximize their potential. However, a tax system should not merely be evaluated for its contribution to achieving equal opportunity for self realization. A tax should be designed to achieve equal opportunity for self realization as one of its principal goals. Viewing equal opportunity for self realization as a design issue leads to the identification of another principle that is foundational—the promotion of democracy. Both political philosophy and empirical literature suggest that equal access to the electoral process and participation in the community must exist in order for equal opportunity for self realization to exist. Thus, the turtle lying at the bottom is equality of opportunity—equality of opportunity to maximize self realization and equality of opportunity to participate in the political process.

He then methodically sets about establishing that having this goal as a foundational concept for the design of a tax system incorporates much of the understanding that was achieved by defining equity in terms of benefits received or ability to pay, while providing a fully reasoned concept of fairness that can guide the choice of appropriate base and rate structure for the tax system.  Along the way, he dispels some of the myths about consumption taxation that have been put forward as "consensus" views of tax academics (even though there is no clear consensus within academe that consumption taxation is preferred over income taxation).  Again, Jim's own words in describing the relative advantages of an income over a consumption tax system are insightful.

To illustrate the importance of designing a tax system based upon these principles of equity, this article revisits the debate about the desirability of an income tax versus a consumption tax. It is well understood that in the short-run democracy is an inefficient form of government, but that in the long-run it is the most successful. The same is true for an income tax. Advocates of a consumption tax assert that investment income should not be taxed in order to maximize efficiency. However, an income tax that burdens investment income makes contributions to the effective operation of our democracy and to the creation of equal opportunity that are far more important than any efficiency gains provided by a consumption tax. Indeed, as discussed in this article, the relative efficiencies of the two types of tax systems, while clear in an idealized world, are far less clear in the real world. A tax system designed to maximize opportunities for self realization and participation in democracy provides benefits that have previously been ignored in evaluating tax systems. In contrast, a consumption tax designed to deal with transition and distributive issues likely to arise in the real world may be no more efficient than the income tax it would replace.

I highly recommend this important article for all those who care about establishing a firm fairness rationale for the tax system that is grounded in concern for a sustainable democratic institution.

CBPP on Income Concentration

The Center on Budget and Policy Priorities has another interesting report today on income inequality in the United States.  See Aviva Aron-Dine, New Data Show Income Concentration Rose Again in 2006 (Mar. 27, 2008).  The report is based on the work of Thomas Piketty and Emmanuel Saez, who issued an updated version of their research on income inequality, based on new information from the IRS.  There are a couple of excellent graphs as well, worth looking at.  Key points include:

• 2006 was the fourth straight year of significant income gains at the very top and very small gains everywhere else:  from 2002-2006, the top 1% had average incomes rise by 44% or $335,0000.  The bottom 90% had incomes rise by 3%, or $1000.
• The share of the nation's income going to the top 1% hasn't been that high since just before the Great Depression.
• Those in the very top income distribution--the top one-tenth of 1 percent--had enormous income gains rising 60%, or $1.9 million per household, since 2002.
• The three decades of booming economic growth after WWII lifted everybody's boats--the incomes of the bottom 90% actually increased more rapidly, on average, than the incomes of the top 1 percent.
• But the three decades since then (from the mid seventies on) have seen the incomes of most Americans increase only a little, while the incomes of the top 1 percent have "soared"

KPMG attorney fee litigation (and tax shelter case): back in the news

If you recall, the US government sought to prosecute  former partners of KPMG and others for their promotion of deals that the government considers tax shelters.  KPMG avoided indictment for a $465 million settlement payment and a cooperation agreement.   

In a hearing last year, District Judge Lewis Kaplan threw the case against 13 of the former KPMG partners out of court, saying that the government had violated their constitutional right to an attorney via the Thompson Memo, a government document that included among factors for prosecutors to consider in deciding whether to prosecute a company whether the company payed for legal defense for indicted employees.  KPMG didn't have a fixed policy of paying legal fees for indicted employees, but that had been its practice in the past.   Kaplan thought it likely that KPMG would have paid their fees in this case without the government's interference.

The Judge seemed to think that nobody could get a decent defense unless they could pay millions for it.  And he also seemed to think that they were constitutionally entitled to the very expensive defense they would have had if KPMG hadn't decided not to provide their legal fees.  Is this an elitist view of the rights of the elite?  I don't see these judges saying poor people are entitled to the best defense money can buy--even in death penalty cases. But there is a point here--the Chief Judge noted in Tuesday's argument that the government has no legitimate interest in impairing the quality or quantity of a defense.  Mark Hamblett, No Coercion in KPMG Case, Prosecutor Says, NYLJ (Mar. 26, 2008).   

Anyway, Judge Kaplan threw out the case.  Now prosecutor Karl Metzner is trying to revive it, arguing before the Second Circuit Court of Appeals that it was thrown out on erroneous grounds .  It didn't pressure KPMG to stop paying the defendants' legal fees, he says.  KPMG used its own business judgment in making the decision.  Mark Hamblett, No Coercion in KPMG Case, Prosecutor Says, NYLJ (Mar. 26, 2008).   Furthermore, even if their legal rights were violated, it was only for a short period of time and didn't merit throwing out the case.  And furthermore, there is the basic problem of Kaplan's ruling:  "It suggests that any defendant in a complicated fraud who doesn't have substantial resources could not get a fair trial."  Emily Chasan, US Tries to Revive ex-KPMG employees tax case, Reuters (Mar. 25, 2008).

The defense counsel claimed the prosecution played "dirty pool" and claimed one of the partners was essentially betrayed by KPMG--being sent before the Senate subcommittee "tutored" and then later having the firm agree that he had testified falsely.  Mark Hamblett, No Coercion in KPMG Case, Prosecutor Says, NYLJ (Mar. 26, 2008).

For the prosecution, Metzner noted that "a defendant has no Sixth Amendment right to spend another person's money--even if those funds are the only way the defendant can have the lawyer of his choice."  Id.

Judge Jacobs wondered if it might not be a rational decision for KPMG to decide now not to pay fees after it has been assessed a $456 million fine for the acts of the defendants.  Id.

I suspect the government is not going to get to reinstate its case.....

Dan Ariely: Predictably Irrational

I listen to WBUR's NPR programs quite a bit these days. I'm "visiting" at Boston College and so I'm away from home, family, and other entertainment.  This morning Tom Ashbrook interviewed Dan Ariely of Harvard about his new book, Predictably Irrational.  If you go to this link, you can read a few brief excerpts.  It's an easily accessible book about bounded rationality--framing, anchoring and other biases that lead us to make decisions that do not maximize our wealth (which, of course, in economist-speak, is what life is all about).  Clearly behavioral economics is a step ahead of plain old economics, but I suspect both have a way to go before they will have incorporated enough psychology, sociology and social justice ideas to even begin to claim to be a good theory of human behavior.  But the insights can still be useful.

Here's what I liked.  Ariely noted that people have trouble making intertemporal comparisons.  When we stop in a Starbucks to buy a cup of coffee, we seldom stop to think what we might do with that money in the future if we didn't spend it now.  It is in fact hard for us to think in those terms--present wants/needs versus future wants/needs.

Congress obviously has that problem in a big way.  Elections push them to think constantly of the "now"--what will impress voters, what will get them re-elected.  It is very hard for them to think of the future--what will happen to the deficit if we patch the AMT, giving a huge tax cut to wealthy Americans, without an offset from somewhere else?  Who will pay eventually, and will that be fair?  And since it is so hard, they just don't do it most of the time.  Too bad.  We get some very bad decisions.

By the way, Ariely was also on All Things Considered back on Feb. 21.  If you go to this link, you can read another excerpt from the book about the fact that we live in two separate worlds--the world of social norms and the world of market norms.  Social norms often provide the glue of society--we lend a hand to a neighbor, and the neighbor later helps us out.  We feel guilty when we break in line, and thus tend not to do it unless it is terribly imporotant (we hope).  Etc.  But if an activity that is ordinarily governed by a social norm is taken over by a market norm, we lose the ability to pay attention to the kinds of things that were important in the social norm.   Areily's example is of parents arriving late at a day-care center.  When they did, they felt guilty.  So it didn't happen often.  The day-care center hoped to discourage it altogether.  So they instituted a fine.  Once the parents thought they were paying for it, they were tardy even more.  The market norm made it okay to be tardy--just pay the fine. 

So, as we know, markets definitely don't solve all problems.  In fact, they create some.....

The Free Marketarian Fallacy, the Shadow Banking System, and Bear Stearns

I've talked here about an approach to tax policy and distributive justice that I call democratic egalitarianism.  Anyone who has read much of what I have to say already knows that I find most economic theory useful in terms of providing insights from a particular perspective, but certainly not the guiding light for understanding either our economic system or ideal tax policy.  In legal scholarship these days, there is a predominant view based on "law and economics" that tends to coordinate well with liberatarian and neo-conservative think tank positions.  I call it the "free marketarian fallacy."  A colleague who embodies that perspective told me when Enron failed that it was not an example of market failure and the need to balance economic risktaking and competitiveness with governmental boundary-setting and regulation.  Instead, he said that he thought that Enron was an example of the market working.  After all, he said, Enron deserved to fail because its business model was built on quicksand, and it eventually did.  So the fact that the market failed, eventually (and with a huge explosion of hot air) is proof that the markets were working all along.

Now, my answer to that was simple.  If that's the way the markets are supposed to work, then something is wrong with the theory of the markets.  It took too long.  It fooled too many people along the way.  It rewarded the very people who created the problem and cost the little people dearly.  The big guys who flew high on Enron's glory days didn't suffer much.  Lay was found guilty, but appealed and died before it ever came to prison time for him.  Fastow went to prison and lost some money, and Arthur Andersen suffered, but many others involved in the big schemes didn't.  It took too long for the hot air balloon that was Enron to burst, and in the meantime California bore a huge cost from the fake energy swaps.  An awful lot of little people were terribly hurt by the Enron fiasco.  So we enacted the Sarbanes-Oxley Act, which has helped, to some extent, by forcing some greater transparency around financial statements.  It's not quite so easy to hide overleveraged business problems off balance sheet.  It's not quite so easy to fool investors.

But then look at the mortgage mess.  It's another example of the free marketarian fallacy at work.  Banks were regulated, but the creed of "free markets" clamored for unregulated financial institutions and innovative financial transactions.  A shadow banking system emerged, mostly outside the scope of federal regulation.  The private equity funds and hedge funds made enormous wealth for the few people running them, who also felt comfortable taking advantage of an ambiguity about treatment of profits interests in partnerships and getting taxed on their services compensation at rates lower than their secretaries paid.  They leveraged themselves at huge odds--debt at 30 times equity.  And then along came Long Term Capital Holding, a hedge fund run by the smart numbers people who figured out how to price options, but it bet itself into a risky corner and had to be rescued.  Still, the shadow system kept growing.  Banks issued subprime loans at very high interest rates to people who otherwise couldn't get credit (and sometimes color was the reason).  They made huge fees again, and then securitized the loans for even more profits.  All along, they repeated the free marketarian fallacy--no regulation, no risk; no risk, no gain; we're making the world grow for you too. 

But now their shadow banking edifice is crumbling.  And guess what.  They are all perfectly willing to step up to the Fed window for a big handout of taxpayer assistance. JP Morgan got the Fed to help it buy off its rival Bear Stearns at a fire-sale price of $2 a share.  The Fed stepped in and took the risk of 30 billion of Bear's bad assets, all to save the shadow financing system that said it didn't need regulation.   The Fed (and that's we, the taxpayers) gets to bear the loss.  JPMorgan gets to make the profits.  Folks, this is a bailout, big time. 

Of course, you've heard the latest chapter in the Bear Stearns story, I'm sure.  Shareholders who loved the company when it was flying high and taking huge risks in the shadow banking world were angry about losing money.  They were greedy.  $2 a share and the Fed taking the losses wasn't enough for them.  They want more.  So now JPMorgan is negotiating to pay them $10 a share.  If it was going bankrupt, then the investors don't deserve to get bailed out with more money--certainly not backed by the Fed.  If JPMorgan has enough to pay 5 times what it planned to pay, then it can do without the Fed's guarantee.   Else it looks like this has all been a racket to get the Fed to open its coffers for the investment banks, who intend to keep right on piling on the risk and the wealth.

The answer is to put an end to the free marketarian fallacy.  There is no such thing as a "free market."  Markets  exist in an intricate web of institutions, public and private.  Without the public--as we see in the case of the shadow banking system--things will go crash in the night. 

So stand by the big banks, now that we've let them get "too big to fail."  But make them stand by the federal fisc.  Two things need to happen: 

1) the investment banks and other financial institutions need to be made subject to full regulation just like regular banks and

2) the financial institutions need to lose the "active financing" exception that lets them defer US tax, possibly forever, on their overseas business income. 

It's time they paid their fair share of the tax burden.  They are surely feeding their fair share--or more--at the taxpayer trough.  Or, as Barney Frank put it in a speech to the Greater Boston Chamber of Commerce:  "The absence of sensible regulation has taken parts of our economy hostage."  Since the investment banks have been riding a "new wave of innovation" in their securitizations that have "outstripped" regulation, government needs to develop a new wave of regulation like the reforms that repaired the financial system under the New Deal.  (But Frank also told reporters after the speech that we're not likely to get it done right under Bush, so we should focus on "get[ting] the patient healthy" first.)  See Frank says Subprime Mortgage Crisis Demonstrates Need for More Regulation, 90 Banking Report (BNA) 535 (Mar. 24, 2008).  Even the Republicans are getting it, finally.  Vito Fossella of New York admitted the US financial regulation is "outdated" and needs "meaningful reform".  Reading the BNA descirption of Fossella's teleconference with reporters, however, I tend to agree with Frank--if we try to do it in this Congress, with these Congressional representatives and this President, we won't get it right.  Fossella seems to be trying to use the need for regulation as an excuse to de-regulate (including finding another reason to give corporations a big tax cut).

For more on the need for regulation and the Bear Stearns mess, read these:

March 24, 2008, theStar online, US$1 billion Offer for Bear Stearns

JP Morgan has now upped its offer 500%, with the Fed still taking on $29 Billion of Bear's losses--Does that make sense?  Now the shareholders--and 30% of them are Bear Stearns employees who ran one of the most risk-loving banks in the business--are getting more (a whole lot more), and the taxpayers are still on the hook for $29 billion...

March 24, 2008, Michael Grynbaum, New York Times, Wall St. Cheers Bear Deal and Housing Data

The Deal made Wall Streeters happy.  Dow went up 187 or so points. Housing sales broke a six-month losing streak.  (Housing sales were up, but not much, above the last two reports. It's spring, after all, and some people have to move this time of year.  Housing prices are still swooping downward, with their "worst year over year drop in four decades" in February.)   Will Wall Street's euphoria last? 

March 24, 2008, Mark Thoma, Economist's View, A Coordinated Way to Destroy Effective Regulation

August 8, 2007, Bear Stearns Fat Cats Cashed Out at the Top

July 18, 2007, Bear Stearns Tells Investors "No Value Left" in two hedge funds

CTJ Finds House Budget Plan Superior to Senate Plan

In a new report, Citizens for Tax Justice (CTJ) finds that the "Budget Plan Approved by the House Deals with Tax Policy in a More Responsible Way than the Senate Version" (Mar. 20, 2008).  "For a nation facing a stalled economy, a healthcare crisis, and a war entering its sixth year, it's hard to imagine how lawmakers can justify giving priority to new tax cuts for the affluent.  The House-Senate conference commmittee that takes up the budget resolutions should reject the choices that the Senate has made." Id.

• The House bill provides reconciliation instructions that would make it easier to offset any AMT relief provided, but the Senate assumes any AMT patch would be deficit-financed, even though AMT relief benefits the best-off fifth of familes in America (excluding the one percent at the very top, who pay tax under the regular tax system at higher rates).  If the AMT is deficit financed, it will mean that middle-class Americans will bear a significant share of the debt burden to pay for the relief for the wealthiest Americans in the upper quintile.

80% of Americans have incomes of less than $88,000, and the AMT patch extended into 2008 provides no tax relief at all for most in this group, and only a small tax cut for those who do get AMT relief--those in the very middle quintile who earn $32,000 to $52,000 would see an average tax cut of a little more than $650, and those in the fourth quintile who earn $52,000 to $87,000 would see an average tax cut of a little more than $900.

In contrast, Americans 5% just under the top 5%, with average $147,000 in income, get an average of $2,514 from AMT relief.  The next 4%--those just under the wealthiest Americans who end up mostly paying regular tax--have an average income of $249,000 and receive an average AMT tax cut of $4,417.

• The Senate intends to cut the estate tax even more for the few extraordinarily wealthy families that are subject to the tax, paying for it with unpredictable budget surpluses.

"This would be a boon for the very wealthiest Americans but would provide no benefit whatsoever to 99 percent of all taxpayers."

The Senate plans to finance the huge cut in taxes for the very wealthiest multi-millionaire families in this country how?--by using Social Security surpluses! The Senate legerdemain  assumes that after 2012, the surpluses won't be needed to pay for the other Bush tax cuts and the war in Iraq. 

Now, folks, the Senators can't be serious.  Or else they are going about this budget plan the way they went about approving Bush's tragic idea of invading Iraq in the first place--with their eyes closed and their nostrils pinched.  Read my post on Stiglitz and Bilmes' calculation of the likely costs  of the Bush war in Iraq--in the best case scenario, it's $3 trillion--enough to make up for the much lamented future shortfall in Social Security funds. 

CTJ provides a state-by-state graph showing the extraordinarly small percentage of estates in 2005 and in 2006 that owed any estate tax upon the death of the owner.  That's worth looking at. 

I noticed a National Association of Manufacturers blog recently pushing estate tax repeal.  The author of the blog item claimed that the small percentage of estates owing tax was due to the fact that only a small percentage of the population died each year--completely warping what the facts show.  Folks, if you are confused, let me state it clearly.  The fact that less than 1% of estates pays any estate tax in this country, under current law,  means that fewer than 1 out of every 100 deaths will result in any estate tax liability.

• The Senate plan cuts taxes on better-off Social Security recipients, reducing revenues that are needed to shore up benefits for the future while benefiting only seniors who are well off to start with.

As CTJ explains, the government increased the taxation of Social Security benefits in 1993, in order to "treat Social Security more like other retirement income such as pensions and IRA distributions. For most retirees, the vast majority of Social Security benefits are income that has never been taxed." 

It's only the best off seniors that are required to pay tax on 85% of the benefits.  Again, CTJ has a useful chart, showing that Seniors in the $200,000 or higher income range are the ones that get the largest tax cut ($2,600) while seniros with incomes less than $50,000 get a tax cut of only $300 to $400.

Mark Thoma at Economist's View on Appropriate Response to the Mortgage-Backed Security Problem

Mark Thoma at Economist's View often has thoughtful pieces on current issues.  I don't always agree with his views, but I always find them worth considering.

I've written that the Federal Reserve's actions in bailing out Bear Stearns (and quite possibly other investment banks, before this credit crisis is resolved) is worrisome though perhaps necessary given the current interconnectedness of the financial markets and the overall economy and the huge impact that the failure of any one of the largest financial institutions might have.  It's unsavory though perhaps necessary because of the moral hazard issue:  bankers are able to exploit the markets and cash in with huge profits, but avoid most of the impact of the losses their recklessness in reaping ever larger profits may cause.  So I've argued that we cannot address the financial market crisis and remain oblivious to the real suffering of many ordinary Americans who are losing their homes, and in some cases their livelihoods, in part because of the reckless loan origination activites of financial institutions that thought they could rid themselves of the risk by securitizing the loans and passing the potential losses off to others.  In light of helping the investment banks out of their crisis, I've said we should impose new regulations that take into account the size of today's banking institutions and create some curbs to prevent the over-leveraged activity that led to the credit crisis.  I've also argued that we should give less weight to the financial institution's concerns about making modification of mortgage loans in bankruptcy possible--it wouldn't have the negative impact the banks are claiming, and it would make a real difference to individuals and families over a long term.

Mark Thoma, in his post today on the Economist's View blog entitled "Are Central Banks Planning to Make Coordinated Purchases of Mortgage-Backed Securities?" (Mar. 21, 2008) adds another thought that resonates with those I've listed above.   He has supported the idea of the Fed acting as "risk absorber of last resort" for the investment banks (and he notes that he probably should have emphasized more strongly the "last resort" nature of that action).  But he recognizes the moral hazard and fairness issues that raises as well as the fact that it is putting taxpayer money at risk.   And he makes an important statement about the relationship between progressive taxation and inequality in the context of these kinds of situations where players are able to reap huge financial rewards backstopped by the US Treasury.

One of many justifications for a progressive tax is to reduce inequities that arise because the economy departs from our ideal, textbook model. These departures from ideal conditions, and things like moral hazard and regulatory capture are certainly departures, allow income to be earned that is hard to justify. Using taxes to reduce the inequities that arise because some groups are unfairly advantaged by an imperfect system is a reasonable response to this problem.