[edited to add links and correct typos 11/28/09]
The current financial crisis and economic recession were caused by a number of factors--from foolishly optimistic homebuyers to greedily speculative bankers, from pushy real estate salespeople to outright fraudulent mortgage brokers who talked naive first-time homebuyers into getting in way too deep, from regulators too closely aligned with the industries that they are charged with overseeing to congressional senators and representatives too intent on making profits easy for their financial institution allies. All are guilty, but we can't do much about individual responsibility or the sales puffery that abounds in the real estate market.
We can do something about shady mortgage brokers, and congress should act to require a plain statement of the actual cost of the loan, the actual monthly payment, the actual financing resources needed to carry a loan--all to be given to a loan candidate at least one week before a closing. Note I said "actual"--not those phony sheets that purport to inform but carry caveats that the information may not be complete or up to date. Terms should be fixed and proper notice given before closing, in plain English.
The remedy for preventing future systemic problems in the financial system must focus on financial institutions (including the shadow banking system), their regulators, and Congress. We need to shine a lot of sunshine in--through reporting requirements for derivatives, among other things--and we need to draw (or, in many cases, redraw) a number of lines in the sand about capital requirements, leveraging and interlocking ownership. We need to make some accounting changes, to ensure that all financial institutions have fewer opportunities to engage in earnings management, and some of those accounting changes need to facilitate the way we measure equity capital for regulatory purposes.
But we also need to think about using the tax system in better ways than we have in the past. Our primary objective with the taxation of financial instruments has been to relieve them of tax--except for those rare periods, such as 1986, when sound minds recognized that there is no justification for the preferential rate. The assumptions underlying the preferential rate are in question as never before, and the value to the economy as a whole of "easy trading" --unrestricted by any tax on the transaction and relieved by lower rates from the income tax burden--is itself under reconsideration.
Krugman's op-ed (NY Times, at A29) says that the US should emulate the UK and EU officials who think financial transactions taxes should be used to deter financial speculation. He notes the UK financial regulator's announcement, in August 2009, that such a tax can discourage "socially useless" activities, used by Gordon Brown at the G20 meeting this month. (This is, of course, another variant of the "sin tax" idea that I raised as a possibility for use to discourage meat production and meat eating, because of their high societal costs--pollution, health, etc. See post last week on vegetarianism).
Krugman notes the "broad agreement" on the part of "almost everyone not on the financial industry's payroll" that speculative trading is socially useless. The problem is that speculation in financial assets has a disruptive effect on the world ecoomy. Tobin proposed, Krugman notes, a similar tax on currency speculation back in 1972. A "Tobin tax" should be small enough that it would not be a disincentive to those buying for long-term invetment, but would "throw some sand in the well-greased wheels" of those trying to get rich quick from outguessing the market with quick trades. It's that "churning" that's problematic.
The tax would therefore discourage potentially harmful activity, while raising much needed revenues for the Federal Treasury. And the revenues would arise primarily from a source that has benefited enormously from the government's guarantee because of the "too big to fail" problem with multinational financial institutions.
Note another benefit of such a tax. It should make it less likely that banks, like Goldman Sachs, could use their high frequency trading software to make billions off customers' trade information just ahead of the customer trade, as they currently do.
Krugman says the main argument against the tax is that traders would just work around it. That, of course, has been a rallying cry for cutting taxes from those on the right--if the rich might be able to avoid the tax, they say, let's just eliminate the tax and give them what they want. That logic leads down a one-way street with a rigid downward slope--all taxes would ulimately be eliminated, and government would find it hard to provide the barest necessities that we have come to think of as the appropriate fruits of citizens working together through government to address common concerns. Krugman notes that the very settlement mechanism that permits traders all over the world to engage in current trades provides a ready mechanism for tracking and taxing the majority of financial transactions.
Yes, a "sin tax" on financial transactions won't cure the gullible homebuyer, the fraudulent mortgage broker, or the potential innovations (llike subprime mortgages themselves) that are intended to bypass rules. But it will hit those managers too besotted by their millions in pay (and more millions in stock) to care that their cost of funds are cheaper because it is the taxpayers backing up their losses while they sock their privatized gains away. It might therefore help to shrink the too big to fail institutions, as it puts a crimp in their quick-trade profits .
One question not answered, though, is how a financial transaction tax will affect securitizations. One assumes that the "sale" into a securitization vehicle will be subject to the tax, as would the sale of interests in that securitization vehicle, and as would sales (or modifications) of existing assets in the securitization vehicle. That's likely a good thing overall if the transaction tax itself is a good thing, but it is one aspect of the tax that would need to be better understood.
Another question is whether there could be some protections for transactions by low and middle income folks. See Kay Bell's Don't Mess with Taxes "The Investment Tax is Back". For links to other blog commentary on Krugman's post and the Tobin tax, see TaxProf here.
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