Saturday, November 28, 2009

Taxing Financial Transactions--Not exactly the Heart of the Matter

Paul Krugman proposes a tax on financial transactions as a way to discourage the day to day churning of accounts on Wall Street.

Tobin’s idea went nowhere at the time. Later, much to his dismay, it became a favorite hobbyhorse of the anti-globalization left. But the Turner-Brown proposal, which would apply a “Tobin tax” to all financial transactions — not just those involving foreign currency — is very much in Tobin’s spirit. It would be a trivial expense for long-term investors, but it would deter much of the churning that now takes place in our hyperactive financial markets.

This would be a bad thing if financial hyperactivity were productive. But after the debacle of the past two years, there’s broad agreement — I’m tempted to say, agreement on the part of almost everyone not on the financial industry’s payroll — with Mr. Turner’s assertion that a lot of what Wall Street and the City do is “socially useless.” And a transactions tax could generate substantial revenue, helping alleviate fears about government deficits. What’s not to like?

I don't have anything against raising money by taxing Wall Street, but a transactions tax doesn't get to the heart of the matter with the American financial system. The financial system was driven by the high profits from the derivatives markets, but that the derivatives markets were so speculative and unstable that they almost brought down the whole world economy. I haven't seen any proposal that either liberates the financial system from dependence on the derivatives markets or regulates the derivative markets in ways that makes them more stable. The problem is that whatever stability the current financial system affords might be completely contingent on the high profit margins of derivative transactions. The derivative markets might themselves by highly unstable, but any regulation effort that reduced derivative profits might also be de-stabilizing.

It's a nasty conundrum that isn't addressed by a financial transactions tax.

To his credit, Krugman admits this.

What about the claim that a financial transactions tax doesn’t address the real problem? It’s true that a transactions tax wouldn’t have stopped lenders from making bad loans, or gullible investors from buying toxic waste backed by those loans.

But bad investments aren’t the whole story of the crisis . . . As Gary Gorton and Andrew Metrick of Yale have shown, by 2007 the United States banking system had become crucially dependent on “repo” transactions, in which financial institutions sell assets to investors while promising to buy them back after a short period — often a single day. Losses in subprime and other assets triggered a banking crisis because they undermined this system — there was a “run on repo.”

In other words, bad derivative investments ("toxic waste") still triggered the financial crisis. They just did so "indirectly" by undermining the system of short-term transactions (churning) on which the banking system was dependent.

So, sure--put a tax on financial transactions as a way to discourage churning and reduce the crush of pointless trading.

But other measures are going to be needed to prevent the next big meltdown.