The futility of Wall Street 'reform'
By Martin Hutchinson
The new liabilities tax on banks announced by President Obama last week will
probably raise the revenue he wants - $117 billion over 10 to 12 years - but
its effects on the industry will not be what he thinks. Congress's attempts at
financial sector "reform" are also doomed to add bureaucracy without providing
significant additional protection against a collapse of the financial system.
The reality is that if the authorities don't get their act together this year,
we are very likely to have to pay for a second financial system collapse. Such
is the baleful influence of the crazed incentive system now driving Wall
Obama's liabilities tax, if it passes congress, is a case of "close but no
cigar". The tax correctly identifies leverage as one of the
major problems with Wall Street's current operations, but then addresses it
only in its "on balance sheet" form. In a world of credit default swaps and
endless dozy securitization structures, it's perfectly simple to take risk of
any kind without putting it on the balance sheet.
Indeed, the leverage tax, by driving banks to opaque and unstable derivatives
structures that do not appear on the balance sheet, will make Wall Street's
instability and rent-seeking worse.
There is a need for a new tax on Wall Street, but not to recoup the cost of
bailouts, nor to satisfy punitive populist fantasies, but simply to make the
place work right. As this column has identified in the past, the twin problems
of Wall Street are poor risk management and excessive rent seeking (the latter
not being a problem with Wall Street itself - seeking rents is human nature but
with an economic structure that allows it to happen). Poor risk management has
been greatly encouraged by the infamous "too big to fail" doctrine while rent
seeking has partly been enabled by new computer technology and has been
relentlessly expanded by 15 years of sloppy monetary policy.
A new tax and a new regulatory system must thus solve the real problems with
Wall Street, without if possible creating new ones. On tax, the solution is
pretty simple. Let the state collect an extra $10 billion annually from the
financial services business, by all means, but collect it not from a
liabilities tax, too easily evaded, but from a tax directly on trading.
A modest "Tobin tax" collected at a small ad valorem level on each
trade, would put out of business the most egregious rent-seeking practices on
Wall Street, in the area of high-speed trading, which rely for their success on
exploiting insider information about funds flows. It would not significantly
hinder the normal processes of investment, even short-term, but would penalize
only the thinnest-margin most trading-heavy operations. It would also have the
benefit of partly restoring the balance between trading and genuinely
economically valuable operations in Wall Street houses, which have in recent
decades become heavily over-weighted toward trading.
A tax on trading alone is not sufficient to reform Wall Street. If that was the
only change, the system would simply cut out the most egregious low-margin
trading excesses. It would instead move toward higher risk businesses such as
credit default swaps in which money is made not by rapid trading but by taking
on grossly asymmetric risks and allowing the successful speculations on
bankruptcy to outweigh the cost of unsuccessful attempts.
By closing the trading avenue toward rent seeking, you would merely have
increased the use of the "too big to fail" excessive risk avenue. In a market
where excessive risk leads generally to profits for the bankers and losses for
the taxpayer, the most likely economic system is one in which crashes happen
much more often than once a decade or so, so that repeated wild speculative
bubbles turn into disaster and chaos every couple of years.
Needless to say, since that is the economic system Wall Street currently finds
most profitable, that is the economic system we appear to have. Grossly
over-expansionary monetary and fiscal policies have made the global economic
system thoroughly unstable, so that now a wild commodities boom is ripping
through the world economy, while stock prices are up over 50% from the sober
properly valued levels to which they had briefly fallen.
The new bubble is doing nothing for small businesses, which according to this
week's National Federation of Independent Business survey are stuck in the most
depressed conditions they have seen for 30 years, with no immediate prospect of
emergence. It is also doing nothing for unemployment, stuck at close to a
post-war record, also with no immediate prospect of improvement - indeed
long-term unemployment seems likely to break through the levels of the early
1980s and set highs in 2010 not seen since the infamous1930s.
However, the bubble is making speculators very rich. Soon, as bubble turns to
crash, the holders of credit default swaps will really clean up, as major
corporations and a few Third World countries spiral into catastrophe, to the
enormous profit of those who have gone "short" on their credit.
When the Wall Street problem is stated this way, the solution becomes obvious.
Fiscal and monetary policies must be reformed, and quickly. The federal budget
deficit must be brought down from the current 10% of gross domestic product
(GDP) to the 5% or so that is normal in recessions, and which the capital
markets can cope with without crowding out small businesses. This must be done
not by major tax increases but by cutting spending both nationally and at state
levels, removing the public sector bloat that has been allowed to accrue over
the last decade.
Far from depressing the economy, this will restore it. Keynesian deficit
spending is at best a fallacy, because government does not create wealth,
although it can give the economy a modest short-term kick. However, in large
quantities, when it produces large budget deficits "stimulus" sucks capital
away from the productive private sector, especially the small business sector.
Currently, the parts of the US financial system too small and dozy to play the
trading game successfully, such as regional banks, are funding themselves
short-term at costs close to zero and investing in government and agency bonds
paying over 4%. So long as Federal Reserve chairman Ben Bernanke doesn't raise
interest rates, why would it ever be worth them taking on the risks and
harassments of financing small businesses when large profits are so easily come
Thus the most urgent reform comes down once again to the Fed. It is just
possible that Fed policy could be shaken up quickly. Bernanke still needs a
full senate vote on his nomination for a second term in office and there must
be some chance that enough senators wake up to economic reality in time to deny
him confirmation. Absent that wake-up call, current sloppy monetary policy will
continue until the Treasury bond market panics seriously at signs of incipient
inflation and collapses. Given the Bureau of Labor Statistics' tendency to
massage the inflation figures, this may not happen until late in 2010, but it
would be surprising if the current arrangements made it through the end of the
Once the bond market collapses and short-term rates are raised (with the
accompanying collapse in stock and commodity prices), small businesses will
initially be no better off, because the government will continue to suck in an
excessive supply of what finance remains. On the other hand, the bond market
collapse will sharply reduce the profitability of financial services,
particularly the trading operations. Given the state of current Wall Street
risk management and its excessive leverage (both visible and invisible), such a
reduction will almost certainly result in a further panic and a call for
That second call should be resisted. Instead, we should follow the advice of
Andrew Mellon, overruled by president Hoover at the start of the Great
Depression: "Liquidate everything ... purge the rottenness from the system."
Wall Street needs to be taught that nobody (including the US government) is
"too big to fail" and that risk management is not just a means of deluding the
auditors and yourselves with a mass of spurious computer-generated data, but is
intended to achieve the genuinely valuable purpose of managing risk.
Imposing risk management systems that work is the most important task of all
those confronting Wall Street. It must abandon "value at risk" and its
derivatives, which grossly fail to address the problem, and adopt reality-based
risk management systems that recognize the dangers of "fat tails" and the
extreme dangers of pathological products such as tranched collateralized debt
obligations and credit default swaps.
However, Wall Street can only reform its risk management internally - risk
management imposed by regulators will be too easy to evade. And for that to
happen, Wall Street must actually want to manage risk and be genuinely scared
of the alternative that may result from not managing it. In other words,
failure and personal loss must be a real possibility, staring it in the face.
"Too-big-to-fail" must be abandoned, for it has failed.
Martin Hutchinson is the author of Great Conservatives(Academica
Press, 2005). Details can be found on the Web site www.greatconservatives.com
(Republished with permission from PrudentBear.com.
Copyright 2005-2010 David W Tice & Associates.)