The Misguided Financial Transactions Tax: Future of Banking #2

Thorstein Beck has edited an e-book for Vox on \”The Future of Banking.\” It consists of 12 short and highly readable essays by expert economists, based on their academic research. The book is packed full of interesting and relevant analysis. This is the first of three posts on a few of the ideas that jumped out at me. The topics of the three posts are:

1) The dangers of persistently low interest rates
2) The misguidedness of a financial transactions tax
3) The rise of global banks in emerging markets

Proposals for a financial transactions tax are a hardy perennial topic. The European Commission proposed one in late September. Even the Vatican has gotten into the act by publicly supporting such a tax, a proposal I reviewed and critiqued in an October 28 post, \”Financial Transactions Tax: The Vatican vs. the IMF.\” In this book, Thorsten Beck and Harry Huizinga offer an overview of why such proposals are misguided policy in \”Taxing banks – here we go again!\”

There are two main arguments for a financial transactions tax: 1) by discouraging high-frequency financial transactions, it will encourage financial stability; 2) it could raise a lot of money at a time when government budgets are stressed.

The first argument is probably incorrect. As Beck and Huizinga explain:

\”As pointed out by many economists, transaction taxes are too crude an instrument to prevent market-distorting speculation. On the contrary, by reducing trading volume they can distort pricing since individual transactions will cause greater price swings and fluctuations. But above all, not every transaction is a market-distorting speculation. Speculation is not easy to identify. For example, which is the market-distorting bet – one against or for a Greek government bankruptcy? Did the losses of the banks in the US subprime sector occur due to speculation or just bad investment decisions? What is the threshold of trading volume or frequency beyond which it is speculators and not participants with legitimate needs that drive the market price for corn, euros, or Greek government bonds? Most importantly, however, FTTs are not the right instrument to reduce risk taking and fragility in the financial sector, as all transactions are taxed at the same rate, independent of their risk profile.\”

There is good reason to be concerned that excessive leverage can help lead to asset price bubbles and economic instability. But it is not at all clear that the raw number of financial transactions creates financial instability; indeed, it is possible that discouraging financial transactions could lead to greater instability. In this sense, a financial transactions tax is misguided.

If the goal is to raise more revenue from the financial sector, there are other ways to do it. In the European context, Beck and Huizinga point out that one simple approach would be to apply value-added taxes to financial services. They write: 

\”An obvious step towards bringing about appropriate taxation of the financial sector is eliminating the current VAT [value-added tax] exemption of most financial services. The current undertaxation of the financial sector resulting from the VAT exemption is mentioned by the European Commission as a main reason to introduce additional taxation of the financial sector. However, if the problem is the current VAT exemption, isn’t the right solution to eliminate it?\”

Another option for taxing the banking sector is to impose a tax on banks that have high levels of leverage. In a way, this is similar to policies where banks with low levels of capital need to pay higher premiums for their government deposit insurance–that is, it\’s an attempt to make banks face the possible social costs of their risky behavior. Beck and Huizinga refer to this policy as one of \”bank levies\”:

\”Bank levies are taxes on a bank’s liabilities that generally exclude deposits that are covered by deposit insurance schemes. Bank levies appropriately follow the ‘polluter-pays’ principle, as they target the banks – and their high leverage – that are heavily implicated in the recent financial crisis. Bank levies have significant potential to raise revenue and they directly discourage bank leverage, thereby reducing the chance of future bank instability. In sophisticated versions of bank levies, they are targeted at risky bank finance such as short-term wholesale finance, and they may be higher for banks with high leverage, or for banks that are systemically important.\”

In short, proposals for a financial transactions tax are an old nostrum. Whether the goal is enhancing financial stability or raising revenue, or both, better options are available. 

Are U.S. Banks Vulnerable to a European Meltdown?

The Federal Reserve conducts a Senior Loan Office Opinion Survey on Bank Lending Practices each quarter at about 60 large U.S. banks. The results of the October 2011 survey, released last week, suggest that these banks do not see themselves as facing a high exposure to risks of a European financial and economic meltdown.

Here are a couple of sample questions from the survey. The first question shows that of senior loan officers at 50 banks who answered the question, 36 say that less than 5% of their outstanding commercial and industrial loans are to nonfinancial companies with operations in the U.S. that have significant exposure to European economies. The second questions shows that out of 49 banks, 24 don\’t have any outstanding loans to European banks, and 17 of the 25 banks that do have such loans have tightened their lending standards somewhat or considerably in the last three months.

Of course, a European economic and financial meltdown could affect the U.S. economy in a number of ways: for example, by reducing U.S. exports to European markets, or by affecting nonbank financial institutions like money market funds, hedge funds or dealer-brokers. But banks, because they hold federally insured deposits, are more likely to be bailed out by taxpayers if they get into trouble. So it\’s good news (if it indeed turns out to be true!) that major U.S. banks don\’t have high exposure either to firms doing business in Europe or to European banks.

Why Didn\’t Dot-Com Crash Hurt Like Housing Crash Did?

In the late 1990s, the U.S. economy suffered the end of the dot-com bubble, but had only a mild recession lasting for 8 months in 2001. But when the housing bubble popped, the U.S. economy had a brutally deep 18 month recession from December 2007 to June 2009, followed by a Long Slump of a recovery. Why did the bursting of the housing bubble hurt so much more? 

The magnitude of the two event is roughly similar. The value of corporate equities owned by households went from $9 trillion in 1999 to $4.1 trillion in the third quarter of 2002, according to stats in Table B.100 of the Federal Reserves Flow of Funds Accounts in September 2003. The value of household real estate dropped from $22.7 trillion in 2006 to $17.1 trillion by 2009, and since then has fallen to $16.2 trillion by the second quarter of 2011, according to stats in Table B.100 of the latest Flow of Funds Accounts released by the Federal Reserve

The answer is that when the dot-com boom collapsed, the lost value was in stock prices. Those who bought stocks knew in advance that stock prices could rise and fall. The losses for pension funds and retirement accounts were large, but they didn\’t cause widespread household or firm bankruptcies. However, when the housing price bubble burst, the losses were in the form of debts that couldn\’t be paid off. People couldn\’t pay their mortgages. Banks and financial institutions which were holding dicey mortgage-backed securities faced huge losses, and a financial crisis resulted. If the dot-com boom had been financed by enormous waves of household and business borrowing, and that borrowing had been turned into securities widely held by banks, then the bursting of the dot-com boom would have been much more economically destructive.

The key difference here is between equity and debt. The value of equity is contingent on what happens in the stock market, and so can rise or fall. But debt is typically not contingent on how other values change: you borrowed it, you need to pay it on schedule. Otherwise, defaults, foreclosures, bankruptcies, and financial crisis can result. Kenneth Rogoff thinks through many of these issues in the 2011 Martin Feldstein Lecture to the Natural Bureau of Economic Research: \”Sovereign Debt in the Second Great Contraction: Is This Time Different?\”

Rogoff focuses on this difference between non-contingent debt and contingent equity: [E]ven before the onset of the Second Great Contraction, it should have bothered macro-theorists more that such a large fraction of world capital markets consists of non-contingent debt, including public and private bonds, as well as bank credit. It is difficult to pin down global aggregates, but a recent McKinsey study found that at the end of 2008, the equity market accounted for roughly $34 trillion out of $178 trillion in global assets, with government debt, private credit, and banking accounting for the rest. This figure, of course, is exaggerated by the global stock market crash that occurred after the collapse of Lehman Brothers in 2008, but even at the pre-crisis equity level of $54 trillion, equity markets represented less than one third of the total. True, there is an entire zoology of derivative markets that makes some of the debt contingent, but incorporating these would not dramatically change the basic point.\”

As Rogoff points out, there have been proposals by Robert Shiller and others that when governments borrow, they should do so in a more contingent form–for example, perhaps the debt payments could adjust automatically if their GDP growth is faster or slower than expected. But in practice, given how governments can play games with their own economic statistics, such an approach has had limited appeal. In general, the clear promise to repay debt is easier to monitor and to enforce than a payment schedule linked to some other variable. But this widespread use of non-contingent debt, which in turn is subject to a wide array of poorly-understood risks, contributes to making the world economy a fragile place when bad news arises.

Four More Ways of Illustrating the Financial Crisis

I\’m always on the lookout for figures that offer vivid illustrations of what happened during the financial crisis. In fact, my first blog post in May was called \”Two Ways of Illustrating the Financial Crisis.\” Here are four additional figures I\’ve run across.

The first shows problems with bank lending. The figure was put together by the Stanford Institute of Economic Policy Research (SIEPR) as part of a \”chartbook\” for its annual economic summit. The note under the figure explains: \”Non-current Loan Rate refers to the percentage of loans and leases 90 days or more past due and loans in nonaccrual status. Net Charge-off Rate refers to the annualized
percentage of loans and leases charged off (removed from the balance sheet because of uncollectibility), less amounts recovered on loans and leases previously charged off.\” Notice how the rise in these negative statistics far outstripped the credit crunch of the early 1990s. Notice also that both of these problems continued past the official end-date of the recession, but appear to have turned a corner in 2010.

The second figure shows the net capital inflow of foreign assets invested in the U.S. economy, constructed using the always-helpful FRED tool–that is, Federal Reserve Economic Data–from the Federal Reserve Bank of St. Louis.  on data from the always  Notice that in the mid-2000s, inflows of foreign assets were very large and rising, topping out above $700 billion. Then during the recession, this inflow plunged all the way into negative territory, although the inflows are now back in the range of $500 billion. When I think about why the Federal Reserve felt compelled to buy Treasury debt during the recession, I think of this sudden disappearance of inflows of foreign capital.

The third figure shows the hump in housing prices, as the housing bubble inflated and then deflated. Again, this is taken from the SIEPR chartbook.

The final figure is a more standard illustration of interest rate spreads: in this case, the so-called \”TED spread.\” The note under the figure explains: \”The TED Spread is defined as the difference between the 3 month London Interbank Offered Rate (LIBOR) and 3 month U.S. Treasury Bill yield. It is an indicator of perceived credit risk in the general economy because Treasury Bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks.\” This measure strongly suggests that the financial crisis itself took off in August 2007 and ended by June 2009. Again, the figure is lifted from the SIEPR chartbook.

Lucas and Stokey on liquidity crises

Robert E. Lucas and Nancy L. Stokey have a lovely readable article in the June 2011 issue of The Region, published by the Federal Reserve Bank of Minneapolis, on \”Liquidity Crises.\” The paper offers a readable overview that connects the main  themes of high-profile academic theory papers in this area to what actually  happened. A few highlights:

\”Any one bank, no matter how large and respected, can go out of business almost without a ripple. Anyone living in an American city can list the downtown banks he grew up with that vanished in the merger movement of the 1990s. Who misses them? Indeed, who misses Lehman Brothers, for generations one of the most respected financial institutions in the world? Its valuable assets, both physical and human capital, were quickly absorbed by surviving banks without notable loss of services. It was the signal effect of the Lehman failure, whether a signal about the situations of private banks or about the Federal Reserve’s willingness to lend to troubled banks, that triggered the rush to liquidity and safety that followed.\”

\”We will argue here that what happened in September 2008 was a kind of bank run. Creditors of Lehman Brothers and other investment banks lost confidence in the ability of these banks to redeem short-term loans. One aspect of this loss of confidence was a precipitous decline in lending in the market for repurchase agreements, the repo market. Massive lending by the Fed resolved the financial crisis by the end of the year, but not before reductions in business and household spending had led to the worst U.S. recession since the 1930s.\”

\”As deposits moved out of commercial banks, investment banks and money market funds increasingly provided close substitutes for the services commercial banks provide. Like the banks they replaced, they accepted cash in return for promises to repay with interest, leaving the option of when and how much to withdraw up to the lender. The exact form of the contracts involved came in enormous variety. In order to support these activities, financial institutions created new securities and new arrangements for trading them, arrangements that enabled them collectively to clear ever larger trading volumes with smaller and smaller holdings of actual cash. In August of 2008, the entire banking system held about $50 billion in actual cash reserves while clearing trades of $2,996 trillion per day. Yet every one of these trades involved an uncontingent promise to pay someone hard cash whenever he asked for it. If ever a system was “runnable,” this was it. Where did the run occur?\”

Lucas and Stokey answer that the run occurred in repo markets, and offer an intriguing table that shows while cash, private demand deposits, and money market funds all  had more money in January 2009 than they had in January 2008, repo contracts held by primary dealers dropped substantially.

Caballero #2: Moral Hazard and Policy During a Crisis

This is  the second of three posts based on an interview that Ricardo Caballero of MIT did  with Douglas Clement of the Minneapolis Fed.

Here\’s Caballero on why it\’s misguided, once a financial is actually underway, to worry that financial bailouts will create moral hazard incentives for high-risk behavior.

\”I still recall politicians and economists calling for the need to teach lessons (in a punitive sense) to the financial system in the middle of the crisis. In fact, I think Lehman happened to a large extent due to the political pressures stemming from this view. What timing! …

\”I draw an analogy between panics and sudden cardiac arrest. We all understand that it’s very important to have a good diet and good exercise in order to prevent cardiac arrest. But once you’re in a seizure, that’s a totally secondary issue. You’re not going to solve the crisis by improving the diet of the patient. You don’t have time for that. You need a financial defibrillator, not a lecture. …

The main dogma behind the great resistance in the policy world to institutionalize a public insurance provision is the idea that if the financial defibrillator were to be implanted in an economy, banks and their creditors would abandon all forms of a healthy financial lifestyle and would thus dramatically increase the chances of a sudden financial arrest episode.

\”This moral hazard perspective is the equivalent of discouraging the placement of defibrillators in public places out of concern that, upon seeing them, people would have a sudden urge to consume cheeseburgers because they would realize that their chances of surviving sudden cardiac arrest had risen as a result of the ready access to defibrillators.

\”But actual behavior is less forward-looking and rational than is implied by that logic. People indeed consume more cheeseburgers than they should, but this is more or less independent of whether or not defibrillators are visible. Surely there is a need for advocating healthy habits, but no one in their right mind would propose doing so by making all available defibrillators inaccessible. Such a policy would be both ineffective as an incentive mechanism and a human tragedy when an episode of sudden cardiac arrest occurs.

\”I think this is one of the many instances when economists and politicians choose to solve a second-order problem they understand rather than focusing on what actually happens in real life.\”

Caballero #1: Demand for Safe Assets in the Financial Crisis

The Minneapolis Fed publishes a magazine called the Region that has consistently excellent interviews with leading economists. The June 2011 issue has an interview with Ricardo Caballero, who is chairman of the MIT economics department. To avoid making this post of encyclopedic length, I\’m going to break it into three parts: Caballero on the demand for safe assets in the financial crisis, on moral hazard concerns during a financial crisis, and on how to do macroeconomics these days. But the excerpts in these three posts just scratch the surface of the interview, and the whole thing is worth reading.

Here\’s Caballero on what he sees as the underlying root of the financial crisis: a global shortage of financial assets, and especially highly-rated fixed income assets. In describing the financial crises, he says:

\”It’s a story in two steps. The first, present at least since the Asian crisis, is that the world has experienced a shortage of assets to store value. Emerging and commodity-producing economies have added an enormous demand for assets that is not being met by their limited ability to produce these assets. I believe this global asset shortage is one of the main forces behind the so-called global imbalances, the low equilibrium real interest rates that preceded the crisis, and the recurrent emergence of bubbles. Contrary to the conventional wisdom, I think these phenomena are not the result of loose monetary policy, but rather the other way around: Monetary policy is loose because an asset shortage environment would otherwise trigger strong deflationary forces. …

\”This is the second step, which began in earnest after the Nasdaq crash, when foreign demand for U.S. assets went back to its historical pattern of being heavily concentrated on fixed income … and especially on highly rated instruments. …The enormous demand for U.S. assets, with a heavy bias toward “AAA” instruments, could not be satisfied by U.S. Treasuries and single-name corporate bonds, and that imbalance generated huge incentives for the U.S. financial system to produce more “AAA” assets. As a result, we saw both the good and the bad sides of the most dynamic financial system in the world, in full force. Subprime loans became inputs into financial vehicles, which by the law of large numbers and by the principles of tranching were able to create \”AAA\” instruments from those that were not. …

\”Unfortunately, by construction, AAA tranches generated from lower-quality assets are fragile with respect to macroeconomic and systemic shocks, when the law of large numbers doesn’t work. That is, this way of creating safe assets may be able to create micro-AAA assets but not macro-AAA assets. In other words, these assets were not very resilient to macroeconomic shocks, even though they might have technically met AAA risk standards. …

\”In principle, this was not a big issue, but it became a huge one when highly leveraged systemically important institutions began to keep these macro-fragile instruments in their balance sheets (directly, or indirectly through special-purpose vehicles, or SPVs This was an accident waiting to happen; AIG and the investment banks should have known better, but the low capital charges were too hard to resist.\”

Two ways of illustrating the financial crisis

When I\’m talking about underlying causes of the financial crisis, it\’s nice to have a vivid graph to display.

For example, I\’ve often used graphs showing how certain key interest rates spiked during the crisis. Here\’s an example of such a graph from the the CBO\’s August 2009 The Budget and Economic Outlook: An Update (p. 35). 

The graph shows the spread between the benchmark LIBOR interest rate and the federal funds rate
starts bubbling with the crisis in fall 2007, spikes in September 2008, then drifts down to near-common historical levels by spring 2009.The problem with this figure, of course, is that explaining it to an audience means needing to explain LIBOR, and the federal funds rate, and why a movement of a few percentage points is so important. If I wave my hands a lot, I can sell it. But I\’m not sure the audience knows what it\’s buying.

So here is my new favorite graph for illustrating the financial crisis. It\’s a graph of net financial lending, taken from the CBO\’s January 2011 Budget and Economic Outlook: Fiscal Years 2011 to 2021 (p. 33).

This graph needs a short explanation of what net lending is (that is, new lending minus repayments and charge-offs). But seeing a graph that goes up and down over the decades since 1950, but then turns violently negative the aftermath of the crisis, really helps to give a visceral sense of what a financial crisis means.