A Financial Sector Small Enough to Drown in a Bathtub

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Dean Baker
TPM Café (Talking Points Memo), December 8, 2008

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As the tale of greed and stupidity that gave us the housing bubble and subsequent crash continues to unfold, it is becoming increasingly clear that the problem was not simply that the regulators were out to lunch. Some regulators saw the problems and wanted to take steps to rein in abuses but were prevented from doing so by the political power of the financial industry.

The best example of politics thwarting effective regulation was when Alan Greenspan, Robert Rubin, and Larry Summers prevented Brooksley Born, the head of the Commodity Futures Trading Commission, from regulating credit default swaps in 1998. However, there are many other instances coming to light in which political interference obstructed efforts to stem questionable practices by the financial industry.

We must come to grips with the power of the financial industry in any effort at regulatory reform. The issue is not just producing the right set of regulations to prevent the sort of abusive practices, over-leverage, and excessive risk-taking that fed the growth of the housing bubble. It is also necessary to ensure that regulators have the power to restrain industry abuses.

In order for the regulators to get the upper hand, it will be necessary to shrink the financial sector to a size where it can be effectively controlled. The sector had experienced explosive growth over the last three decades. At its peak in 2004, it accounted for almost 30 percent of all corporate profits.

This figure by itself should have raised alarm bells. Finance is an intermediate good. We need the sector to be able to borrow money to buy a home or start a business, but it is not an end in itself. While spending more on health and housing may make us better off, spending more on finance is evidence of an inefficient financial system. An efficient financial system is a small financial system.

The financial industry constantly develops new and more complex financial instruments as a way to siphon away wealth created elsewhere in the economy. The system of regulation must be designed to prevent this from happening. While we need specific and detailed rules to ensure that the industry runs properly, keeping it small and manageable will also be crucial.

The best way to restrict the size of the financial industry is through a system of modest financial transactions taxes (FTT). A tax of 0.25 percent on a stock trade, or a 0.02 percent tax on the purchase of an option or future, will have almost no impact on those looking to invest in the stock market or hedge their wheat crop. However, it will impose a heavy cost on short-term traders, and therefore will substantially reduce the volume of trading.

Such a tax is also likely to make complex derivative instruments less practical, since they could involves several taxed transactions. An FTT can also raise a huge amount of revenue, more than $100 billion a year (0.6 percent of GDP) according to calculations that I did in a paper with Robert Pollin.

FTTs have been widely used in financial markets around the world. The United States had a stamp tax on stock trades until 1964 and continued to have a very small tax to finance the Securities and Exchange Commission. The United Kingdom still imposes a tax of 0.25 percent on stock trades. Adjusted for this size of its economy, this tax raises the equivalent of almost $30 billion a year in the UK.

While the UK experience shows that an FTT is enforceable, we can adopt stronger provisions to limit evasion on a more extensive set of transactions taxes. The most obvious enforcement tool would be to give workers a percentage of any unpaid tax and penalties if they report their bosses. They are few workers that would not enjoy getting a million dollar payday at their boss's expense.

An FTT can play a crucial role in keeping the financial sector at a controllable size. If we let the industry return to its former strength, even the best-designed regulation is doomed to fail.

At a meeting of central bankers in 2002, Lawrence Meyer, a former Federal Reserve Board governor, argued that it would not have been politically acceptable for the Fed to have deliberately burst the stock bubble, destroying trillions of dollars of bubble wealth. If we get the regulation right, then it will not be politically acceptable for the Fed to let a bubble grow unchecked as Alan Greenspan did twice in the last decade. This shift in politics will require permanently reining in the financial sector.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.