Sunday, May 17, 2009

How About a Tax on Derivatives Transactions?

Last week, the administration made its proposal for reforming the derivatives market. A lot of it was old news. For standardized derivatives, the settlement and clearance process would be improved, and regulatory oversight of derivatives dealers would be increased. The latter measure would mostly affect hedge funds, since broker-dealers that transact in derivatives are already heavily regulated.

Largely left out of regulatory purview are so-called customized derivatives contracts. These, by definition, are not standardized. Establishing regulatory regimes for them would be harder because they come in a variety of sizes and shapes. However, they may prove to be extremely important. After all, the derivatives contracts that have been so problematic in the last two years—collateralized debt obligations and credit default swaps—were customized (although there has been a recent trend toward standardization). The fact is that customized contracts may cause no end of problems. Regulators have said they intend to impose tough margin requirements and strong risk management measures to deal with the problems presented by customized derivatives. Okay, we’ll stipulate to that. But should more be done?

A flaw in the derivatives market, especially the customized derivatives market, is that the cost of excess and recklessness has largely been borne by the U.S. taxpayer. When Bear Stearns, AIG and other Wall Street firms were on the verge of the abyss because of their derivatives losses, the taxpayers stepped forward (or rather were pushed forward by the Bush administration) into the line of fire and absorbed the losses that would otherwise have fallen on the creditors of these firms. Of course, we’re all grateful to be able to take a bullet for Wall Street. But economists would say that a large part of the cost of undesirable behavior in the derivatives market has been externalized by the willingness of the government to foist the cost on taxpayers. When costs are externalized like this, private interests will leap to take advantage of the favorable asymmetry and the economy’s resources will be misallocated in ever-increasing proportion until yet another bubble bursts. Too much capital will flow into the derivatives market, and too little into, say, investments in manufacturing, environmental protection, repair of our highways and bridges, and educational opportunity.

What happens in the absence of a bailout? Look at the high tech bubble of the late 1990s, which burst in 2000-2002. That bubble created the all-time high valuation for the stock market, which has never fully recovered. There were no taxpayer bailouts of investors in high tech companies, and the tech sector has been much more rational since then. Tech companies no longer go public simply on the promise that some day they might have revenues and perhaps even earnings. Tech investors have learned, of all things, that they need to be sensible about what they put their money into.

Because of the central role of the financial system in our economy, there’s no way to get the taxpayer off the hook for banking bailouts. More manic depressive behavior from the financial services sector, at taxpayers’ expense, is surely in our future. So, why not impose a tax on derivatives transactions? It would, in an approximate way, compensate taxpayers for at least some of the burdens they bear. It would moderate the imbalance between risk and reward that taxpayer guarantee of derivatives transactions has created. It might indeed slow down the activity in this market, but consider whether taxpayer subsidized financial mania shouldn’t be discouraged. A tax on, say, the market price of derivatives transactions, would, in plain English, be abundantly fair considering what an incredible pain in the arse the derivatives industry has been.

Of course, many on Wall Street would be horrified at the notion of such a tax. They would argue that it would impede innovation and burden a market that’s important to reviving the economy. But these arguments are like saying that a sales tax shouldn’t be imposed on purchases of the iPhone or flat screen TVs. There's plenty of innovation in crucial industries subject to sales taxes.

The government already imposes a tax on stock trades. In addition, companies offering stock and other securities to the public pay registration fees to the SEC (which forwards them to the U.S. Treasury; the agency doesn't keep them). There’s, in effect, a tax on deposits you make in your bank account (federal deposit insurance premiums effectively reduce the interest rates that a bank could otherwise pay customers). With the federal deficit ballooning by the day and Wall Street's losses the biggest single reason for the bloat, some revenue from a derivatives tax would be just thing to make the world a little better for the taxpaying public.

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