issue: Financial Services

The Beginning of the End?

Posted on by The Progressive Policy Institute

The news yesterday that the U.S. Federal Reserve raised the discount rate 25 basis points (to 0.75 percent from 0.50 percent) is being interpreted as an indication of a fundamental change in how the Fed views our economic crisis. The hike in the discount rate could signal the beginning of the end of our economic crisis.

The discount rate is not to be confused with the more prominent Fed funds rate. The Fed funds rate is the rate at which banks lend money to each other in overnight loans for regulatory and liquidity requirements. The discount rate is the rate at which the Fed lends money to private retail banks — traditionally at a percent above the Fed funds rate — in short-term loans aimed at easing liquidity constraints. But in recent decades borrowing from the so-called discount window had been seen by large banks as the financial equivalent of pulling over to ask for directions — you can do it, but it’s seen as a sign of weakness. The aftermath of 9/11 was the last time the discount window had seen serious activity prior to the 2008 economic crisis.

The Fed met the current crisis in part by making the discount window more available to banks. The terms of loans through the discount window went from being overnight to ultimately 90 days. The discount rate was cut from being 100 basis points (one percent) above the Fed funds rate to 50 basis points. And in a move that underscored the gravity of the October 2008 liquidity crisis, Goldman Sachs and Morgan Stanley turned themselves into bank holding companies — a technical change in their operating structure that required much more oversight — in part to be able to access the discount window in case they faced a liquidity crunch.

This opening of the discount window was part of a larger project by the Fed — which involved pumping liquidity into the economy by buying up almost two trillion dollars in assets — to prevent the crisis of fall 2008 from leading to a global depression. But now that the worst seems to be over from a monetary perspective, the Fed is beginning to step away from the crash position it assumed almost two years ago.

Newly reappointed Fed Chairman Ben Bernanke laid out a plan for unwinding the Fed’s position in the economy last week, testifying to Congress that “when the times comes,” the Fed will move to sell that two trillion in assets (in an orderly fashion) to a stronger market. This would give the Fed more room to manage the economy to bring us out of recession. The raising of the discount rate would be the first step in that process.

The phrase “when the time comes,” however, makes all the difference in the world, and many wiser people than I are expecting the Fed to go easy on its plan to shrink it’s balance sheet and raise rates. With unemployment hovering at 10 percent, this recession isn’t over for a lot of Americans. And, despite last quarter’s strong headline number, there is no obvious driver of GDP growth (like exports) on the horizon, so it may not be over for the rest of us, either. So it may be too soon to call the recession over and begin raising rates. The fear is that this may not be the beginning of the end, but the end of the beginning.

Photo credit: https://www.flickr.com/photos/laurapadgett/ / CC BY-ND 2.0

One Step Forward, One Step Back

Posted on by The Progressive Policy Institute

The White House yesterday announced new restrictions on banking activity, designed to address the issues that caused the crisis 15 months ago. Wall Street reacted by letting stocks fall 200 points, which initially would make you think the announcement must be right. The White House’s plan has two main parts: a limit on the scope of banking activity and a limit on the size of banks. One part makes sense, but as presented, the other should be re-thought.

Limit on Size – The good part is the limitation on the size of banks. This will include a tighter cap on the control of deposits. Currently no bank can control more than 10 percent of the nations deposits — but Bank of America got the Bush administration to waive that in 2007 to buy LaSalle. The administration’s proposal would have this cap include non-insured assets and other deposits. While this is a good first step, its effectiveness will be spelled out in the details. Bank of America is the only bank that exceeds the current cap, and almost 25 institutions could be considered “Too Big To Fail.”

Limit on Scope – At first blush, this seems to be a ban on banks taking FDIC-insured deposits – or having received TARP money – from engaging in proprietary trading. Prop trading is a major part of Wall Street activity, in which investment banks trade with “their own money.” That is, they engage in trading on their own behalf, not on the behalf of customers. The administration is right that a lot of this trading on prop desks is speculation. However, prop trading is also how investment banks and market makers engage in risk management and hedge positions. Banning prop trading by banks would severely curtail their market-making ability, and dry up liquidity on Wall Street faster than a sponge in the sun. Better than limiting the type of activity trading desks engage in would be to limit the amount of leverage they can use in that speculation.

The administration has said it is going to work with Congressional leaders in the coming weeks to spell this out in details. We’ll see if Congress is able to improve on these suggestions.

Taking It to the Banks

Posted on by The Progressive Policy Institute

Following a week of trial balloons about a tax on banks and bankers, President Obama today unveiled a “financial crisis responsibility fee,” to be levied against 50 of our nation’s largest banks. While the tax will not be able to seriously address the deficits that the government faces – it’s expected to raise only $90 billion over 10 years – any tax on the financial system can affect the course of our economy. The details of the proposed tax have yet to be outlined. Compared to the alternatives, this tax is a good start – but it doesn’t go far enough.

In the discussion of taxing banks and bankers, a couple of possibilities have been floated, some of which can reap short-term political points, others of which have the potential to promote progressive policies:

Bonus tax – One of the easiest – and politically most satisfying – would be a tax on excess bonuses. The British exercised this option on London bankers this past year. Bonuses in the City above a certain amount were taxed at a 50 percent rate. Banks responded by threatening to move offshore and – when that threat rang hollow – doubled the bonus pool they paid out to bankers. The end result was that the bankers whose decisions led in part to the crisis were financially unharmed, the British government raised a relative pittance in taxes, shareholders in City banks took a hit (as the bonus pools were increased at their expense), and the underlying fault lines in the British banking system remain unaddressed.

Transaction tax – The worst of the options would be a tax on transactions. As discussed before, this would merely pour sand in our financial system, breaking it and slowing economic recovery.

Excess profits tax – A more appealing option would be a tax on excess profits. A defining aspect of the financial bubble of the last decade was the fact that financial profits were 40 percent of overall corporate profits – more than double the slice financials made up of profits in the 1980s. A tax on these excess profits would rein that in. But while this could be useful, as Simon Johnson points out, it would be fairly easy to game, and end up being ineffective.

Tax on assets – A tax on bank assets above a certain amount addresses not just political sentiment that banks have made it through the crisis unscathed, but also the fact that banks are too big to fail. Encouraging banks to “right-size” themselves would make our economy safer from the systemic risk imposed by banks like Citigroup or Bank of America – which are debilitated but whose failure would be economically catastrophic.

Excess leverage tax – Taxing the leverage that financial institutions use to increase returns would allow us to avoid situations like that faced a year and a half ago when Lehman Brothers – leveraged over 30:1 – collapsed over the course of a weekend. It would make banks “safer” but would leave them still too big. In the event a bank were to fail, it would still be a systemic threat to our economy. This would be a more targeted version than an assets tax, but it would be harder to implement — definitions of leverage differ – and if not properly defined would leave hedge funds, insurance companies and other “non-bank financial institutions” untouched, leading to a crisis like that perpetuated by Long-Term Capital Management in 1998 or AIG last fall.

The taxes unveiled today are a very tentative step down the path towards an effective tax on assets. But the administration’s proposal is too broad – affected institutions could be as small as $50 billion — and too light to be effective.

If the Obama administration were strictly looking to tax the problem of an outsized and dangerous financial industry out of existence, a combination of the last two taxes — properly implemented to cover the whole financial sector when looking at leverage and focused on banks that are bigger than, say, $300 billion when looking at assets — would be the most effective. But hastily implemented, they could have unintended consequences, crippling our economy while merely pushing the problem offshore. Coordination with the EU and other G-20 countries will be vital to help with the de-leveraging of our economy.

Making the Interest Rate Interesting

Posted on by The Progressive Policy Institute

As we head into the new year, one of the biggest questions facing the economy is: “Whither the interest rate?” This number is set by the Federal Open Market Committee and its targeting of the fed funds rate – or the rate at which banks lend funds to each other – is currently effectively zero (technically in a range from zero to 0.25 percent). It’s been there for just over a year, and is likely going to stay there for the better part of 2010 (if I could tell you when, I wouldn’t be here – I’d be lighting cigars with hundred-dollar bills some place much warmer).

Despite its provenance as a dry economic term, the interest rate is interesting. It’s a fundamental piece of how our economy works. It determines everything, from how likely you are to get a loan or a mortgage (ceteris paribus – as the economists like to say – the lower the rate, the more lending that is done), to how likely we’re going to have inflation (high interest rates head off inflation, ceteris paribus), to how much a dollar is worth (a higher interest rate relative to overseas rates means it’ll be worth more, cete- you get the idea), to how fast the economy will grow (higher interest rates mean slower growth). It is usually the most powerful tool in any central banker’s toolbox, and certainly the one that’s most often used.

In addition to its central role in the economy, the interest rate is interesting for two other reasons these days.

First, there is the discussion of where the interest rate should be for recovery. There’s a good rule of thumb to determine what the ideal interest rate is: the Taylor rule. Very briefly put, the Taylor rule takes the inflation rate and the unemployment rate and uses them to compute what the ideal interest rate should be (check out the San Francisco Fed for more info). According to some Fed research last spring, the Taylor rule says that interest rates should be at -5 percent (that’s negative five percent – as unemployment is 1.5 percent higher now, the Taylor rule would say the rate now should be even lower).

The problem with negative interest rates is that while they’re technically feasible, they really discourage lending (would you give me a dollar today if I promised you ninety cents next Tuesday?). More realistically, negative real interest rates are possible if you encourage inflation. But inflation eats away at economic growth – ask Zimbabwe – and the “inflation tax” of high inflation falls disproportionately on the poor.

But inflation hawks have been arguing for the Fed to raise rates for a couple of months – to two percent. These hawks tend to be strongly laisse faire conservatives, One of the voices saying we should ignore the Taylor rule is – as Brad DeLong points out – the man who invented it himself, Stanford University’s (and Bush Treasury appointee) John Taylor.

Secondly, as the old saying goes: when the only tool you have is a hammer, every problem begins to look like a nail. Interest rates, while powerful, cannot solve every economic problem. The Taylor rule tells us we shouldn’t raise the interest rate, we can’t lower the interest rate, and no one is happy where the economy is now. At a time when the interest rate is at zero, and should be negative, alternatives need to be explored. As Clive Crook says in his latest column:

Interest rates that take into account asset prices as well as general inflation are part of this, of course. But when it comes to financial regulation, the key thing is rules that recognise the credit cycle, and change as it proceeds. Most important, as argued by Charles Goodhart in these pages, capital and liquidity requirements should be time-varying and strongly anti-cyclical. In good times, when lending is expanding quickly and financial institutions’ concerns about capital and liquidity are at their least, the requirements should tighten. Under current rules, they do the opposite.

Crook is right that unusually low capital ratios (and their counterparts – high leverage ratios) were a catalyst of last year’s crisis. Now that we need to get the economy going again, banks need to lend. One way to do so would be to lower capital ratios (if it wouldn’t bring the solvency of some large banks into question). As part of a regulatory reform package, policymakers should pursue a counter-cyclical capital requirements policy.

They should also expand who has to follow capital requirements. As currently defined, only depository institutions and not investment banks – such as Lehman Brothers and Merrill Lynch were, and Goldman Sachs and Morgan Stanley used to be – are required to follow the Fed’s Board of Governor’s capital requirements. Getting other financial institutions to respond to capital requirements will make that a much more powerful tool.

Breaking the Glass-Steagall Myth

Posted on by The Progressive Policy Institute

Bank of America Tower, Seattle, WAWord going around Washington this week is that Sens. John McCain (R-AZ) and Maria Cantwell (D-WA) are pushing to reinstate Glass-Steagall:

McCain and Cantwell, a Washington Democrat, join other lawmakers in Congress proposing to reinstate the 1933 law, repealed a decade ago by the Gramm-Leach-Bliley Act that led to a rise in conglomerates including Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. active in retail banking, insurance and proprietary trading. Legislation to reinstate the ban was introduced today in the House.

While this move is a well-meaning attempt to rein in the financial sector, it doesn’t address the issues that caused last fall’s crisis.

Glass-Steagall was aimed at separating “boring” retail banking (the Bailey Building and Loan Association, for example) from “risky” investment bankers (Gordon Gekko). It was eventually repealed, as U.S. banks felt it put them at a disadvantage in the global marketplace against European “universal” banks, such as Deutsche Bank, Credit Suisse, and HSBC.

At the time there was concern that repealing Glass-Steagall would create banks that were systematically dangerous. In hindsight, that concern would seem to be born out — but it isn’t. After all, the three major bank collapses that precipitated the crisis were Bear Stearns, Merrill Lynch, and Lehman Brothers. All three were obviously Too Big Too Fail, but all three would have been unaffected by a reinstatement of Glass-Steagall — none of them is a retail bank (this is why you never saw Merrill or Lehman ATMs).

Rather than focusing on micromanaging bank structure, and stifling entrepreneurship in the financial sector, the Senators would be better served by evaluating different options to limit the size of Too Big Too Fail banks. A smarter idea would be to extend the retail bank deposits cap idea to total bank assets. Currently, no bank can have more than 10 percent of total national retail deposits (Bank of America got a waiver for the 2007 purchase of Chicagoland’s LaSalle bank and now has 12.2 percent of national deposits). Peter Boone and Simon Johnson suggest applying this simple principle to total bank liabilities. They recommend a limit of 2 percent of GDP, which is in line with the $300 billion that Felix Salmon has been recommending since March. Importantly, it’s also in line with the de facto $100 billion threshold that bank regulators are using now.

This way the government isn’t running banks and bankers can pursue the capitalist impulse that drives our economy. But with a cap on liabilities, the decisions of bankers cannot threaten our economy like they have in the past.

A Game Plan for Infrastructure

Posted on by The Progressive Policy Institute

A Game Plan for InfrastructureIt’s a sign of the times when “our bridges and roads are falling apart” gets cited as an issue more pressing than college football’s annoying Bowl Championship Series (BCS) on ESPN.

And, while the president hasn’t fulfilled his promise to set up an eight-team playoff yet, he’s taken the issue of infrastructure head-on. The administration’s focus on infrastructure investment is good for both long-term growth and generating jobs through the quick start-up of “shovel ready” projects.

However, one-time disbursements like those outlined in the Recovery Act or the president’s announcement earlier this week fall short of fixing more fundamental issues.

On the heels of Obama’s speech at Brookings on Tuesday, Rep. Keith Ellison (D-MN) is at the same venue today pushing a much more sustainable approach.

Ellison is a co-sponsor on Rep. Rosa DeLauro’s (D-CT) National Infrastructure Development Bank Act, a good start on developing sustainable infrastructure funding the country so desperately needs.

DeLauro and and Ellison’s bill builds on the work of a bipartisan commission chaired by former Sen. Warren Rudman (R-NH) and titan of finance Felix Rohatyn. The bill envisions $5 billion a year from the federal government to capitalize the bank and a government debt guarantee of up to $50 billion.

But even Ellison and DeLauro’s idea can be improved upon. As outlined in Jessica Milano’s PPI policy memo, “Building our 21st Century Infrastructure,” an American Infrastructure Bank (AIB) seeded with a one-time investment at the federal level — a potential use for the TARP funds the president announced this week — and stakeholder buy-ins from the states would be a more effective way to fund a bank dedicated to financing infrastructure programs.

An infrastructure bank would offer a way to leverage much larger private sector investments from a strapped public budget. The bank would raise inexpensive funding for infrastructure projects by issuing debt on the capital markets backed by the U.S. government’s credit rating. By backing these bonds with the revenue or assets of the projects they are financing, taxpayers would not be left to pick up the bill. These projects would be determined according to strict criteria that promote economic development while being fiscally and environmentally sound.

After the President’s remarks on Tuesday, Gov. Ed Rendell of Pennsylvania — an infrastructure bank supporter — said the president had “essentially” endorsed the idea of an AIB. But while the president sounded open to the idea this week, he hasn’t gotten behind the legislation needed to get it done. President Obama endorsed an infrastructure bank back when he was candidate Obama. But, much like his promise of reforming the BCS, this threatens to become another campaign promise that falls by the wayside. Now’s the moment for the president to come off the sidelines and lead a sustained drive down the field.

Some Unanswered Questions on Financial Reform

Posted on by The Progressive Policy Institute

The Rep. Barney Frank (D-MA)-authored Wall Street Reform and Consumer Protection Act passed the House Financial Services Committee last Wednesday, and could come to a floor vote in the House as soon as this week. Through legislative jujitsu on Frank’s part, the bill will have a lead on Sen. Chris Dodd’s (D-CT) efforts in the Senate.

The day after the committee passed the legislation, I saw Rep. Ed Perlmutter (D-CO) talk about it at an event hosted by the National Journal and got to exchange a few words with him on the subject. He was positive about the bill and its chances in the House (it will likely pass easily), and gave positive marks to the administration’s handling of the crisis in its first year in office.

But while Perlmutter said he felt the House has done its part to address regulatory reforms, I thought some of the accomplishments he touted leave unanswered fundamental questions raised by the financial crisis.

He spoke about the legislation’s planned Financial Stability Council, that would provide a forum for regulators like the Fed to address systemic risk. But the Financial Stability Council, instead of facilitating coordination among regulators, won’t live up to expectations — much like what happened with the Director of National Intelligence (DNI) that was supposed to facilitate information-sharing in the intelligence sector, but has had limited effectiveness in getting different agencies to talk to each other. The weak mandate of a Financial Stability Council would lead to regulator shopping by financial institutions, a temptation that can lead to problems similar to those seen in the case of under-regulated AIG. Moreover, the resolution authority that the council would have is useful only after the fact — it would not preemptively deal with the Too Big To Fail problem we still face.

Fixing Mark-to-Market Requirements

More generally, however, Perlmutter mentioned two ideas the House is considering that could actually contain the seeds of our next crisis.

One idea is extending the Financial Accounting Standards Board’s (FASB) loosening of mark-to-market requirements for financial institutions to value their securities. Perlmutter wants to suspend mark-to-market and make permanent the FASB’s contentious April decision to ease mark-to-market rules.

The rule would let the Financial Stability Council order FASB to suspend mark-to-market in cases where there is no market in a security or securities are being sold in a “fire sale” or distressed environment. More worrisome, however, is that banks get to declare whether the market in the securities they are holding is distressed or not. Banks can drive a truckload of bad investment decisions through this loophole without having to disclose them on their bottom line or affecting capital requirements. Under this new rule, banks will have no incentive to conduct diligent analysis of the securities they hold — anything that turns out to be worthless (like bonds backed by subprime loans) can just be called “distressed.” This would decrease transparency and not restore confidence to the system.

But mark-to-market does have the bad consequence of increasing volatility in bank balance sheets. During crises like last year’s, banks can even perversely see mark-to-market improve their bottom line the closer they get to bankruptcy.

A better idea than the one Perlmutter mentioned has been put forward by PPI contributor Robert Pozen in his new book, Too Big To Save. Pozen suggests delinking banking capital regulations from accounting mark-to-market rules by effectively recognizing all securities as being “held for sale” (an accounting distinction) for regulatory purposes. This would allow us to continue to keep the transparency in assets that mark-to-market allows, while avoiding the bottom line volatility that banks would like to avoid.

What to Do About Sarbanes-Oxley

The second idea is exempting firms from some Sarbanes-Oxley (SOX) reporting requirements. Passed in the wake of Enron, SOX was designed to hold companies and their executives accountable for their auditing, and eliminate some glaring conflicts of interest in financial auditing.

SOX does two good things. It makes a publicly held company have legitimate auditors, and ensures that those same auditors aren’t also advising the company on how to prepare the books for auditing (thereby basically handing over the answer key before a test). SOX also made sure that companies had proper controls that minimized the risk of errors in financial statements and of people either using company money inappropriately (as Enron did in off-balance-sheet shell companies) and of people embezzling money. Exempting firms from this would eventually lead to the same bad behavior happening again.

That said, SOX isn’t without flaws. Many in the auditing industry perceive it as very manpower intensive and, as a result, a significant burden to publicly listed companies, especially smaller ones (with income under $100 million). The SEC has responded by annually exempting small companies from some reporting requirements, but the exemption is not going to be extended past next year.

The solution to this problem is to streamline SOX to make it less burdensome to companies, not gutting it and letting new Enrons bubble up. Instead of providing an internal control report with each annual filing to the SEC — which can require up to three percent of a small company’s income — the SEC and Congress should encourage accounting oversight boards to spell out further guidelines and best practices to adopt. This streamlined SOX could even be extended to non-public financial institutions, as a key part of what allowed Bernie Madoff to steal people’s money for so long was having a small one-man upstate auditor keep tabs on his multi-billion dollar Ponzi scheme.

Too Big to Run

Posted on by The Progressive Policy Institute

In discussions about the dismal state of the economy, the existence of “too big to fail” institutions has emerged as a recurring cause for concern. In particular, Bank of America and Citigroup (the first and third largest banks in the country, respectively) are firms whose size makes them an “existential threat” to the well-being of the economy.

(Bank #2 in size is JPMorgan, whose chief, Jamie Dimon, has been going around saying that we can end “too big to fail” without capping the size of financial institutions by providing regulators with resolution authority over banks — the ability to wind them down in an orderly fashion. While resolution authority can help in cases — like Lehman’s — where banks become insolvent, these after-the-fact measures would not prevent the liquidity crisis that selling against a too-big-to-fail institution would cause.)

While Citigroup has made efforts to break itself up, including selling off its half of the Smith Barney joint venture with Morgan Stanley, Bank of America under Ken Lewis has been resistant to downsizing, adamant that clients benefit from its size. But with the embattled Lewis having announced he will step down at the end of the year, the bank is looking for a new chief.

And that search has run up against a problem — not only are these firms seen as “too big to fail,” they’re also too big to run:

At least two candidates for the top job at Bank of America Corp. told directors that the giant bank should consider breaking itself up… [One candidate, former Bank of Hawaii CEO Michael O’Neill] recently told the Bank of America search committee that the bank’s risk-adjusted capital wasn’t being used productively. He added that the company should become simpler and less prone to volatility

How big is Bank of America? With over $2.25 trillion in assets, it has a pervasive presence in our economy. The numbers from the Wall Street Journal are staggering:

Bank of America is the largest U.S. bank by assets and has 6,000 branches, 18,000 automated-teller machines and relationships with 53 million households, or roughly one out of every two households in the U.S.

Whereas the mantra “bigger is better” was applied to the financial industry over the past 20 years, there is now a reassessment of that idea. But instead of providing clear guidance on how to get financial institutions to a more reasonable size (and, indeed, what that size is), the government is sending unclear signals, with conflicting announcements on which companies it is willing to bail out and tepid additional reporting requirements that won’t rein in outsized firms.

Rather than add to the uncertainty, the administration should come out with guidelines on how it proposes to solve the “too big to fail” problem. Whether through voluntary break-up of banks it has a stake in, anti-trust measures, or by instituting a too-big-to-fail tax, the administration should lay out clear rules for banks to follow. This will allow big banks to stop chasing their tails on executive decisions — like Bank of America is doing — and get back to business.

A Different Take on the Financial Transaction Tax

Posted on by The Progressive Policy Institute

Having just joined the Progressive Policy Institute from a stint on Wall Street, I’d like to offer a different perspective on the financial transactions tax (FTT).

Last week, Lee Drutman argued in favor of an FTT, saying that a transaction tax modeled after the one our British friends have would raise much-needed funds. Writing in light of the past year’s economic crisis, Drutman also said that an FTT would “throw a little sand in the gears of the giant financial speculation casino.” While both raising revenue and reining in Wall Street are goals worth pursuing, I would argue that the FTT is a second-best solution.

According to Dean Baker of the Center for Economic and Policy Research, a proponent of the FTT, a Yankee equivalent of John Bull’s 0.25% transaction tax wouldn’t raise $100 billion — it would raise less than a third of that. You need to crank up the tax — to double the proposed amount on stocks and higher on other products — to get close to a hoped-for $100 billion in revenue.

Also, it’s worth pointing out that a transaction tax didn’t spare the British from any of last year’s financial crisis — they had housing crises, government bailouts, and bank nationalizations comparable to what we saw on this side of the Atlantic.

A transaction tax is simply too blunt an instrument. Pouring sand in the gears is not a way to slow a machine down — it’s a way to try to bring the machine to a halt. Trying to second-guess trader activity by taxing stocks and other securities at differing levels to generate sufficient revenue will only drive broker dealers to encourage trading in high-margin products to make up for the dead-weight loss of the tax. This would drive traders away from liquid products to illiquid ones, increasing systemic risk. This increased focus on complex structured products drains liquidity from the system, as we saw last fall.

A better solution is one along the lines in Sen. Chris Dodd’s (D-CT) proposed financial reform bill. In addition to heightened capital and leverage requirements for systemically significant, “too big to fail” banks, higher capital requirements and stricter leverage controls could be imposed on trading in complex financial instruments. This would drive Wall Street firms looking to goose returns through leverage from trading the complex products that contributed to last year’s crisis to more liquid — less systemically threatening — products.

Investors that would want to speculate on complex derivatives could still do so, providing they did it with their own money. And banks that wanted to sell those products could still do so, provided they had adequate capital to backstop those activities. Letting these properly priced incentives work their magic would allow the market to behave in a responsible manner. Revenue could then be generated from that market activity by taxing gains made by speculators at a rate in line with income tax rates.

This would achieve the goals the FTT sets out to do — rein in derivatives risk and raise revenues — in a way that leaves market forces free to be a driver of renewed growth in our economy. But I suspect the supporters of the FTT will want to have their say, and I look forward to hearing it.

The Real Reason to Support a Financial Transaction Tax

Posted on by The Progressive Policy Institute

Thanks to Gordon Brown’s support, the idea of a financial transaction tax has been gaining a bit of attention over the last couple of weeks. The idea is simple: place a small tax (say, 0.25 percent or less) on all financial transactions.

Partially, it’s a way to raise a little revenue from those who can most afford to pay to create an insurance fund against future bailouts, which is how it is being billed. And just yesterday, it was reported that House Democrats have discussed using it to fund a jobs bill. (Dean Baker has estimated that the tax could bring in $100 billion.)

But mostly, it’s a good idea because it throws a little sand in the gears of the giant financial speculation casino.

Wall Street banks make a good deal of money by running very sophisticated computer programs, looking for tiny (and supposedly risk-free) arbitraging opportunities, and then making those opportunities pay off by investing with incredibly high volume. These trades are something like the equivalent of buying a bunch of dollars for 99.75 cents each. It’s a great deal if you can do it en masse, and an even better deal if you can also borrow almost all of the money you are investing.

But if banks had to pay a 0.25 percent tax on every dollar they sold, then it suddenly wouldn’t seem like such a good deal to buy dollars for 99.75 cents each. This is what a transaction tax would do.

This would mean that Wall Street banks would spend less time looking for short-term opportunities to buy dollar bills for 99.75 cents. This a good thing, because it’s hard to see how having some of the smartest people and most sophisticated computer programs dedicated to this kind activity helps the economy. Something is wrong when 40 percent of all U.S. corporate profits are coming from the financial sector, as they were for much of the 2000s.

A transaction tax would mean that banks would instead devote more time to investing their capital in good, long-term investments. This seems to me what a banking sector is supposed to do — allocate capital to the most promising business ventures, which then sometimes actually spur innovation and improve the standard of living for everyone, not just those who happen to be clever enough to take part in the big casino.

Unfortunately, Treasury Secretary Tim Geithner is against such a tax, and his support is pretty important, since any transaction tax would require an international agreement. This is not surprising, since Geithner is and always will be a creature of Wall Street.

Still, it’s hard not to marvel at the latest round of bonuses on Wall Street and wonder how it is that these guys are making $30 billion while the economy continues to stumble. Slowing down the Wall Street speculation machine might help channel some energy elsewhere — maybe into actual productive recovery.

Stuck in Dubai with the Kabul Blues

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I hope that’s the last time I get stuck in Dubai.

This past Sunday, I boarded a plane with ten other election monitors from Democracy International (including my PPI colleague Mike Signer) to head to Kabul and serve as monitors for the second round of Afghanistan’s presidential elections.

We never made it.

Before boarding the flight, we knew that Abdullah Abdullah — incumbent President Hamid Karzai’s main challenger — planned to boycott the election. We were under the impression that Abdullah’s boycott was unofficial, meaning that his name would still be on the ballot and that the election would proceed as a formality. But there was still reason to go — any election should be monitored for fraud, even when there’s only one active candidate.

Somewhere over Eastern Europe, however, we learned that Karzai had been declared the victor. Rather than risk further violence, expense, and logistical complications en route to a pre-determined outcome, the election’s cancellation was understandable, if disappointing.

However, that still left us several hours from Dubai, our transfer city. After being offered the unappetizing possibility of immediately jumping on a return flight to DC, our weary team came to grips with the situation.

“So what’s Dubai like?” I asked the group, not knowing much about my surroundings and anticipating that I had stumbled upon a short vacation in the Middle East. I forget who said it but, “It’s like Vegas but without the gambling and booze,” stuck out. And so it was.

Dubai is a city of contradictions piled on top of one another. It has glitz and glamour: towering skyscrapers, the world’s only seven-star hotel, an indoor ski slope, and a brand new metro system. Oil money, right? Nope. Dubai isn’t actually rich — petro-dollars only flow to Dubai’s “big brother” in the south, Abu Dhabi. Dubai adheres to a more Costner-ian vision: build it and they will come. And build it the sheiks did, all with highly leveraged debt.  The Emirate’s business plan is predicated on the success of the companies that invest in Dubai.

And this house of cards is starting to crumble as world’s financial sand shifts beneath its feet: real estate prices are dropping fast as international firms search for efficient investments.

The statistic that is most striking is tourism, down 60 percent this year. Why would it affect Dubai so harshly when other areas, though suffering, are muddling through? As far as I can tell, it’s because Dubai lacks an intellectual or cultural soul. In the race to construct the world’s largest X, they forgot to construct anything actually worthwhile, like a university, a museum, or cultural center. The sheiks seem to have recognized the deficit, but haven’t come up with an original idea — the planned museum is apparently a copy of the Louvre in Paris, and the new opera house mimics Sydney’s.

After two days, I understood why tourists had abandoned Dubai — I could spend a month marveling at Paris’ diverse cultural tapestry, but couldn’t muster a third day just to stick around for the indoor roller coaster at the Dubai Mall (the largest in the world, if you’re keeping score).

I was surprised to learn on my second morning that I had apparently observed an election during my diverted trip.  I opened my courtesy copy of Gulf News to find that Sheikh Khalifa Bin Zayed had been re-elected to a five-year term as president of the UAE. Mind you, I didn’t see any campaign posters about, but that may be due to the rather limited electorate: turns out you have to be a ruler of one of UAE’s seven Emirates to have a vote.

If he had one, I imagine Sheikh Khalifa’s platform on domestic issues would have raised some eyebrows. For example, despite legal adherence to a strict Islamic code, it’s easy to buy alcohol provided the establishment is foreign-owned (which is 85 percent of the city) and you’re willing to pay the 50-percent sin tax. But if you want to buy, say, a bottle of wine for your home, you can’t do that at any corner store; those places are a 45-minute drive into the desert and you need a personal alcohol license.  You can’t get one if you’re Muslim, of course, but no one checked my friend Mohammed for his as he sucked down a double vodka Redbull at the Calabar.

If you’re caught publicly intoxicated, then it’s curtains. I heard the story of a French girl who was rear-ended as she drove home a 9:00 a.m. on a Saturday morning after a night of carousing. Despite the fact that she was the victim, the police breathalyzed her and found her blood alcohol content to be a miniscule 0.009 BAC – but still in excess of the strict zero-tolerance law. Her punishment was six months in jail, followed by deportation.

But that’s Dubai — you can get away with anything unless you’re unlucky enough to be caught. It meshes nicely with Dubai’s motto: “What’s good for business is good for Dubai.” True enough.

The Best Hour You’ll Ever Spend on Insurance

Posted on by The Progressive Policy Institute

 

 

The radio show This American Life is a staple in every progressive’s listening schedule, and I’m no different. While occasionally there’s a show that I end up fast-forwarding through, more often than not it’s better to just pop some popcorn and listen.

This past week’s episode was the second of a two-part series the show put together on the insurance industry — apropos as Congress and the administration look at the chronic problems of health insurance in this country. The first part was informative, but not riveting. This second part, however, taught me that:

  • Insurance companies have a billing code for injuries from spacecraft
  • 20-25% of all doctor’s bills are spent on taking care of billing issues with insurance companies
  • Co-pay coupons for pills make them more expensive
  • There’s pet health insurance and hedgehog cancer
  • And the solution to our insurance woes could lie in…Maryland

One of the drivers of insurance cost growth is the fact that rates for procedures are negotiated between insurers and hospitals. That cost can see some big variance depending on who has the upper hand. A procedure can be 10 times more expensive in an area where a hospital is dominant than in another area where the insurance carrier is dominant. That’s where Maryland’s approach comes in: the state has a Maryland Insurance Administration that sets statewide rates for procedures.

But the bottom line of the episode is summed up in the anecdote of how — by ruling that companies can take a tax deduction for providing healthcare — an unknown bureaucrat in the 1950s IRS gave us the health care system we have today. No matter the outcome of negotiations on the Hill as they overhaul the industry, it’s these incentives that will drive how our health care industry will work.

The Right Way to Curb Executive Pay

Posted on by The Progressive Policy Institute

Yesterday, word was leaked that after telling Bank of America head honcho Ken Lewis to expect a goose-egg in salary for 2009, the Obama administration pay czar Ken Feinberg was going to give pay cuts to chief executives at four other financial firms, including Citigroup and AIG, and the automakers GM and Chrysler. While no one to the left of Steve Forbes can really defend multimillion dollar payouts to executives for driving companies and the economy into the ground (and don’t be fooled — despite getting $0 in salary, Lewis will take home $53 million in “other compensation” this year), this plan isn’t the way to rein in payouts. It might feel good in the short term, but it doesn’t solve anything and could cause problems in the future.

First, cutting pay for financial executives in 2009 is a bit like slamming the barn door after the horse has bolted. These problems were festering for many years, and most of the chief executives who are running these companies weren’t in charge when errors were made — the beleaguered Lewis excepted, and he’s stepping down at the end of the year. So they’re getting blamed for their predecessors’ decisions.

It also doesn’t affect the main culprits who got us into this mess. The notorious Joe Cassano from AIG FP in London — who almost single-handedly drove the insurer into the ground — is untouched by the decision.

And, despite what the administration might hope, the rest of Wall Street is not going to rein in salary practices either in sympathy with their comrades or fear of rebuke. The companies affected are the ones that still have significant stakes owned by the government. Those that have returned their TARP money — Goldman and JP Morgan — are unaffected.

Given the incentive to work for a company with pay limited by the government or one where pay isn’t limited, people will jump ship for the latter. This has the potential to make the already weak companies — Bank of America and Citi, for example — even weaker. Which means that we might have a bigger problem on our hands if either of the two largest banks in the country drift with no one at the wheel (Lewis’ decision to resign without a replacement means we might see this at Bank of America anyway).

Finally, there is the concern that this will be the only chance we have to move on keeping salaries in the financial industry in line with a level that benefits the country, not bankers. When taking a hard look at pay in the future, bankers can use this as political cover, claiming that the administration has already “dealt with the issue.”

A better solution to the pay issue is to look not at short-term, feel-good measures, but to implement longer-term solutions. Line up incentives for bankers with those of shareholders and the American people. Eliminate “guaranteed” bonuses. Replace cash payouts and options with restricted stock grants, vesting over time, keeping executives interested in the long-term health of companies.

Rep. Barney Frank (MA) has pushed the Corporate and Financial Institution Compensation Fairness Act of 2009 through the House with a “Say on Pay” measure, giving shareholders a non-binding say on management salaries at the annual meeting, an idea that has merit. But its non-binding nature and the fact that most shareholder votes are made by institutional investors (more often than not either current or former I-bank employees) as proxies for their clients limit the measure’s effectiveness. A more effective part of the same bill also requires bonuses to be in line with risk-taking.

Even better is the fact that incentives will be disclosed. A little known secret on Wall Street is that traders can make more than the CEOs, and the trader’s payouts are normally undisclosed. If such incentive structures were spelled out to investors, they might not be so sanguine in signing off.