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Does The Financial Sector Pollute?

I liked this point by Financial Times columnist Martin Wolf:

A market works well if, and only if, decision-makers confront the consequences of their decisions. This is not – and probably cannot be – the case in finance: certainly, people now sit on fortunes earned in activities that have led to unprecedented rescues and the worst recession since the 1930s. Given this, the industry has become too big. If implicit and explicit guarantees and externalities, including volatility, were fully charged, the sector would surely shrink.

A number of commentators with the same insight have argued that better regulation is required. That's not Wolf's solution. Rather, he argues that this problem is intrinsic to finance. It will not go away. You cannot grow regulators so wise that they scrutinize it away. You cannot craft regulations so elegant that they rule it out of existence.

The financial sector, he says, must simply be smaller. How do you manage an inherently problematic sector? he asks. "The answer is: in the same way as any polluting activity. One taxes it." This is usefully radical: The climate change activists propose to tax coal power plants, they're not doing it so coal power plants become a bit cleaner. They're doing it so we have fewer of the plants.

I'm pretty much in agreement with this point, and I'll just add a graph I rather like. This was drawn up by Adam S. Posen and Marc Hinterschweiger and it tracks the rise of derivatives against the rise in actual capital. The basic takeaway: Fake money grew a lot faster than real money.

fig-posen-20090507-1.gif

And as Wolf says, the people who gave us that rapid rise in fake money still, in general, have their fortunes. Or at the least, they have a lot more money than the people who became teachers and didn't blow up the world economy. The problem is that if you want less "bad" finance, you can't go in after the fact and separate the good from the bad. You have to have less finance in general. You have to stop the bad before it happens.

By Ezra Klein  |  May 27, 2009; 10:04 AM ET
Categories:  Financial Crisis  
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Comments

Using notional value is very misleading (I don't know whether Ezra is doing this intentionally or unintentionally). Rather than close out a position a trader would just open a new position on the opposite side of his original contract to net out the profit or loss. Though the position would be "closed" the notional value would have doubled.

This issue of "new money" supply is actually very interesting in regards to monetary policy but it deserves a serious look, rather than a breezy "just so" type story from Ezra to back his political beliefs.

Posted by: kovachs | May 27, 2009 10:30 AM | Report abuse

Agree with the complaint about measuring notional value. Klein continues to attempt to delude the less astute.

If we look at the home speculators as the underlying creators of this, many were stuck with large losses, but they were highly leveraged. It is the excessive home buying leverage offered to speculators and the artificially low interest rates they were able to get that are the root causes of this mess. Without Fannie/Freddie buying over leveraged loans, Mortgage interest deductions, and Fed policy this mess doesn't happen.

There is a separate problem of aligning equity speculators with the longer term interests of the firm- and a much higher short term capital gains tax goes a long way to address that.

Posted by: staticvars | May 27, 2009 11:11 AM | Report abuse

"You cannot grow regulators so wise that they scrutinize it away. You cannot craft regulations so elegant that they rule it out of existence."

I don't know anyone who actually claims this. What I'm reading from this statement is that people will always game whatever system of regulatory rules you come up with, so concentrating on regulation isn't a solution. I'd point out that, for the most part, those calling for regulation don't disagree about the tendency for the system to get 'gamed', but this isn't a point in favor of 'giving up'. The underlying truth of the need for regulation is that there are huge collective action problems for an un-regulated economy. Any regulatory scheme created to mitigate these problems will inevitably be circumvented by the adaptive behavior of individuals gaming the system. But the prima-facia need for a working regulatory environment combined with adapting individual financial players leads one to conlcude that what is required is a strong and adaptive regulatory environment... not a captitulation that regulation can't work.

Now this leads me to my next point. One of the reasons our efforts at regulatory adaptation have been so bad (or non-existent) is the influence of fincancial players on our political system that our campaign finance laws allow. So while it may be true that "You cannot craft regulations so elegant that they rule it out of existence.", it may also be true that such things cannot be crafted because they get cut off at the pass.

Indeed, has the US ever been able to engage in honest-to-god regulatory work under circumstances that don't have our political leaders undermining it?

Posted by: MrLynne | May 27, 2009 12:26 PM | Report abuse

2/3 of the needed change could be achieved simply by taxing capital gains profits the same as manufacturing profits. Another 1/4 of the needed correction would come from taxing capital gains income the same rate as wages. The remaining 1/12 should be left to enforcing the existing laws aggressively and electing good Presidents.

Posted by: Aatos | May 27, 2009 10:22 PM | Report abuse

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