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The problem of Wall Street profits

finprofitpk.png

Matt Yglesias gets my point wrong here: The profits of Wall Street don't bother me for reasons of social justice or inequality. Rather, I don't believe you can effectively regulate the financial industry so long as it's sucking up about a third of domestic profits. The incentives to take massive risks will just be too great. The power to bribe Washington to dismantle regulations and legislation will be irresistible over time.

The situation is worsened because the financial sector doesn't face the countervailing political pressures that other industries face. Take health-care reform. That's a rich industry, of course, and it gets a lot of what it wants. But there are also forces on the other side. Dozens of powerful legislators such as Henry Waxman and Jay Rockefeller who understand the issue and continually push toward a more just system. Wealthy advocacy groups and foundations that spend heavily to create a better system. An enormous Washington-based expert class that members of Congress trust and ask for counsel.

Wall Street faces none of these opponents. Once the memory of this crisis fades a bit, they're basically alone in the issue space. There's little in the way of politically connected expertise. Few legislators have strong, preexisting interest and understanding of the issue. There's no real advocacy community. Maybe there'll be somewhat more of all this after this crisis finishes. But I doubt there'll be that much. And that makes me very skeptical that regulatory solutions will survive for very long. There's money, expertise and interest on one side of the ledger, and the other side is likely to be spending its time on other things. How long till one party or the other needs to fund a tough reelection campaign and cuts a quiet deal with the financial sector? Particularly in a post-Citizens United election environment? It's probably more than five years, but is it more than 15?

But Matt and I do agree about the solution: Taxing Wall Street such that it's no longer so incredibly profitable. That's how you get at the basic incentive of outsized risk offering unimaginable reward. Such a tax would probably need to be global, as anything like this would really be a material change to the banking sector, which makes it doubly unlikely.

Graph credit: Paul Krugman

By Ezra Klein  |  April 22, 2010; 4:24 PM ET
Categories:  Financial Regulation  
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Comments

While the issue space argument is certainly relevant, I think the real differences that distinguish financial industry are more basic.

One major difference between the finance and other sectors has to do with the ways in which the industry's customers can respond to profit and pricing decisions. In health care, at least when real markets exist, big employers (customers) can help to hold down insurance company profits. Those of us on the individual market have had little such leverage. But we will now with health insurance market reform. The point is that information on prices and service levels are available to customers - and in fact many large employers self-insure as a way to have more leverage over prices.

In the financial services industry there is very little transparency around real prices - Goldman is tip of that iceberg. Buyers of what are turning out to be the most profitable products do not face true markets and and do not have good information about real costs, value and risks. Hopefully financial reform will help improve market transparency and reduce these profits to more reasonable levels. And that explains Wall Street reluctance to embrace these market reforms.

Posted by: docstu1 | April 22, 2010 5:33 PM | Report abuse

I'm with Ezra and Matt that Wall Street needs some significant taxation to reduce speculation and outsized profits.

Note the graph just below this post: Derivatives alone accounted for $700 trillion in annual volume just two years ago. Now imagine an absolutely minimal tax -- say 1/2 of 1%. If my math is correct, the Treasury would get $3.5 trillion in such a boom year and presumably at least $2 trillion in a bum year. That's real money.

Such a sum, paid by the gamblers, would fund the gaps in Social Security, Medicare and universal health care for a very long time.

Posted by: rkarraker | April 22, 2010 10:17 PM | Report abuse

Dozens of powerful legislators such as Henry Waxman and Jay Rockefeller who understand the issue and continually push toward a more just system. Wealthy advocacy groups and foundations that spend heavily to create a better system. An enormous Washington-based expert class that members of Congress trust and ask for counsel.

Wall Street faces none of these opponents.


Mr. Klein,

While certainly consumer groups and proregulatory forces have been heavily outmatched for many years in the financial services area and there are important shades of truth in this comment, it also belies a naivete and newness to these issues.

It is drastically oversimplified and ignores a long, if largely frustrated, struggle to reign in an out of control financial sector. Just because you were not aware of policy debates in this arena before 2007 and the good, strong work of groups like the National Consumer Law Center and many others, doesnt mean it did not exist. It also ignores the good work of folks like Paul Sarbanes and many state Attorneys General who resisted the general trend of most politicians to tread far too lightly around the financial sector.

The country might be better served by a progressive blogosphere that spent more time recalling the important work that advocates of greater regulation did for well more than a decade before the financial crisis hit. Perhaps this would be better time spent than the incessant referencing of each other's latest wisdom.

Posted by: danimmer | April 22, 2010 10:32 PM | Report abuse

"Rather, I don't believe you can effectively regulate the financial industry so long as it's sucking up about a third of domestic profits. The incentives to take massive risks will just be too great. The power to bribe Washington to dismantle regulations and legislation will be irresistible over time."

Exactly this. Concentrated wealth = concentrated political power = diminished democracy. Liberal policies (including taxes) are pretty much the only tools we have for minimizing this problem. Or we could just clap harder and see how that goes.

Posted by: slag | April 22, 2010 10:32 PM | Report abuse

"Taxing Wall Street such that it's no longer so incredibly profitable."

I may still be in health care mode, but that sorta seems analogous to treating the uninsured once they're in the ER: it may save some lives, but we could've done it more cheaply by mandatory insurance.

Okay, that analogy sucks. My point is that we need to get banks competing to bring down their profits. The market is messed up, and we need to *regulate* to encourage a more efficient market. When there's only a couple big banks, that's nearly impossible. What you're proposing solves many of the current symptoms of the problem, but doesn't really address the core issue.

In the long term, though, I wonder if taxation would drive banks to self-regulate so they wouldn't have to pay out? Or would they merely find a way around the tax? I'm betting the second one -- which is why we need better markets and competition.

Posted by: Chris_ | April 22, 2010 11:28 PM | Report abuse

... the better markets part IS helped though by the derivatives stuff, though. I bet that solves a bunch of the leverage/pricing/transparency problems that drive up profits. However, they still will make a ton of $$ without more competition, especially as they find ways around this very narrowly-focused derivatives part.

Posted by: Chris_ | April 22, 2010 11:36 PM | Report abuse

Ezra: "How long till one party or the other needs to fund a tough reelection campaign and cuts a quiet deal with the financial sector? Particularly in a post-Citizens United election environment?"

I've said it before, I'll say it again: public campaign financing. Taxing Wall Street may be one part of the equation. But freeing our elected representatives from an improper dependence on the funding of private groups is the other part.

Posted by: dasimon | April 23, 2010 12:09 AM | Report abuse

"More than five years"? You are not cynical enough, young EK! We'll be lucky if it does not take place in 2010, and the 2012 Presidential election? Fugeddaboutit.

Posted by: ajw_93 | April 23, 2010 11:23 AM | Report abuse

Beyond the lack of advocacy in opposition aspect, there's a more basic problem: Cost of Business. With such incredible profits, you can't make them follow the law. The cost of litigation becomes well within their budget. And with an inscrutable product and a couple fancy lawyers, they don't even lose very often. The law is meaningless.

Posted by: roquelaure_79 | April 23, 2010 11:35 AM | Report abuse

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