<blockquote>
'...we should follow the advice of Andrew Mellon, overruled by President Hoover at the start of the Great Depression: "Liquidate everything ... purge the rottenness from the system." Wall Street needs to be taught that nobody (including the U.S. government) is "too big to fail" and that risk management is not just a means of deluding the auditors and yourselves with a mass of spurious computer-generated data, but is intended to achieve the genuinely valuable purpose of managing risk.'</blockquote>
The futility of Wall Street "reform"By Martin Hutchinson
January 18, 2010
SourceThe new liabilities tax on banks announced by President Obama last week will probably raise the revenue he wants, $117 billion over 10 to 12 years – but its effects on the industry will not be what he thinks. Congress's attempts at financial sector "reform" are also doomed to add bureaucracy without providing significant additional protection against a collapse of the financial system. The reality is that if the authorities don't get their act together this year, we are very likely to have to pay for a second financial system collapse. Such is the baleful influence of the crazed incentive system now driving Wall Street.
Obama's liabilities tax, if it passes Congress, is a case of "close but no cigar." The tax correctly identifies leverage as one of the major problems with Wall Street's current operations, but then addresses it only in its "on balance sheet" form. In a world of credit default swaps and endless dozy securitization structures, it's perfectly simple to take risk of any kind without putting it on the balance sheet. Indeed, the leverage tax, by driving banks to opaque and unstable derivatives structures that do not appear on the balance sheet, will make Wall Street's instability and rent-seeking worse.
There is a need for a new tax on Wall Street, but not to recoup the cost of bailouts, nor to satisfy punitive populist fantasies, but simply to make the place work right. As this column has identified in the past, the twin problems of Wall Street are poor risk management and excessive rent seeking (the latter not being a problem with Wall Street itself – seeking rents is human nature but with an economic structure that allows it to happen). Poor risk management has been greatly encouraged by the infamous "too big to fail" doctrine while rent seeking has partly been enabled by new computer technology and has been relentlessly expanded by 15 years of sloppy monetary policy.
A new tax and a new regulatory system must thus solve the real problems with Wall Street, without if possible creating new ones. On tax, the solution is pretty simple. Let the state collect an extra $10 billion annually from the financial services business, by all means, but collect it not from a liabilities tax, too easily evaded, but from a tax directly on trading. A modest "Tobin tax" collected at a small ad valorem level on each trade, would put out of business the most egregious rent-seeking practices on Wall Street, in the area of high-speed trading, which rely for their success on exploiting insider information about funds flows. It would not significantly hinder the normal processes of investment, even short-term, but would penalize only the thinnest-margin most trading-heavy operations. It would also have the benefit of partly restoring the balance between trading and genuinely economically valuable operations in Wall Street houses, which has in recent decades become heavily over-weighted towards trading.
A tax on trading alone is not sufficient to reform Wall Street. If that was the only change, the system would simply cut out the most egregious low-margin trading excesses. It would instead move towards higher risk businesses such as credit default swaps in which money is made not by rapid trading but by taking on grossly asymmetric risks and allowing the successful speculations on bankruptcy to outweigh the cost of the unsuccessful attempts. By closing the trading avenue towards rent seeking, you would merely have increased the use of the "too big to fail" excessive risk avenue. In a market where excessive risk leads generally to profits for the bankers and losses for the taxpayer, the most likely economic system is one in which crashes happen much oftener than once a decade or so, so that repeated wild speculative bubbles turn into disaster and chaos every couple of years.
Needless to say, since that is the economic system Wall Street currently finds most profitable, that is the economic system we appear to have. Grossly over-expansionary monetary and fiscal policies have made the global economic system thoroughly unstable, so that now a wild commodities boom is ripping through the world economy, while stock prices are up over 50% from the sober properly valued levels to which they had briefly fallen.
The new bubble is doing nothing for small businesses, which according to this week's National Federation of Independent Business survey are stuck in the most depressed conditions they have seen for thirty years, with no immediate prospect of emergence. It is also doing nothing for unemployment, stuck at close to a post-war record, also with no immediate prospect of improvement – indeed long-term unemployment seems likely to break through the levels of the early 1980s and set highs in 2010 not seen since the infamous1930s. However, the bubble is making speculators very rich. Soon, as bubble turns to crash, the credit default swap holders will really clean up, as major corporations and a few Third World countries spiral into catastrophe, to the enormous profit of those who have gone "short" on their credit.
When the Wall Street problem is stated this way, the solution becomes obvious. Fiscal and monetary policies must be reformed, and quickly. The federal budget deficit must be brought down from the current 10% of GDP to the 5% or so that is normal in recessions, and which the capital markets can cope with without crowding out small businesses. This must be done not by major tax increases but by cutting spending both nationally and at state levels, removing the public sector bloat that has been allowed to accrue over the last decade.
Far from depressing the economy, this will restore it. Keynesian deficit spending is at best a fallacy, because government does not create wealth, although it can give the economy a modest short-term kick. However, in large quantities, when it produces large budget deficits "stimulus" sucks capital away from the productive private sector, especially the small business sector. Currently, the parts of the U.S. financial system too small and dozy to play the trading game successfully, such as regional banks, are funding themselves short-term at costs close to zero and investing in government and agency bonds paying over 4%. So long as Ben Bernanke doesn't raise interest rates, why would it ever be worth them taking on the risks and harassments of financing small businesses when large profits are so easily come by?
Thus the most urgent reform comes down once again to the Fed. It is just possible that Fed policy could be shaken up quickly. Bernanke still needs a full Senate vote on his nomination for a second term in office and there must be some chance that enough senators wake up to economic reality in time to deny him confirmation. Absent that wake-up call, current sloppy monetary policy will continue until the Treasury bond market panics seriously at signs of incipient inflation and collapses. Given the Bureau of Labor Statistics' tendency to massage the inflation figures, this may not happen until late in 2010, but it would be surprising if the current arrangements made it through the end of the year.
Once the bond market collapses and short-term rates are raised (with the accompanying collapse in stock and commodity prices), small businesses will initially be no better off, because the government will continue to suck in an excessive supply of what finance remains. On the other hand, the bond market collapse will sharply reduce the profitability of financial services, particularly the trading operations. Given the state of current Wall Street risk management and its excessive leverage (both visible and invisible), such a reduction will almost certainly result in a further panic and call for help from taxpayers.
That second call should be resisted. Instead, we should follow the advice of Andrew Mellon, overruled by President Hoover at the start of the Great Depression: "Liquidate everything ... purge the rottenness from the system." Wall Street needs to be taught that nobody (including the U.S. government) is "too big to fail" and that risk management is not just a means of deluding the auditors and yourselves with a mass of spurious computer-generated data, but is intended to achieve the genuinely valuable purpose of managing risk.
Imposing risk management systems that work is the most important task of all those confronting Wall Street. It must abandon "Value at Risk" and its derivatives, which grossly fail to address the problem and adopt reality-based risk management systems that recognize the dangers of "fat tails" and the extreme dangers of pathological products such as tranched Collateralized Debt Obligations and credit default swaps.
However, Wall Street can only reform its risk management internally – risk management imposed by regulators will be too easy to evade. And for that to happen, Wall Street must actually want to manage risk and be genuinely scared of the alternative that may result from not managing it. In other words, failure and personal loss must be a real possibility, staring it in the face. "Too-big-to-fail" must be abandoned, for it has failed.
"Purging the rottenness" will only happen then.
The Bears Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005). Details can be found on the Web site www.greatconservatives.com