The Corner

‘Socially useless’ and nuisance-taxed, but still government-guaranteed

Paul Krugman is on board with slapping a small tax on financial firms’ transactions “to deter financial speculation” and better protect the economy from Wall Street’s meltdowns.

This idea has been around for a long time. Yale economist James Tobin, now deceased, suggested a tax on foreign-currency trades back in 1972 to tamp down speculation. Less intellectually, 2005 New York City mayoral candidate Freddy Ferrer proposed a stock-transactions tax to pay for education.

This summer, the head of Britain’s Financial Services Authority (FSA), Lord Turner, revived the idea in relation to the current crisis, saying that a financial-transactions tax would help shrink “a swollen financial sector” by curtailing its “socially useless” activities” and slicing off “excessive profits.”

Krugman agrees. In today’s New York Times column, he repeats Tobin’s initial argument that such a tax would “ ‘throw some sand in the well-greased wheels’ of speculation. And a transactions tax could generate substantial revenue,” Krugman notes, combining Tobin and Ferrer. “What’s not to like?”

A financial-transactions tax doesn’t solve the real problem, which is that much of the financial-services industry benefits from an implicit government guarantee of its debt.

What’s a pesky tax in relation to this priceless guarantee? Not much. OK, the tax may be grease in the wheels – but the government is just coming along and power-spraying more grease.

Krugman’s main argument disintegrates under this reality. A tax on every financial transaction, Krugman writes, would make financial firms – and the economy — less vulnerable to panic.

It would do so by cutting down banks’ and investment companies’ reliance on short-term debt, he writes, because they would have to pay the tax every time they renewed any of their borrowing, including overnight borrowing. To avoid the tax, financial firms thus would borrow more money long-term, in fewer transactions. Long-term lenders would be unable to yank their money out in a crisis as short-term lenders did in 2008.

A tax is not enough to overwhelm the government’s distorted incentives, though. The sand is no match for the grease.

From financial firms’ perspective, there is too much money to be made in borrowing nearly for free short term – thanks to the government’s implicit guarantee and thanks to zero-percent interest rates – and speculating on everything from oil and copper to Brazilian stocks.

A new tax on financial transactions may make the “too big to fail” problem worse, in fact, because it allows the government to reap a tangible short-term benefit from its policy of state subsidy.

Government-guaranteed financial firms would still reap unnaturally large profits at the expense of other industries. But they would throw a little bit more off to Washington for healthcare or somesuch, quelling the desire for needed financial-regulatory changes that would cut profits and revenues from the new tax.

Then, there’s the inconvenient incoherence. If so much of financial services is “socially useless,” why does Washington need repeatedly to bail it out?

The solution is for Washington to end “too big to fail,” and allow the market to decide what is “socially useless” and what isn’t.

Nicole Gelinas, contributing editor to the Manhattan Institute’s City Journal, is author of After The Fall: Saving Capitalism From Wall Street – and Washington, out Monday.

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