22 April 2010

IMF Proposes that Governments Tax More

Got a long post today…

The IMF has proposed a series of bank taxes to avoid future meltdowns of the international financial system. Its proposal is basically two pronged: tax financial companies to the extent that they represent a systemic threat to the economy as a whole, and tax excessive profits so that these companies avoid risky investments. The idea has some merit, but it will probably not burst any future bubbles. Market distortions helped bring about the financial crisis, and distorting investment markets further will not provide any remedy.

The road to the financial crisis started with loose fiscal policy in the United States that encouraged home ownership. Since the price of debt was kept artificially low with the help of huge currency reserves amassed by foreign lenders this positive demand shock to the housing market created a positive feedback cycle that culminated in the housing asset bubble. Banks for their part had poorly calibrated risk models and brand new investment instruments that diffused risk as well as responsibility and destroyed information about the composition of their investments. When the asset bubble burst, as they always do, lenders had tied up billions of dollars in houses that nobody could afford and none of the investment banks could tell who owned the bad debt. This caused credit to tighten, which then affected the “real” economy through decreased demand.

I can identify several market distortions in this narrative: fiscal policy to subsidize housing, monetary policy that permitted the amassing of foreign debt, the investment vehicles (derivatives) that destroyed information about debt ownership, faulty risk models, the “too big to fail” strategy of the banks that led them to take on excess debt, and a principle-agent problem between the banks as an institution and their representative agents (their executives).

Levying taxing on banks is very tempting for policymakers right now. Not only is there a lot of political support for it (Tax the rich! They got us into this mess!), but the US, UK and others who are stimulating their economies with aid packages need a way of paying off all their new debt. However, I am firmly convinced that the best solution to this problem will not come through tax laws. Taxes can be evaded, and are subject to too much political jockying. The only permanent and real reforms must come from the industry itself. Banks (as an institution) need to make their executives more accountable for the risks they take, and expend the time and resources to gather proper information about the assets they are buying with their money. Tax laws are not needed for this, though legal reforms making executives more liable for taking excessive risks would definitely be an improvement. This will also help remove the moral hazard of the "too big to fail" mentality. Why would executives care if the government steps in to bail out thier company if they are still going to be held criminally accountable for thier actions? Governments also need to learn the lessons of their own mistakes, and stop relying so much on fiscal and monetary policy to achieve political goals (this will also have the duel affect of reducing public debt).

As for preventing any and all future bubbles… that’s not going to happen. Liberalizing investment means giving agents the latitude to make risky decisions, and every once in a while those risky decisions will agglomerate into an asset bubble. Shocks and volatility are the costs of having free markets. If you don’t like bubbles, you shouldn’t be a capitalist.

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