Do we have the financial sector we need? The quality and cost of payment services from M-Pesa in Kenya to Apple Pay in the U.S. are steadily improving. However, the channeling of saving to investors is lagging behind.
But what is the explosive growth of “Wall Street” from a market capitalization of $40 billion in 1987 to $1.25 trillion in mid-2007 for the ten largest commercial and investment banks in the United States, and the banks they absorbed along the way, all about?
The growth in the financial services industry has dramatically outstripped the services it actually performs: payments and allocating saving to investment. While experiences have varied around the world, the dramatic growth in bank risk-taking, especially in the U.S., has its origins in President Nixon’s termination in the early 1970s of the global monetary system – the Bretton Woods system – that anchored most currencies to gold and thus to each other, and dysfunctional and distorting tax systems that favor debt over equity.
Regulatory efforts to limit such risk-taking and thus avoid the severe damage to the world economy experienced from the Great Recession of 2008-09 have proliferated the costs of providing financial services and are likely to fail in their objective.
The growth of regulations along with the growth of the size and economic role of governments more generally are propelling the United States and others into the clutches of crony capitalism. Below I will offer some radical suggestions for changing directions.
Floating fiat currencies. The abandonment of the gold standard not only removed an important pillar of stability in international trade and payments, but also freed individual governments, and especially the U.S. government, from the restraining discipline of sound money on deficit financed spending. Financial markets responded to the new world of floating exchange rates by developing instruments to hedge the new exchange rate and interest rate risks.
The foreign exchange market (spot transactions, outright forwards, foreign exchange swaps, currency swaps, and options) grew from virtually nothing in 1970 to $1.2 trillion per day in 2001, reaching over $5.3 trillion per day in 2013. By comparison the daily value of goods trade in 2013 was $52 billion dollars making the turnover in the foreign exchange market a thousand times larger. The U.S. central government debt outstanding rose from $371 billion in 1970 to $5.8 trillion in 2001, reaching $17.8 trillion in 2014. The purchasing power of one dollar in 1970 fell to 22 cents in 2001 and to 16 cents in 2014.
Efforts to counter recessions with monetary policy, something made possible by the abandonment of the gold standard or any other hard anchor to money’s value, have produced serious distortions in the U.S. and other economies as the result of prolonged periods of abnormally low interest rates. In the U.S. the dot.com and the subsequent real estate bubbles combined with the Greenspan put, then the Bernanke put, have encouraged highly leveraged financial risk-taking unimaginable even in the roaring 20s.
Tax jungle. Efforts to tax the profits of globally active companies are a daunting challenge. However, the tax breaks given to powerful special interests has so complicated the U.S. and some other tax codes that it has become virtually impossible to raise much revenue from such taxes. Some politicians have attempted to excuse their own failure to enact simple and enforceable tax laws by criticizing companies that fully comply with them, while also minimizing their tax payments. The resulting mess has been discussed in these pages on many occasions.
Existing U.S. tax laws subsidize debt over equity and thus contribute to the excessive leverage that has made the financial sector so vulnerable. The pockmarked and complex American tax code creates many other distortions in the economy as well. According to the CCH Standard Federal Tax Reporter it now takes 73,954 pages to explain the U.S. federal tax code, compared with 400 in 1913 when the personal income tax was first introduced.
Former U.S. Senator Bob Packwood recently pointed out the main source of the problem in an article that explained what was done to enact the last sweeping income tax reform and simplification in the U.S. – the Tax Reform Act of 1986. The U.S. Senate Finance Committee, which he chaired at that time, met in secret with a bipartisan group of senators with the full cooperation of the president and prepared the bill in one week.
Within a few months it was signed into law. By closing most tax loopholes (special exemptions etc.) the bill reduced the top personal income tax rate from 50 percent to 27 percent and the top corporate income tax rate from 48 percent to 33 percent without any loss of revenue. The reason that secrecy and speed were needed was to keep the many special interests from mounting lobbying campaigns to protect their special tax treatments.
Ever growing regulation. The American tax code reflects America’s gradual slide into crony capitalism. Unlike real capitalism, the crony type results when special interests are able to collude with politicians to promote or protect their special financial interests rather than the general public interest. President Eisenhower famously worried about the dangers of the military industrial complex as he sought to conduct a cold war with the USSR.
The American government’s expansion into many other areas of the economy, including the financial sector, has extended the government’s capture by industry to areas not imagined by Eisenhower.
It is difficult for the government to objectively serve the public interest while dealing with and regulating industry. The relationship that develops in such a situation often serves the interests of the regulated industry more than the general public. The larger government becomes and the more involved it becomes in the economy, the larger the risks of regulatory capture. The resulting crony capitalism is the enemy of true capitalism as much as its variants socialism and fascism.
The financial sector is no exception. In 2012 Andrew Haldane and Vasileios Madouros of the Bank of England noted this phenomena as follows: “Contrast the legislative responses in the U.S. to the two largest financial crises of the past century – the Great Depression and the Great Recession. The single most important legislative response to the Great Depression was the Glass-Steagall Act of 1933. Indeed, this may have been the single most influential piece of financial legislation of the 20th century.
Yet it ran to a mere 37 pages.
“The legislative response to this time’s crisis, culminating in the Dodd-Frank Act of 2010, could not have been more different. On its own, the Act runs to 848 pages – more than 20 Glass-Steagalls. That is just the starting point. For implementation, Dodd-Frank requires an additional almost 400 pieces of detailed rule-making by a variety of U.S. regulatory agencies.”
According to Martin Wolf, whose latest book is reviewed later in this issue, “The evolutionary approach being taken to reform the global financial and monetary systems is unlikely to prevent further crisis.” It is also greatly increasing the costs of performing financial services. We need a different approach.
We need a shift in the balance between market and government regulation of financial services toward more market regulation. To achieve this we need a change in the legal and policy foundations on which these markets operate.
Tax system: The least radical but still politically challenging reform of the tax system “would be to abolish corporation tax and to attribute all corporate income to shareholders.” (Martin Wolf, page 336) A more radical tax reform would be the elimination of all income taxes, personal and corporate, in favor of a value added tax as I have proposed in an earlier issue.
In addition to being simple and economically efficient, it would make special interest carve outs much more difficult.
Monetary system: A critical reform is to return to the monetary discipline of a hard anchor to the money supply. The gold standard was such a system but had weaknesses that could be overcome with a broader and more stable anchor (a small valuation basket of goods). The logical starting place is to reform the International Monetary Fund’s reserve asset, the Special Drawing Right (SDR).
The IMF should replace the SDR’s valuation basket of key currencies with a basket of goods and replace the allocation of SDRs with their issue according to currency board rules. In addition to replacing the U.S. dollar as the international reserve currency this Real SDR would become an ideal anchor to which to peg national currencies, thus restoring a global currency that contributed so much to the expansion of world trade during the classical gold standard era.
Banking system: Modest reforms of the banking system that may be underway are to significantly increase bank capital requirements and to rigorously adhere to a policy of imposing losses from insolvent banks on their owners, creditors and depositors (no bailouts). The combination of these two should greatly increase the safety of banks and the incentive for their investors and customers to monitor their risk-taking and thus to reduce the need for micromanaged supervision from regulators.
A more fundamental reform would be to separate the payment system from financial intermediation services by adopting the Chicago Plan of 100 percent reserves against monetary deposits at banks as proposed by Milton Friedman, Martin Wolf, Laurence Kotlikoff and others. If all monetary deposits were fully backed by deposits of the same amount with the central bank, no further regulations (beyond normal accounting and reporting requirements) would be needed for the payment subsidiaries of banks.
There would be no reason for bank runs and they would do no harm if they occurred. The lending and financial services subsidiary of a bank, or other financial institutions, would be funded with equity, as are equity mutual funds, as is required by Islamic banking, and would thus only require minimal regulation (fit and proper owners and transparency).
These admittedly radical reforms would provide a foundation for the development and operation of the financial sector that could rely very heavily on the regulation of its activities by its owners, investors, and customers with minimal government oversight. This would greatly lower the cost of regulation, improve the competitive environment for delivering financial services and innovating new ones, and limit risk-taking to levels acceptable to those financing them. It would result in a sounder and more efficient financial sector.
In summarizing his often over the top 745-page rant against crony capitalism, The Great Deformation, David Stockman stated that: “My point in the book is that bad policy causes smart people to engage in activities that wouldn’t occur in the free market.
“If we didn’t have a massive bias in the tax code for debt and capital gains, and we didn’t have a monetary policy that was driving interest rates to absurdly low levels, most of this massive leveraging wouldn’t occur.
“I don’t hold it against someone who makes a killing. I’m saying this kind of start-stop, boom-bust monetary policy is pointless, and it’s one of the mechanisms by which windfalls are shifted to the 1 percent.”