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Martin Wolf: c'mon, make the jump

by Jerome a Paris Wed Jun 24th, 2009 at 06:06:39 AM EST

Martin Wolf has yet another hard-hitting article on the banking sector, which demonstrates with clarity how the sector has a structural incentive to engage in high-risk activities: betting with other people's money which is essentially guaranteed by the State, it can keep the profits during good times and dump a large part of the losses in bad times. His conclusion is simple:

A business that is too big to fail cannot be run in the interests of shareholders, since it is no longer part of the market. Either it must be possible to close it down or it has to be run in a different way. It is as simple and brutal as that.

His article is about the skewed incentives for bankers, but he fails to touch on the simplest solution: ultimately, this is about the oversized monetary gains that a relatively small number of people can make. The goal is to eliminate the possibility for these people to make such gains, and the way to do this is to tax such gains at massively increased rates. If bankers see that they will keep very little of what they can gain by betting the bank, they will have much less incentive to do.

The history of the second half of the 20th century rather strongly suggests a link between high marginal tax rates and the lack of banking crises. And if people threaten to move away to other places, cal ltheir bluff, and play hardball: how many people will be willing never to set foot in London or New York again in order to escape some taxes?

It's easy to do in practice; what's missing is the political will to do so - and the support from pundits who, so far, don't even seem to consider that tax increases could be a solution to many of our current problems (such as budget deficits, potential pension shortfalls and decaying infrastructure).

Higher marginal taxes! C'mon Martin, you can do it!


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It's been a while since I sent them an LTE, this is maybe a good opportunity...


Dear Sirs,

Martin Wolf ("Reform of regulation has to start by altering incentives", 24 June) makes a convincing case that it is necessary to change the system whereby financiers get to bet other people's money, keep a large part of the gains if things go well, and pass on a large part of the losses if they don't. The financial history of the 20th century suggests that there is some link between the frequency of banking crises and the marginal rate of taxation. High tax rates after WW2 were simultaneous with a period where banking crises were few, while economic growth was strong. In other words, hit the bankers where it actually matters: in their ability to actually keep for themselves the profits they can capture.

Beyond making banking boring again, as prescribed, and having no impact on likely growth rates, this would have the additional advantage of providing a solution to the other big problem of the moment: public deficits.



In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jun 24th, 2009 at 06:25:22 AM EST
with minimal edits, in the absence of any comments:


Dear Sirs,

Martin Wolf ("Reform of regulation has to start by altering incentives", 24 June) makes a convincing case that it is necessary to change the system whereby financiers get to bet other people's money, keep a large part of the gains if things go well, and pass on a large part of the losses if they don't. The financial history of the 20th century suggests that there is some link between the frequency of banking crises and the marginal rate of taxation. High tax rates after World War 2 were simultaneous with a period when banking crises were few, while economic growth was strong. In other words, hit the bankers where it matters: in their ability to actually keep for themselves the profits they can capture.

Beyond making banking boring again, as prescribed, and having no impact on likely growth rates (despite self-interested claims to the contrary from predictable quarters), this would have the additional advantage of providing a solution to the other big problem of the moment: public deficits.

Kind Regards,



In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jun 24th, 2009 at 11:46:53 AM EST
[ Parent ]
The absence of high marginal taxes also increases the risk appetite of managers of non-banks. Why spend 10 years patiently trying to grow your telecom when you can engage in a debt-fueled binge of acquisition that may produce massive returns before you cash out?

The other needed solution is encouragement of alternative finance methods that do not involve casino enterprises.

by rootless2 on Wed Jun 24th, 2009 at 07:07:04 AM EST
Ah, the privilege of fame...
No one replied when I posted that article in the Salon ;-)

Earth provides enough to satisfy every man's need, but not every man's greed. Gandhi
by Cyrille (cyrillev domain yahoo.fr) on Wed Jun 24th, 2009 at 07:17:52 AM EST
I responded by flagging the article you brought up - so your contribution is valued in the most visible way!

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jun 24th, 2009 at 08:18:06 AM EST
[ Parent ]
you/we/ET should send him some champagne the first time he mentions it.

FT.com / Columnists / Martin Wolf - Reform of regulation has to start by altering incentives

The unpleasant truth is that, today, the incentive to behave in this risky way is, if anything, even bigger than it was before the crisis.

At least he addresses the problem - but he seems a bit stuck on the solutions.

by Nomad on Wed Jun 24th, 2009 at 07:39:08 AM EST
Give him time.  Martin's been coming around faster than most.  I'm confident he'll get it.

Be nice to America. Or we'll bring democracy to your country.
by Drew J Jones (pedobear@pennstatefootball.com) on Wed Jun 24th, 2009 at 08:16:37 AM EST
[ Parent ]
Need a redefinition of "fiduciary duty" to involve the long term value of the company as a whole, not the interests of stock speculators.
by rootless2 on Wed Jun 24th, 2009 at 09:03:44 AM EST
how can we tell the difference between investors and stock speculators? I think the answer again is steeply progressive taxation, which penalises high annual rates of economic gains, not necessarily high longer-term rates. All depends on your definition of "high" I suppose.
by PIGL (stevec@boreal.gmail@com) on Wed Jun 24th, 2009 at 09:35:05 AM EST
[ Parent ]
PIGL:
how can we tell the difference between investors and stock speculators?
An investor buys securities when they're issued. A speculator "invests" their money in the secondary markets.

A man of words and not of deeds is like a garden full of weeds; a man of deeds and not of words is like a garden full of turds — Anonymous
by Migeru (migeru at eurotrib dot com) on Wed Jun 24th, 2009 at 09:37:45 AM EST
[ Parent ]
for transactional taxes like the Tobin tax.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jun 24th, 2009 at 09:58:28 AM EST
[ Parent ]
I agree with Jerôme re the Tobin tax, but I don't agree that time-of-purchase is a sure diagnostic of speculation. In fact, who but a speculator or insider of some sort can buy tasty securities at time of issue?

By this criteria, would not every middle class person with a investment portfolio containing common stocks count as a speculator?

by PIGL (stevec@boreal.gmail@com) on Wed Jun 24th, 2009 at 10:12:30 AM EST
[ Parent ]
PIGL:
In fact, who but a speculator or insider of some sort can buy tasty securities at time of issue?
Rights issues are usually open to the public. Insiders profit hugely from their existing equity share suddenly acquiring a large liquid value. You can also buy treasury bonds at the time of issue if you like.

A man of words and not of deeds is like a garden full of weeds; a man of deeds and not of words is like a garden full of turds — Anonymous
by Migeru (migeru at eurotrib dot com) on Wed Jun 24th, 2009 at 10:26:45 AM EST
[ Parent ]
Rights issues (here in the UK) are open only to existing shareholders.

A shareholder can choose to sell on his/her right to buy those additional shares, but only these "leftovers" make their way to sale, and not necessarily to the public. They might be sold to institutional investors in a job lot, for instance.  The same often happens when new equity is issued without going down the rights route: the shares are often placed directly with big investors and are not offered to the public.

by Sassafras on Wed Jun 24th, 2009 at 11:34:23 AM EST
[ Parent ]
Then 1) how did the existing shareholders acquire their shares in the first place; 2) if there's nothing but institutional shareholders, why do we pretend that the interests of shareholders somehow intersect with the interests of the voting public?

A man of words and not of deeds is like a garden full of weeds; a man of deeds and not of words is like a garden full of turds — Anonymous
by Migeru (migeru at eurotrib dot com) on Wed Jun 24th, 2009 at 11:42:40 AM EST
[ Parent ]
Well, it was actually a PN on company law (which may in any case only apply in the UK).  However:

  1. Through either a public issue/subscription (which does happen, but not all that often, because it's a lot easier for a company to issue 1,000,000 shares each to four investors than sell 4,000,000 shares in blocks of 500) or the secondary market.

  2. In theory, the money managed by the institutional shareholders belongs to the voting public.  Pension schemes, annuities, endowment policies, share ISAs, etc etc etc...
by Sassafras on Wed Jun 24th, 2009 at 11:57:34 AM EST
[ Parent ]
Sassafras:
it's a lot easier for a company to issue 1,000,000 shares each to four investors than sell 4,000,000 shares in blocks of 500
That's why companies don't do rights issues by themselves but enlist investment banks as "underwriters" and for "placement".

A man of words and not of deeds is like a garden full of weeds; a man of deeds and not of words is like a garden full of turds — Anonymous
by Migeru (migeru at eurotrib dot com) on Wed Jun 24th, 2009 at 12:17:59 PM EST
[ Parent ]
Sassafras:
In theory, the money managed by the institutional shareholders belongs to the voting public.  Pension schemes, annuities, endowment policies, share ISAs, etc etc etc...
Yes, but when I subscribe a pension scheme, buy units in a trust, or get an ISA, I don't actually own any stock. I am giving the fund manager my money and getting a return indexed to the performance of his fund, but I don't have any rights as a shareholder in the companies the fund manager invests in, because he does the share purchases, not I.

A man of words and not of deeds is like a garden full of weeds; a man of deeds and not of words is like a garden full of turds — Anonymous
by Migeru (migeru at eurotrib dot com) on Wed Jun 24th, 2009 at 12:20:02 PM EST
[ Parent ]
Absolutely.  However, the value of your pension/ISA depends on the pooled performance of the shares bought with everyone's money and held by the institutional investor. So your interests are pretty much identical to those who own shares directly.  Except, as you point out, without voting rights.

But I know you know this, so are we at cross purposes over definitions?

if there's nothing but institutional shareholders, why do we pretend that the interests of shareholders somehow intersect with the interests of the voting public?

I took "interests" to mean "the desire/need for security of and return on savings" and the "voting public" to mean "average citizens". So my reply was, I thought, the practical point that most people do have interests that rely directly on the performance of shares, even if, legally, they're a step away from being shareholders themselves.

(That doesn't, obviously, make the current system any less rotten. More so, if anything.  But I don't think there is really any "shareholder class" separate from the rest of us whose genuine interests lie in an unsustainable fast buck. Apart from bonus-driven fund managers, that is.)

by Sassafras on Wed Jun 24th, 2009 at 01:54:12 PM EST
[ Parent ]
I may be at risk of becoming just as predictable repetitive as Chris on banking reform, but let me repeat once more: There is nothing wrong with insolvent private pension funds that cannot be solved by better public pensions. And if improving the public pension system is considered politically unacceptable, there is nothing to prevent the political system from bailing out failing pension funds without bailing out the companies whose shares are plummeting and causing the private pension crisis.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Jun 24th, 2009 at 03:05:59 PM EST
[ Parent ]
In the USA buying of Initial Public Offerings of stock is tightly controlled for the profit of the "underwriters" and their favored clients.  Absent strong rules to control this behavior, a better measure of "investing" vs. "speculation" could be the length of time the stock is held.  I would suggest that the capital gains tax be set to decline by 2% per year down to a fixed value around 20% after seven years.  Selling loosing stocks would not be penalized and holding winners would be rewarded.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jun 24th, 2009 at 01:19:43 PM EST
[ Parent ]
BTW, this approach is similar to "back end loaded" fees on mutual funds, so it is hardly a novel concept to the market.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jun 24th, 2009 at 01:21:27 PM EST
[ Parent ]
Not just investors - but there are other stakeholders in the company.

The fiduciary duty of the management should be to try to ensure that the company meets its obligations to shareholders via profitability, to creditors, and to employees.

Fiduciary duty is breached by actions that are intended to risk the longer term financial health of the company for short term stock upticks.

by rootless2 on Wed Jun 24th, 2009 at 09:46:43 AM EST
[ Parent ]
the threat of prison might concentrate a few minds...

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jun 24th, 2009 at 10:03:13 AM EST
[ Parent ]
I think this is really an argument for reducing dramatically the "limited" part of LLC. What is the case against the existence of LLCs (ie in favour of partnerships and other forms of company structures, which have a more balanced risk/reward)?



--
$E(X_t|F_s) = X_s,\quad t > s$

by martingale on Wed Jun 24th, 2009 at 09:19:40 PM EST
[ Parent ]
The problems here are, I think, threefold:

  1. Activist shareholders are more likely to be raiders than builders. A shareholder in a modern, technologically advanced company cannot stay sufficiently abreast of the operations of the company to make a useful contribution to the management. Looting, on the other hand, requires no detailed concept of the day-to-day operation of the company, only power to set required dividends and the will to go the nuclear option and liquidate the enterprise if it fails to provide those dividends.

  2. Insufficient marginal taxation means that it is more profitable for CEOs to assist the looting in exchange for a cut of the take, than to resist the looting in order to preserve their long-term tenure within the firm. If marginal taxes are raised, steady salaries become more valuable relative to lump sum payments. And vice versa. Looting gives you lump sum payments, tenure in a healthy organisation gives you a steady salary.

  3. Insufficient countervailing forces within the corporate hierarchy. If more groups from within the company were represented in the boardroom, it would be harder to loot the company (or at least to loot it profitably). People and groups within the company's technostructure have both the knowledge to exercise actual influence from the boardroom (as opposed to shareholders and their nominal representatives), and a strong interest in the preservation of the corporate technostructure that pays their salaries and is the source of their personal power. Of course these groups could also be bought by a prospective looter, but the more people you have to cut in on the take, the less profitable looting becomes.

Raising marginal tax rates solves issue 2), but not 1) and 3). Issue 3) could be solved by giving employees formal representation in the boardroom. How to solve issue 1) I don't know, but Tobin taxes would probably be a good start.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Jun 24th, 2009 at 01:35:29 PM EST
[ Parent ]
An attempt to increase the marginal tax rate in Spain lasted all of 6 hours. From the time the PSOE announced an agreement with the left-wing parties in the parliament to the time they were told by the conservative Catalan Nationalists that they would retaliate by defeating some other important vote.

A man of words and not of deeds is like a garden full of weeds; a man of deeds and not of words is like a garden full of turds — Anonymous
by Migeru (migeru at eurotrib dot com) on Wed Jun 24th, 2009 at 09:39:42 AM EST
FT.com | Willem Buiter's Maverecon | Too big to fail is too big

(5) Tax bank size

When size creates externalities, do what you would do with any negative externality: tax it.

The other way to limit size is to tax size.  This can be done through capital requirements that are progressive in the size of the business (as measured by value added, the size of the balance sheet or some other metric).  Such measures for preventing the New Darwinism of the survival of the fattest and the politically best connected should be distinguished from regulatory interventions based on the narrow leverage ratio aimed at regulating risk (regardless of size, except for a de minimis lower limit).

Read the whole piece. It's excellent as usual.

A man of words and not of deeds is like a garden full of weeds; a man of deeds and not of words is like a garden full of turds — Anonymous
by Migeru (migeru at eurotrib dot com) on Wed Jun 24th, 2009 at 09:58:22 AM EST
that we'll end up with his option n°1: too big to save: ie the parasites will die only when they have killed the host.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jun 24th, 2009 at 10:04:26 AM EST
[ Parent ]
I fear you are right. It seems impossible for our political systems to design and implement effective policies in any domain whatever. It's very distressing. Maybe, I should crack my old copy of Legitimation Crisis.
by PIGL (stevec@boreal.gmail@com) on Wed Jun 24th, 2009 at 10:19:04 AM EST
[ Parent ]
It's impossible for our political systems as currently captured by moneyed interests to design and implement effective* policies in any domain whatever.

* with "effective" meaning something else than "making the rich richer"

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Jun 24th, 2009 at 10:21:43 AM EST
[ Parent ]
And nothing effective will be done until the financial class has conclusively shown that they are incapable of getting us out of this mess.  That will constitute a crisis of legitimacy.  It is, in fact, already ocuring, but this is not widely recognized as yet.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jun 24th, 2009 at 01:27:33 PM EST
[ Parent ]


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