By Edward L. Glaeser
Mary Altaffer/AP 
Financial market regulation seems dauntingly complex, but conceptually it is no different than an efficient highway toll.
Both public interventions are justified by negative externalities, which occur when one person’s activity adversely impacts other people. On the highways, each driver slows everyone else, and tolls can speed traffic by keeping price-sensitive drivers off the road. In the financial markets, institutional risk-taking creates the risk of failure and federal bailout. The reason to intervene, on either the highways or the Bourse, is to limit the social damage created by people and companies that act without worrying about the costs that they impose upon others.
In the old days, everyone pretended that financial institutions had no federal guarantee other than deposit insurance. Public officials even kept up the fiction that Freddie Mac and Fannie Mae were independent, a pretense belied by the nearly risk-free interest rates that these institutions paid to their lenders. Now we know that Freddie and Fannie and plenty of other institutions were gambling with our money, and that gave them an incentive to take on plenty of extra risk.
The risk of future bailouts makes the case for further regulation, but we can’t design good policies until we know the new rules that will govern those future bailouts. Will the feds backstop everyone or just big banks? Does this guarantee always apply, or just during a downturn big enough so that a bank collapse could destroy the credit system?
In order to make a public case for particular rules, rather than just a vague sense that more regulation is needed, the government itself needs to act first and articulate a more transparent set of rules governing future fights against market meltdown.
Despite a few well-known exceptions, taxes generally beat regulations as a tool for correcting externalities.
For example, some places have tried to regulate their way out of traffic congestion by limiting access to central city roads based on license plate numbers — for example, saying that cars with plates that end in 5 or 6 cannot drive on Wednesday. These policies do nothing to separate drivers who really need to get downtown from unmotivated motorists. The rule does wonders, though, to inefficiently encourage the buying of extra cars. A congestion charge is better. It allocates roads to the people who value them most and generates extra revenue.
The case for taxes, rather than regulation, can also hold in financial markets.
Three years ago, Dwight Jaffee and I argued that the risks that Freddie Mac and Fannie Mae imposed on United States taxpayers could be handled either by limits or taxes on these institutions’ portfolios. Slapping an appropriate tax on these entities would have generated revenue and limited their desire to impose extra risks on the American taxpayer.
In principle, the appropriate systemic-risk tax on a financial institution is the product of two figures: the probability that this entity will receive a bailout, times the expected cost of that bailout. Obviously, that number is impossible to know without better understanding the rules concerning future bailouts.
Calculating such a tax may seem incredibly hard, but well-designed regulations require even more knowledge. Consider the proposal to ban certain firms from trading in derivatives. To determine whether this ban makes sense, we would need to know both the impact of such trading on expected bailout costs and the private benefits that such trading yields for each firm. To micromanage a firm’s trading strategy, a regulator needs to know private benefits and social costs. Designing a sensible tax just requires knowing the costs to the taxpayer.
A tax is also less likely than regulation to stifle innovative activity. Giving a firm the option to act, for a price, is less intrusive than banning actions altogether. Regulations have often served industry insiders by creating barriers that prevent the entry of smaller competitors. An appropriate systemic-risk tax would have no such effect, since new firms would usually be small enough to fail. Since new entrants impose no risks on the rest of us, they wouldn’t need to be taxed.
A tax also generates revenues, which offset the cost of future bailouts. Of course, the fear, which I mentioned last week when writing about soda taxes, is that politicians may find such tax revenue so appealing that that they keep on increasing tax rates.
In the old days, we could pretend that tax dollars weren’t going to bail out banks, but we now know that this is false. The possibility of future bailouts provides a strong rationale for intervention, but before we act, we need to understand the rules concerning future bailouts, and to design policies that make companies pay for the social costs of their actions.
Mary Altaffer/AP Financial market regulation seems dauntingly complex, but conceptually it is no different than an efficient highway toll.
Both public interventions are justified by negative externalities, which occur when one person’s activity adversely impacts other people. On the highways, each driver slows everyone else, and tolls can speed traffic by keeping price-sensitive drivers off the road. In the financial markets, institutional risk-taking creates the risk of failure and federal bailout. The reason to intervene, on either the highways or the Bourse, is to limit the social damage created by people and companies that act without worrying about the costs that they impose upon others.
In the old days, everyone pretended that financial institutions had no federal guarantee other than deposit insurance. Public officials even kept up the fiction that Freddie Mac and Fannie Mae were independent, a pretense belied by the nearly risk-free interest rates that these institutions paid to their lenders. Now we know that Freddie and Fannie and plenty of other institutions were gambling with our money, and that gave them an incentive to take on plenty of extra risk.
The risk of future bailouts makes the case for further regulation, but we can’t design good policies until we know the new rules that will govern those future bailouts. Will the feds backstop everyone or just big banks? Does this guarantee always apply, or just during a downturn big enough so that a bank collapse could destroy the credit system?
In order to make a public case for particular rules, rather than just a vague sense that more regulation is needed, the government itself needs to act first and articulate a more transparent set of rules governing future fights against market meltdown.
Despite a few well-known exceptions, taxes generally beat regulations as a tool for correcting externalities.
For example, some places have tried to regulate their way out of traffic congestion by limiting access to central city roads based on license plate numbers — for example, saying that cars with plates that end in 5 or 6 cannot drive on Wednesday. These policies do nothing to separate drivers who really need to get downtown from unmotivated motorists. The rule does wonders, though, to inefficiently encourage the buying of extra cars. A congestion charge is better. It allocates roads to the people who value them most and generates extra revenue.
The case for taxes, rather than regulation, can also hold in financial markets.
Three years ago, Dwight Jaffee and I argued that the risks that Freddie Mac and Fannie Mae imposed on United States taxpayers could be handled either by limits or taxes on these institutions’ portfolios. Slapping an appropriate tax on these entities would have generated revenue and limited their desire to impose extra risks on the American taxpayer.
In principle, the appropriate systemic-risk tax on a financial institution is the product of two figures: the probability that this entity will receive a bailout, times the expected cost of that bailout. Obviously, that number is impossible to know without better understanding the rules concerning future bailouts.
Calculating such a tax may seem incredibly hard, but well-designed regulations require even more knowledge. Consider the proposal to ban certain firms from trading in derivatives. To determine whether this ban makes sense, we would need to know both the impact of such trading on expected bailout costs and the private benefits that such trading yields for each firm. To micromanage a firm’s trading strategy, a regulator needs to know private benefits and social costs. Designing a sensible tax just requires knowing the costs to the taxpayer.
A tax is also less likely than regulation to stifle innovative activity. Giving a firm the option to act, for a price, is less intrusive than banning actions altogether. Regulations have often served industry insiders by creating barriers that prevent the entry of smaller competitors. An appropriate systemic-risk tax would have no such effect, since new firms would usually be small enough to fail. Since new entrants impose no risks on the rest of us, they wouldn’t need to be taxed.
A tax also generates revenues, which offset the cost of future bailouts. Of course, the fear, which I mentioned last week when writing about soda taxes, is that politicians may find such tax revenue so appealing that that they keep on increasing tax rates.
In the old days, we could pretend that tax dollars weren’t going to bail out banks, but we now know that this is false. The possibility of future bailouts provides a strong rationale for intervention, but before we act, we need to understand the rules concerning future bailouts, and to design policies that make companies pay for the social costs of their actions.
No comments:
Post a Comment