Dean Baker
Co-Director of the Center for Economic and Policy Research, Washington, DC
Most of the debate over reforming the financial system in the wake of the financial crisis has not addressed the fundamental problems that led up to the crisis: an enormous asset bubble and a bloated financial sector. Serious reform should place these items at the top of the agenda.
The asset bubble took the form of a huge over-valuation of housing prices in the United States and many other countries. This over-valuation led to a distorted
pattern of growth, with enormous overbuilding of housing and a consumption boom driven by trillions of dollars in housing bubble wealth.
The pattern of growth was more distorted in the United States than many other countries because there are few obstacles to construction and it is relatively easy for homeowners to borrow against the wealth in their homes. During the peak years of the bubble, the residential construction share of US GDP expanded by more than 2 percentage points above its normal level. The savings rate fell to less than zero from a historic level of close to 8.0 percent, implying that housing bubble driven consumption was more than 4 percentage points of GDP.
When the bubble burst, residential construction and consumption both fell sharply. There is no simple mechanism for replacing a sudden drop in GDP of more than 6 percentage points. The financial crisis accompanying the bursting of the bubble worsened the situation, but the bubble itself virtually guaranteed a severe recession. This fact was entirely foreseeable. It was therefore remarkable negligence on the part of central bankers, most importantly the Federal Reserve Board in the United States, to allow a housing bubble to grow to such enormous proportions.
The lesson from this episode is that central bankers must take very seriously their responsibility to prevent major asset bubbles that distort patterns of economic growth. In this case, deflating the housing bubble before it reached dangerous levels was a far more important priority than any other possible concern of the central bankers.
A commitment to maintaining economic stability required that they take every possible measure to attack the bubble. The first and most important step would have been to use their research capabilities and their platform in public debates to carefully document and present the evidence for the existence of a bubble and the harm that will caused by its collapse. It is likely that this information alone would have had a substantial impact on the housing bubble, since an explicit and well-documented warning from central bankers that homeowners and lenders would lose money by investing in housing, likely would have been a substantial deterrent.
Central bankers also should have used their regulatory powers to clamp down on bad lending practices (such as offering low initial ‘teaser’ rates, which subsequently re-set to higher levels) that were inflating the bubble. These practices were quite evident in the United States, where the non-prime segment of the mortgage market exploded in a period in which the labour market was weak and income growth non-existent. Accounts of fraud in mortgage issuance were widespread. Not seeing these practices required an effort at deliberate avoidance on the part of regulators.
The best way to ensure that regulators don’t fail to the same extent in the future is to fire the ones whose failure led to the current crisis. This is essential for eliminating the asymmetry of incentives that now exist. It will always be difficult for regulators to take steps to curtail the actions of powerful financial institutions. Therefore they have a strong incentive to ignore lending practices by banks even when they are harmful to the economy. For this reason, regulators must know that the failure to stem dangerous practices by the financial industry also will involve serious risks to their careers. If the failure to regulate effectively does not imply career risks, the predictable result of these asymmetric incentives is that the regulators will defer to the financial industry and ignore dangerous practices in the future.
This raises the second essential financial reform that is needed. The financial industry needs to be downsized. In the United States, the financial sector accounts for more than 30 percent of all corporate profits. The investment banking and commodity trading sectors of the U.S. economy have nearly quadrupled as a share of GDP over the last three decades. Financial services are an intermediate good, something that is produced in order to be able to make the final goods that we want to consume. If any other intermediate goods sector had similarly expanded relative to the economy, for example trucking or warehousing, there would be concern over the enormous inefficiency of these sectors. There should be concern about the incredible waste of resources in the financial sector, the vast majority of which are consumed in highly profitable rent-seeking activity, not greasing the wheels of the real economy.
The bloat in the financial sector is especially pernicious because of the patterns of compensation in the sector. The sector offers its top earners salaries that are out of line with pay in other industries. This undermines pay structures elsewhere in the economy, leading to greater inequality.
The obvious way to limit the size of the financial sector is with a system of modest financial transaction taxes (FTT) similar to the stamp tax on stock transfers in the United Kingdom. A modest tax will have almost no impact on financial transactions that serve the real economy. For example, almost no one is dissuaded from buying stock for long-term investment by the 0.25 percent tax in force in the UK; in fact this tax just raises the transaction cost back up to the levels that existed two decades ago. However, this tax will have a large effect in dissuading short-term speculation. Scaled taxes on options, futures, credit default swaps and other instruments would have a similar effect. Fewer transactions will shrink the industry. A system of FTT can also raise an enormous amount of revenue. The stamp tax in the UK raises a bit less than 0.3 percent of GDP. A broader set of FTT could raise close to 1.0 percent of GDP. The experience of the UK also demonstrates that such a tax is easily enforceable (it has the lowest administrative cost of any tax). Rewards to employees for reporting non-compliance by their employers would help to stem efforts at evasion of more far-reaching taxes.
The revenue raised through a set of FTTs would help to offset the debt incurred by governments across the world as a result of this crisis. In this sense it would be especially appropriate to have a tax on the sector that was resposible for so much damage to the economy and society.