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Tuesday, January 26, 2010

What is the Role of Politics in Implementing Economic Policy?

Greg Mankiw points to Thomas Cooley's discussion of Obama's proposed bank tax:

The Problems With The Bank Tax, by Thomas F. Cooley: Last week the Obama administration announced a plan to impose significant new taxes on banks. It was high political drama. ... The whole tone of the announcement was that of a trip to the woodshed for misbehaving banks. The tax was presented as ... punitive...
The problem here is not the taxes per se. It is that the administration elected to treat the imposition as populist political theater. In doing so it missed the opportunity to articulate a well-reasoned economic policy to deal with too-big-to-fail institutions. ...
Another problem with treating the tax as punitive rather than regulatory is that it gives the banks and other financial institutions the ammunition to fight it. This administration tends to treat too many of the economic problems it faces as political. They end up being far less effective.
There is a very sound argument for levying new fees on financial institutions. The financial system as it is currently structured is extremely distorted, and its distortions are due to the way the system was regulated and by the regulators' responses to the financial crisis. ...
It is now clear to almost everyone except the institutions themselves that we created a big problem. Firms that are deemed too big or too systemic to fail have a safety net. They can take bigger risks and make bigger bets, secure in the belief that the government (or taxpayers) will guarantee their liabilities if they fail. Not only does this create perverse incentives for the risks that they take, it lowers their cost of raising new capital.
In the heat of the financial crisis Henry Paulson, Tim Geithner, Ben Bernanke and others decided it was better to protect all of the troubled firms (except Lehman and Washington Mutual) rather than let them fail. ...
That was then. Now we must figure out how to undo the damage. In a more perfect world we would do three things: 1. modify the bankruptcy code and create mechanisms to allow for the orderly failure of these institutions; 2. impose a tax on them that is proportional to the risk to the system that they create; and 3. treat that tax as an insurance premium to cover the cost of future problems, just as the FDIC charges banks for deposit insurance. ...
An important flaw in the tax is that it is designed only to recover the bailout costs already incurred. It should be an ongoing charge for the insurance against risky behavior. There should be two parts to such a charge: A portion to cover the risk a firm creates for itself and its investors by taking on excessive leverage, and a portion to cover the risk that leverage creates for the system as a whole. Ideally what we want is a fund that can cover the costs of a shock to the system in the future without the involvement of taxpayers. ...
At the end of the day what we need are mechanisms to deter excessive risk-taking at the expense of the taxpayer. The proposed tax is a very imperfect step in that direction. But we should hope that at the end of the process of designing a new regulatory structure we will have a set of measures that protect the taxpayer from having to bail out the financial system in future crises. One lesson that history teaches us very clearly is that crises will occur.

Before I read this, I assumed I'd disagree strongly, but I don't -- I mostly agree. However, I don't think the recommendation that the administration focus on economics rather than politics is good advice.

The main reason he gives for this advice is that the the current strategy "gives the banks and other financial institutions the ammunition to fight" the tax. However, the banks are going to fight the tax in any case, and they can play the "victim of populist backlash" whether or not the administration specifically identifies the tax as punitive (e.g. "the Obama administration says it's for economic reasons, but this is nothing more than populist pandering resulting from fear of losses in November...").Why fight with just one hand when the other side will use both?

And anyway, what's wrong with saying that banks need to punished when the meaning of punished is to pay taxpayers taxpayers back? He objects that this was portrayed as "a trip to the woodshed for misbehaving banks," but isn't that how changing incentives works? Would bank behavior improve in the future if they weren't asked to pay for the damage they caused, if they weren't figuratively "taken to the woodshed"? How do you change incentives without the fear of a penalty (punishment) of some sort? How do you credibly establish that the penalty will be assessed in the future if it is not assessed now?

We're not even asking that banks and other financial institutions pay the full cost of the damage they caused, only the part that taxpayers covered. That is far, far short of the total damage.

I don't want politics to be used to implement bad economic policy as has clearly happened in the past, so I fully agree that the economic arguments need to be clearly articulated. Good economics is, or at least should be, a necessary condition before the political arguments are made. But good economics is not a sufficient condition for good policy, and the political arguments have a role to play.

[I'm not completely comfortable with this argument, so let me offer it as something to argue for or against rather than a solidly held position.]

    Posted by on Tuesday, January 26, 2010 at 04:34 PM in Economics, Financial System, Regulation, Taxes | Permalink  Comments (22)


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