AIG headlines have overshadowed the important policy discussion about systemic risk created by the “too big to fail” (toobtof) institutions. The best way to manage systemic risk is to minimize it. The most effective way to minimize systemic risk is to tax the Toobtofs who create it. This is a market-based approach which should appeal to serious policymakers across the political spectrum.
Financial markets will remain in turmoil until the outlines of federal economic and regulatory policy become clear. Nearly all of our policy actions under both the Bush and Obama administrations in this crisis have tended toward the further centralization of power and control in the federal government. The source of the problem is the systemic risk created by over centralization. The impulse to grab federal control of this risk is understandable, but amounts to creating one politically controlled Toobtof. Regulating is expensive and it hasn’t worked. Taxing the Toobtofs will raise revenue and devolve economic power to institutions that truly compete with private capital. It will re-personalize and depoliticize finance.
The policy debate is really dominated by so-called free-market advocates and those with more socialist impulses. We actually have a hybrid system which doesn’t correspond well to either school of thought. The federal centralizers are talking as if there was no regulatory oversight of financial markets. The free-marketeers are trying to blame Fannie and Freddie for the whole mess. In reality the regulatory framework favored the aggregation of risk and the minimization of capital. Market participants acted in accordance with the incentives the regulatory framework gave them.
The official Federal position was that there were no Toobtofs, but everyone knew otherwise. When the umpire pays for the strikeout, the batter’s incentive is to swing for the fence. The umpire’s incentive is to not see the strikes. This problem is aggravated by the seamless manner with which public officials come and go between the New York and Washington. The umpires have usually been batters and they call today’s game knowing they may be batting in tomorrows. As one wag put it, “Presidents come and go but Goldman always runs the Treasury”.
There is a tremendous amount of private capital on the sidelines awaiting an understanding of the emerging relationship between public and private risk. This money will not step out on the dance floor until the federal orchestra strikes up a danceable tune.
We are not really getting a clear picture of President Obama’s vision of the federal framework within which financial markets should operate. Campaign promises aside, we shouldn’t expect him to have solved the problems in 60 days. We should expect him to stop reminding us that he inherited the problem. It is dangerous to have someone managing a problem they refuse to own. He could say that these problems are simply beyond the scope of the federal government to solve. This observation would be both true and a powerful policy clarification. The goal of federal policy shouldn’t be to solve the problem. The goal should be to create a federal framework within which people can solve problems on a decentralized basis.
The systemic risk posed by Toobtofs is what economists refer to as an external social cost. It creates a misallocation of resources because the producer does not experience the total cost of production. When I studied economic policy, the textbook said that these external social costs should be taxed in order for markets to function efficiently.
The massive infusion of capital into the banking system really just makes explicit the implied public capital support these Toobtofs have benefitted from. The Toobtofs have defined the competitive landscape of financial markets to the detriment of those institutions which truly operate with private capital. Naming and taxing Toobtofs accomplishes three important policy objectives.
1. It discourages and minimizes systemic risk.
2. It provides the public an “equity” return on the implied public capital these institutions employ.
3. It levels the playing field for those institutions which do not operate with implied public support.
Therefore, it will draw private capital back into straightforward financial intermediaries.
This is an idea that should enjoy broad public support. It will reduce risk, reduce regulatory costs, raise revenue and make financial markets more efficient. The opposition will come from Toobtofs and their regulators.