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The Wall Street Journal seems to have let a moderate into its lair. John Cassidy, the author of How Markets Fail: The Logic of Economic Calamities, explains several novel concepts to the market worshiping legions, whose disbelief/horror is clear from the comments. The article is a discussion of the theories of Arthur Cecil Pigou:
Mr. Pigou pioneered the study of market failure—the branch of economics that explores why free enterprise sometimes [sic].
…
But while Mr. Pigou believed capitalism works tolerably most of the time, he also demonstrated how, on occasion, it malfunctions. His key insight was that actions in one part of the economy can have unintended consequences in others.
One example is the subprime market. The crash in this market was partly responsible for the Crash of 2008. Pigou would say that this kind of risk requires governmental regulation. He would agree that some market risks can be dealt with by private parties, but there will always be some spillovers between different markets that cannot be solved by private agreements.
To correct the problems that spillovers created, Mr. Pigou advocated government intervention. Where the social value of an activity was lower than its private value, as in the case of a railroad setting ablaze the surrounding woodland, the authorities should introduce “extraordinary restraints” in the form of user taxes, he said.
The huge securities trading of the giant banks is just that kind of problem: the value to traders is much greater than the social value. Society gains nothing from flash trading. In fact, every one of those trades costs investors money. It amounts to a tax on small investors, one that only exists because traders make rules that favor themselves. Day traders, who try to make a few pennies per share on rapid trading are doing nothing of value, and neither are computer programs that try to exploit price differences between markets. It isn’t clear that big chunks of trading have any value.
Goldman Sachs is a great example of this problem. For the last 12 years, GS has reported four categories of income: investment banking, which includes both income from underwriting issuance of securities for others, and income from mergers and acquisitions; asset management; trading; and interest. The following chart shows the percentage each has contributed to total revenues over that period (2009 is the first three quarters only.)
click chart to enlarge
The benefit to GS is obvious: trading is hugely profitable, and contributed most of its revenues. The benefit to society isn’t. To me, this justifies the imposition of a tax on securities trading, called a Tobin Tax. The original idea was to impose a small tax on every foreign currency transaction, to reduce the risk that currency speculators might wreck a nation’s economy. Of course every country has to do it or it trading will move somewhere where there is no tax. Now the idea is to impose it on all securities transactions. Geither is opposed.
Cassidy points to a Washington Post Op-Ed by Treasury Secretary Geithner and Larry Summers of the National Economic Council, discussing the Great Crash, in which they say that one function of the financial system is to reduce and distribute risk. This is a novel description of the role of the financial markets. I thought their role was the allocation of capital to its best use, as Lloyd Blankfein explains. However, it is clear from the chart that raising money for business is a tiny part of Goldman Sachs’ business.
Let’s take a look at a recent case discussing this risk reduction and distribution business. In BKB Properties, LLC v. SunTrust Bank, 2009 WL 3169677 (M.D. Tenn. 2009), the borrower wanted a bank loan with a long term fixed rate, and the bank wanted a variable rate to protect itself. The parties agreed to an interest rate swap agreement which had the effect of creating a fixed rate. The loan agreement had a provision permitting the borrower to prepay the loan at any time without a penalty. The swap agreement had a prepayment penalty.
The borrower asserts that he didn’t know that. He argued that the termination penalty for the swap agreement contradicts the idea that there was no penalty for prepayment on the loan. That seems right to me, because the two were so closely related. The Court points out that the swap agreement is really complex, and that it may well have been the case that the borrower didn’t know. But, says the Court, the borrower took the risk that he didn’t understand, signed anyway, and is stuck with his contract.
This is a typical holding in swap cases. The Court finds that both parties are sophisticated, and the fact that the bank understands what it is doing better than the borrower isn’t enough to call for court protection. This is what Geithner and Summers are talking about when they refer to “reducing and distributing risk”.
Tell me again why we don’t tax this business?
Goldman Sachs Tower courtesy wallyg
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Gee, back in the 1990s, when I was on Wall St., I thought the most important part of economics in the period ahead would be studying market imperfections and figuring out the most efficient way to deal with them. Imagine that. Haven’t heard a thing about that in the intervening 15 years until today.
The idea of taxing transactions which have harmful social effects but benefit the parties to the transactions is getting some play. In today’s NYT, columnist Robert Frank discusses several other examples.
The problem I have with a transaction tax is that it has a greater affect on the small guy. A retail investor doesn’t have the tax loop holes that GS has – nor an off-shore office, “losses”, and so on. When your investment strategy is designed to make a few percent a year (retail), the investment tax takes a bigger hunk than for the computerized traders, who make hundreds of percent per year. We already have laws on the books to tax income – and if the High Frequency Trading is causing too much income, how about fixing the tax laws so that GS actually pays some tax on their income?
Alternatively, if High Frequency Trading or arbitrage are causing problems, then regulate them, and enforce the regulations. Set hold time minimums, don’t allow front-running, and so on. But to stop me from trading leveraged assets (options, futures) through taxes on possibly losing trades, does nothing to stop the large investment firms. Tax income, not transactions. It sounds too much like the Stamp Act.
You can hold your breath for the amount of time it will take O’s Wall St. buddies to get him to snuff that idea.
Small fry need to have their heads examined if they’re doing day trading. Anyhow, if you feel sorry for them, you could waive the tax for a certain number of transactions/entity, or whatever. Regulating is much more difficult than taxing and the govt needs revenue.
Cause the banks are probably still leveraged to the hilt and any drop in profits could destroy them?
My point is that trading for the sake of trading is has no actual value. A small tax, say .1%, won’t harm a buy and hold investor, but will cut into the profits of a guy trying to make .2% on a trade. Reducing the potential profit will significantly reduce the trades. Alternatively, it will capture a big chunk of the profits for the government, and thus for society at large.
It is important to remember that most nations would have to do it, or the trading would move to the holdouts.
I think your idea will be implemented…after we have another banking crisis.
They could pay their executives less – nobody needs more than $2 million a year. (They don’t need that much, but I’m willing to pay them that – if they don’t f*ck up the economy. Again.)
as you point out, a lot of these trades are done for that one or two cent advantage, let’s add some of that to our treasury.
Additionally, buy-and-hold investors – which is most of them, I suspect – aren’t doing a lot of trades, all the time, so they aren’t loading down the system.
And the proposals generally have a minimum below which they won’t apply.
Perhaps you’re more up on the laws being considered than I am. I didn’t see the transaction tax being restricted to day trading.
If I buy IBM, I pay a tax. If I sell IBM, I pay a tax. If it goes up 5% between those trades, I’ve given 10% of my profits to the transaction tax (0.25% each way), plus I’ve paid income tax on the 4.5% profit remaining, so another 1.5% or so. So in an investment that I held for months (or years), which on paper makes 5%, I get 3% and the U.S. and state government gets 2%.
Now, if I lose 5% over that time, I actually lose 5.5% (a 10% greater loss) due to the income-blind transaction tax.
In fact, volatile shorter term trades make more sense with a transaction tax, not less. This punishes the slow, gradual approach to investing much more than the risky, very short term trades.
Because speculation or prepackaged financial instruments are effectively borrowing from the taxpayer, there should be a fund, like the FDIC, that charges a tax or fee to cover the risk if the loan from the taxpayer fails. The reason it is a loan is that for all intents and purposes the taxpayer is providing a guarantee or collateral for any failure. Companies could either opt to pay the fee or restructure their business–downsize–so that there is no risk to the taxpayer. In addition, taxpayers should be allowed to sue in court any company that puts them at risk financially by adding on the national debt. “Too big to fail” is a misnomer. The reality is “So large as to be liable” to the taxpayer.
Agreed but it won’t happen until the banks collapse again.
Well, it’s not gonna happen, but anyhoo…
Buy & hold investors, a PJEvans points out, don’t do a lot of trades.
I don’t understand. Could you please explain?
And if such a company lost such a lawsuit, how would it pay the award?
Without going into the ethics of short-term trading, it still is better to trade highly volatile stocks, bonds and even futures with the transaction tax, rather than trading the slow-moving, stable stocks. If you have a method that makes two or three times the transaction tax per trade, then the more trades, the better you do. Only the “buy-and-hold” strategy, which makes much less than short term trading, per trade, is hurt to such a great degree.
How often have you heard investors brag about making 10% per year, especially in down years? And if transaction taxes take 0.5% out of each trade, and they made 10 big trades averaging 1% each, then they now have only made 5% – before income tax!
But the different rates of return in your hypothetical already exist, and influence behavior. All the transaction tax does is make the frequent trading of volative financial instruments less profitable than it currently is.
My last message (18) partly addressed this. If you watch the Dow Jones or S&P, you find that most days the range is much larger than the difference from the opening price to the closing price. The same is true when you compare the low and high for a week, to the Friday closes. “intra” ranges are relatively large, while the long-term hold moves slowly, if at all.
To beat a 0.5% transaction fee, you need to make, say, 1% or better. A short-term trader can do that many times, even in a declining market, while a long-term, buy-and-hold investor may have to wait months (or years in a Bear market) to come out ahead.
This is true comparing all time frames. Many days the S&P 500 closes almost exactly where it opened (see Monday, 11/30/09), while covering a tradable range (13.5 points – $675 in emini futures). That low-to-high is about 8% of the margin for the emini – so paying 0.5% to make 8% is worth it. [That would be a perfect trade - but making just 4% is worth it.] While a buy-and-hold position made nothing that day.
Unless the round-trip transaction tax is large compared to the intra-day moves, it won’t stop day trading, but the larger the tax is, the worse it is per trade for everyone, including long-term investors.
I’m not talking about ethics. I’m directly saying in-and-out trading may be fun and profitable, but it has little social value. It doesn’t cause much problem when people with little money do it, but when Goldman Sachs does it for billions and billions of dollars, it causes all kinds of serious problems. Among other things, it is a direct tax on the vast number of investors who follow the buy and hold theory, that is, actual investors.
Yes, I agree. The transaction tax makes trading less profitable, but not necessarily “less profitable relative to X”, where “X” is the socially desirable method of trading. It will have some unintended consequences. How about all those highly traded mutual funds in peoples IRAs? Especially the ones barely breaking even, or losing money? How high will their transaction taxes be? Or do I hear the “exception” being written? We like some frequent traders but not others?
Directed regulation and laws are a better method than transaction taxes.
I agree completely. Again, without too much of the ethics of trading, I think that front-running, HFT, direct high speed connections to markets (which lay-people can’t access), and other methods GS and other “big boys” use are to the detriment of the markets, and thus to society in general (as many here have mentioned). Those firms, however, will get around a transaction tax, I’m sure of it, but I don’t think everyone else will be able to avoid it.
By the way, I’m opposed to social engineering via taxes, though I’m in favor of progressive taxes, including progressive corporate taxes. If something is bad, make it illegal, if it is just sort of bad, regulate it. If group A doesn’t like what group B does, I can’t get behind taxing group B more.
This “trading” tax, or “Wall Street only tax”, as they are disguising it, is purely Main Street, middle class wealth destruction. Bait and switch and increase: As bait to lure investors into the trap, some in Congress are proposing a modest dollar amount and insignificant exemption for our accounts. How long will that last? “Oh, our new tax is not bringing in the projected revenue. There go your exemptions.” How long will that “tiny” tax of 0.25% last? “Oh, it’s not bringing in the projected revenue. Let’s increase it to a modest 2%.” “Now that we’ve got our foot in the door, we can do anything we want.”
Going back to 0.25% tax with or without an exemption: The cost of the transaction tax is nothing compared to the increase in the bid-ask spread as result of all that competitive, “socially useless” trading activity being halted. That’s the whole point the proponents say. A few far out, pro tax economists gleefully say it will shrink the financial sector and trading activity back to the 1980′s. I remember paying $100 broker fees and paying more than $0.50 per share on the spread. The spread cost alone would be 2% on a buy or sell of a $25 stock. So expect annual yields to be reduced by several percent. Reduced compounding over a lifetime will easily result in achieving only half of our retirement goals. Not to mention the hundreds of thousands of jobs lost, most not even directly related to finance as the dominoes tumble. A few in Congress are up to something no good as the studies I have read from countries that have or have tried this tax reveal results including net negative revenue, huge job loss, and economic growth reversal. With all the negative evidence, no one in their right mind would even propose such a tax.
Thanks. I started to discuss volatility, but thought this wasn’t probably the place. Glad you did. Few people realize the overhead associated with bid/ask, commissions, taxes, interest rates on margin, and so on. It adds up, and fleeces the small investor, more so than the big boys, who write the laws, and don’t pay commissions or interest.
Perhaps you have a better idea for funding the government. Goldman Sachs made over $50bn trading securities over the last 12 years. Every nickel of that came out of someone else’s pocket.
One or two tenths of a percent.
To make this clearer, take another look at my admittedly brief explanation of Pigou’s idea. The article I linked gives a much better idea of this theory, which I think deserves attention. A lot of people argue for a consumption tax, like a VAT, on the theory that investing for the future should be protected at the expense of decreasing current consumption.
Generally, I agree that using the income tax to effect social policy is a pretty bad idea. That isn’t true of sin taxes, nor is it true of the Tobin tax and many other examples of taxing the thing we don’t want.
First, masaccio, thanks for this thread. It has really made me think. Still opposed to the transaction tax (on my only source of income), but I’ve thought about the issue a lot today.
As for sin taxes, I’m opposed to those on my sins (beer, wine, gasoline), but okay on other folks sins (tobacco, luxury autos …). No, I’m really opposed to using taxes to regulate, since they almost always hit the less fortunate disproportionately. What percent of a millionaire’s income goes to gas tax? Tobacco tax? Alcohol tax? But they can add up for low-income, commuting or rural cigarette smoker with a drinking problem… I’m not talking about me ;-)
Would that source of income be dividends from held securities or gains from speculative trading?
Thanks. These are difficult issues indeed, and putting aside our own interests in the search for good policy isn’t easy.
Goldy makes so much money because they are so huge. We had the perfect chance to have Goldman and their kind go through a systematic and orderly bankruptcy and let responsibly run businesses divvy it up and continue with Goldman’s assets and business….. these bailed out firms and the government are so entrenched you can’t tell them apart…….while small town banks as a result of what the big firms did are left to fail. A decade or two ago, government policy required riskier lending and these businesses did a poor job of negating the risk. And the government and business fail to acknowledge that.
The various local and Fed governments are spending plenty of money. It’s well over $20,000 per capita now. Where does it all go? That’s more money than I make annually the last few years. I’ve had to take extreme measures on how to scrimp, save and do without. The governments have never considered going through what I have.
Other countries and studies have made it clear that a transaction tax of any sort will reduce net revenue. The huge UK financial firms are entirely transaction tax exempt, while the only payers of the tax are the unknowing poor and middle class. The UK studies show that if they removed the tax, revenue would be much higher from increased investing and increased economic growth and capital gains, but there is resistance from the exchequer that collects the transaction tax. The transaction tax acts as huge inefficiency. When people and their capital are allowed to fill in the inefficiencies and perhaps make money on their investment, the economy and businesses grow along with increased tax revenue.
If this tax is enacted, unbeknownst to most of us, like in the UK, Goldy and their ilk will receive an exemption or find a loophole to the transaction tax or simply pass the cost onto us. Small financial firms will have to pay the tax, or go out of business. Main Street investors simply will not invest in new businesses that create jobs for us.
Goldman Sachs: ‘Trading With Advantages’
I am doubtless naive. But I don’t understand the claim that you are making. To my untutored eye, it seems that the transaction tax as proposed would hit traders but not investors. If anything, it would protect small investors by removing one of the incentives for gaming the system and skimming off value before small investors can realize it.
Flipping stocks continually to exploit–or drive–small price fluctuations seems like something only a giant like Goldman could make money at. It requires capital in serious volume and exemptions from the retail transaction fees that small traders and investors have to pay to a brokerage. They make a lot, but the amount per trade is pretty small. An actual investor, as opposed to a speculator, will hold stocks and engage in relatively few trades. The investor pays nothing as long as he holds his stock, and a tiny fraction of the accumulated value when he cashes out in handful of trades, and, say, retires. The flash trader pays the same amount but on vastly more trades and over far too little time for much value to accumulate. So, to him, the tax amount is just a little more than each of his high-volume trades nets. So the tax hits the speculator much more than the investor and, in effect, wrecks the former’s business.
Which itself sounds like a good thing. The value that goes into Goldman’s pockets as a result of all this flipping has to come from somewhere. My guess is that it comes out of the long-term value of the stock. So, in effect, the big trading outfits are skimming the profit off before it ever trickles down to my little 401K. My 401K gets to subsidize the overhead costs of the big traders and takes the hit when a stock drops. But it never gets the full value when the stock peaks, because the peak is gone by the time it gets to me.
Putting money into an enterprise that you think will do well and hoping to share in the profit when it does is one thing. What Goldman does–what any stock flipper, flash trader, or speculator does–is just gambling. It just lacks the respectability of craps (at least the guys dicing on the corner play with their own money).
So, at this point, I have to think that anything that hurts Goldman is good for the country. Either this tax puts them out of the flash trading racket and the value stays in my portfolio. Or Uncle Sam takes the value away from them and, maybe, uses it for the public good. Either way, I think I would be better off.
So what is it that I don’t understand?
I’m not a writer and not good at explaining things. Many try to rationalize the big moves down or lack of rising markets by simply believing the system is being gamed. Markets have always moved in chunks, with or without high volume trading. No one was complaining about high trading activity during the 80′s and 90′s as stocks increased 15+ times. This was when technology became affordable for smaller trading firms and individuals. This created a huge increase in trading volume. The bid-ask spread fell further from all of the trading volume and competition, helping long-term investors reduce costs. Long-term investors reacting to fundamentals data are the only ones capable of moving the markets up or down over a significant time period of weeks, months, years. The market has gone nowhere the last decade. The fundamentals have been awful for the last decade as other countries are taking US market share. Long-term investors react to that. Long-term investors are the ones that crashed the market as they reacted in fear to the crisis and are the ones driving it back up as fear subsides.
The bid-ask process entails multiple intraday trading of stock inventory where positions are not held overnight. This activity does not move the market in the long term direction that we are interested in. Traders can’t take profits from the long term price accumulation of the stock, only from the spread and hopefully from any intraday price volatility inefficiencies. Prices become less volatile during the day with more trading activity which can help the long-term investor get a fairer price instead of a range of up to 2% or more in price swings.
There is an economist that is a huge promoter of this tax, to sell his book apparently. He says that the tax will definitely return trading volume to the 1980′s. Right now when we or our fund managers buy a stock share, because of all that competitive trading activity, we pay $0.01 per share. That is the bid-ask spread cost that we pay and the market maker gets. The bid-ask spread will go up because this tax will stop more than 90% of the trading activity, eliminate trading competition and send what is left to the surviving big firms like GS. Then the cost increase happens. In 1986 the average spread was $0.53, that is about 2% cost upfront that we will pay to a market maker like GS. The transaction tax exemption will not exempt us from the bid-ask spread cost. Broker fees will also rise considerably as most will fail to stay in business. I expect to lose about 4% per year just on the purchase of stock or in my fund’s yield.
The big firms have been silent on this issue. The rumors are that once the tax shuts down independent traders and small firms, the competition will be eliminated and drive business to GS and ilk. Then the spread cost will go up. They will be charging you 2+% or charge you via your fund manager. I see that most of GS profits come from the bid-ask spread as they are acting as market maker and not their disastrous banking division.
Again, it does not matter if our accounts will be exempt from the tax, as the cost of the tax will be minor in comparison to the increase in fees and the bid-ask spread that we will not be exempt from. I’ve been worried about this tax for the past year after hearing about it for the first time. I have read hundreds of articles and studies. It does not make any sense at all to implement this tax.