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.)
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