How to Make TARP Politically Acceptable: Add a Tax on Securities Transactions

I propose that the Congressional leadership re-introduce the Trouble Asset Relief Program accompanied by a major new policy: a small tax on securities market transactions. This will accomplish the political goal of aiming a silver bullet into the heart of the (understandable) popular outrage that blocked passage of the TARP bill on Monday. It will simultaneously accomplish the fiscal goal of raising revenue, which the federal government sorely needed even before the bailout arose and will need even more if the taxpayer is to be protected against subsidization of the financial sector.

A tax on securities market transactions might sound like a wild populist policy that would damage the functioning of the economy. But in fact it is far more sensible than such populist measures as banning short sales which have already been tried to no effect.

Proposals along these lines have a distinguished pedigree. Best-known was the Tobin tax proposal, by Nobel Prize winner James Tobin which was specifically aimed at volatility in foreign exchange markets. More relevant to what I am proposing are two articles by the pre-Treasury Larry Summers: “A Few Good Taxes” and “When Financial Markets Work Too Well: A Cautious Case for a Securities Transactions Tax” (1989).   Add another Nobel Prize Winner, Joe Stiglitz.

There is extensive experience with securities transaction taxes, especially in other countries, and there have been quite a few studies of their effects. On the one hand, often the motivation for such proposals is to reduce short-term speculative turnover (a tax of 0.1% means nothing to a long-term investor, but is a strong disincentive to those who trade hold their positions for only minutes or hours), with the idea that this will reduce volatility. On the other hand, often the defenders of unfettered financial markets argue that such a tax will reduce liquidity and thus hurt the customers who depend on the market. The historical experience with small taxes seems to be that there is no discernible effect on volatility. In some cases the volume of trading within the country is affected. But what the tax does usually do is raise a lot of money.

The UK has long had a securities transactions tax known as a stamp duty on the order of 0.3%.  Sweden introduced a 0.50 per cent tax on the purchase and sale of equities in 1984, and kept it until 1991.  (Froot and Campbell, studied these two examples in a 1994 book that I edited.)   India introduced a securities transactions tax in 2004 and Japan, Korea, Taiwan and Hong Kong did so earlier; in these cases there were not significant reductions in either price volatility or market turnover.  Other countries that have had financial turnover taxes of at least 0.10% include Australia, Austria, Finland, Germany, Malaysia, and Singapore.  In addition there are other countrires that have smaller trading fees.

Even the United States imposes an SEC fee of .0033%.  Thus our virginity is already lost.

An important potential drawback if the US were to impose a more substantial transactions tax alone, is that it might drive financial business offshore.   There is an answer to this point.  As noted, lot of countries already have such transactions taxes. Furthermore, lots would love to cooperate with the United States in an international program to harmonize such taxes internationally. This is precisely the sort of thing that many abroad have always asked Americans to participate in, but that we have not hitherto wanted to do.

The level and longevity of the tax could be adjusted over time to achieve the goal of Section 134 the TARP bill: that the taxpayer recoup the costs of the bailout. A 2004 study by the Congressional Research Service reported that an 0.5% tax on stock transfers could raise $65 billion a year. (Others have produced higher revenue estimates.) A tax extended to bonds and derivatives (especially derivatives!) would of course raise more.   Remember that one does not compare this annual revenue to the $700 billion headline cost of the bailout;  rather one compares the present discounted value of the annual flow to whatever of the $700 billion is left over after the government (we hope) collects something on the troubled loans and also recoups something on the warrants obtained from the banks.

The tax might on the margin contribute to a shrinking of the size of the financial sector; but this shrinking needs to happen anyway, as Ken Rogoff has pointed out. And most important politically, it would give expression in a non-damaging way to the blood lust that the public feels toward Wall Street, a venting that needs to take place if the bailout bill is going to be approved.

The Revised Troubled Asset Relief Plan Deserved to Pass

When the Treasury came out with its $750 bailout plan on September 22, I thought it lacked so many necessary ingredients that it deserved a thumbs down. (Many others had similar objections, including George Soros.)

But in the negotiations between the Treasury and Congressional leaders over the course of last week, the missing ingredients were inserted. Starting with the additions that were most necessary on the merits, and moving toward the ones where the necessity was more political, they were:

  • Institutionalized oversight of the Treasury, which had previously been startlingly absent.
  • Provisions so that the taxpayer would share in the upside potential of banks and other financial institutions, rather than just socializing the losses, allowing the possibility that the government could recoup most or all of its short-term losses as has often ultimately been true in past unpopular bailouts.
  • First, by letting the government have equity stakes in the banks that sell their bad loans to the Treasury.
  • Second by having the president in five years submit legislation to recoup the cost from the financial sector if the taxpayer is still in the red at that point.
  • Limits on executive compensation, especially golden parachutes, at banks taking advantage of the opportunity to dump their bad loans on the Treasury
  • Dividing the $750 billion into three slices over time, which at least offers the congressional negotiators a little bit of cover.
  • A provision for possible government insurance of mortgages instead of acquisition of them. This was a bone thrown to the Congressional Republicans who had blocked the plan several days ago; I don’t know why they would want this provision, but at least it can’t do much harm.

    Some other proposed provisions, from both the right and left, were left out, and for good reason in most cases.

The plan (TARP for Troubled Asset Recovery Program) would still be unprecedented in magnitude and in the discretion it gives the Treasury Secretary. Even if the congress had passed it today, it would not have guaranteed an end to the financial crisis, let alone averting the recession that is probably already inevitable at this point. Furthermore it does little to begin with the reforms in regulation that our financial system now clearly needs.

Nevertheless, as distasteful as it is to be “bailing out” Wall Street, or even bailing out those homeowners who took out loans that they shouldn’t have, or bailing out policymakers who were asleep at the switch, my view is that the program is necessary. It is better than the alternatives:

  • better than the Treasury proposal of 9/22,
  • much better than the proposal we would have gotten from a pre-Paulson Bush Administration,
  • better than the alternative that the House Republicans were offering, and
  • (most important of all) better than the alternative of doing nothing, which would (will?) quite likely mean a severe recession.

I suppose it is not surprising that Congressmen facing elections in 5 weeks don’t want to go on record supporting something so unpopular. What will happen now that the House rejected the deal in its vote today?

Most likely the stock market and real economy will plummet, until the pain gets so bad that a bailout package like this one accumulates more support.

I expressed my views this morning on the NPR radio show On Point.

An Emerging Consensus on the Paulson Plan: Government Should Force Bank Capital Up, Not Socialize the Loans

Treasury Secretary Henry Paulson briefs reporters about efforts to heal the crisis in the U.S. financial markets, Sept. 19, 2008. (AP Photo)

In time of war, there is a tendency for both parties to rally around the president, as we saw (all too well) in Iraq after September 11. In time of financial panic, there is often a similar inclination. The two presidential candidates, for example, are being very careful in their statements. I don’t blame them. The issues are too complex to be taken on inside the context of a political campaign. Both candidates realize that the danger of a verbal misstep that the other side can try to blame for worsening the crisis is far greater than the likelihood that either one will come up with a brilliant solution that will gain widespread support or will solve the problem, let alone both.

Having said that, opposition to the $700 billion plan proposed by Treasury Secretary Henry Paulson September 19 has coalesced quickly, from both ends of the political spectrum.

Sebastian Mallaby also pursues the Iraq analogy in “A Bad Bank Rescue” in the Washington Post, September 21: “…in buying bad loans before banks fail, the Bush administration would be signing up for a financial war of choice. It would spend billions of dollars on the theory that preemption will avert the mass destruction of banks.”

We can all join in, tweaking the supposed free-market conservatives of the Bush Administration for proposing the biggest bailouts of history. But it is not the hypocrisy of the bailout that bothers me, or the size. I have used yet another military analogy: “They say there are no atheists in foxholes. Then there are also no libertarians in financial crises.”

The explicit lack of oversight or checks and balances in the Treasury proposal is worrisome — and it worries Congressional Democrats — with its overtones of suspending constitutional rights and checks in what was supposed to be a war on terrorism.

But the nature of the bailout, how the money is to be used, is what bothers me. As Mallaby says, “Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans.” Examples are not tied to a particular political viewpoint or party. He mentions the proposal of Ragu Rajan and Luigi Zingales that the government could tell banks to cancel all dividend payments; and one by Charlie Calomiris and Doug Elmendorf that the government could buy equity stakes in banks themselves, rather than just buying their bad loans.

Similarly, in today’s New York Times op-ed page, Paul Krugman on the left side and Bill Kristol on the right side both attack the plan. Krugman’s logic (“Cash for Trash“) is a good example of what Mallaby calls the core insight: “…the financial system needs more capital. And if the governments is going to provide capital to financial firms, it should get what people who provide capital are entitled to – a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.” Sounds right to me. You can’t socialize the losses if you don’t also socialize some of the gains.

What Does It Take to Define Away the Statistics Showing Superior Economic Performance Under Democratic Presidents than Under Republicans?

Economic Policy Institute, September 2008.

A panel on Supply Side Economics in Washington, September 12, included statistics on the superior performance of the American economy under President Clinton compared to his Republican successor. (The graph to the right, from Ettlinger & Irons, shows the first term of each administration. The growth gap widened subsequently.) Former Treasury Secretary Larry Summers gave some statistics that included Democratic versus Republican presidents throughout the postwar period. (The event was jointly sponsored by the Center for American Progress and the Economic Policy Institute.)

By coincidence, in a column in that day’s Wall Street Journal, Donald Luskins sought to “get something settled once and for all. Have the stock markets and the economy historically done better under Democrats or Republicans?”

Here is what he wanted to straighten us out on: “Superficially at least, the Democratic claims are true: Since 1948, the Standard & Poor’s 500 total return (capital gains plus dividends) has averaged 15.6% when a Democrat was in the White House and only 11.1% when a Republican was in the White House. You get a similar result if you look at growth in real gross domestic product. Under Democratic presidents, the average since 1948 has been 4.2%. Under Republican presidents it has been only 2.8%.” But then he goes on to argue that Kennedy should really be classified as a Republican (he cut taxes), Nixon as a Democrat (wage-price controls), George H.W. Bush as a Democrat (he raised taxes), and Bill Clinton as a Republican (free trade; and he might have added eliminating the budget deficit, supporting the Fed, reforming welfare, other policies that would normally be thought of as conservative). He argues that if you make these switches in party assignments, then the US stock market and economy has performed better under “Republican” presidents (which, remember, now includes Kennedy and Clinton) than under “Democrats” (which now includes Nixon and the first Bush).

I am still not sure whether the column was meant as a joke. At the risk of finding out that I have been taken in by a prank, I will assume that the author is serious. Brad de Long picked this one up right away, and thinks the author is serious. (Luskins, it turns out, is the guy who has apparently devoted much of his adult life to attacking Paul Krugman.) But Brad didn’t offer any sort of detailed rebuttal. I suppose one could argue “live by ad hominem, die by ad hominem.” But I think blogosphere courtesy, such as it is, calls for a substantive reply.

My first response is to point out that the Nixon, Bush and Clinton policies he cites are not isolated cases, but appear on a longer list of examples I like to give showing how for the last 40 years, rhetoric notwithstanding, Republican presidents have pursued policies that are surprisingly farther removed from the ideal of good neoclassical economics than have Democratic presidents. This is especially true if one defines neoclassical economics as the textbook version, which allows government intervention for externalities, monopolies, etc. But I would argue that it applies even to the “conservative economics” version that puts priority simply on small government.

The criteria underlying this generalization about Republican presidents are:
(1) Growth in the size of the government, as measured by employment and spending.
(2) Lack of fiscal discipline, as measured by budget deficits.
(3) Lack of commitment to price stability, as measured by pressure on the Fed for easier monetary policy when politically advantageous.
(4) Departures from free trade.
(5) Use of government powers to protect and subsidize favored special interests (such as agriculture and the oil and gas sector, among others).

I have documented in writings listed elsewhere that Republican presidents have since 1971 indulged in these five departures from “conservatism” to a greater extent than Democratic presidents. The name I would give to this set of departures, as well as to the parallel abuses of executive power in the areas of foreign policy (intervening in Iraq) and domestic policy (intervening in people’s bedrooms), is neither “liberal” nor “conservative” but, rather, “illiberal.”

My second response is to point out that the author is re-defining “Republican” and “Democrat” tautologically to be “good” or “bad.” A definition that departs so far from actual party affiliation does unacceptable linguistic violence. And of course it is circular logic to then find that the economy does better under “Republican” presidents than “Democratic.”

An analogy: Marx and Engels of course professed to have the welfare of the common man as their goal. The Soviet Constitution asserted that the USSR expressed “…the will and interests of the workers, peasants, and intelligentsia.” It claimed to embody democracy, the rights of freedom of speech, freedom of the press, freedom of assembly, freedom of religion, inviolability of the person and home, and the right to privacy. Needless to say, this was all pure rhetoric, which was continuously and comprehensively violated by the actual operations of the Soviet state. But by Luskins’ logic, the western democratic system, which did put these ideals into practice should be re-classified as communist, and the superior performance of the western system should be chalked up as going to the credit of communism! It makes no more sense to credit the achievements of Bill Clinton to the Republicans than it would to credit the achievements of western democracy to the Communists.

Supply-Side Economics Contradictions Live on in Washington

Politicians have always faced the temptation to give their constituents tax cuts.    But in recent decades “conservative” presidents have enacted large tax cuts that have been anything but conservative fiscally, and have justified them by appealing to theory.   In particular, they have appealed to two theories:   the Laffer Proposition, which says that cuts in tax rates will pay for themselves via higher economic activity, and the Starve the Beast Hypothesis, which says that tax cuts will increase the budget deficit and put downward pressure on federal spending.     It is insufficiently remarked that the two propositions are inconsistent with each other:   reductions in tax rates can’t increase tax revenues and reduce tax revenues at the same time.    But being mutually exclusive does not prevent them both from being wrong.   

The Laffer Proposition, while theoretically possible under certain conditions, does not apply to US income tax rates:  a cut in those rates reduces revenue, precisely as common sense would indicate.    As detailed in a new paper of mine “Snake-Oil Tax Cuts,”  for the Economic Policy Institute, this conclusion was the outcome of the two big experiments of recent decades: the Reagan tax cuts of 1981-83 and the Bush tax cuts of 2001-03.   It is also the conclusion of more systematic scholarly studies based on more extensive data.    Finally, it is the view of almost all professional economists, including the illustrious economic advisers to Presidents Reagan and Bush, even though it contradicted the views of their employers.  So thorough is the discrediting of the Laffer Hypothesis, that many deny that these two presidents or their top officials could have ever believed such a thing.   But abundant quotes  show that they did.

The Starve the Beast Hypothesis claims that politicians can’t spend money that they don’t have.  In theory, Congressmen are supposedly inhibited from increasing spending by constituents’ fears that the resulting deficits will mean higher taxes for their grandchildren.     The theory fails on both conceptual grounds and empirical grounds.   Conceptually, one should begin by asking: what it the alternative fiscal regime to which Starve the Beast is being compared?     The natural alternative is the regime that was in place during the 1990s, which I call Shared Sacrifice.    During that time, any congressman wishing to increase spending had to show how they would raise taxes to pay for it.   Logically, a Congressman contemplating a new spending program to benefit some favored supporters will be more inhibited by fears of constituents complaining about an immediate tax increase (under the regime of Shared Sacrifice) than by fears of constituents complaining that budget deficits might mean higher taxes many years into the future (under Starve the Beast).   Sure enough, the Shared Sacrifice approach of the 1990s succeeded.  Compare this outcome to the sharp increases in spending that took place when President Reagan took office, when the first President Bush took office, and when the second President Bush took office.    As with the Laffer Hypothesis, more systematic econometric analysis confirms the rejection of the hypothesis.


These matters are not solely of interest to historians or economists.   The presidential campaign of Senator John McCain appears set to drive its wagon down the same road in which Reagan and Bush have already worn deep ruts.   The candidate is apparently selling the same snake oil:  he says he believes that tax cuts increase revenues.   His principle policy director disavows the Laffer Principle, just as the economists who advised Presidents Reagan and Bush did.   But the views of the economic advisers are not what determines what these presidents do. 

“The Queen in Alice in Wonderland  said that, with practice, she was able to believe as many as six impossible things before breakfast.   Most of us are more limited in our capacity for credulity.  If John McCain believes both the Laffer Proposition (tax cuts raise revenues) and Starve the Beast (higher revenues lead to higher spending, anathema to conservatives), then as a good conservative, his duty is clear.  He ought to run on a truly novel platform of higher tax rates!   Why?   Higher tax rates would reduce revenues (this is what Laffer says would happen) and thereby reduce spending (this is what Starve the Beast says would happen).   

Seriously folks.   If McCain continues to propose extending the Bush tax cuts, he should at least be forced to choose between the Lafferite defense and the “Starve the Beast” defense. Only then can the rest of us know which of the two mutually inconsistent propositions to refute.


            I will be discussing my paper, in a September 12 panel where Larry Summers and Gene Sperling also give their thoughts on Supply Side Economics, at a joint meeting of the Center for American Progress    

and the Economic Policy Institute.     

Goldman Sachs Puts Odds That NBER Committee Will Declare Current Recession at 95%

A guest post, from Goldman Sachs — U.S. Economic Research:

September 9, 2008


To us, the very weak employment report last Friday pretty much closes the argument when it comes to whether or not the economy is in recession—it is.


The model puts the chance that August will be classified as part of a recession by the NBER at 95%.  Several factors push the probability so high.  Most important is the ongoing labor market deterioration.  The large increases in unemployment combined with the decline in payroll employment, both over the last three months, are very significant signs pointing toward recession.  The decline in the stock market and the fact that housing starts are off 30% from the prior year also push up the estimated probability.

In fact, April was the only month this year for which the data did not signal a recession, as the probability temporarily dipped below 50%.  The reasons for this were: (1) some temporarily better labor market data, since largely revised away; and (2) the brief rally in the equity market following the government brokered purchase of Bear Stearns.  Apart from this dip, the general trend has been a slow drift up from a somewhat high probability of being in recession to a very high probability.,.. 

….  Put differently, if the economy is not in recession now, then the meaning of the term has changed, at least according to this model. 

Anti-Shirking Import Penalties in US Climate Change Bills Could Backfire

 So both the Democratic and Republicans have officially nominated their candidates.  Remarkably — from the vantage point of just a few years ago – both Senators McCain and Obama are on record as supporting strong action for aggressive cuts in US emissions of greenhouse gases (GHGs).   In June 2008, the floor manager’s version of the Lieberman-Warner bill  – S. 2192: America’s Climate Security Act of 2007, which would cut emissions more than 50% by 2050 — came close to passing the Senate.   Some think that with the likely Democratic gain in Senate seats in November, and a more supportive White House, a form of the bill may well pass next year.  

 (Incidentally, the July Snowmass presentations regarding Integrated Assessment models of the effects of such emission-reduction policy plans, which I plugged in my preceding blog post, will be accessible to the public any day now.)


But issues of competitiveness and how to address it have risen to the top in the climate change policy debate among politicians.      The Lieberman-Warner bill – would have required the president to determine what countries have taken comparable action to limit GHG emissions;  for imports of covered goods from covered countries, the importer would then have had to buy international reserve allowances – equivalent to a tariff.  (The same with some of the bill’s competitors such as the Bingaman-Specter “Low Carbon Economy Act” of 2007.) 


In theory, there is a possible legitimate role for border adjustments in facilitating a multilateral regime such as the Kyoto Protocol.  One might think of penalties on carbon-intensive imports:

1.      as sanctions to apply pressure on non-participants,

2.      as a calibrated “countervailing duty” to equalize a distortion that will otherwise see carbon-intensive activities migrate to less-regulated countries (a phenomenon known as leakage)   or

3.      as political reassurance to domestic firms worried about their international competitiveness.

If designed properly, they need not necessarily be inconsistent with the WTO (World Trade Organization).    There are precedents, most importantly (and most ironically) the famous/infamous shrimp/turtle case.


But U.S. politicians are unlikely to do it properly.   They may be unaware that the US is more likely to end up as the target of such tariffs than as the enactor – to end up as the defendant, rather than as the prosecutor.   The European Union is way ahead of us in cutting back GHG emissions under the Kyoto protocol, and its EC Directive earlier this year had similar language calling for penalties aimed at shirking competitors.   That’s us.  The difference between their provisions for dealing with shirkers and ours is that their system is already in operation, while for the time being, we are the shirkers.  So US politicians had better look before they leap on this one.


The Brookings Institution had a conference in June that was well-focused on this set of policy issues, organized by Lael Brainard.  Interested readers can link to the papers at Climate Change, Trade and Competitiveness: Is a Collision Inevitable     Mine was titled  Addressing the Leakage/Competitiveness Issue In Climate Change Policy Proposals,” in the panel on Proposals to Deal with Leakages.   

The issues are reminiscent of larger fears on the part of anti-globalizers — that the WTO and free trade are obstacles to environmental regulation more generally — fears that I think are largely misplaced.   With well-designed multilateral policies, we can work to protect the global environmental from climate change while simultaneously preserving the economic advantages of free trade.