prohibition vs taxation: A novel way to think about financial regulation

Andrew Haldane of Bank of England once again gives a super speech.

The speech is divided into two parts.

The first part discusses the costs of current crisis. In this he looks at various ways to estimate the  cost of the crisis. Overall the numbers are similar whichever method you apply- it is around USD 100 billion. 

The narrowest fiscal interpretation of the cost of crisis would be given by the wealth transfer from the government to the banks as a result of the bailout. Plainly, there is a large degree of uncertainty about the eventual loss governments may face. But in the US, this is currently estimated to be around $100 billion, or less than 1% of US GDP. For US taxpayers, these losses are (almost exactly) a $100 billion question. In the UK, the direct cost may be less than £20 billion, or little more than 1% of GDP.

But these direct fiscal costs are almost certainly an underestimate of the damage to the wider economy which has resulted from the crisis – the true social costs of crisis. World output in 2009 is expected to have been around 6.5% lower than its counterfactual path in the absence of crisis. In the UK, the equivalent output loss is around 10%. In money terms, that translates into output losses of $4 trillion and £140 billion respectively.

However, output costs could overstate:

It could plausibly be argued that these output costs are a significant over-statement of the damage inflicted on the wider economy by the banks. Others are certainly not blameless for the crisis. For every reckless lender there is likely to be a feckless borrower. If a systemic tax is to be levied, a more precise measure may be needed of banks’ distinctive contribution to systemic risk. One such measure is provided by the (often implicit) fiscal subsidy provided to banks by the state to safeguard stability. Those implicit subsidies are easier to describe than measure. But one  particularly simple proxy is provided by the rating agencies, a number of whom provide both “support” and “standalone” credit ratings for the banks. The difference in these ratings encompasses the agencies’ judgement of the expected government support to banks.

Table 2 looks at this average ratings difference for a sample of banks and building societies in the UK, and among a sample of global banks, between 2007 and 2009. Two features are striking. First, standalone ratings are materially below support ratings, by between 1.5 and 4 notches over the sample for UK and global banks. In other words, rating agencies explicitly factor in material government support to banks.

Second, this ratings difference has increased over the sample, averaging over one notch in 2007 but over three notches by 2009. In other words, actions by government during the crisis have increased the value of government support to the banks.

Table 4 shows the estimated value of that subsidy for the same sample of UK and global banks, again between 2007 and 2009. For UK banks, the average annual subsidy for the top five banks over these years was over £50 billion – roughly equal to UK banks’ annual profits prior to the crisis. At the height of the crisis, the subsidy was larger still. For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year. These are not small sums.

So, overall we have similar results. He even calculates the net present value of future crisis and finds figure somewhere between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK!!

However, it was the second part of the speech which interested me more. He helps you understand the debate on financial regulation so much better.

In the beginning of the speech, Haldane says systemic banking risks are also pollutants.

The car industry is a pollutant. Exhaust fumes are a noxious by-product. Motoring benefits those producing and consuming car travel services – the private benefits of motoring. But it also endangers innocent bystanders within the wider community – the social costs of exhaust pollution.

Public policy has increasingly recognised the risks from car pollution. Historically, they have been tackled through a combination of taxation and, at times, prohibition. During this century, restrictions have been placed on poisonous emissions from cars – in others words, prohibition. This is recognition of the social costs of exhaust pollution. Initially, car producers were in uproar.

The banking industry is also a pollutant. Systemic risk is a noxious by-product. Banking benefits those producing and consuming financial services – the private benefits for bank employees, depositors, borrowers and investors. But it also risks endangering innocent bystanders within the wider economy – the social costs to the general public from banking crises.

So in a way you can classify all the recent proposals for financial regulation as two kinds – Taxation and Prohibition.

To date, the public policy response has largely focussed on the role of prudential regulation in tackling these problems. Higher buffers of capital and liquid assets are being discussed to address the first problem. And add-ons to these capital and liquidity buffers for institutions posing the greatest systemic risk are being discussed to address the second. In essence, this is a taxation solution to the systemic risk pollution problem.

There is a second approach. On 21 January 2010, US President Barack Obama proposed placing formal restrictions on the business activities and scale of US banks. Others have made complementary proposals for structural reform of banking.  Typically, these involve separation of bank activities, either across business lines or geographies. In essence, this is the prohibition solution to the systemic pollution problem.

 This sets the scene for a great debate. It is not a new one. The taxation versus prohibition question crops up repeatedly in public choice economics. For centuries it has been central to the international trade debate on the use of quotas versus subsidies. During this century, it has become central to the debate on appropriate policies to curtail carbon emissions.

Excellent stuff from Haldane. Makes it much simpler.

He then reviews Martin Weitzman’s 1970’s framework which helps categorise whether we should go for prohibition or taxation:

In making these choices, economists have often drawn on Martin Weitzman’s classic public goods framework from the early 1970s.13 Under this framework, the optimal amount of pollution control is found by equating the marginal social benefits of pollution-control and the marginal private costs of this control. With no uncertainty about either costs or benefits, a policymaker would be indifferent between taxation and restrictions when striking this cost/benefit balance.

In the real world, there is considerable uncertainty about both costs and benefits. Weitzman’s framework tells us how to choose between pollution-control instruments in this setting. If the marginal social benefits foregone of the wrong choice are large, relative to the private costs incurred, then quantitative restrictions are optimal. Why? Because fixing quantities to achieve pollution control, while letting prices vary, does not have large private costs. When the marginal social benefit curve is steeper than the marginal private cost curve, restrictions dominate.

The results flip when the marginal cost/benefit trade-offs are reversed. If the private costs of the wrong choice are high, relative to the social benefits foregone, fixing these costs through taxation is likely to deliver the better welfare outcome. When the marginal social benefit curve is flatter than the marginal private cost curve, taxation dominates. So the choice of taxation versus prohibition in controlling pollution is ultimately an empirical issue.

Wow!!

It does not end here. He revisits US financial regulation post great depression and studies the various proposals via this Weitzman lens.

To illustrate the framework, consider the path of financial regulation in the US over the past century. The US announcements in January are in many respects redolent of US financial reforms enacted during the late 1920s and early 1930s. Then, restrictions were imposed on both bank size and scope, in the form of the McFadden (1927) and Glass-Steagall (1933) Acts. The history of both, viewed through Weitzman’s lens, is illuminating for today’s debate.

He shows how these two proposals which were in the prohibition category prevailed. And how when both were lifted the same problems surfaced. The Banks became too big to fail. Very exciting analysis.

He then asks do we go bank to prohibition of 1930s. For this we need to understand the costs and benefits. He says there is evidence that prohibitions might just make banks better

In the light of the crisis, and in the language of Weitzman, the marginal social benefits of restrictions could be greater than the marginal private costs. The maximum efficient scale of banking may lie below the maximum resolvable scale. A large part of the effort of the international community over the past few years has been directed at increasing the maximum resolvable scale of banks – for example, through improved resolution regimes and living wills.

If successful, that effort would shift the balance of the Weitzman cost/benefit calculus in the direction of bigger banks; it could help achieve the modularity, robustness and better aligned incentives which restrictions otherwise deliver. But if this effort is unsuccessful, past evidence and present experience pose a big question about existing banking structures. Against that backdrop, it is understandable that restrictions on scale  and activity are part of today’s debate about solutions to the systemic pollution problem. $100 billion may not just be the question; it may also be part of the answer.

Hmmm.

Actually the speech has so much food of thought that it takes time to absorb the whole thing. Will require a couple of readings to understand it better.

Addendum:

Haldane also gave an interesting speech on fair value accounting recently

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2 Responses to “prohibition vs taxation: A novel way to think about financial regulation”

  1. Tachoblog » Archives » Scoop! No More Smelly Exhaust Fumes Thanks To Aromatab – The Tacho Blog Says:

    […] prohibition vs taxation: A novel way to think about financial regulation « Mostly Economics […]

  2. The Pros and Cons of Hybrid Cars | Lightning Hybrid Cars Says:

    […] prohibition vs taxation: A novel way to think about financial regulation « Mostly Economics […]

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