03/18/2010 05:12 am ET | Updated May 25, 2011

Why Taxing Wall Street Makes Sense

Today, the Obama administration announced a sweeping "financial crisis responsibility fee" designed to recoup taxpayer losses over last year's bailouts of Wall Street's financial institutions. The New York Times reports that the fee will be in place for the next ten years and will tax banks' eligible liabilities.

Industry observers recoiled at the announcement, claiming that this tax would hinder lending at a time when the economy needs it most.

Still, the logical merits of the responsibility fee remain, despite political posturing from the measure's detractors. Here are two reasons why:

1) Despite the ostensible stability of the financial sector, the fundamental causes of the original bailouts remain unaddressed
When the history of the 2008 financial crisis is finally written, a central cause of the crisis will be the existence of systemically critical financial institutions at the heart of the economy's financial system. The broader US economy is still beholden to the banking behemoths of JP Morgan, Citigroup, Bank of America, and converted investment banks such as Morgan Stanley and Goldman Sachs. During the fall and winter of 2008, the US government de facto guaranteed the existence of these financial institutions by insuring their liabilities and bailing out their trading counterparties like A.I.G.. In the aftermath of the botched decision to allow Lehman Brothers to fail, the Federal Reserve and Treasury implicitly acknowledged that the failure of another large scale financial institution would wreck the interbank lending market, thereby arresting lending elsewhere in the economy and bringing economic activity to a standstill.

Short of the most ardent free market, laissez-faire activists, economists largely agree that these bailouts were essential for preventing another Great Depression.

Still, the status quo is one where these financial institutions exist with the implicit backing of the US government (in other words, their downside risk remains socialized or borne by the taxpayer), while their profit potential remains firmly privatized in the hands of several thousand financiers.

While an admittedly blunt instrument, the proposed tax will serve as a check against the ballooning balance sheets of these financial institutions, thereby naturally limiting their size and decreasing their likelihood of being a systemic actor. Further, the tax increases the pain of receiving taxpayer bailout funds, lowering their high risk propensity that precipitated the financial crisis in the first place.

2) The tax could change the labor market dynamics that concentrated America's top talent on Wall Street
At the height of the housing bubble, financial service profits as a percentage of corporate profits was approximately 41%, compared to roughly 20% for most of the 1990s. In this time, Wall Street compensation soared, attracting the nation's smartest workers. Typical Wall Street trading desks boasted physicists, mathematicians, numerous Ph.D.s across a variety of disciplines, and countless MBAs from the world's top business schools. The road to Wall Street seemed to run through the Ivy League, as hedge funds, investment banks, and private equity firms recruited a generation of budding professionals from America's top universities.

This move of America's best and brightest from the real economy to Wall Street is a well documented phenomenon, and certainly one of the hidden costs of Wall Street's recent excesses that are imposed on society at large. When business historians look at flagging American industry, they will undoubtedly place some blame on the shift in society from real engineering to financial engineering. And although the links between financial sector engineering and economic growth are tenuous, surely the opportunity cost of this real economy brain drain will be felt for a generation.

Again, while a blunt tool, Obama's Wall Street tax could alter the incentives faced by professionals when choosing how to allocate themselves in the economy. Surely this is a welcome development as America grapples with challenges potentially solved by a redoubling of efforts in those fields. Instead of a team of Ph.D.s designing new ways to slice risks in baskets of leveraged financial products, perhaps these teams can comprise a clean energy Manhattan project, for instance.

Wall Street will complain that it is yet another victim of populist backlash. They are agents of economic recovery, they argue, as those responsible for the financial market meltdown have long since been fired, their risky practices replaced by the self-regulatory mechanisms inherent in their institutional memory.

But such arguments ring hollow when considering that Wall Street's primary function, taking deposits and lending, stands conflated with an institutionalized, casino culture of speculation, excessive risk taking, and greed.

To the banks' credit, they are right to claim that the purported economic benefits of Obama's financial institution tax are limited. I would agree, and claim that Obama's tax does not go far enough.

At the beginning of Obama's presidency, I had great hopes that his sweeping electoral mandate would give him the political capital necessary to take on the nation's financial institutions and exact real concessions and reform. A year later, this dream remains mired in partisan bickering over health care overhaul, imperial overstretch in Afghanistan, and double-digit unemployment. Time will tell if this tax is the sign of further reform to come, or yet another palliative to sooth populist political pressures without substantive change. Here's to hoping for the former.