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In The Public Interest : New Insights into Preventing Wall Street Meltdowns and Reducing Debt

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This Week's Basel Accord and New Poll Show How to Prevent Wall Street Meltdowns and Reduce the Debt with One Tool

This week's news made the path for great idea a lot clearer. The international agreement in Basel this weekend introducing mild controls on financial firms is proof that a bolder proposal to reduce instability by taxing speculation is an idea whose time has come. Further urgency came this week with yesterday's AP-CNBC poll showing that "Wild gyrations on Wall Street have made U.S investors leery of buying individual stocks and skeptical that the market is a fair place to park their money."

For decades various economists have proposed a simple way to make the American financial system more stable. As the 2008 Wall Street meltdown reminds us, financial markets become more volatile when huge volumes of money slosh across financial markets seeking tiny margins on high-volume trades. Nobel Laureate economist and presidential adviser James Tobin proposed in 1972 the first version of this simple solution currently before Congress. By placing an infinitesimal fee on short-term financial trades, real productive investments won't be discouraged; but purely speculative trades seeking tiny gains will disappear because they'll no longer be profitable.

The simple elegance of a speculation fee has captured the imagination of a broad swath (PDF) of world leaders and economists (PDF) because it would dry up the financial waves that disrupt markets and can devastate communities (link). Government budget writers have also been drawn to the promise of raising billions in tax revenue while improving capital markets. A tax of a measly quarter ($0.25) per $100 would not discourage investors, but would raise an estimated $150 billion annually that could be dedicated to funds against future financial meltdowns, paying down debt, or other needs. Dozens of far-sighted members of Congress have even lined up behind Rep. DeFazio to introduce legislation to create a "Financial Transaction Tax" that would exempt smaller middle-class investors and pension funds.

Wall Street doesn't like this idea. Financial firms make a bundle flipping large sums back and forth. Their lobbyists and think tanks have succeeded in dismissing the idea even while politicians of all stripes position themselves as enemies of Wall Street.

The fact that proposed legislation would return trading costs to where they stood in the 1980s is not the biggest impediment. After all, many other transactions are subject to much higher sales taxes or gas taxes. Problems with speculative trading even remain in the public consciousness due to wild swings in the Dow and "flash crashes" created by hair-trigger computers at major financial firms that anticipate and magnify slight market fluctuations with instant mega-trading. Yesterday's poll indicates that 61 percent of Americans say the market's recent volatility has made them less confident about buying and selling individual stocks.

No, despite Wall Street's best efforts, opponents of a speculation fee haven't convinced the country that there isn't a problem, but simply that a speculation fee couldn't be effectively applied or wouldn't actually work. Never mind that the Securities and Exchange Commission already imposes a miniscule fee to finance its own operations or that the UK has long imposed a financial tax that raises $30 billion annually on stock trades. Opponents claim that the world's financial titans could never agree to measures that would reduce the profits of bankers. Without impossibly close international coordination, they argue, the financial industry will simply circumvent new fees and conduct trades through shadow markets and other countries, leaving the U.S. less able to control financial speculation. Globalization and electronic trading, the argument goes, have made financial regulations obsolete.

But alas, this week's news declares that the United States, along with over two dozen of the largest and most economically important nations agreed this weekend to new banking rules that will lend some stability and reduce Wall Street profits by increasing the amount of money banks must set aside to secure against loans and other bets. These new rules signed in Basel will do little to reduce speculative sloshing and don't go far enough to reduce financial risk, but they are exactly the kind of accord that naysayers claim could never happen for a financial speculation fee. Yet it did.

The claim that financial regulation is obsolete in the face of globalization and the Internet is one that should have died with all the babble about a "New Economy" during the 1990s. Back then the swelling dot-com bubble inflated, fantasies about the end of financial regulation because traders could re-reroute transactions around regulatory and tax structures and place their legal structures in unregulated havens such as the Cayman Islands, Panama or Gibraltar.

Putting aside the fact that electronic transactions have been around since the telegraph, the argument may be persuasive when applied to regulation of activities such as hate speech or pornography.

But the fundamental difference is that the financial industry ultimately needs regulatory authority to function. As I've written at greater length elsewhere, the international capital exchange system is specifically constructed so that electronic funds can not be reproduced in a haphazard and decentralized manner the way hate speech or pornography can. International financial players have a great interest in keeping it this way.

Financial transfers may take the form of a digitalized string of zeros and ones, just like an image or a political petition circulating over the Internet; but the value of this binary code can not similarly be multiplied through instant reproduction. When a bank wires money it relies on a centralized infrastructure guaranteed by governments to make sure the money is subtracted from that account and added only to a specific location. Even though individuals can create their own instant offshore banks over the Internet, globalized money will never be like free-flowing information because the infrastructure that makes it possible to electronically send money across borders also makes it technically possible to restrict and tax these transfers. A system of mutual recognition and settlement between powerful institutions anchored by government Central Banks confirms that a person who transfers money actually owns those funds and is not simultaneously promising them to banks all over the world.

The obstacles to enforcing a financial speculation fee are, as economist Dean Baker has argued, trivial compared to enforcement of copyright laws. Unlike a copy of a Hollywood movie or a computer game, traders have a much stronger incentive in maintaining a system that keeps track of their financial assets, so that the same dollar or stock share can not be promised or sent two places at once.

In addition to growing investor fears about financial volatility, the biggest impetus behind a financial speculation tax may be Congressional interest and a Presidential commission to reduce the national debt. As U.S. PIRG has shown, a financial speculation fee can be part of a package of reforms to reduce the debt by trillions while reducing wasteful subsidies and making the economy more efficient.

Thus, with opposition arguments laid bare and the need for a financial speculation fee increasing clear, it's time for reformers in Congress to push legislation forward.