CAMBRIDGE – When the next full-scale global financial crisis hits, let it not be said that the International Monetary Fund never took a stab at forestalling it. Recently, the IMF proposed a new global tax on financial institutions loosely in proportion to their size, as well as a tax on banks’ profits and bonuses.
The Fund’s proposal has been greeted with predictable disdain and derision by the financial industry. More interesting and significant are the mixed reviews from G-20 presidents and finance ministers. Governments at the epicenter of the recent financial crisis, especially the United States and the United Kingdom, are downright enthusiastic, particularly about the tax on size. After all, they want to do that anyway. Countries that did not experience recent bank meltdowns, such as Canada, Australia, China, Brazil, and India, are unenthusiastic. Why should they change systems that proved so resilient?
It is all too easy to criticize the specifics of the IMF plan. But the IMF’s big-picture diagnosis of the problem gets a lot right. Financial systems are bloated by implicit taxpayer guarantees, which allow banks, particularly large ones, to borrow money at interest rates that do not fully reflect the risks they take in search of outsized profits. Since that risk is then passed on to taxpayers, imposing taxes on financial firms in proportion to their borrowing is a simple way to ensure fairness.
“What risks?” the financial firms demand to know. The average cost of the bailouts was “only” a few percentage points of GNP. And the crisis was a once-in-a-half-century event.
The IMF rightly points out that these claims are nonsense. During the crisis, taxpayers were on the hook for almost a quarter of national income. Perhaps the next crisis will not turn out so “well and the losses borne by the public will be staggering. Even with the “success” of the bailouts, countries suffered massive output losses due to recessions and sustained subpar growth.
But, while regulation must address the oversized bank balance sheets that were at the root of the crisis, the IMF is right not to focus excessively on fixing the “too big to fail” problem. A surprising number of pundits seem to think that if one could only break up the big banks, governments would be far more resilient to bailouts, and the whole “moral hazard” problem would be muted.
That logic is dubious, given how many similar crises have hit widely differing systems over the centuries. A systemic crisis that simultaneously hits a large number of medium-sized banks would put just as much pressure on governments to bail out the system as would a crisis that hits a couple of large banks.
There are altogether too many complex ideas floating around that look good on paper, but might well prove deeply flawed in a big-time crisis. Any robust solution must be reasonably simple to understand and implement. The IMF proposal seems to pass these tests.
By contrast, some finance specialists favor forcing banks to rely much more on “contingent” debt that can be forcibly converted to (possibly worthless) stock in the event of a system-wide meltdown. But how this form of “pre-packaged bankruptcy” could be implemented in a world of widely different legal, political, and banking systems is unclear. Financial history is littered with untested safety-net devices that failed in a crisis. Better to rein in the growth of the system.
The IMF is on much weaker ground, however, in thinking that its one-size-fits-all global tax system will somehow level the playing field internationally. It won’t. Countries that now have solid financial regulatory systems in place are already effectively “taxing” their financial firms more than, say, the US and the UK, where financial regulation is more minimal. The US and the UK don’t want to weaken their competitive advantage by taxing banks while some other countries do not. But it is their systems that are in the greatest and most urgent need of stronger checks and balances.
Let’s not go too far in defending the “holdout” countries that are resisting the IMF proposal. These countries need to recognize that if the US and the UK do implement even modest reforms; a lot of capital will flow elsewhere, potentially overwhelming regulatory systems that seemed to work well until now.
And what about the second tax proposed by the IMF, on banks’ profits and bonuses? Such a tax is politically appealing, but ultimately it makes little sense – except, perhaps, in a crisis year when bank subsidies are glaringly transparent. It would be better to improve financial-market regulation directly and let national tax systems handle banks’ income like that of any other industry.
The IMF’s first effort at prescribing a cure may be flawed, but its diagnosis of a financial sector bloated by moral hazard is manifestly correct. Let’s hope that when the G-20 leaders meet later this year, they decide to take the problem seriously instead of tabling discussion for a decade or two until the next crisis is upon us.
Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF. Copyright: Project Syndicate, 2010. www.project-syndicate.org