Martin Wolf on the Need to Rein in Finance

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I always enjoy reading the Financial Times’ editor, Martin Wolf, but I sometime forget how refreshing and pointed he can be when he decides to let loose at a deserving target. Today’s lesson is the almost ludicrous efforts of the financial services industry to explain why the debacle that they just foisted on all of us isn’t sufficient cause to put it on a choke chain.

Wolf pillories a report produced by some leading lights of the UK’s banking industry. Its main failing, as Wolf points out, is that the industry has already captured Alistair Darling, chancellor of the exchequer, who sponsored the effort and sat on the committee. The verdict was pre-deetermined: “to examine the competitiveness of financial services globally and to develop a framework on which to base policy and initiatives to keep UK financial services competitive”.

Ulp. Darling lives in a parallel universe, preoccupied with saving the perps who took down the economy with their recklessness. But he is hardly alone in how badly he has been captured by the industry.

Wolf has a remarkably straightforward recommendation.. The industry produces extenalities, like polluters, so tax it. I’ve long been a fan of Tobin taxes without being able to prove my pet suspicion, that too much ease of trading benefits intermediaries more than the principals, by encouraging more speculation than is needed to lubricate markets. Wolf provides another rationale. And he dismisses the notion that innovation is ever and always good (radiation tonics were innovative too, and killed people) and that determined regulators cannot restrain big financial players.

From the Financial Times:

The UK has a strategic nightmare: it has a strong comparative advantage in the world’s most irresponsible industry. So now, in the wake of the biggest financial crisis since the 1930s, the UK must ask itself a painful question: how should the country manage the cuckoo sitting in its nest?

The question is inescapable. London is one of the world’s two most important centres of global finance. Its regulators have, as a result, an influence on the world economy out of proportion to the country’s size. In the years leading up to the crisis, that influence was surely malign: the “light touch” approach led the way in a regulatory race to the bottom.

The fiscal costs of this crisis will be comparable to those of a big war….Loss of jobs and incomes will also scar the lives of hundreds of millions of people around the world.

All this occurred, in part, because institutions replete with highly qualified and highly rewarded people were unable or unwilling to manage risk responsibly….This is a time for self-examination.

A recent report on the future of UK international financial services…fails to provide such self-examination…the report’s remit was “to examine the competitiveness of financial services globally and to develop a framework on which to base policy and initiatives to keep UK financial services competitive”.

If you ask the wrong question, you will get the wrong answer. The right question is, instead, this: what framework is needed to ensure that the operation of the financial sector is compatible with the long-run health of the UK and world economies?

Quite simply, the sector imposes massive negative externalities (or costs) on bystanders. Thus, the recommendation “that the financial sector be allowed to recalibrate its activities according to the sentiments and demands of the market” is wrong. A market works well if, and only if, decision-makers confront the consequences of their decisions. This is not – and probably cannot be – the case in finance: certainly, people now sit on fortunes earned in activities that have led to unprecedented rescues and the worst recession since the 1930s. Given this, the industry has become too big. If implicit and explicit guarantees and externalities, including volatility, were fully charged, the sector would surely shrink.

So how should one manage a sector that produces such “bads”? The answer is: in the same way as any polluting activity. One taxes it. At this point, the authors of the report will surely ask: “How can you suggest taxing a sector so vital to the UK economy?” The answer is: easily. Financial services generate only 8 per cent of gross domestic product. They are more important for taxation and the balance of payments. But this tax revenue turns out to be perilously volatile. True, in 2007, the last year before the crisis, the UK ran a trade surplus of £37bn in financial services, partially offsetting an £89bn deficit in goods. But smaller net earnings from financial services would have generated a lower real exchange rate and more earnings elsewhere. Given the costs imposed by the financial sector, a more diversified economy would have been healthier. Such sacrilegious ideas are, of course, not to be found in the Bischoff report.

How then should the UK approach policy towards the sector? I would suggest the following guiding ideas.

First, the UK needs to make global regulation work. It should discourage regulatory arbitrage even if it expects to gain in the short run.

Second, it must, in particular, help ensure that owners and managers of financial institutions internalise most of the costs of their actions.

Third, it must reject egregious special pleading from the industry. The sector argues that moving derivatives trading on to exchangesmight damage innovation. So what? Maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety. If institutions threaten to take trading activities offshore, banking licences should be revoked.

Fourth, while trying to create a stable and favourable environment for business activities, the UK should try to diversify the economy away from finance, not reinforce its overly strong comparative advantage within it.

Fifth, UK authorities need to ensure that the risks run by institutions they guarantee fall within the financial and regulatory capacity of the British state. They should not let the country be exposed to the risks created by inadequately supported and under-regulated foreign institutions. At the very least, they should not undermine other governments’ efforts to regulate their own institutions.

The “old normal” was simply unsustainable. The “new normal” must be very different. It is far from clear that the industry and government recognise this grim truth.

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  1. The Ror

    He has a point, but as someone who worked in the UK’s financial industry (Lehman UK!), I think any major taxation would just force finance out of the UK, and to some other center prepared to take a punt on loosely regulated (and untaxed) international finance.

    For this to work, you need a coalition of the willing, with synchronized tax regimes, that bar outside investment (i.e from untaxed/unregulated regions). I can’t see Goldamn Shachs allowing Geithner and Darling to make this kind of communal leash.

  2. attempter

    This is right on. Negative externalities are a core refutation of the “free market” lie, since in a true free market 100% of costs would be paid and harms compensated by the willing patricipants in a transaction. (That’s why I refer to myself only half-ironically as one of the only true free marketeers, since I would use whatever level of government action was necessary to purge the false market of externalities, to free us of them.)

    I especially like the cuckoo metaphor. Parasitic feudal entities indeed do nothing but take up space and resources and generate cost and complexity. The FIRE sector does not add real value but only a froth of hype, pseudo-growth, and debt.

    Any alleged economy built on false growth and exponential debt is built on sand. It seems the only possibilities from here on are to take adult responsibility and transform ours to a steady state economy, as described by Hermann Daly and others, or to continue to experience the violence of ever more chaotic boom-bust convulsions.

    All TPTB can think of is to seek to reflate bubbles. That’s the British government’s only idea, just as it is the Obama admin’s only idea. That’s why their only policy is to try to restore the “market” as dictated by the feudal FIRE pseudo-industry.

  3. Yves Smith

    The Ror,

    You can also accomplish it by clamping down hard on fiduciaries (ie, prohibiting them from dealing with offshore players), and most important, denying those who go offshore to access to funds transfers (in the US, Fedwire and CHIPS). They would have to go through other parties. If you are a big intermeidary (bank, broker dealer) that is a very unattractive position to be in, Mere Japanese corporates in the 1980s needed their banks to have access to Fedwire and CHIPS (I worked with a bank that looked into giving up its banking license to do a US deal and concluded the cost was unacceptable). You also bar anyone inside the cordon from lending to parties outside it.

    Trust me, it could be done if anyone had the will. At the very worst, you’d have wealthy individuals (maybe) able to invest offshore. You don’t need to achieve an absolute prohibition to have won this battle, merely to make it so difficult as to make the size of it not very consequential.

  4. Brick

    A potential difficulty would be that you might need to micromanage aspects of their business to prevent them just passing on the costs of taxation.

  5. Eleanor

    I love FT. I can’t stand reading the WSJ anymore, and I don’t bother with any of the other MSMs.

    But I fully agree that a determined regulator can make this work – however, it is much easier if the five or so largest financial markets all agree to tax the externalities. Naturally they will try to pass through the costs. But the markets already pass through the cost, it is just that none of the wealth is publicly captured, only the downside.

  6. X

    Bravo, bully, and all that to Wolf. He is right. Furthermore it is obvious what needs to be done to reign in finance and actually quite simple compared to the current regulatory regime. The only problem is that the ruling class has flatly rejected solutions in favor of continuing the current system and tightening their control over it. Many people know what must be done, but I don’t think our leaders can communicate to us any more clearly than they have that they are not going to do it. So what, if anything, are we going to do about it?

  7. The Ror


    I agree that it could be done, but your suggestion is essentially an end to free flows of capital in and out of the regime.

    For instance, Goldman Sachs become regulated by the new regime, and are (still) in the US. Can they lend money to a bank in China? Can they invest in Chinese stocks? Can they act as a broker for Chinese stocks to US clients?

    On the other side, can a Chinese business buy stocks in the US if China has a different tax regime? Can a Chinese bond fund buy US treasuries (that’d cause a few headaches)?

    How would Citi live in this world? Would it need to sell it’s overseas enterprises? Could it even be an American bank anymore?

    To really make it work, there would be a massive wrenching of money flows, money moving in and out, fire sale prices, cries of protectionism (which having lived in Asia for a while, doesn’t really seem that bad), and probably general chaos. Politically, it’d be too difficult and while Geithners in charge, and the FED consolidates is powers (by superceding the SEC) there’s little hope.

    You guys need a revolution. It’s the only hope.

    Personally I think there should be loads of little banks, with very little leverage (i.e. 1:5 , with some maximum limit on the 1 e.g. $1b (or whatever) ). This would massively spread the risk about, with more Birth / Deaths of small banks.

    The irony is in the US and the UK the opposite seems preferable to the authorities.

    P.S Thanks for the blog: been reading it avidly for a year now. Makes me yell at the screen, but I don’t blame the messenger :)

  8. carol765

    “The UK has a strategic nightmare: ….. how should the country manage the cuckoo sitting in its nest?”

    Well said; reminds me of his recent comparison of the UK government to a python having swallowed a hippopotamus.

    “ll this occurred, in part, because institutions replete with highly qualified and highly rewarded people were unable or unwilling to manage risk responsibly….This is a time for self-examination.”

    unable or unwilling; that only leaves unwilling.

    Time for self-examination? Oh, just like self-regulation?!

    These bonus-bankers and lobby-sensitive regulators have shown themselves to be unable to self-examine.
    Instead, it is time for examination by the people! If only our ‘representatives’ are willing to act upon our findings!
    Yesterday’s Grayson petition could be a start.

    Perhaps Martin Wolf meant the self-examination in a tongue-in-cheek-way. His 5 points do not imply any self-examination at all.

    “The “old normal” was simply unsustainable. The “new normal” must be very different. It is far from clear that the industry and government recognise this grim truth.”

    Martin Wolf seems to put the financial industry and the government on the same side of the grim truth. That is illustrative of the recent developments showing governments taking the side of the financial industry. If we get to a ‘new normal’, then the loss to the financial sector’s ability to extract (loot) massive sums of money (their grim truth), is a gain for everybody else (our healing truth).
    We can only get to a new normal if the governments involved chose the side of the people (as is required for Martin Wolf’s 5 point plan).

  9. "DoctoRx"


    Your suspicion that ease of trading sucks in speculation can be extended. CDS basically exist as a line extension of this&that other stuff basically so that the financial industry can transact more business. What business doesn't matter, just so the industry can snarf up a larger share of society's goods and services.

    This is why no one in power has any interest in Nassim Taleb's recommendation that ALL derivatives except plain vanilla options be banned.

  10. doggett

    attempter said (3.30am) …

    “Negative externalities are a core refutation of the “free market” lie, since in a true free market 100% of costs would be paid and harms compensated by the willing patricipants in a transaction.”

    I like “patricipants”. Distinctly Freudian if it was a slip, witty if it wasn’t.

  11. Red Pill

    I am a fan of heavily regulating derivatives with the banning of most types that are clearly just gambling plays.

    However, I would like to point out that if these toxic derivative contracts had been allowed to consume the bad actors (I am looking at you AIG and your IB counterparties) then there would be very few to lobby for their preservation and we would have less regulatory capture to worry about. I am starting to think the pain of their failure would have been better in the long term. Will this actually require some sort of revolution?

  12. S. Myles S.-G.

    I don’t think Ms. Smith has a very good idea of how crucial the City is for the British prosperity of the last two decades. Without the City England would still be stuck in the second-tier low-rent banana republic status of the 70’s.

    We wouldn’t repeat the Suez. Let’s not repeat the degradations of the 70’s. Whatever costs this crisis will impose, it will be worth having Great Britain being a viable power again.

  13. Yves Smith

    S. Myles S.-G.,

    I lived in London in 1984 consulting to the biggest FX dealer and had to do a fair bit of travel within the country to do research. I would hardly call the UK then a "banana republic". And if the country has a financial implosion (no less than Willem Buiter thinks the UK could be the next Iceland), the consequences would be grim indeed. And Martin Wolf disputes your other assumption, that an overheavy finance sector was the only growth option for the UK>

    The reckless pursuit of growth cannot be permitted to trump the safety of the collective. That is why we have product safety regulations for everything from drugs to electrical products. Finance is now threatening the safety of the polity. It cannot go on as before.

  14. attempter

    @doggett: Yeah, that was just a typo, but I’m glad you like my inadvertent wit. :)

  15. donebenson

    Having worked in finance for 40 years [and now retired], I find it interesting how some of the readers of this blog are still addicted to the old disastrous financial ways [they supposedly are too important to change/shrink], despite the multiple trillions of dollars of losses these out of control financial methodologies created.

    If Joe Kennedy, the SEC, and Glass-Steagall could clean up the mess on Wall St. in the 30’s, then what Martin Wolf proposes in his excellent article, would work, and is vitally necessary.

  16. jlivesey

    I note Taleb’s assertion that all derivatives except plain vanilla options should be banned.

    But the word I note is “banned”. First of all, you only have to ban what is in demand. You have to ban drugs, not broccoli.

    Secondly, you would have to ban instruments that barely existed three decades ago. Why not? Because they are not so much tangible objects as intellectual creations.

    It’s not clear how you can ban creations of the intellect. If it were east, we would have no nuclear proliferation problem.

    Ban derivatives all you like, and they will simply come back in a different form or in a different place.

    And what goes for derivatives goes for most of Banking. Bankers will always test the limits of the current regulatory regime, find ways around it, or invent new mechanisms to make it irrelevant. The only two things you can really do is impose transparency, and to make sure that Bankers suffer – personally – the effects of bad behaviour.

    Ironically, we aren’t doing very well with the only two things we can really do, are we.

  17. S. Myles S.-G.

    With all due respect (I am sure you have a far more hands-on experience with high finance than I), Ms. Smith, I will only need point you to a drive through Surrey or Kensington to have a visceral appreciation of how intertwined the British fate is with its success in financing.

    A century ago Lloyd’s of London insured the world. The ramifications of the Second World War, ending an internationalist era as it were, brought an interruption to British prosperity. However, the revival in globalization also revived Britain. But I think it’s clear at this point that Great Britain will never out-compete Germany in exports. It has not done so in approximately 150 years. That basically leaves us with services and financing. And all service industries, frankly, involve an element of capital financing. The role of Carrefour in France, for example, is partially a financial one; a great deal of French GDP it generates comes from the financing and administrative roles it serves for its overseas subsidiaries. So it is with HSBC, DHL, Satander, et al.

    It’s a bit of an agglomerating cycle. Finance brings money; money brings shops; shops bring in Russian billionaires; and Russian billionaires bring in more money. I, for one, am not looking to end this.

  18. S. Myles S.-G.

    Which brings me to the other point: an anti-City government will not survive. The cardinal rule of modern (post-Thatcher) British politics is appealing to Middle England, or Home Counties. Neither Labour nor Tory governments will dare go against the Home Counties, and the Home Counties are resolutely against hurting the City, it being the source of much livelihood.

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