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$100 billlion of financial pollution



20 April 2010 08:32

Is the financial system a pollutant? If so, what is the cost of that pollution? And how should we handle it – should we tax it or otherwise regulate it? Or should we seek to ban the more harmful forms of it?

In the prologue to his new book, The Big Short, Michael Lewis reminisces about the reaction to an earlier effort, Liar's Poker. Lewis writes that when he left Wall Street in 1988 to write that earlier book, he figured the situation was already 'unsustainable', and that '(s)ooner rather than later' there would be a 'Great Reckoning'.

Sure enough, he notes, in the following two decades, a series of rogue traders, the collapse of LTCM, and the bursting of the dot-com bubble all meant that '(o)ver and over again, the financial system was, in some narrow way, discredited.' 

Yet, at least until the latest debacle, none of these shocks turned out to be large enough to produce fundamental changes in the way the financial system operated sufficient to reduce the chances of further crises. Cue the mega-shock which finally arrived in 2007-08. 

In other words, the polluter kept getting caught pumping effluent into the world's rivers and oceans and toxic chemicals into the planet's atmosphere. Yet nothing much was ever done about it. What went wrong?

One answer looks to regulatory failure. David Leonhardt, in a lengthy essay for the NYT magazine a few weeks ago, argues that the problem was the inadequate provision of the public good of strong regulation:

Just as an oil company can profit from pollution, Wall Street profited from weak regulation, at the expense of society.

If you buy this diagnosis, it follows that the solution is to invest more in the under-provided public good – that is, invest in new regulation (or, alternatively, re-regulation). Leonhardt covers some of the suggested US regulatory solutions, discussing the Obama Administration's idea of a Financial Product Safety Commission to protect consumers, the calls for new and tougher rules on capital for financial institutions, the proposed Volcker Rule, and the imposition of new taxes and levies.

Leonhardt quotes US Treasury Secretary Timothy Geithner suggesting that since '(f)inancial crises cause a huge amount of damage...there is a very good argument you should put a tax on finance, like a tax on pollution.'

The thought-experiment of treating the financial sector as a pollutant is also the starting point for an interesting new paper by the Bank of England's Andrew Haldane. He begins by noting that the banking industry produces systemic risk as a 'noxious by-product' of its actions.

Thus while banking provides benefits for those producing and using its services – bank employees, depositors, borrowers and investors – it also imposes costs on the general public in the form of periodic banking crises. But how big are the costs of banking pollution?

Haldane provides a range of estimates. His starting point is the fiscal cost of the current crisis, in terms of the wealth transfer from government (taxpayers) to the banks due to recent bailouts. Current estimates put this cost at around US$100 billion in the US and at £23 billion in the UK. So on this calculation, for US taxpayers 'banking pollution' raises at least a US$100 billion question.

But these direct fiscal costs do not take into account the damage done to the wider economy by the crisis, so they represent a lower bound for the costs involved. To find an upper bound, Haldane notes that world output in 2009 is estimated to have been around 6.5% lower than it would have been in the absence of crisis (US$4 trillion), while in the UK the output loss is around 10% (£140 billion). Moreover, some of the loss to output is likely to have been permanent, so that these current costs will be significantly smaller than the total cost – adding up to trillions of dollars (and pounds) in losses.

Still, as he notes, it would be unfair to allocate all of these costs to the financial sector: reckless borrowers and others also merit a share of the blame.

A third set of estimates comes from calculating the fiscal subsidy to banks provided by government support. Haldane estimates that the value of that subsidy for the top five UK banks between 2007 and 2009 was more than £50 billion – which is roughly equal to UK banks' annual profits before the crisis. For the top five global banks, the average annual subsidy was just less than US$60 billion per year.

As Haldane notes, these estimates provide at best only a rough guide to the scale of banking pollution. But they do suggest that it is a 'real and large social problem'. Most of the proposed solutions to this problem to date (more capital, more liquidity, more levies) take the form of taxation solutions to the pollution problem, although others (the Volcker Rule) instead look to prohibition.

The final balance between taxation, regulation and prohibition, and of course the tug of war between the banks and those who seek to regulate them, will shape the way the post-GFC financial sector looks in the US, the UK, and in large parts of the rest of the world.

Photo by Flickr user Eden-lys, used under a Creative Commons license. 

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