Bank bailouts and taxes

Chris Farrell From chief economics correspondent Chris Farrell

Narayana Kocherlakota, the newly appointed head of the Federal Reserve Bank of Minneapolis, gave a fascinating talk at the Economic Club of Minnesota on May 10th. The topic: Future bank bailouts. It’s worth reading.

At first blush his overall perspective seems depressing.

The Congress of the United States is currently considering legislation to restructure financial regulation. However, no matter how well-written or how well-intentioned the legislation may be, no law can completely eliminate the kinds of collective investor and regulator mistakes that lead to financial crises. These mistakes have taken place periodically for centuries. They will certainly do so again. And once these crises happen, there are strong economic forces that lead policymakers–for the best of reasons–to bail out financial firms. In other words, no legislation can completely eliminate bailouts. Any new financial regulatory structure must keep this reality in mind.

But as Kocherlakota quickly adds, this is a cause for despair. It’s simply realistic.

Booms and busts are in the nature of a capitalist business cycle. There is nothing smooth about innovation. The speed of financial transactions is quicksilver. We’re flooded with information, as well as gossip, rumor, data, analysis, judgment, knowledge, and noise. The global economy keeps getting larger. The human population was about 1.5 billion in 1900 and it is now numbers 7 billion. The world is an increasingly crowded and complex place. Simply put, the number of people who need financial products and financial services has grown exponentially, especially now that the wealth that was largely confined to a handful of advanced industrial nations is now spreading throughout emerging markets.

The late Peter Bernstein, the dean of finance economists, once wrote:

In any case, the animal spirits of enterprise, risk-taking, and innovation will always breed booms rather than sleepy and stable environments. Without a punchbowl to enjoy, there will be no innovation, no technological change, no rise in living standards, no dreams of a brighter future–which include a home of one’s own.

Or, Orson Welles, playing Harry Lime in the movie The Third Man, put it:

In Italy for thirty years under the Borgias they had warfare, terror, murder, bloodshed–but they produced Michelangelo, Leonardo da Vinci, and the Renaissance. In Switzerland they had brotherly love, 500 years of democracy and peace, and what did that produce? The cuckoo clock.

Okay, back to Kocherlakota. His solution is tap into a long economic literature of using taxes to pay for an “externality,” in this case the risk of big financial bets gone bad.

My theme today is that, although bailouts are inevitable, their magnitude can be limited by taxes on financial institutions. I arrive at this conclusion about the usefulness of taxes by thinking through an analogy that I’ll develop at some length. I will argue that, knowing bailouts are inevitable, financial institutions fail to internalize all the risks that their investment decisions impose on society. Economists would say that bailouts thereby create a risk “externality.” There is nearly a century of economic thought about how to deal with externalities of various sorts–and the usual answer is through taxation. I will suggest that the logic that argues for taxation to deal with other externalities is exactly applicable in this case as well.

It’s definitely intriguing. Its using taxes not as punishment for profligacy or revenge for bad decisions, but to have the money when it’s needed.

  • Brian

    I completely agree with Narayana’s thesis. It sounds like we have a logical, bright leader of our regional Federal Reserve Bank.