Should we apply a transactions tax to REPO?

A number of readers wrote me this morning and asked what I thought of Paul Krugman's column today.  Krugman writes:

As Gary Gorton and Andrew Metrick of Yale have shown, by 2007 the United States banking system had become crucially dependent on “repo” transactions, in which financial institutions sell assets to investors while promising to buy them back after a short period – often a single day. Losses in subprime and other assets triggered a banking crisis because they undermined this system – there was a “run on repo.”

And a financial transactions tax, by discouraging reliance on ultra-short-run financing, would have made such a run much less likely. So contrary to what the skeptics say, such a tax would have helped prevent the current crisis – and could help us avoid a future replay.

My view is different.  I do favor such a tax in the following sense: capital requirements on financial institutions should rise with our best estimate of risky behavior and of course these capital requirements serve as a tax.  From this follows a few points:

1. The net tax applied, whether through capital requirements or a demand for a revenue payment, can only be so high.  I would prefer to "convert" all of the applied tax into the form of capital requirements.  Krugman doesn't call his idea "a proposal for lower capital requirements," but relative to the better and more politically feasible reform of higher capital requirements, that's what it is.  At the margin we have to choose between various forms of tax.

2. Is the quantity of short-term REPO, or other financial transactions, really the best measure of risky behavior?  I doubt it.  So we're taxing the wrong thing, relative to what we might do.

3. Taxing short-term credit means that firms will resort to long-term credit.  In most models longer-term credit increases moral hazard and excess risk, even if it does limit the short-term "runs" effect.  

A few broader points are relevant:

4. In many jurisdictions, REPOs are already taxed, as the "borrowed" security is counted for tax purposes as "owned" and the income from it is subject to tax.  Of course the tax could be higher, but is there evidence that the taxes to date have had beneficial effects on financial stability?

5. There are many substitutes for REPO — virtually any transaction can include an implicit short-term credit component — and I am skeptical of the ability of the regulators to catch them all and prevent destabilizing regulatory arbitrage.

6. There was a transactions tax on sale and transfers of stock before and during the Great Depression; it did not obviously help matters.

7. There will always be some untaxed network for speculators to trade in and a transactions tax would push them into such a network, probably in destabilizing fashion.  The fact that trading is relatively centralized now does not refute this effect.

Of these points, only #6 and #7 apply to the standard Tobin "currency tax."  No matter what you think of the Tobin tax, overall there is not sufficient logic or empirics to justify its extension to REPO and related short-term transactions.

Addendum: I am more in agreement with Krugman's post on Dubai.

Comments

See also calls to tax CHAPS transactions in UK and one response. So would killing the interbank lending market be a bug or a feature?

I guess it depends on whether you are trying to raise revenues or limit risky behaviour

What about money market funds? These are essentially lending institutions with 0% capital. Of course, most people think of them as lending institutions with 100% capital. But after Lehman, the govt basically admitted that the right side of their balance sheets are viewed as deposits as opposed to equity. Unit holders received de facto govt guaranties. Shouldn't these NBFIs be subject to banking rules if they receive taxpayer-subsidized risk insurance?

A transactions tax will also act as a wealth tax. Suppose the T-tax is 0.25%. Suppose you wish to invest today in a mutual fund that you'll liquidate during retirement. Suppose you pick an almost-zero-turnover index fund to minimize internal T-taxes. The fund should charge you the 0.25% tax when you buy, to be fair to the existing fund investors, and should charge you the 0.25% tax when you sell, for the same reason. Viola! A 0.50% wealth tax.

Krugman's brain is great. Krugman's keyboard is great - he can write both fast and very well. Krugman's prejudices are fun; policy debate would be much duller without them. But when he engages keyboerd and prejudices without brain, the results can be painful.

Tyler says go for higher capital requirements. Was not this where we all started in this crisis? Back well before Lehman imploded, weren't we all chorusing that the banks needed more capital? Surely higher capital requirements are the first regulatory priority. Isn't the second to make finance pay in full for the guarantees it trades upon? The system is evidently unstable if we do not; and the obvious way to do it is to set 'premiums' for all guaranteed institutions, payable to the public purse. Do those, and the case for taxing financial transactions vanishes.

(Of course, it is nonsense to think of slapping any form of extra 'taxes' on banks right now. They would lend even less because the tax would make their balance sheets even more rickety; so slowing recovery. However, if our governments forced the banks to take on really adequate amounts of capital, with all the unwelcome political attention to bank managements that would imply, we could get on with proper recovery and necessary regualtory refom pretty quickly. Beats me why this is not top of Krugman's agenda.)

Love the title of Krugman's Dubai post: "Rashomon in the desert" .

Yes. Don't.

Krugman says that the increase in treasury prices says the risk of default has lowered today because of Dubai. I think earlier this week he said something about there not being any crowding out. Tyler, can you create a shorthand guide for us on these Krugman posts a la PG1, PG2, etc.? 'Preesh.

Where can I send my check and to which bank to underwrite their risks that we are afraid of charging them for assuming the risk for their bondholders? I read the posts that talk about "taxing" wealth, but we are taxing wealth when interest rates on deposits go to zero so that banks can recapitalize? Why shouldn't we tax (read: charge) those whose debts we guarantee? And, its not just US debt that is guaranteed by US institutions: it is Abu Dhabi loans that Citi and other banks make, and if those go belly up, guess who will be asked to write a check because the bank is "too big to fail" and because we don't want to regulate. So, where can I send my check; I'm trying to close out the year.

Will they be taxing interest rate swaps at the same rate? If not, then the repo trades may simply become interest rate or total return swap trades. Or bond futures? Or bond forwards? Or Eurobonds?

I don't understand if all these blogging economists honestly don't understand how these things happen, or if they just don't care.

Why engage in policies that fight risky behavior caused by government, when you could eliminate that behavior by reducing the scope of government intervention?

It's like feeding your child rat poison and then punishing him for sleeping too much.

Get real.

Under a bill being drafted by Democratic Reps. Peter DeFazio (Ore.) and Ed Perlmutter (Colo.), the sale and purchase of financial instruments such as stocks, options, derivatives and futures would face a 0.25 percent tax.

The bill, a copy of which was obtained by The Hill, is titled the “Let Wall Street Pay for the Restoration of Main Street Act of 2009.†

Half of the $150 billion in tax revenue would go toward reducing the deficit, while the other half would be deposited in a “Job Creation Reserve† to support new jobs.

Why are people opposed to paying a transaction tax that will be assessed against foreigners? Today, if Citibank does a bad deal with Abu Dhabi, and comes to the government for a bailout, I pay--I pay, in effect, to guarantee the debt of Citi's bondholders as well, many of whom are not in the US.

So, unless you say you never will (and this is a promise that will not be kept in extremistan) act to mitigate default costs, why do you want to go on subsidizing Citi's bondholers, go on supporting Citi's loans with implicit guarantees. Wouldn't you rather assess the beneficiaries of the guarantees?

You are awfully generous. No free riders.

good post - you and Buiter and others are right that transactions are a bad metric for systemic risk. one quibble though - capital requirements aren't necessarily a tax.
does capital cost firms more? yes. but largely because debt of systemically important banks is implicitly guaranteed by the state. in this sense capital requirements reduce the subsidy the banking system currently receives.
capital may also cost more because debt costs are tax deductible:in this sense higher capital requirements would raise tax paid by banks

Jeez, one would almost think that the reliance on short-term borrowing wasn't caused by policies that Krugman himself has advocated over and over. What happens if such a tax makes loose monetary policy less effective?

This transaction tax stuff really scares me. I make my living trading financial instruments, where my average profit/trade is around .025% making a .25% transaction tax a 1000% tax on me and my industry, meaning it will cease to exist. I work for a small company that never has and never would get bailed out by the government, and our activities have absolutely nothing to do with the bailouts other than that some of the companies that got bailed out also had (profitable) divisions that engage in similar activities. Here are a couple questions for any advocate of new and punishing transaction taxes:

1. Why do exchange-traded instruments need to be taxed when all the exchanges and clearing houses were fine and it was the OTC derivatives that blew up?

2. Why should a firm that does a ton of transactions but ends up flat every day have to pay a huge tax while one that takes big bets in illiquid instruments and blows up pays a trivial amount in tax?

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