To reduce inequality, let’s downsize the financial sector

by
Dean Baker
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from Dean Baker

Matt Bruenig — the president of the progressive, grassroots-funded People’s Policy Project think tank — put forward a creative set of policy proposals last month on child care and family policy under the title of the Family Fun Pack. It prompted a major discussion in progressive circles on child care policy, helped in part by Sen. Elizabeth Warren’s important proposal in this area that was released the next week.

In the hope of prompting the same sort of debate on policy directed toward the financial sector, I am putting forward the “Finance Fun Pack.” While the full list of policies to rein in finance would be far more extensive, this one has three main components:

1. A modest tax on financial transactions;
2. Complete transparency on the contract terms that public pension funds sign with private equity companies; and
   
3. Complete transparency on the contract terms that university and other nonprofit endowments sign with hedge funds.

The goal of these policies is to have a smaller and more efficient financial sector. They are also likely to reduce the opportunity for earning huge fortunes in the sector. People looking to get fabulously rich will instead have to do something productive.

A modest tax on trades in stock, bonds and derivatives (like options, futures and credit default swaps) can raise a large amount of money while making the financial sector more efficient. According to the Congressional Budget Office, a tax of 0.1 percent on trades, as proposed in a new bill by Sen. Brian Schatz, would raise close to $100 billion a year or 0.5 percent of GDP. 

While this is a good chunk of change (it’s almost 50 percent more than we spend on food stamps each year), the really fun part of it is that it comes almost entirely out of the pocket of the financial industry rather than investors. The reason is that most research finds that the volume of trading is highly elastic, meaning that the volume of trade is likely to fall by a larger percentage than the increase in trading costs as a result of the tax.

Suppose that Senator Schatz’s tax increases the cost of trading for a typical investor by 30 percent. The research implies that most investors (or their fund managers) are likely to reduce their trading volume by at least 30 percent. This means that they will pay 30 percent more for each trade, but they will be doing 30 percent less trading. As a result, their total trading costs are likely to remain unchanged or even decline.

While every trade has a winner and a loser, on average these net out. This means that most investors will not be harmed if they or their funds trade less frequently. The only losers in this story are the folks in the financial sector who make their money on needless trades.

We do want active financial markets, but even if volume fell by 50 percent we would still be at the levels we were at in the 1990s. No one questions that the United States had a very deep financial market in the 1990s. If we could get back to this level of trading volume and save $100 billion a year or so in trading costs, this would be a huge gain for the economy. It would also reduce inequality, since many of the people doing the trading that would be eliminated are very rich.

The next part of the financial fun pack would be a requirement to make fully public all the terms that public pension funds sign with private equity companies and other investment managers. Their returns would also be fully public. This would mean that anyone could go on the website for any state or local pension fund and see exactly the terms of any contract it signed with a private equity company and also whether the investment turned out to be a good deal for them.

Private equity companies engage in many dubious practices, typically loading up firms with debt and often pushing them into bankruptcy. These practices raise many issues, but a really simple point is that pension funds often don’t make money on these investments. The private equity partners get very rich (think of Mitt Romney), but the investors often don’t.

As it stands, private equity companies typically require that the terms of their contracts be kept secret, making it difficult to know whether pension funds are being ripped off. Federal legislation requiring full disclosure could be a remedy for this situation.

There is a similar story with hedge fund types who are the favored investors for university endowments. It seems that these millionaires and billionaires have cost places like Harvard billions of dollars with their bad investment choices in recent years.

A recent study found that the average return on the Ivy League’s endowments substantially lagged a portfolio with an indexed 60 percent/40 percent, stock-to-bond mix. Harvard led the underperformers, falling behind this portfolio by more than three percentage points. On its $40 billion endowment, this would imply Harvard was throwing more than $1 billion a year into the toilet to make its investment managers rich.

The government could require that to keep tax-exempt status a non-profit has to make all the terms of its investment contracts fully public. This way, everyone at Harvard could know who was getting rich at the expense of students’ financial aid and workers’ salaries.

Anyhow, that’s the Finance Fun Pack. It may not make the rich people in the financial sector very happy, but it should provide plenty of entertainment for the rest of us.

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