Back when I was a 10-year-old rascal, I frequently found myself glued to the black-and-white television in the downstairs playroom of our northern New Jersey suburban home, watching the “Soupy Sales Show” on WNEW, channel 5. Most of his show has disappeared from mind, with one exception: Soupy routinely employed the comedic vehicle “show me a … and I’ll show you a … ”
“Show me a country that has only pink automobiles … and I’ll show you a pink carnation.” My elementary school brain could grasp that one. “Show me a midget king … and I’ll show you a 12-inch ruler.” I recall drawing attention to that one in art class.
“Show me the ocean floor … and I’ll show you the prints of whales.” That one stumped me. My Canadian wife might have been better prepared to enjoy that pun at age 10.
We have been spending some time addressing the tax proposals of the remaining Republican presidential candidates. If Soupy were here he might say, “Show me a Republican tax cut … and I’ll show you welfare for the wealthy.”
At this point we should give equal print space to the Democratic hopefuls’ tax plans. Both Bernie Sanders and Hillary Clinton have advanced a financial transactions tax. To better understand the issues at stake, it might be helpful to review the economics surrounding Wall Street.
During the past two decades, Wall Street has supplied to liberals, conservatives, libertarians, moderates, and anyone else we have forgotten, volumes of validation with which to vilify our financial industry. Shall we mention the dot-com bubble, Bernie Madoff, the housing bubble, mortgage fraud, market manipulations, price-fixing, and sky’s-the-limit bonuses?
With that said, I call on Soupy once again. Show me an economy without a well-developed financial sector … and I’ll show you a banana republic.
The main activity of the financial sector is “intermediation,” the matching of savers and borrowers. The primary function of Wall Street is to take the savings of our nation and parcel it out to borrowers, the importance of which is hard to overstate.
As an example, what house would you be living in without a mortgage? What car could you afford without a consumer loan? How would your business operate without a line of credit and a corporate loan?
I venture to say that most of the products we enjoy today were, at some point, a radical and speculative venture. Someone on Wall Street made a decision to lend money to the various enterprises which then developed cars, and refrigerators, and telephones, and computers, and the list is endless.
As an additional point, consider the nature of liquidity. Savers typically desire immediate or nearly immediate access to their funds. Entrepreneurs, in contrast, usually need resources for a long period of time. Do homebuyers take out a one-year mortgage or a 20-year mortgage? Yet lenders often require their money back next month or next year.
Wall Street, despite its well-earned reputation for skullduggery, performs a vital role within our economy. Take it away and you go back to agrarian times. In addition, many of the seemingly useless pieces of Wall Street are also important.
I spent my career as an arbitrage trader. My Canadian socialist mother-in-law, whom I dearly love and admire, considered my work immoral. Yet, even my little firm played a useful role in the Wall Street machine.
As arb traders, we were opportunistic. When we saw a security trading “cheap” to other securities, we would buy the cheap and sell the rich. When the securities came back into line, we would unwind the trade with a profit.
The value to society from this activity may not be obvious. In reality, arb traders add to the depth of the markets. When, for example, General Motors pension fund decides to sell a large block of stock, arb traders ensure that the price received is better than would have been the case in their absence.
The better price translates into higher pension benefits for GM retirees. Show me a market without arb traders … and I’ll show you people who pay too much and receive too little for their securities. OK. I know. Soupy would have done it so much better.
We now come to the question of why Sanders and Clinton would like to interfere in this machine we call Wall Street, by implementing a financial transactions tax. Each of the candidates has a different perspective on this; each perceives a problem which a properly programmed financial transactions tax can fix.
On a micro level, Clinton sees abuse in high-frequency trading connected to our flash-trading system. The issue is as follows.
The same financial products now trade at more than one exchange and on more than one platform. Sometimes a large buy or sell order comes into an exchange, and the price attached to the order is beyond the price offered at another exchange. Before the order is sent on to the other exchange, the order is flashed to certain market players at the first exchange to see whether they are willing to fill the entire order.
Many Wall Street firms have put into place a high-frequency trading algorithm which will execute within a few milliseconds a trade at the second exchange, thereby stepping in front of the large order and allowing the high-frequency trading firm to profit through the practice of “front-running.” Clinton proposes to tax these types of transactions, effectively eliminating them.
The philosophy behind Bernie Sanders’ proposal for a financial transactions tax is more global in nature. From his perspective, Wall Street has become too big. The percentage of economic resources devoted to the financial sector is too high. As such, it is now collecting economic “rent,” a term used to describe a payment which is beyond the amount justified on economic grounds.
Sanders has been singing this tune for quite some time. Interestingly, last year the International Monetary Fund, an institution which could hardly be called a left-wing socialist operation, published a report entitled, “Rethinking Financial Deepening: Stability and Growth in Emerging Markets.” The study gave ample evidence to conclude that the U.S. financial sector has indeed grown to a size which now reduces growth. Reducing the size of Wall Street could actually increase growth within our nation.
Further along these lines, French economist Thomas Philippon, working at New York University’s Stern School of Business, recently published a paper entitled, “Has the U.S. Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation.” I found this a fascinating read on several levels. I would, wouldn’t I?
Perhaps one of the most surprising results within his study was a chart showing the unit cost of financial intermediation from the late 18th century until now. Astoundingly, during the past century when the cost of food production, manufacturing, computation, communication, travel, and so forth has gone dramatically lower, the unit cost of financial intermediation has remained fairly constant.
None of the innovations such as computers, internet, and so forth, have lowered the cost of our financial sector. Something is not quite right here. It would appear that the financial sector has grown past its contribution to society.
How will the financial transactions tax work to address the issues and how much can actually be raised by such a tax? Show me another week … and I’ll show you another column.
(Marcus Hutchins is a former economist, treasury bond arbitrage trader, and hedge fund manager. He retired to Southport in 1997, where he resides with his wife, Andrea, and youngest daughter, Abbey. He welcomes feedback at email@example.com.)