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Flip Charge

If we cannot prevent another financial crisis, banks should pay the taxpayer an insurance premium

If progressives do not respond to the current financial crisis, a significant opportunity will have been missed. We can chart a progressive course that avoids unfettered markets and old left anti-capitalism. As governments and central banks tackle the problems in markets, now is the time to think afresh. We need to examine ourselves to check that we have not been captured by what the American economist JK Galbraith called ‘the conventional wisdom’.

Finance ministers are under pressure to introduce new regulation to prevent anything like this happening again. The stable door is being slammed shut, while the bolting horse continues to run havoc around the grounds. As Galbraith noted, ‘Regulation outlawing financial incredulity or mass euphoria is not a practical possibility’. It cannot be done, human nature being what it is.

The taxpayer benefits from a successful financial sector, driving the rest of the economy by channelling funds to profitable investment opportunities. Every few years however the taxpayer is expected to spend or risk billions of pounds preventing financial and economic catastrophe.

Regulation is essential but we should consider also using a tax. We could embed the progressive principle that market intervention can be necessary.

Banks have conceded that government intervention is essential for the survival of financial markets. The taxpayer should demand an insurance premium from banks against future disasters. This would be in the form of a regular tax, the proceeds of which would be used to reduce the national debt. This would strengthen the government’s fiscal position in preparation for the next bailout.

Of course, such a tax could tempt a future government looking for ways to increase revenue. To avoid this, we should cede direct control of this tax to the Bank of England. It could vary the tax rate along a scale according to its level of concern about asset price inflation and financial leverage. The Bank warned last year about levels of risk. If financial euphoria returned it could raise the ‘insurance premium’ since the probability of a crisis would have increased. The increased tax revenue would put the government in a better position to deal with the next crisis but it could only be used to pay down national debt (unless the government was running a surplus).

There is a further potential objection. Government could take advantage of the improved fiscal position to spend more or cut taxes, so stimulating the economy during times of financial euphoria. Due to time lags affecting the impact of taxation and expenditure policies, it is possible that the reverse may happen and a fiscal stimulus arrives just as a financial bubble is bursting. However, the concern can probably be addressed by adjusting the government’s fiscal rules to ensure prudent government finance is still encouraged.

As with any insurance scheme, it is important to avoid moral hazard. The existence of insurance could change banks’ behaviour and encourage them to take on more risk. This could be prevented if the government was not obliged to rescue banks in future. The nature of government intervention in a future crisis should remain at least partially obscure.

Banks would probably resist such a tax which, as with financial regulation, should apply in some form across financial centres. It would however encourage them to examine their balance sheets to ensure they were not overstretched. What should we call this new measure? If it is not introducing inappropriate levity (flippancy?) to the current situation, I suggest ‘financial Leverage insurance premium’. It would be known as ‘FLIP’, one of the milder expressions heard in the City when a bubble bursts. It also accurately describes the change in the attitude of the financial sector towards government intervention when a crisis occurs.

This article previously appeared on the Progress Online web site.
Stephen Beer, Friday 18 April 2008
Progress Online 18 April 2008, 18/04/2008

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