A New Financial Transaction Tax and Glass-Steagall Act: Two Equally Misguided Ideas

COMMENTARY Markets and Finance

A New Financial Transaction Tax and Glass-Steagall Act: Two Equally Misguided Ideas

Apr 1st, 2021 8 min read
COMMENTARY BY
Norbert J. Michel, Ph.D.

Director, Center for Data Analysis

Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.
Trading ends for the day on the floor of the New York Stock Exchange (NYSE) on March 20, 2020 in New York City. Spencer Platt / Getty Images

Key Takeaways

There is virtually no evidence that banks engaged in securities trading prior to the Depression were in worse financial condition than their peers.

Stock (and bond) trades of all kinds help ensure that capital flows to where it is most needed and most productive, thus helping working families.

Penalizing people for creating wealth does not help the typical American, nor does penalizing people for trying to create wealth.

Progressives have never let go of the notion that the 1933 Glass–Steagall Act outlawed the problems that caused the Great Depression. They have also consistently sought to tax every activity known to man because they feel that profit and wealth accumulation—by people other than themselves—are unjust.

Basing policies on these misguided ideas is dangerous, but the Biden administration appears to be moving in that direction.

Apparently, President Biden sees “eye to eye” with Sen. Elizabeth Warren (D-Mass.) on reimposing some version of Glass-Stegall. Warren’s big idea is to use a new version of Glass-Steagall to start “breaking up the biggest U.S. banks.” Biden also supports a financial transaction tax, and Sen. Warren has just co-sponsored a new bill to implement “a 0.1% tax on each sale of stocks, bonds and derivatives.”

Even some conservatives are now supporting these ideas, but ultimately it doesn’t matter who is advocating for them.  

The only thing that these policies will do to boost living standards is make well-connected lawyers and consultants filthy rich for helping write and navigate all the new rules and regulations. They will shrink—not expand—economic opportunity for the middle class and lower-income workers. Both these ideas are based on flawed logic and distorted history.

Let’s start with Glass-Steagall.

>>> The Glass–Steagall Act: Unraveling the Myth

As difficult as it may be to believe, there is virtually no evidence that banks engaged in securities trading prior to the Depression were in worse financial condition than their peers who stuck to retail banking. In fact, the evidence suggests that banks engaged in both types of financial activities were stronger than those that engaged in only retail banking. Incidentally, the evidence is perfectly consistent with basic financial theory—investing all of one’s eggs in a single basket is never a good idea.

True, numerous reports cite many abusive and reckless investment practices that Congress uncovered prior to passing the Glass–Steagall Act. But most of these assertions are exaggerated or untrue. They typically refer to secondary sources rather than the original record, and to opinions and allegations rather than actual evidence of abuses. In many cases, commentators refer to practices that had nothing to do with the combination of investment and commercial banking, such as tax avoidance and “excessive” salaries.

The most recent Glass–Steagall myth is that its repeal (via the 1999 Gramm–Leach–Bliley Act (GLBA)) led to uncontrolled speculation that caused the 2008 financial crisis. But the GLBA repealed only two sections of Glass–Steagall while leaving intact key financial market restrictions from the 1933 law, and the same mortgage investments were allowed under both regulatory regimes.

Furthermore, although the GLBA allowed some firms to engage in activities from which they were previously restricted, those financial activities remained heavily regulated after the law was enacted.

If anything, the Glass-Steagall Act made financial markets less safe, and the blame lies mainly with Sen. Glass. Like many progressives and populists after him, Glass was preoccupied with the notion that “purely speculative” investment activity was harmful and had to be kept out of commercial banks.

They ignore, of course, the fact that commercial lending involves many of the same types of financial risks as the securities activities they loathe. There is no objective definition of purely speculative investment, and there is no reason to believe that quelling anyone’s version of it will make the financial system any safer.

Yet, Warren and her acolytes would have us believe that if we can just give regulators the right set of tools, they can finally keep everyone safe and make them wealthy. This naïve view ignores (among other things) that regulators have no special ability to determine which investments are safest. It also disregards the fact that financial regulators were instrumental in building every piece of the pre-2008 regulatory framework. (There is no doubt that risk-based bank capital regulations contributed mightily to the 2008 crisis.)

Americans have every reason to distrust anything that remotely resembles the Glass-Steagall Act, as well as anyone who insists that regulations can ensure financial safety. They also have every reason to be skeptical of a financial transaction tax, not least of all because its supporters use the same rhetoric as those who champion Glass-Stegall.

Last week, Sen. Brian Schatz (D-Hawaii) introduced a new financial transaction tax bill and noted that “a tax on financial transactions would discourage unproductive trading and redirect investment toward more productive areas of the economy.” He went on to argue:

During the pandemic, Wall Street has cashed in on high-risk trades that add no real value to our economy and leave working families behind. We need to curb this dangerous trading to reduce volatility in the markets and encourage investment that can actually help our economy grow. By raising the price of financial transactions, we can make our financial system work better while bringing in billions in new revenue that we can reinvest in our workers and our communities.

Schatz does a great impersonation of Sen. Glass, but he has no special knowledge of which areas of the economy are the most productive. More important, this is not 1933.

In this era, too many Americans—of all economic backgrounds—invest in the stock market to fall for this political pandering. The proof is in the polling evidence that shows strong opposition, across the political spectrum, to a financial transaction tax.

As my former colleague Adam Michel points out:

Some of the largest shareholders and beneficiaries of our modern financial system are pension funds for public-sector employees and private retirement account holders. Firefighters, teachers, university endowments, and private retirement savings all benefit from sophisticated equity markets.

It is also factually incorrect that “high-risk trades” add no real value to the economy, or that they “leave working families behind.” Stock (and bond) trades of all kinds help ensure that capital flows to where it is most needed and most productive, thus helping working families. Even short-selling provides valuable information to help direct capital, and earning millions of dollars per year is not a prerequisite for tapping into the wealth created by any of these trades.

Proponents insist that the tax will have few (if any) adverse effects, but history shows large negative responses to these taxes in multiple countries—so much so that they raise “significantly lower revenues than projected.” The U.S. experience is also illustrative—the federal transaction tax that was enacted in 1914 (and doubled during the Depression) was repealed in 1965 by an overwhelmingly bipartisan vote (the House voted 401-6 and the Senate voted 84-3).

>>>New Bill to Tax Stock Market Could Devastate Ordinary Savings and Retirement

The early part of that history seems to be lost on recent advocates—it was in place during the 1920s which, of course, ended with the crash of 1929 and the Great Depression. That tax was much smaller than the one Schatz and Warren are proposing now, but it seems strange to argue for an even higher tax than the one in place just before the market crashed in 1929.

It is especially odd given that the likely effect will be to make markets less diverse and more volatile. While it is difficult to judge the size of this effect, the direction is clear. The tax will discourage trading and investing, thus reducing portfolio rebalancing and hedging, both of which people use to reduce risk.

The tax will also unambiguously raise the cost of capital, a particularly weird idea to promote as a devasting pandemic is winding down. Covid-19 aside, everyone enjoys the benefits that derive from a lower cost of capital. Purposely increasing its cost harms workers because it results in capital being employed less effectively and efficiently. It effectively tells workers to do more with less, an unambiguously losing proposition.

Schatz’s rhetoric amounts to little more than the typical class-warfare themes that allow the ruling elite to gain political and economic power at the expense of everyone else, especially the working class.

All Americans should celebrate when other Americans create wealth. Penalizing people for creating wealth does not help the typical American, nor does penalizing people for trying to create wealth. Both are distinctly un-American.

The last thing American workers need is regulators with even more authority to judge the quality of their individual investments, or to further restrict how they can invest their own money.

This piece originally appeared in Forbes https://www.forbes.com/sites/norbertmichel/2021/03/31/a-new-financial-transaction-tax-and-glass-steagall-act-two-equally-misguided-ideas/?sh=1786d6c67dde