Derivatives Clearinghouses Are No Magic Bullet. By MARK J. ROE
Will the Dodd bill create another kind of institution that's too big to fail?WSJ, May 06, 2010
As the Senate finalizes its financial reform legislation, a consensus is developing that if we could just get derivatives traded through a centralized clearinghouse we could avoid a financial crisis like the one we just went through. This is false. Clearinghouses provide efficiencies in transparency and trading, but they are no cure-all. They can even exacerbate problems in a financial crisis.
If I agree to sell you a product next month through a clearinghouse, I'll deliver the product to the clearinghouse and you'll deliver the cash to the clearinghouse on the due date. Let's say we both have many trades going through the clearinghouse and we've posted collateral to cover any single trade that fails. This is more efficient than each of us posting collateral privately for each trade. Moreover, we're not worried that I won't deliver or you won't pay because we both count on the clearinghouse to deliver and pay up if one of us doesn't.
This clearing system makes trading more efficient. If you default, the cost is spread through the clearinghouse so I don't get hurt severely. And if the clearinghouse has enough collateral from you, there's no loss to spread. But there's also a potential downside: The clearinghouse reduces our incentives to worry about counterparty risk. Your business might collapse before you need to pay up, but that's not my problem because the clearinghouse pays me anyway. The clearinghouse weakens private market discipline.
Still, if the clearinghouse is as good or better at checking up on your creditworthiness as I am, all will be well. But one has to wonder how good a clearinghouse will be, or can be.
Consider two of our biggest derivatives-related failures—Long-Term Capital Management in 1998 and the subprime market in 2008. When Russia's ruble dropped unexpectedly, LTCM was exposed on its more than $1 trillion in interest-rate and foreign-exchange derivatives. It could not pay up and collapsed. Ten years later the market rapidly revalued subprime mortgage securities, rendering several institutions insolvent. AIG was over-exposed in credit default swaps tied to the value of subprime mortgages.
Could a clearinghouse really have been ahead of the curve in getting sufficient capital posted before these problems became serious and well-known? I'm not so sure. Worse yet, major types of derivatives have built-in discontinuities—"jump-to-default" in derivatives-speak.
For a credit default swap, one counterparty guarantees the debt of another company to you, in return for you paying a fee for that guarantee. If no one goes bankrupt, the counterparty just collects the fees from you. But if the guarantee is called because the company you were worried about goes bankrupt, the counterparty must all of a sudden pay out a huge amount immediately.
Yet the guarantor is often called upon to pay in a weak economy, just when it can itself be too weak to pay. You get credit default protection on your real-estate investments from me, just in case the economy turns sour. But just when you need me the most, in a sour economy, I turn out to be so overextended I can't pay up. Collateralizing and monitoring such discontinuous obligations will not be so easy for the clearinghouse.
Moreover, if trillions of dollars of derivatives trading goes through a clearinghouse, we will have created another institution that's too big to fail. Regulators worried that an interconnected Bear or AIG could drag down the economy. Imagine what an interconnected clearinghouse's failure could do.
AIG needed $85 billion in government cash to avoid defaulting on its debts, including its derivatives obligations. Could one clearinghouse meet even a fraction of that call without backup from the U.S.? True, we could have many clearinghouses, each not too big to fail—but then maybe each would be too small to do enough good.
The Senate bill would allow a clearinghouse to grab new collateral out from failing derivatives-trading banks to cover old, but suddenly toxic, debts the banks owe to the clearinghouse. This could harm other creditors and cause the firm to suffer a run. Nevertheless, to protect itself in a declining market, a clearinghouse would have to make those big collateral calls. That's good if it protects the clearinghouse. But it's bad if it starts a run on a weakened but important bank.
One key but missing element in the search for reform has yet to gain traction in Washington. Derivatives players obtained exceptions from typical bankruptcy and bank resolution rules in the past few decades for their contracts with a bankrupt counterparty. This allowed them to grab and keep collateral other creditors cannot. That gives derivatives traders reason to pay less attention to their counterparties' riskiness and weakens market discipline. These rules should be changed before the Senate is done.
To say that a clearinghouse solution is very incomplete is not to say there is an easy solution out there. We may be unable to do more than to make incomplete improvements and muddle through.
Derivatives trades first of all should not just be centrally cleared, but should also be taken out from the government-guaranteed entities, such as commercial banks (or at least we need to impose tight capital requirements on those banks that deal in derivatives). Derivatives traders like doing business with Citibank because they know the government won't let Citibank go down. But this puts taxpayers at risk. It would be better to run those trades through an affiliate, not through the bank, so counterparties realize they might not be bailed out if the affiliate failed. If a banking affiliate's counterparty is the clearinghouse, then the clearinghouse will have incentives to make sure that the affiliate is well-capitalized. This is particularly so if the clearinghouse won't get any special priority treatment in a bankruptcy.
Critics of proposals to establish separate bank affiliates for derivatives trading complain about the large amount of capital that would be needed for such affiliates. But the capital that might be needed to buttress a bank affiliate indicates some level of the value (i.e., the taxpayer subsidy) to derivatives players of trading with a too-big-to-fail entity that they know the government will step in to save. They are implicitly getting insurance and should pay for it.
And, since a clearinghouse is itself at risk of being too big to fail, regulators need to police its capital and collateral requirements. If the derivatives market sees the clearinghouse as too big to fail, the potential for derivatives players making overly risky derivatives trades becomes real. Clearinghouses can help manage some systemic risk if they're run right. If not, they can become the Fannie and Freddie of the next financial meltdown.
Mr. Roe is a professor at Harvard Law School, where he teaches bankruptcy and corporate law.
Thursday, May 6, 2010
Time to Junk the Corporate Tax
Time to Junk the Corporate Tax. By MICHAEL J. BOSKIN
Nobel Laureate Robert Lucas says reform would deliver great benefits at little cost, making it "the largest genuinely true free lunch I have seen.'WSJ, May 06, 2010
President Obama has put tax reform on the agenda, but surprisingly little attention is being paid to fixing the most growth-inhibiting, anticompetitive tax of all: the corporate income tax. Reducing or eliminating the corporate tax would curtail numerous wasteful tax distortions, boost growth in both the short and long run, increase America's global competitiveness, and raise future wages.
The U.S. has the second-highest corporate income tax rate of any advanced economy (39% including state taxes, 50% higher than the OECD average). Many major competitors, Germany and Canada among them, have reduced their corporate tax rate, rendering American companies less competitive globally.
Of course, various credits and deductions—such as for depreciation and interest—reduce the effective corporate tax rate. But netting everything, our corporate tax severely retards and misaligns investment, problems that will only get worse as more and more capital becomes internationally mobile. Corporate income is taxed a second time at the personal level as dividends or those capital gains attributable to reinvestment of the retained earnings of the corporation. Between the new taxes in the health reform law and the expiration of the Bush tax cuts, these rates are soon set to explode.
This complex array of taxes on corporate income produces a series of biases and distortions. The most important is the bias against capital formation, decreasing the overall level of investment and therefore future labor productivity and wages. Also important are the biases among types of investments, depending on the speed of tax vs. true economic depreciation, against corporate (vs. noncorporate) investment, and in favor of highly leveraged assets and industries. These biases assure that overall capital formation runs steeply uphill, while some investments run more, some less uphill. It would be comical if the deleterious consequences weren't so severe.
Of course, the corporation is a legal entity; only people pay taxes. In a static economy with no international trade, the tax is likely borne by shareholders. The U.S. economy is neither static nor closed to trade, and taxes tend to be borne by the least mobile factor of production. Capital is much more mobile globally than labor, and the part of the corporate tax that is well above that of our lowest tax competitors will eventually be borne by workers. In a growing economy, the lower investment slows productivity growth and future wages.
There is considerable evidence that high corporate taxes are economically dangerous. In a 2008 working paper entitled "Taxation and Economic Growth," the Organization for Economic Cooperation and Development concluded that "Corporate taxes are found to be most harmful for growth, followed by personal income taxes and then consumption taxes." Virtually every major tax reform proposal in recent decades has centered on lowering taxes on capital income and moving toward a broad-based, low-rate tax on consumption. This could be accomplished by junking the separate corporate income tax, integrating it with the personal income tax (e.g., attributing corporate income and taxes to shareholders or eliminating personal taxes on corporate distributions), and/or allowing an immediate tax deduction (expensing) for investment (which cancels the tax at the margin on new investment and hence is the priority of most economists). The Hall-Rabushka Flat Tax, the Bradford progressive consumption tax, a value-added Tax (VAT), the FairTax retail sales tax, four decades of Treasury proposals and the 2005 President's Tax Commission proposals would all move in this direction.
Reducing or eliminating the negative effects of the corporate tax on investment would increase real GDP and future wages significantly. Junking both the corporate and personal income taxes and replacing them with a broad revenue-neutral consumption tax would produce even larger gains. Nobel Laureate Robert Lucas concluded that implementing such reforms would deliver great benefits at little cost, making it "the largest genuinely true free lunch I have seen."
Reducing taxes on new investment could help strengthen what is a historically slow recovery from such a deep recession. It would also strengthen the economy long-term. American workers would benefit from more jobs in the short run and higher wages in the long run.
However, if a new tax device is used to grow government substantially, it will seriously erode our long-run standard of living. The VAT has served that purpose in Europe and, while better than still-higher income taxes, the larger-size governments it has enabled there are the prime reason European living standards are 30% lower than ours. Trading a good tax reform for a much larger government is beyond foolish. No tax reform can offset losses that large. Hence, a VAT should only be on the table if it is not only revenue-neutral but accompanied by serious spending control.
Further, the fraction of Americans paying no income taxes is approaching 50%. That sets up a dangerous political dynamic of voting ever-rising taxes to pay for ever-rising spending. We need more people with a stake in controlling spending. Replacing corporate and personal income taxes with a broad-based consumption tax could increase the number of those with "skin in the game." But some reforms, for example a VAT, might be much less transparent and may not serve this purpose.
Congresses (and presidents) seem unable to avoid continually tinkering with the tax code. A tax reform that is quickly riddled with special features would lose much of its economic benefit. We need a stable tax system that changes much less frequently, so families and firms can more reliably plan their future. Current fiscal policy, loaded with immense deficits, ever-growing debt, and the prospect of higher future taxes, is the biggest threat to such stability. To balance proposed spending in Mr. Obama's budget in 2015, his Deficit Commission's target year, will require at least a 43% increase in everyone's income tax. Thus, spending control is vital to tax stability.
American companies and their workers compete in the global marketplace saddled with a costly, anachronistic corporate tax system. To compete successfully in the 21st century, we will need to reform corporate taxation. There are several paths to doing so, each with its advantages. Unfortunately, tax policy is headed in exactly the wrong direction, raising taxes on corporate source income. Business investment is growing again after the collapse in the recession, which is usual in a cyclical recovery with very low interest rates. But eventually structural drags, from our antiquated tax code to massive public debt, will impede investment and economic growth.
Mr. Boskin is a professor of economics at Stanford University and a senior fellow at the Hoover Institution. He chaired the Council of Economic Advisers under President George H.W. Bush.
Nobel Laureate Robert Lucas says reform would deliver great benefits at little cost, making it "the largest genuinely true free lunch I have seen.'WSJ, May 06, 2010
President Obama has put tax reform on the agenda, but surprisingly little attention is being paid to fixing the most growth-inhibiting, anticompetitive tax of all: the corporate income tax. Reducing or eliminating the corporate tax would curtail numerous wasteful tax distortions, boost growth in both the short and long run, increase America's global competitiveness, and raise future wages.
The U.S. has the second-highest corporate income tax rate of any advanced economy (39% including state taxes, 50% higher than the OECD average). Many major competitors, Germany and Canada among them, have reduced their corporate tax rate, rendering American companies less competitive globally.
Of course, various credits and deductions—such as for depreciation and interest—reduce the effective corporate tax rate. But netting everything, our corporate tax severely retards and misaligns investment, problems that will only get worse as more and more capital becomes internationally mobile. Corporate income is taxed a second time at the personal level as dividends or those capital gains attributable to reinvestment of the retained earnings of the corporation. Between the new taxes in the health reform law and the expiration of the Bush tax cuts, these rates are soon set to explode.
This complex array of taxes on corporate income produces a series of biases and distortions. The most important is the bias against capital formation, decreasing the overall level of investment and therefore future labor productivity and wages. Also important are the biases among types of investments, depending on the speed of tax vs. true economic depreciation, against corporate (vs. noncorporate) investment, and in favor of highly leveraged assets and industries. These biases assure that overall capital formation runs steeply uphill, while some investments run more, some less uphill. It would be comical if the deleterious consequences weren't so severe.
Of course, the corporation is a legal entity; only people pay taxes. In a static economy with no international trade, the tax is likely borne by shareholders. The U.S. economy is neither static nor closed to trade, and taxes tend to be borne by the least mobile factor of production. Capital is much more mobile globally than labor, and the part of the corporate tax that is well above that of our lowest tax competitors will eventually be borne by workers. In a growing economy, the lower investment slows productivity growth and future wages.
There is considerable evidence that high corporate taxes are economically dangerous. In a 2008 working paper entitled "Taxation and Economic Growth," the Organization for Economic Cooperation and Development concluded that "Corporate taxes are found to be most harmful for growth, followed by personal income taxes and then consumption taxes." Virtually every major tax reform proposal in recent decades has centered on lowering taxes on capital income and moving toward a broad-based, low-rate tax on consumption. This could be accomplished by junking the separate corporate income tax, integrating it with the personal income tax (e.g., attributing corporate income and taxes to shareholders or eliminating personal taxes on corporate distributions), and/or allowing an immediate tax deduction (expensing) for investment (which cancels the tax at the margin on new investment and hence is the priority of most economists). The Hall-Rabushka Flat Tax, the Bradford progressive consumption tax, a value-added Tax (VAT), the FairTax retail sales tax, four decades of Treasury proposals and the 2005 President's Tax Commission proposals would all move in this direction.
Reducing or eliminating the negative effects of the corporate tax on investment would increase real GDP and future wages significantly. Junking both the corporate and personal income taxes and replacing them with a broad revenue-neutral consumption tax would produce even larger gains. Nobel Laureate Robert Lucas concluded that implementing such reforms would deliver great benefits at little cost, making it "the largest genuinely true free lunch I have seen."
Reducing taxes on new investment could help strengthen what is a historically slow recovery from such a deep recession. It would also strengthen the economy long-term. American workers would benefit from more jobs in the short run and higher wages in the long run.
However, if a new tax device is used to grow government substantially, it will seriously erode our long-run standard of living. The VAT has served that purpose in Europe and, while better than still-higher income taxes, the larger-size governments it has enabled there are the prime reason European living standards are 30% lower than ours. Trading a good tax reform for a much larger government is beyond foolish. No tax reform can offset losses that large. Hence, a VAT should only be on the table if it is not only revenue-neutral but accompanied by serious spending control.
Further, the fraction of Americans paying no income taxes is approaching 50%. That sets up a dangerous political dynamic of voting ever-rising taxes to pay for ever-rising spending. We need more people with a stake in controlling spending. Replacing corporate and personal income taxes with a broad-based consumption tax could increase the number of those with "skin in the game." But some reforms, for example a VAT, might be much less transparent and may not serve this purpose.
Congresses (and presidents) seem unable to avoid continually tinkering with the tax code. A tax reform that is quickly riddled with special features would lose much of its economic benefit. We need a stable tax system that changes much less frequently, so families and firms can more reliably plan their future. Current fiscal policy, loaded with immense deficits, ever-growing debt, and the prospect of higher future taxes, is the biggest threat to such stability. To balance proposed spending in Mr. Obama's budget in 2015, his Deficit Commission's target year, will require at least a 43% increase in everyone's income tax. Thus, spending control is vital to tax stability.
American companies and their workers compete in the global marketplace saddled with a costly, anachronistic corporate tax system. To compete successfully in the 21st century, we will need to reform corporate taxation. There are several paths to doing so, each with its advantages. Unfortunately, tax policy is headed in exactly the wrong direction, raising taxes on corporate source income. Business investment is growing again after the collapse in the recession, which is usual in a cyclical recovery with very low interest rates. But eventually structural drags, from our antiquated tax code to massive public debt, will impede investment and economic growth.
Mr. Boskin is a professor of economics at Stanford University and a senior fellow at the Hoover Institution. He chaired the Council of Economic Advisers under President George H.W. Bush.
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