Dean Baker
Yahoo! Finance, July 9, 2012

See article on original website

Over the past week, the business news has been filled with stories about major British banks manipulating the LIBOR rate. While these stories are undoubtedly confusing to most of the public, which is not generally familiar with the intricacies of different interest rate indexes, the basic story is fairly simple: Big banks were caught lying about interest rates in order to make big profits.

For the most part the victims were other high-rollers who were taking the other side of bets on complex financial derivatives. However there were also pension funds and even governmental units such as school districts and park services that were persuaded by their financial advisers to get into this high-stakes game. These folks were among those who lost because of the LIBOR liars.

A Fundamental Problem

While there should be a thorough investigation that results in the guilty parties being severely punished, this incident sheds light on the fundamental problem with the modern financial industry. There is enormous money to be made by shaving a small fraction of a penny here or there. When this shaving is done on trades that can run into the hundreds of billions or even trillions of dollars, those fractions of a penny can run into really big bucks. And when we give people enormous incentive to lie and steal, it is likely that many will take advantage of the opportunity.

There is an obvious answer to this problem and a simple way to do it. The answer is to take the money away. If bankers didn't have the opportunity to make hundreds of millions or billions of dollars by manipulating the market, they wouldn't do it. And the simplest way to take away this opportunity is to reduce the size of these markets with a modest tax.

A small tax on flipping stock, options, credit default swaps and other derivative instruments would drastically reduce the size of these markets, thereby reducing the opportunities for market manipulation. Such a tax could also raise a substantial amount of money.

The Joint Tax Committee of Congress calculated that a 0.03 percent tax on all trades, as was proposed by Iowa Senator Tom Harkin and Oregon Representative Peter DeFazio, could raise more than $350 billion in the first nine years that it was in place. This is almost ten times the sum at stake with the Buffet rule and more than 10 times the amount of money that would be saved by ending subsidies for the oil industry.

A Targeted Tax

The great thing is that almost all of this tax would come out of the hide of the Wall Street crew. While many of us hold some stock either directly or through a mutual fund in a retirement account, there is a considerable amount of evidence that shows people respond to higher trading costs by trading less.

This means, for example, that if this tax doubled the typical cost of a trade (it doesn't), then most people will cut back their trading by roughly 50 percent. That means that a typical investor will pay little or nothing as a result of this sort of tax. They may pay more money on each trade, but they will make fewer trades, leaving their total trading costs pretty much unchanged.

It's also important to remember that trading costs have been falling rapidly as a result of the advance of computer technology.  While the financial industry's lobbyists have been claiming that the Harkin-DeFazio tax would be the end of the world, in reality it would just raise trading costs back to where they were 5-10 years ago.

Shrink the Financial Sector

In addition to be being less corrupt, a smaller financial sector is likely to better serve the economy. Finance is an intermediate good, like trucking. We need the financial sector to allocate money from lenders to borrowers, just like we need trucking to move goods from point A to point B. But the financial sector doesn't directly produce items we consume, like food, housing or health care. In principle, the smaller the financial sector, the better.

Recent research indicates that countries with large financial sectors have slower growth. It appears that a bloated financial sector pulls highly skilled people away from research intensive sectors of the economy such as computers and biotechnology. The sort of financial shenanigans we saw with the manipulation of the LIBOR rate also seems to pull capital away from start-ups that need to borrow to finance investment.

In short, there are some very good reasons to want a smaller, more efficient financial sector. And a tax on financial speculation is a great way to get there.