The Ticking U.S. Fiscal Bomb

The administration lacks the political capital for financial reform.
In the last few weeks we've witnessed a series of events that reveal the Obama administration's juggling act. It has sought to introduce policies to maintain growth and tame the fiscal deficit, while also garnering the Congressional support it needs to see them pass. The Democrats' loss of the Massachusetts Senate seat, though, raised questions about President Obama's ability to move forward on financial regulation, fiscal austerity and health care reforms. Obama's waning political capital will stand in the way of achieving his fiscal, social and economic goals.

Obama on Jan. 14 proposed a Financial Crisis Responsibility Fee, a tax levied on the non-deposit liabilities of the largest financial institutions to cover the expected losses from the TARP program. The tax, expected to be imposed for at least 10 years, with an assessment of 15 basis points per year, would raise $90 billion over that period and approximately $117 billion over 12 years. Only firms with consolidated assets greater than $50 billion would be affected, and over 60% of revenues would most likely be garnered from the 10 biggest firms. U.S. subsidiaries of foreign firms would also be subject to the fee.

Among the tax options on the table, which also include a global financial transaction fee (called a "Tobin tax" after Nobel-winning economist James Tobin, who proposed a tax on foreign-currency transactions in the 1970s) and a Bonus Tax, a risk-based fee is the most efficient solution. As I've advocated, a similar systemic risk levy to finance a "resolution fund" is being considered in Congress as a way to internalize potential bailout costs stemming from too-big-to-fail institutions. Obama's risk-based fee model is gaining traction at the international level. At the Davos Forum some leaders of the largest financial institutions have voiced support for the proposal. Jaime Caruana, the chief of the Bank of International Settlements, stated that the most realistic way to institute a global levy would be to implement a similar levy in Europe. Moreover, at the G20's request, the IMF is producing a study on the various ways in which the financial sector could help recoup the costs of public-sector crisis support.

On Jan. 21 the president proposed the "Volcker Rule," named after former Fed chairman Paul Volcker, one of the biggest proponents of Glass-Steagall-type restrictions (although his current proposal--endorsed by the president--does not call for a separation of commercial and investment banking activities). The President's proposal would put limits on the size and scope of the U.S. banking sector in the interest of addressing risk management and conflict-of-interest concerns. According to Volcker, the rationale for limiting the size of institutions arises from the vital capital intermediation and payment system functions they provide for the real economy. The complexity that arises from the combination of these activities is reason enough to limit each institution's size, to ensure that an individual failure would not disrupt the economy. For the same reason, he argues, the risk inherent in commercial banks' proprietary trading activities is not warranted and should not be backstopped by the safety net provided to ensure deposit-taking institutions' core activities. The same reasoning applies to bank ownership of private equity and hedge funds, with conflicts of interest an additional aggravating factor.

The new Volcker Rule is a step in the right direction. More radical reforms, like breaking up too-big-to-fail financial firms and returning to Glass-Steagall-type restrictions, which are needed to stave off asset bubbles and tame systemic risk, may be politically difficult to implement.

On Monday the Obama administration released its fiscal year 2011 budget, which forecasts fiscal deficits of $1.55 trillion (10.6% of GDP) and $1.3 trillion (8.3% of GDP) for 2010 and 2011 respectively. To support economic recovery in the near term, the administration plans to increase spending on several stimulus measures: extending unemployment benefits and health care subsidies for unemployed workers; providing tax and credit incentives for small businesses to invest and hire workers; extending payroll tax cuts for the middle class; and increasing funding for states, infrastructure and transportation. Meanwhile, the administration plans to begin to reduce the fiscal deficit in 2012 and bring it below 4% of GDP by 2014 by adopting fiscal consolidation measures and reducing the primary deficit. It aims to do so by raising taxes on high-income households and investors, and cutting spending on health care and discretionary programs.