Minneapolis Fed President Endorses Tax To Ensure That Banks Pay ‘The Full Costs’ Of Their Riskiness

Minneapolis Federal Reserve Board President Narayana Kocherlakota

Minneapolis Federal Reserve Board President Narayana Kocherlakota

During the financial regulatory reform debate, a fee on the country’s biggest banks that would have gone towards a resolution fund for unwinding a systemically risky financial firm was discarded after complaints from Republican lawmakers. At the same time, the financial services industry is gearing up to fight a $90 billion bank fee proposed by the Obama administration (even though such a fee is required by law to recoup losses resulting from the Troubled Asset Relief Program) on the grounds that “it violates the bill of attainder clause of the Constitution.”

The notion that a bank tax violates the Constitution is silly, but this highlights the difficulty that Democrats in Congress and the administration have had getting such a tax enacted. Today, though, bank tax advocates have one more ally — Minnesota Federal Reserve Bank President Narayana Kocherlakota, who in a speech advocated for creating a tax on bank risk:

I will argue that, knowing bailouts are inevitable, financial institutions fail to internalize all the risks that their investment decisions impose on society. Economists would say that bailouts thereby create a risk ‘externality.’ There is nearly a century of economic thought about how to deal with externalities of various sorts — and the usual answer is through taxation. Taxes are a good response because they create incentives for firms to internalize the costs that would otherwise be external.

“It is useful to tax a financial institution producing a risk externality, just as it is useful to tax a firm generating a pollution externality. The purpose of the tax in both instances is to ensure that the targeted firm pays the full costs — private and social — of its production decisions,” Kocherlakota added.

As Bloomberg News pointed out, the speech puts Kocherlakota, “closer than any other Fed official to the positions taken by the Obama administration and International Monetary Fund.” Plus, the concept of a bank tax has been embraced by the European Union, so there’s no need to worry about competitiveness issues with European banks (though those concerns are likely overblown anyway).

As David Leonhardt wrote in the New York Times, “a bank tax is akin to an insurance policy that taxpayers would require Wall Street to hold. The premiums on that policy would keep Wall Street from making big profits in good times while foisting its losses on society in bad.” Senate Finance Committee Chairman Max Baucus, meanwhile, has called for the U.S. to “step up and lead” by implementing a bank tax, thereby showing the rest of the world that such a move can work. Now it’s just up to a reluctant Congress to actually get it done.