Let's Play Jazz!

It's time to devise a new financial architecture.

Prune the exotica

The meltdown of 2008 and the ensuing economic recession it triggered can be laid firmly at the door of speculators in banks, hedge funds and other institutions who had created a shadow financial system, operating with intertwining and overlapping derivatives. Not only were these barely comprehended, even by those using them, the ways in which they would interact were almost impossible to predict.

Some derivatives are useful; others are largely vehicles for speculation. All should be presented for inspection by the financial authorities and only those approved should be used – and traded on public exchanges so that everyone is aware of who owns what and which institution is exposed to what risk. Trading in unapproved derivatives would be stifled if these were legally unenforceable.

Among the most dangerous derivatives are credit default swaps, currently valued at around $55 trillion – an indirect and opaque form of insurance that could yet sink many more lenders. These should be banned, requiring lenders to take full responsibility for the credit they offer and denying speculators this particular form of get-rich scheme.

Also in line for pruning should be the hedge funds. At present these are largely unregulated since it was wrongly assumed they were a risk only to themselves. One way toreduce the damage would be to prevent short-selling by banning other institutions from lending them the shares they need for this purpose.

Tax the transactions

Distortions and bubbles of all kinds are encouraged by electronic trading, which can see shares or currencies or bonds changing hands continuously at lightning speed.This encourages “momentum” trading which has nothing to do with underlying values and more to do with what other traders will do in the subsequent seconds or minutes.

One of the most promising ways of addressing this, but as yet untried thirty years after it was proposed by Nobel laureate James Tobin, would be to tax every transaction. At present only around 5 percent of currency trdes, around $3 trillion per day, are linked to actual trade. The rest is speculation which can wreak havoc with national budgets, especially for developing countries.

Applying a sales tax of around 0.2 percent on each trade would skim off much of the speculative froth – while also generating valuable revenue. Assuming the annual trade were cut to a more reasonable level of $100 trillion this would yield tax revenues of $200 billion for public purses. The same principle could be applied to stock exchanges, which would have the merit of stifling some of the endless churning of stocks in hedge funds which achieve little other than to enrich traders and brokers.

Match risks and rewards

The most repulsive aspect of the 2008 financial crisis is that even disgraced chief executives of failed banks walked away with huge bonuses, as reward for failure. This is because the incentive systems encouraged employees to take bets on the markets that would produce short-term gains, in risky deals and crazy loans that would later turn toxic, by which time the trader of chief executive would have collected millions of dollars. This is akin to betting against a number coming up on a roulette wheel—you can take quite a few spins before being caught out, by which time you could have moved on to a different game.

When chief executive Stan O’Neal was ousted from Merrill Lynch in October 2007, he was comforted with a $160-million payoff, in part based on a rise in the share price that had yet to reflect his dangerous strategies. The pay for bankers and others should be based instead on continuous assessment of their performance and, where appropriate, reflect the full implications of their activities, even if these may not be known for several years. This will mean devising new contracts, so now’s a good time while the bankers are looking for jobs and are not so picky about the perks.

Close tax havens

The world’s tax havens serve no purpose other than to boost corporate profits and rich individuals at the expense of regular tax payers. The British government bears much of the responsibility since it is in a position to exert direct control over some of its own territories.

But there are other measures that could be taken to lift the veil of secrecy under which many companies and individuals operate, as they shuffle money from one dubious jurisdiction to another. This would involve, for example, demanding that companies declare their profits, losses and taxes they pay in every country they do business. Just as important would be to end banking secrecy and ensure that tax authorities in each country are able to exchange the necessary information.

A fresh start

The 2008 financial meltdown has had huge costs, not just for taxpayers in the rich countries but also for millions of people in developing countries who are suffering from a global economic crisis. But it also represents an opportunity for a fresh start—looking again at the most basic assumptions under which our financial systems operate.

The corporate lobbyists are, of course, busy preparing their arguments as to why it would be dangerous to react to the latest drama by stifling the creativity of financial markets. They claim that the latest crisis is simply a part of a cycle of creative destruction, a Darwinian process that will permit the survival of the most robust financial models and sweep away those that have proved useless or dangerous.

But we now know the true cost of this free-for-all. The financial markets are not to be trusted. They expect to be given free rein to make huge profits while the sun is shining, but hasten to the shelter of the state when the skies darken. Never again. We now know better. Time to devise a new financial architecture.

Now get on it! Head to the Meme Warfare Hub and start playing jazz!

Peter Stalker is a freelance writer and editor based in the UK. He authored The No-Nonsense Guide to Global Finance and has written three books on international migration. He is a former co-editor of the New Internationalist, has edited the UN Development Programme’s “Human Development Report” and now works as a consultant to a number of UN agencies. This is excerpted from People First Economics, New Internationalist Publications, 2009.