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Democrats are Gluttons for Punishment

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Late yesterday, Democratic negotiators caved to an effort from Tea Party Sen. Scott Brown, R-Mass., to shield big banks and hedge funds from taxes that will fund Wall Street reform. As a matter of policy, the move is bad, but not bad enough to sink the legislation. As a matter of politics, it's a complete disaster, and reflects a series of poorly handled negotiations on the financial overhaul.

And guess what? Now that Brown's tax protection for hedge funds is part of the bill, he still won't say whether or not he'll vote for the final legislation.

If Brown still refuses to support the bill, it will be the third time in a month that Democratic leaders had cut a deal with him on the Wall Street package, only to see it arbitrarily undone after the Tea Party favorite got what he wanted. Back in May, he agreed to vote for the bill on the Senate floor, only to reverse his support at the last minute without informing Democratic leaders. Last week, Sen. Chris Dodd, D-Conn., agreed to carve out a massive loophole in the Volcker Rule—one of the last serious reforms still on the table during conference committee negotiations—on the condition that Brown would vote for the bill when it was kicked back to the Senate for final approval. As soon as the bill cleared the committee with Brown's pet loophole, he announced that he could not support the bill, after all, and raised a fuss over the tax issue.

Brown's vote only matters because Dodd has frozen two Democrats out of the negotiation proceedings entirely, in an effort to punish them for voting against the bill in the Senate. Both Sens. Maria Cantwell, D-Wash., and Russ Feingold, D-Wis., opposed the bill on the Senate floor back in May on the grounds that it was too weak to rein in obvious abuses. Cantwell has always made very clear what the price of her vote would be. She wants regulators to actually be able to enforce new derivatives regulations that the new law will allow them to write. Feingold's demands are much broader in scope—he wants to separate risky investment banking operations from safer, boring commercial banking operations—but we'll never know whether he could have been won over or not, because Dodd simply refused to deal with him. Let me repeat that: Instead of negotiating with members of his own team, Dodd went back to a Republican who had screwed him over just one month ago.

On policy, both Cantwell and Feingold have it right. There is no point to writing new rules if regulators can't enforce them, and when risky activities are attached to commercial banks, taxpayers actually end up subsidizing financial excess.

What policy did Brown want? The Tea Partier, who was joined by Sens. Olympia Snowe, R-Maine, and Susan Collins, R-Maine, made a big stink about plans to pay for the bill. Establishing new agencies and getting them up to speed will cost about $19 billion—pocket change in the grand scheme of the federal budget, but pocket change still subject to PAYGO rules in the House. So the bill planned to tax banks with more than $50 billion in assets, and hedge funds with more than $10 billion in assets. That made sense—in environmental regulation, there's a rule called "polluter pays" which states that whoever deals out ecological damage has to pay for its clean-up (we're testing the political effectiveness of that principle with BP right now). The same concept applies to finance—companies that engage in the riskiest activities should have to pay the lion's share of the regulatory costs that keep that risk from backfiring. Basically, that means big banks and big hedge funds should have to foot the bill—the economy is not going to collapse because a $1 billion community bank makes too many business loans, but it very well could if J.P. Morgan Chase goes bankrupt (see: bank bailout, 2008).

Even better, regulators would have had the discretion to levy this tax against the riskiest practices at big banks and hedge funds, forcing them to run safer businesses. The tax was not a major element of the reform package, but it was nevertheless good policy.

But thanks to pressure from Brown, Collins, and Snowe, we aren't going to see a bank tax to pay for the bill. Instead, about half of the cost will be borne by higher deposit insurance premiums from banks, and another half by the redeployment of TARP money. The TARP money doesn't matter so long as banks are forced to pay off losses from the TARP program, something Obama has promised, but is yet to be delivered.

But the premiums are a different issue. They basically serve as a tax on deposits, and they mean that firms who don't have many deposits—including hedge funds and two of the biggest and riskiest banks, Goldman Sachs and Morgan Stanley—won't have to pay for the bill. Instead, much smaller banks that do not pose a threat to the economy at large will have to shoulder much of the burden, as the higher premiums apply to all banks with $10 billion in assets or more.

There's an even deeper problem with this plan. The FDIC's deposit insurance fund—the pool of money that pays off depositors when banks fail—is already in big trouble. We've had far more bank failures than the fund could have handled, and was going to be demand a lot more money from banks over the next few years regardless of what is included in this bill. Claiming that a boost to the FDIC insurance fund will actually pay for anything other than bank failures for the next several years is simply a joke. In effect, Brown, Snowe and Collins have replaced a real tax with a statistical mirage. So much for Republicans getting tough on the deficit.

In other words, Dodd and Frank chose to adopt a bad policy being pushed by a proven liar instead of trying to get members of their own party on board. That's a bad decision.

There is a political silver lining here, and it is significant. The Obama administration ultimately supported removing the $19 billion tax, because they're pushing a separate $90 billion bank tax to recoup losses from the Troubled Asset Relief Program, and Obama doesn't want to see that effort undercut by a much smaller issue.

As a matter of political strategy, there is room for reasonable people to disagree about this move—would it really have hampered the separate bank tax? Can we get a separate bill to pass? But broadly speaking, Obama's position is great news. It means that the administration officially does not believe that the Wall Street reform fight will be over once this bill is passed. That's critically important, because despite the hype coming from Democratic leaders, this bill simply will not dramatically alter the relationship between big banks and the economy. There are things to support—a significant audit of the Federal Reserve and the creation of a new consumer watchdog make the bill worthy of a "yea" vote from anyone in either party. But we still need much stronger medicine, and Obama's position on the Brown negotiations indicates that he recognizes the need for further legislation.

What the actual scope of that legislation will be is unclear, but it's up to activists and reformers to make sure that real reform remains on the table after the current Wall Street legislation is finally approved.