The Ideas section in today’s Boston Globe has an interesting article called The Black Box Economy. The basic thesis is that ever more complex and abstract kinds of investments have outstripped governments’ ability to exercise oversight and ensure the stability of the financial system. Exhibit A is, of course, the subprime mortgage meltdown in which “collateralized debt obligations” and such have spread loan risk around so much that everyone – except apparently the makers and takers of the bad loans themselves – has become a victim of the current crisis, but the authors contend that CDOs are just the tip of the iceberg. The claim that the aggregate paper value of various “derivatives” is many times larger than the total global GDP, if it’s true, should scare anybody who thinks about the implications for even a little while.

The thing that these derivatives and futures and such have in common is that they represent “assets” that are many levels removed from any visible component of the real production and value-creation process. People who make such investments can reap tremendous profits, or do tremendous damage – neither of which ever does any good for the people who actually create the physical assets on which these paper fortunes are built. In the subprime case, one of the problems is that lenders had absolutely no incentive to ensure that they were making good loans, because they were selling them as CDOs anyway. Those birds were never coming home to roost. Nobody was reaping what they were sowing. One proposed solution, accordingly, has been to require that lenders do retain an interest in the loan, restoring the incentive to exercise proper diligence instead of collecting their fees and then dumping bad loans on Somebody Else.

I think this idea should be extended. We already tax different kinds of investment income (e.g. short vs. long term) differently, so let’s create many more classes of investment income according to the rule that every level of separation from productive reality increases the tax rate. If you invest in actual physical assets, which we’ll call investment class A, then any profit you make on that investment is taxed at a certain rate. If you invest in simple futures or options on those same assets, you’re one level removed so we’ll call those investments class B and tax any profits on them a bit more. A higher-level option derivative might be class C and taxed still more. Let’s put all those theories about “capital market fluidity” to the test. If all of this high-finance speculation is such a wonderful thing, then investors – the real investors, the ones who actually earned the money they’re putting into the system and not just moving Other People’s Money around – will still be willing to buy class E investments despite the high tax rates. If all of the abstraction and leverage is just a sham, though, benefiting only the brokers and not the consumers of investment products, then those consumers might stick to investing in things more directly tied to reality. That should force some of the pathological gamblers in the financial industry to go out and get real jobs instead of messing up the economy for everyone else. As always when the current incentives are perverse, changing the incentives and letting the market do its thing is the way to achieve a better outcome for everyone except the thieves and frauds.