03 September 2009
In defense of the Tobin Tax
Willem Buiter, Professor of European Political Economy, London School of Economics and Political Science, often writes in the FT and has a blog on FT.com. His article in the FT, 1/9/09 about Tobin Tax caused me to write the below response.
The original article can be seen at http://blogs.ft.com/maverecon/ for 2nd Sept 2009 (subscription may be required).
I don’t think that you can argue that the financial sector is too large because government effectively subsidises its cost of capital by providing guarantees. This form of governmental help is less than a year old, but the problem of the oversized financial sector had developed well before that time. In fact it was the oversized “too big to fail” aspect of the financial sector, which effectively meant that government had no choice but to provide the guarantees.
It seems to me that your analysis of the problems is absolutely correct. You mention excessive churning, incentives that drive traders to make transactions, too much financial activity that is not just socially worthless but actually harmful, and too much speculation and not enough insurance. You imply that regulation should be used to directly restrict the undesirable features of contracts.
But how in practice could regulators do this? How could they keep pace with market innovation? How could they be sure that each regulation added does not create some new perverse incentive?
The first step for regulators must be to distinguish socially helpful financial transactions from unhelpful ones. It seems to me that there is no clear cut test for this. However as a general rule of thumb the nearer a transaction is to the real requirements of the real economy the more likely it is to be socially helpful. If a business needs to buy a currency in order to pay for a particular import, then this is a real requirement for a currency transaction. If a foreign currency is required in six months time for an import in six months time that must be accurately costed in the home currency now, then this is a real requirement for a currency futures transaction. Such transactions, driven by real requirements, create real value in the real economy and so are socially helpful.
In contrast a financial transaction that represents a nil sum game between the participants is much more likely to be socially problematic. When a trader takes a long or short position against another trader such that one will win money and one will lose money on the transaction then this is a nil sum game which adds no real value. A small number of such transactions are useful because they provide liquidity and facilitate the efficient spreading of risk. However a large number of such transactions actively destroy value because the transaction costs are high (traders are well paid) and risks inevitably flow towards places where they are hidden or not properly understood.
In real life it would be almost impossible for regulators to distinguish socially helpful transactions from unhelpful ones. Any attempt to do this would create an unhelpful incentive to disguise transactions to make them look socially helpful. However a Tobin tax does have a real chance of making the correct distinction. Basically a transaction that is driven by a real requirement in the real economy can usually afford to pay a small Tobin tax. In contract a nil sum game transaction cannot, because it becomes a negative sum gain after the tax has been deducted.
The question you quite rightly ask is “What distortion is a tax on financial transactions targeted at?” The answer is that we have far too many nil sum game transactions, and a Tobin tax targets these because it makes them economically unattractive.
The original article can be seen at http://blogs.ft.com/maverecon/ for 2nd Sept 2009 (subscription may be required).
I don’t think that you can argue that the financial sector is too large because government effectively subsidises its cost of capital by providing guarantees. This form of governmental help is less than a year old, but the problem of the oversized financial sector had developed well before that time. In fact it was the oversized “too big to fail” aspect of the financial sector, which effectively meant that government had no choice but to provide the guarantees.
It seems to me that your analysis of the problems is absolutely correct. You mention excessive churning, incentives that drive traders to make transactions, too much financial activity that is not just socially worthless but actually harmful, and too much speculation and not enough insurance. You imply that regulation should be used to directly restrict the undesirable features of contracts.
But how in practice could regulators do this? How could they keep pace with market innovation? How could they be sure that each regulation added does not create some new perverse incentive?
The first step for regulators must be to distinguish socially helpful financial transactions from unhelpful ones. It seems to me that there is no clear cut test for this. However as a general rule of thumb the nearer a transaction is to the real requirements of the real economy the more likely it is to be socially helpful. If a business needs to buy a currency in order to pay for a particular import, then this is a real requirement for a currency transaction. If a foreign currency is required in six months time for an import in six months time that must be accurately costed in the home currency now, then this is a real requirement for a currency futures transaction. Such transactions, driven by real requirements, create real value in the real economy and so are socially helpful.
In contrast a financial transaction that represents a nil sum game between the participants is much more likely to be socially problematic. When a trader takes a long or short position against another trader such that one will win money and one will lose money on the transaction then this is a nil sum game which adds no real value. A small number of such transactions are useful because they provide liquidity and facilitate the efficient spreading of risk. However a large number of such transactions actively destroy value because the transaction costs are high (traders are well paid) and risks inevitably flow towards places where they are hidden or not properly understood.
In real life it would be almost impossible for regulators to distinguish socially helpful transactions from unhelpful ones. Any attempt to do this would create an unhelpful incentive to disguise transactions to make them look socially helpful. However a Tobin tax does have a real chance of making the correct distinction. Basically a transaction that is driven by a real requirement in the real economy can usually afford to pay a small Tobin tax. In contract a nil sum game transaction cannot, because it becomes a negative sum gain after the tax has been deducted.
The question you quite rightly ask is “What distortion is a tax on financial transactions targeted at?” The answer is that we have far too many nil sum game transactions, and a Tobin tax targets these because it makes them economically unattractive.
Labels: regulation, Tobin Tax, trading
