Wednesday, April 23, 2014
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Tobin Trouble

CAMBRIDGE – European leaders are seriously considering a Tobin tax, which would put a small levy on financial transactions, thereby dampening trading. But will the tax do as much as its proponents hope?

The popularity of the tax (named for the late Nobel laureate economist James Tobin, for whom its aim was to reduce exchange-rate volatility in currency markets) reflects widespread animus directed at the financial sector, but it far exceeds any real benefits that the tax would deliver. Nonetheless, elected officials find a Tobin tax highly appealing, because it could blunt criticism and divert attention from fundamental, but politically paralyzing, problems surrounding economic policy, particularly budgets, debt, and slow growth.

A Tobin tax does have benefits, even if it cannot address enough of the problems that afflict financial markets today. A tax on stock transactions encourages longer-term holdings. It taxes liquidity, which many believe is overly abundant. It encourages fundamental analysis of a company’s operations, and some advocates hope that a Tobin tax would push firms themselves to focus even more on long-term value.

Moreover, a Tobin tax moves financial traders – talented people with strong work habits – into other activities, which (policymakers hope) will benefit the economy more. And, if financial innovations like derivatives and short-term repurchase agreements have made markets more volatile and fragile, a Tobin tax could help to stabilize and strengthen them.

While these are worthy goals, there are good reasons to believe that the tax would not achieve most of them. Long-term stockholders alone do not encourage a firm’s managers to manage for the long term. In fact, to the extent that dampened trading diminishes market feedback to firms and their directors, it could make managers complacent. Traders might stop trading, but shareholders still might not conduct more fundamental, long-term analysis: the rise of index funds, which hold a broadly-diversified swath of the entire stock market, reflects this trend toward stockholder passivity.

Lowering volatility and sopping up excess liquidity can be beneficial, but there are risks here as well: regulators can easily overshoot the mark, leaving financial markets with weakened capacity for price discovery and too little liquidity.

That leaves the hope that a Tobin tax would induce high-IQ financial traders to do something else, with higher net benefits to society. If trading today is not helping to move capital to its highest and best use, reallocating inefficiently employed financial talent could yield big benefits. But is too much trading really a critical economic problem?

Consider the following. The financial crisis erupted in 2008 when mortgage-backed securities were revalued at much less than what they had been thought to be worth. The problem was not that these securities were ferociously traded (most were not, and thus were not the kind of security that a Tobin tax would hit hard), but rather that everyone in financial markets revalued them at the same time. That left the financial institutions that held mortgage-backed securities in much weaker condition, and several failed. At the time of the crisis itself, however, the main problem was not too much trading, but too little, as liquidity dried up for many financial transactions.

Still, in one area, a Tobin tax could provide an unmitigated benefit. Many of the largest, most precarious financial institutions now finance themselves via repo: they buy a long-term security (often government debt) and sell it, promising to buy it back the next day for a slightly higher price.

Dampening the repo market could be economically useful, because this funding has proven to be unstable: Bear Stearns and Lehman Brothers used repo heavily in ways that made them unable to withstand investment reversals elsewhere in their business. The same was true of MF Holdings last fall. Stronger, longer-term financing might have allowed these firms to survive. If a Tobin tax induced financial institutions to finance themselves with more longer-term debt and less overnight repo, it could play a significant stabilizing role.

While it is well known that a Tobin tax would have little effect on markets unless all major financial centers adopted it, what is true of markets is not necessarily true of financial institutions. If, say, French President Sarkozy wanted to stop too-big-to-fail French financial institutions from transacting in ways that weaken them, a Tobin tax on their transactions, wherever in the world they occurred, could work; the tax would affect the institutions, even if it could not shape world-wide markets.

To be sure, markets might move those transactions from France and from French financial institutions, and, if the regulators erred – because the business was profitable and not destabilizing – French institutions would lose out. But, if the regulators were right, the French institutions would be more stable. If the Tobin tax aims to strengthen institutions (instead of altering markets), it could bite hard, even without the buy-in of every major country.

Overall, there is not much to be said against the tax (other than what is said against all taxes), and something to be said for it. But it does not help to solve major financial problems, and those that it does address (short-term, overnight financing) could be dealt with more directly, with a more focused tax, better rules governing those transactions, and improved prudential regulation.

As of now, Europe’s Tobin tax proposals are not well targeted. Sound transactions would be taxed along with destabilizing, overnight financing of fragile financial institutions.

A Tobin tax does, however, allow elected politicians to look like they are doing something useful – which they are, but without addressing more serious economic problems.

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  1. CommentedJonathan Lam

    Gamesmith94134: global finance’s Supply-chain Revolution
    “Open feedback mechanisms ensure a supply chain’s ability to respond to a changing environment, but, in the case of financial supply chains, feedback mechanisms can amplify shocks until the whole system blows up.” It was because there is no firewall available during the crisis, and the pipeline was open with few operators in the financial control like Mr. Sheng said, also, there is even fewer currencies like Euro-dollar only was available in most transactions, even though the public funds like sovereignty debts were being privatized in the open trade, and it create the explosion by volume in sum of money was credited. Firewalls I took off the technical terminology means there is no safety transitory zone established physically, that our financial system allowed the flow in the supply chain freely as the computerized transaction allowed, and there is less time available for reexamination on application of control, source of origin, birth of credits.
    Especially, when the parties took the international reserves for granted that Fed and ECB cut it interest rates to its minimal for the non-inflationary measure that many would consider money are free if they can beat the time. Generally, the 22 players turned the international financial market into their casino. When their governments were the ones who called to upbeat its economies from the recession after the expansion of the debts hitting it fiscal ceiling, and the slow down cut their productivity in near recession. At the same time, the rigid exchange rate went lopsided that created the tension between the debtor and creditor. It exploded.
    At present, the financial system must evolve itself with firewalls that stop contagion of the collateral damage over the money with no backing, and shrink the pool of cash for credit lending. Some might call it deleverage of the past 20 years mishaps, or change of climate in our global financial that the supply-chain must stop and check itself; besides, most of us would know by now that money supply and productivity are not on the same parallel at certain point under the influence of inflation an deflation. Without the assurance of the balance payment or imbalance of its exchange rates, the supply-chain will reverse itself.
    Perhaps, I like it better if the sovereignty debt and private investment should not be classified as same in enjoying the low interest rate, that sovereignty debt should be handled separately by the Central Banks and World Bank if it does affect the exchange rate when evaluated by IMF for it answer to lack of control.
    Transfer Unions must be established to void unsafe transaction and the Trans-continental Zoning to confirm the source of the origin on all transactions when the transaction is registered to enter its zones, or cut hot cashes that undervaluing ones currency from another that influences the international currency exchange rate. Besides, I see the floating rate system is a joke if it put sovereignty in defensive; and it should go with its yardstick like performance that values at each quarters.
    Finally, international banks are “too big to fall” should became a legend only, and they must be downsized that international is not licensed to evade sovereignty. There are more of reforms available in regional account and obey to safety net where it allows. Perhaps, if the banker can purchase these sovereignty bonds and metro bonds from the central bank like FED or ECB instead of chasing the wild goose in the open market; the general public can have some credits available for doing business.
    If someone question on the equities dealing among the banks, why only the politicians who talk over the policy on financial and there is no financial police system to oversight the banking as a whole. I think the United Nations Security Council can build a better division on financial security than G7 or G20, and it is inclusive for the globalized finance and my past experience tells me so. Evolve or not, we may stand by and watch the outcome of our present crisis and it not over yet till everyone would feel safe from hegemony through these firewalls. If some suggest cooperation from community in forgiving ones’ debt, it would be worse than my New Year project in losing weight every year, and I have been laughing at myself all my life. Without firewall in safeguard one’s wealth, each would isolate itself from contagion for a long, long time.
    May the Buddha bless you?

  2. CommentedProcyon Mukherjee

    The article ignites some long standing doubts on the contribution of the financial sector towards the overall economic good. Going by the corporate sector, there can be no doubt that the financial sector had served to their cause by bringing a range of products and services that were quite non-existent. This allowed the corporate sector to confront the shocks with far higher resilience and it provided checks and balances to the overall functioning between boom-bust cycles. The question is how some of these instruments have been used and to what extent the risk taking ability have brought in market distortions that went beyond the limits of normative assumptions that went into the creation of these instruments. The fact remains that the buoyancy brought in by the financial sector towards availability of credit for a range of activities from leveraging to access to pool resources and pool risk have gone far beyond the original expectations that this buoyancy was intended to generate; the malaise perhaps lies more in the leadership that guided management of these instruments. There are many examples of entities that blossomed and flourished in the same conditions, while the others went broke.

    Procyon Mukherjee

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