The Tobin Tax: Coping with Financial Volatility
Edited by Mahbub ul Haq, Inge Kaul and Isabelle Grunberg
Oxford University Press 1996, £17.50
The faces of the world's international financiers grow longer by the day. The rout on the exchanges in southeast Asia is thought to pose a serious risk to global economic growth in 1998. The speculators have claimed a succession of victims: the European exchange rate mechanism in 1992; the Mexican peso, which crashed by 70 per cent in the winter of 1994-95; now the once mighty Asian tigers. In the words of George Soros, "the international financial system is suffering a systemic breakdown."
It is hardly surprising that economists have been searching for new systems of controls on international markets. The latest attempt takes up a proposal put forward 25 years ago by James Tobin, US Nobel laureate, for a levy on international currency transactions. This collection of essays is the first serious attempt to assess its feasibility.
Since 1973 the foreign exchange market has grown fourteenfold, thriving in a market free from capital controls. The $1.3 trillion daily foreign exchange trading registered in 1995 has grown by 50 per cent since 1992 alone. By comparison, the annual global turnover in equity markets in 1995 was $21 trillion-equivalent to just 17 days trading on the foreign exchange market.
The rapid growth of derivatives trading is more recent, but none the less remarkable. The Basle-based Bank for International Settlements (BIS) estimates that the notional principal outstanding in financial derivatives rose from just over $1 trillion in 1986 to about $56 trillion in 1995. Fewer than half of these were traded on regulated exchanges.
It is no accident that the growth of international capital flows followed the 1973 collapse of the Bretton Woods system of fixed exchange rates. Under that system, currencies tended to move in tight bands, offering few opportunities for traders to make profits from arbitrage. Banks did not find it worthwhile to invest in the large-scale currency dealing facilities with which we are now familiar. All that changed with the break-up of the system, leading to an explosion of short-term capital flows. What subsequently happened has been described by John Eatwell, president of Queens' College, Cambridge, and former adviser to Neil Kinnock, as the "privatisation of foreign exchange risk."
The privatisation of risk meant that millions could be made from correctly predicting events-or indeed, forcing them in a particular direction. It led to a situation in which speculation became the predominant preoccupation of the participants. As Keynes described it, we have a "beauty contest" in which the markets are dominated by traders in the game of guessing what other traders are up to. Thus the exchange rate became divorced from long-run fundamentals and countries were forced to take deflationary action to stave off exchange rate crises.
Tobin started with two aims. The first was to make the exchange rate reflect long-run fundamentals relative to short-run expectations and risk. The second was to preserve the autonomy of national macroeconomic and monetary policy. One way to achieve both goals would be to tax foreign currency transactions. The beauty of the idea, Tobin suggested, is that a simple tax would automatically penalise short-term "round trips" (selling a currency and buying it back in the near future), while negligibly affecting the incentives for longer-term trade and investments. A 0.2 per cent tax on a round trip to another currency could cost 45 per cent a year if transacted every business day, 10 per cent if transacted each week and only 2.4 per cent if transacted each month.
Tobin believes that hot-money flows produce disruptive real effects and therefore the costs of an unfettered exchange rate system far exceed any benefits. Is Tobin right? Should exchange markets be fettered? Purists think not, presuming that government intervention can only impose costs. In efficient markets, they argue, City economists and foreign exchange dealers base their expectations of future exchange rate movement on informed estimates of the long run "real economy" exchange rate. The average outcome of trading should hover around this equilibrium exchange rate. Speculation, they argue, is the engine which moves actual rates to the equilibrium exchange rate.
There is plenty of evidence, however, that foreign exchange markets do not behave in this way. The Tobin idea is that adjustment in international goods and labour markets is slow; and when some markets adjust imperfectly, welfare can be enhanced by intervening in the adjustment of others. The Tobin tax is designed to slow the adjustment speed of capital flows and the exchange rate, but not to distort the level of the exchange rate over the long run.
What are the supposed benefits of financial liberalisation? One advantage-often cited-is that a free market in capital helps companies manage risk more effectively. Another benefit is that in a world of free capital movements, savings will be directed to the most productive investments, even if they are in the world's poorest countries. Neither of these advantages has yet been proven. Indeed, it is likely that by causing greater financial volatility, liberalisation itself created many of the risks that derivatives have been designed to hedge. And indeed, the growth of derivatives trading may have increased systemic risk, as the sheer complexity of the products limits the ability of firms to manage risk effectively (as in the troubles at Barings and at the Union Bank of Switzerland).
Nor is it clear that developing countries have reaped the benefits of previously restricted capital inflows. While gross capital flows to developing countries have been very large since liberalisation, net flows have been very small. Most mobile capital flows around the developed world. Furthermore, flows of finance do not necessarily correspond to flows of real investment. In so far as there has been a flow of capital towards the "opportunity rich" developing world, it is a flow which has been very volatile, with investors reluctant to purchase anything other than the most liquid of financial assets. The beneficial effects of capital inflows have been overshadowed by the impact of stock market volatility, particularly following the Mexican financial crisis.
So, if we accept that the costs of financial liberalisation can exceed the benefits, the Tobin tax has a simple appeal. Yet since the time it was first proposed the idea has been persistently attacked: it would be impossible to implement; financial activity would migrate off-shore; it would penalise legitimate trade; perhaps most damaging, it would not actually deal with the problem it was designed to overcome.
These criticisms are tackled directly in the book. The general view-although not unanimous-is that such a tax would be feasible. One difficulty is that the tax can be evaded by moving transactions to tax-free jurisdictions, because it would be impossible to secure 100 per cent international participation. Peter Kenen's proposals are reassuring on this point. He suggests that to be workable, the tax would have to include the EU, the US, Japan, Singapore, Switzerland, Hong Kong, Canada and Australia.
The authors agree that the tax would have to be set at a rate well below the 0.5 per cent originally proposed by Tobin-a figure which would overwhelm current commission charges. They agree that 0.1 per cent would be more appropriate; and that such a tax, were it to be levied on cash transactions, would have to be matched by a similar tax in the forward markets.
But, writing in the Economic Journal ("Are grains of sand in the wheels of international finance sufficient to do the job when boulders are required," May 1997), Paul Davidson suggests that the Tobin tax would not act as a deterrent to short-run round trip speculation on exchange rate movements. The tax would at best slow down speculative fever when small exchange rate changes are expected. But, almost by definition, during a speculative run on a currency we can expect significantly large changes in the exchange rate over a very short period of time. For movements of large sums, the normal transactions costs quickly shrink to a negligible proportion of the total transaction-and the Tobin tax becomes insignificant in the calculation. Finally, because under the current flexible exchange rate system there may be four or more normal hedging financial transactions involved in any real economy international trade transaction, a Tobin transaction tax might throw larger grains of sand into the wheels of real international commerce than into speculative hot money flows.
Tobin's general concern is that the capital markets do not move quickly and smoothly enough towards equilibrium, and that their short-term gyrations can have damaging effects on real economies. But there may be other ways of tackling this type of problem. Writing in the Financial Times on New Year's Eve, George Soros argued that private banks are poor at allocating international credit; they move in a herd and provide either too little or too much. It follows that international capital markets need to be supervised, and the allocation of credit regulated, by an international authority. This, he says, would guarantee international loans for a modest insurance fee and set a ceiling on the amounts it is willing to insure in any particular country.
The currency market is alone in being wholly unregulated. Nobody questions the need for the BIS to supervise the capital adequacy of banks operating across international boundaries. And the Basle Committee on Banking Supervision is currently proposing that standards for the supervision of banks' market risks include their positions in foreign exchange. It may be possible to build on this by imposing capital charges on banks' open trading positions in foreign exchange. Although this initiative is more narrowly directed at the prudential supervision of banks, it would nevertheless impinge directly on the banks' currency speculation and is worth examining more closely.
As Keynes put it, in normal times "the speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubbles on a whirlpool of speculation."
