Why Turner is right

In his interview in September’s Prospect, Adair Turner, chairman of the Financial Services Authority, argued that many financial activities were “socially useless” and raised the possibility of a Tobin or transactions tax to restrain the explosive growth in financial transactions seen in recent years. Although criticised in many quarters, Turner’s proposals should be taken seriously.

The object of economic activity is to produce goods and services. Financial transactions are the means by which that production is funded. But in recent years transactions have grown much more rapidly than production and trade. This raises two big questions. First, why have they grown so rapidly? Second, what should be the ideal volume of transactions, relative to the trade and production they support?

In the 1960s, world trade grew by 8.2 per cent a year. That trade, together with long-term investment flows, was financed by foreign exchange transactions that were roughly double the value of the trade deals themselves. Between 2000 and 2007 growth in trade had slowed to just 5.8 per cent. Yet the value of foreign exchange transactions had risen to more than 50 times the value of the underlying trade and long-term investment.



Consider another example of transactions growth, particularly relevant to the current financial distress. At the centre of much of the turbulence have been financial instruments known as credit default swaps (CDSs). Essentially a CDS is an insurance contract that protects an investor if someone defaults on their obligations—say a loan or a mortgage. The Bank for International Settlements estimated that, at the end of June 2008, the value of CDSs outstanding in major financial markets was $57.3 trillion. In late 2008, the US Depository Trust and Clearing Corporation revealed that the value of CDS transactions was ten times greater than the value of risk being insured.

What explains these increases? The sharp rise in international capital flows coincided with the collapse of the Bretton Woods system of fixed exchange rates in the 1970s. After Bretton Woods, fluctuations in exchange rates became commonplace, opportunities for profit proliferated, and rules restricting flows of capital were removed. And this, in turn, reinforced the need for investors to hedge against fluctuating rates: under the new system, foreign exchange risk was no longer borne by the public sector, but by the private sector

This privatisation of risk created an expansion in the scale and variety of derivative instruments designed to hedge risks. The total value of such contracts rose from just over $1 trillion in 1986, to around $516 trillion in 2007. And less than a third of these were standardised traded instruments, bought and sold on exchanges. The rest were customised transactions between two parties, provided, as the jargon goes, “over the counter” (OTC).

When confidence collapsed last year, liquidity vanished because it was impossible to sell on OTC assets, or to use them as collateral. It became clear that neither the senior executives of sophisticated banks, nor their regulators, understood the deals made in their names.

But the risk to the economy as a whole was not just a function of complexity, but also of the sheer size of the transactions themselves, relative to the underlying trade or loan on which they were written. For example, Lehman Brother’s OTC credit default swap book had a notional value of $72bn, yet Lehman’s net exposure to OTC credit default contracts is estimated to have been only about $5.2bn. When the credit rating of AIG was downgraded, it had to post new collateral of $13bn on its gross liabilities—something it was unable to do.

The problem of the seemingly ever-growing tower of transactions erected on foundations of relatively small underlying assets has led to a now widely accepted policy response: as many assets as possible should be forced into clearing systems, or markets where they can be readily bought and sold. If financial instruments are traded, this reveals what they are actually worth. And it has the further advantage of encouraging the development of simpler “plain vanilla” assets, rather than complicated derivatives. The British and US authorities, as well as international bodies such as the G20, the Financial Stability Board and the EU are now all proposing some form of central clearing for CDSs. Some, including the US treasury and the EU, are calling for all standardised contracts to be traded through a clearing house or an exchange.

This would be a major improvement, but there will still be the issue of the growing volume of non-standard, over-the-counter contracts, and the apparently inexorable growth of the ratio of gross-to-net transactions. That is where Adair Turner’s transactions tax comes in. The growth of transactions imposes a risk on society as a whole. Those who impose that risk should pay for it. If they don’t, then risk is mis-priced.

But what should be the socially desirable volume of transactions? How high should the tax be? The truth is nobody knows. But it’s rather like drinking too much. Exactly what is “too much” might be an imprecise science. But we all know a drunk when we see one. Turner is attempting to reduce the damage that inebriated markets can do.

Many people argue that Turner’s idea is doomed to failure in a world of global financial markets, where companies readily threaten to abandon London for more favourable jurisdictions. But this is not necessarily so. First, Britain already has a transactions tax in the form of stamp duty on share transfers (albeit not levied on professional traders). Second, if the major economies, in their current determined mood, agree to sober up drunken markets by common action, and deny legal status to transactions in non tax-collecting jurisdictions, then clearing houses would refuse to settle such transactions and the game would be up. Of course, there would still be evaders. But just as drinking and driving has become unacceptable, so tax evaders would become economic pariahs. And we would be some way towards discovering the true socially useful ratio of financial transactions to the production of real wealth.