A Worthy Experiment: The EU Contemplates A Tobin Tax

So says the Forex Blog (excerpt):

EU Ponders Tobin Tax

Only two years after the worst financial crisis in decades, the DJIA is now back above 12,000. Yield-hungry investors are pouring record amounts of cash into emerging markets. Commodities and food prices are rising into bubble territory. In fact, not a single meaningful reform has yet to be passed that would prevent such an event from erupting again. The EU, however, is trying to change that, with the proposed introduction of the first-ever Tobin tax on foreign exchange trades...

...The so-called Tobin tax was first proposed in 1971 by Nobel Laureate James Tobin. While it has always enjoyed support from a handful of leftist economists, it has never been seriously considered by any western country. In the wake of the financial crisis, however, anger towards speculation seems to be peaking, and some governments might finally have enough political capital to push forward the idea. In fact, France has already obtained the tepid support of other EU members, notably Austria. In addition, the Economic and Monetary Affairs Committee of the European Parliament has backed the idea. The EU is fighting to keep the Euro alive and its member states solvent, and it clearly resents the (perceived) role of speculators in betting on default and breakup.

Proponents of the Tobin tax generally cite the amount of revenue it could raise as its chief benefit. For example, it has been estimated that a .005% on forex transactions could raise $26 Billion worldwide, while a .05% tax on all financial transactions could generate as much as $700 Billion in revenue. Even though studies suggest that it wouldn’t do much to reduce volatility (and perhaps speculation), the fact that it shouldn’t destabilize markets is enough to satisfy some of its naysayers.

Not surprisingly, the US remains opposed to such a policy, on the grounds that it could “send misleading signals that could hamper investment to end extraction and cause production bottlenecks.” This kind of incantation rings hollow, however, and it’s clear that the biggest obstacle to its being implemented is almost certainly the bank lobby, which has insisted that a Tobin tax would “cause serious damage to this highly efficient [forex] market.”

If you’re unclear on the concept think of a Tobin Tax as a sales tax, except that instead of falling on consumers it’s levied primarily on financial market participants, specifically on foreign exchange transactions.

Whether its effective or not depends largely on the profit and cost structure of financial trading. If the tax is set high enough, than in principle it should reduce both the volume and price volatility of trading – the higher the tax, the lower both should be. That’s enough to intrigue me since my own reading suggests that much of the information that free and open financial markets convey through prices is actually lost in noise i.e. volatility. In other words, highly “efficient” markets might actually be more efficient – prices convey more information and less noise – with reduced volume, not with more.

We’re talking here about markets where the volume of transactions is orders of magnitude higher than the underlying intrinsic value of the assets traded (I’m including here capital markets as well, not just forex). For example global merchandise exports in 2009 reached US$12.9 trillion for the year (source: WTO), but average daily forex volume in that year was well over US$3 trillion and nearly US$4 trillion in 2010 (source: BIS – pdf link). Back in the early 70s, economists were caught off-guard because price volatility of foreign exchange markets with floating currencies was three times greater than expected.

Volatility increases risk, because it raises uncertainty (statistically, higher volatility means a wider range of possible values), which is where imposing a Tobin tax would be helpful. More than that, it could also reduce potential portfolio capital flows, as it raises the costs of transactions and the spread that has to be covered before a trade is profitable. The fact that it also raises revenue is a nice after effect.

So I’ll be watching this experiment with great interest – assuming it ever gets off the ground. To be effective a Tobin Tax should ideally be implemented globally, and that’s not terribly likely.