Why Tobin Taxes Wouldn’t Have Prevented The Financial Crisis

The Economist discusses the populist rhetoric from Gordon Brown on the topic of the Tobin Tax, a fee levied by government on any financial transaction. US Treasury Secretary Tim Geithner admits that any such policy would be useless unless adopted world-wide, because trading would simply migrate to unregulated jurisdictions.

Public support for such measures is worrying though, as the Tobin Tax is ineffective in preventing risk-taking in financial markets or harmful asset price bubbles. It would be extremely effective at making markets inefficient though..

The idea behind the Tobin Tax is to reduce speculation on financial markets, which can often be distortionary and lead to bubbles. When these burst and prices return to their long-term real value, the economy can often be left in ruins – as in the Great Depression, Japan’s Lost Decade, and the recent Financial Crisis.

To be sure, the Tobin Tax does deter speculation in the sense that it deters all kinds of financial transactions. But asset price bubbles are driven by the belief that prices are going to rise, often substantially. This policy suffers from classic adverse selection.

Why? The targeted behaviour is the kind most likely to ignore a Tobin Tax. Such a measure is only going to deter sensible trading in efficient markets, where the spread (the difference between the bid and offer prices available in the market) is small and liquidity (the degree to which you can buy and sell without affecting prices) is high. That’s bad for reasons we’ll discuss later.

Let’s start at the beginning of the financial adventure. Investment banks and financial institutions attract capital by promising return to investors. Then by leveraging their assets, a typical investment firm can borrow multiples of their holdings from banks to bet in the markets.

How does the Tobin Tax come into this? Note that your ability to take huge risks through leverage and general financial legerdemain is unaffected by taxing individual transactions. You can adopt a hugely risky position through a handful of trades. Thus, the Tobin Tax doesn’t solve that problem – which most regard as the primary cause of the financial crisis.

Because the Tobin Tax has no means of distinguishing risky and safe firms, it would have to be low enough not to completely destroy highly-liquid markets. Invariably, this means that it will have minimal impact on low-frequency trading for the purposes of achieving highly-leveraged, risky positions.

Similarly, you can still maintain very little risk through frequent high-volume trading. If you’re responsible and understand financial markets very well, that can be very profitable and makes the market more efficient. Indeed, many financial firms specialise solely in types of ‘arbitrage’, riskless profit earned when you buy an asset from one actor and sell it immediately to someone else at a higher price.

What happens once firms are trading in the markets? They then buy and sell risk to each other, according to their ability to hold it while maintaining profit. Depending on what else is in their portfolio, different firms can more easily hold an asset than everyone else.

For example, a risky asset for your friend might suit you very well if it correlates negatively with another asset in your portfolio. Suppose the other asset is a bond belonging to a green technology firm, and you already hold stock in an oil company. When one does badly, the other is more certain to do well either today or tomorrow.

This is known as ‘diversification’. Although perhaps unattractive individually, financial assets look nicer depending on how they’re bundled with others. This efficient bundling of financial assets reduces risks all over the system. When transactions charges like the Tobin Tax preclude such trades, they can actually expose the market to more risk.

Remember the adverse selection problem earlier? The markets most susceptible to the Tobin Tax are the most efficient financial markets, those that operate on incredibly low profit levels for any given transaction. The spread here may be only a few basis points wide (that’s a percent of a percent), so many trades won’t happen in the presence of a Tobin Tax.

Many of the most important markets internationally are efficient and highly liquid (for example, foreign exchange markets). Indeed, that’s why they’re efficient and highly liquid. But when these markets are brought to a stand-still, you reduce the capacity of that market to efficiently allocate risk.

If the precedent of government bail-outs make it necessary to regulate the financial sector, the government should head for the root of the problem. Capital ratios (the amount of money that financial firms need to keep in reserve) may need to be increased, in order to reduce the necessity for massive government intervention. This is the true source of risk, and instability.

Amongst other suggestions, this commentator here suggested progressive capital ratios as a long-term solution to government involvement in banking. It’s worrying that the head of the International Monetary Fund yesterday openly admitted that he will consider the case for the Tobin Tax. Let’s hope it was just a publicity stunt..

Republished in slightly altered form as “Why Tobin Taxes wouldn’t have prevented the financial crisis” in Trinity News (26th of January, 2010).

© The Free Marketeer 2009


2 Responses to Why Tobin Taxes Wouldn’t Have Prevented The Financial Crisis

  1. Barry says:

    Krugman wrote an article about Tobin taxes today.


  2. thefreemarketeers says:

    I love how he calls it a ‘trivial expense’ over and over again, as though that makes it true. also, the claim that it’s easy to tax because it’s centralised. if you tried to tax it, it would become decentralised very quickly. he didn’t address that at all! bad journalism with an agenda.. completely ignores the actual source of risk-taking and the real benefits of buying and selling risk unimpeded..

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