Are their other solutions within the dominant paradigm to financial crises besides IMF rescues? One which has been bandied about the last couple of years is the so-called “Tobin tax” on currency transactions. In my opinion, it is not a viable solution, because it is based on some fundamental misunderstandings about how the financial markets work. Because it has many supporters, I will spend some time explaining why it won’t solve the “hot money” problem.
The attraction to some observers of a tax on currency transactions is based on the turnover statistic of one trillion dollars per day in the currency markets – more than ten times the actual underlying trade and investment flows. The thinking is that even one per mil of that would represent a billion dollars a day. If at the same time such a tax could eliminate “non-productive” currency trading, would not currency volatilities be reduced and would not a currency tax make investors think twice before repatriating their investments?
It sounds to good to be true. And it is. Leave aside for the moment the usual objection that it would be impossible to get all the major nations to agree. Even if they could agree, the effect of such a tax would be disastrous and would have the opposite effect to all the above supposed beneficial expectations. To begin with, the 90% so-called “non-productive” trading between the banks and large corporations plays a vital and purely beneficial role, by creating liquidity, spreading the risk among many banks and corporations across the world, minimizing volatility, and reducing the buy/sell spreads to order of magnitude 0.05% for the business community for the major currencies, a little more for the less liquid currencies. This means that businessmen and investors can eliminate their currency risk at very low cost. The turnover statistics from the IBS (International Bank for Settlements) are rather meaningless because they are measuring the same underlying deal ricocheting around the market all day between the banks as the risk is atomized into many small parcels in what is actually a very efficient allocation process. The actual money being moved by all this “froth” is trivial and has nothing to do with the “hot money” problem as such. A tax, even one of 0.1% would triple the normal spread and thus be a major cost to the market makers. It would have the effect of immediately drying up interbank trading and hence liquidity and the efficient allocation process. Many banks would drop out of the market entirely, joining many who already have done the same in latter years as competition has increased and spreads narrowed. Market liquidity would be reduced to a small fraction of what it is today without any affect whatsoever on the “hot money” problem. The immediate effect would be to increase volatility and the buy/sell spreads many fold, as the banks passed on the tax to their corporate clients, making it more expensive for businessmen and investors to eliminate their currency risk.
The predictable result is that businessmen would be forced to be even more speculative than they are now , i.e. more exposed to currency swings. Also international trade volume would decline as it would be much more expensive to import and export, which could trigger a global recession or exacerbate an ongoing recession. Furthermore, currency volatilities would be greater than today, as liquidity is the second most important factor that affects volatility, the less the liquidity, the greater the volatility. This is, of course why central banks like to intervene on Friday afternoons and around Christmas time. Incidentally, the most important factor is new information. Also, the income projections would be only a small fraction of the estimated because of the drying up of volume. And it would be the businessmen of the world paying the tax, not the financial speculators who were the target.
But most important of all, a tax, even one much larger than in my example, would have no effect whatsoever on the fundamental problem we are trying to deal with – the repatriation of “hot money”, because the amount of the tax is insignificant compared to the losses on the stock and currency markets in any real crisis. Just look at the recent experience of 1997-98, where the Russian stock market dropped 80% and the dollar/ruble rate almost tripled. Other markets in Asia had similar, though less drastic collapses when the “hot money” pulled out, but all were far greater than any tax could have stopped. Much as I sympathize with the motive of its supporters, my conclusion on the Tobin tax idea? Forget it.