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Financial markets

Do we need a Tobin tax?

Recently, the G-20 leaders asked the International Monetary Fund to review a financial sector tax that could be used to pay for shutting down battered megabanks and other financial institutions whose failure could threaten, once again, the global economy.

In a speech on Monday the IMF’s deputy managing director, John Lipsky, said he was open to the idea of a Tobin tax, which was initially dismissed by IMF Managing Director Dominique Strauss-Kahn.

A Tobin tax is the suggested tax on all trade of currency across borders. The tax was proposed in the early 1970s by Nobel laureate James Tobin and is intended to put a penalty on short-term speculation in currencies. Lipsky said Tobin’s proposal was aimed at limiting foreign exchange transactions, and not as a revenue raiser. But now some “have extolled such a tax as a potential source of earmarked revenues for a variety of purposes.”

However, Charles Goodhart says that the Tobin tax is a bad idea, since it would greatly increase both the costs and volatility of foreign exchange dealing and throw a huge spanner into the workings of the global financial economic system.

The proponents of the Tobin tax mistake the fact that commercial end-use of foreign exchange (forex) dealing is not more than about 10%, at most, of the total of forex transactions into a belief that the other 90% is a form of ‘socially useless’ speculative froth, which could, and should, decline without real loss. This latter viewpoint is just wrong. Taking an unhedged, open forex position is risky, and, hence, bank market makers are not allowed to do so, beyond limits. So any new commercial order unbalances a market maker’s initial position, almost forcing him to rebalance by trading out of his new position with another market maker. The ‘hot potato’ will pass from hand to hand until prices and quantities eventually adjust to a new equilibrium.

Essentially a Tobin tax imposes much greater costs , even if it seems proportionately low, because the margins on which the market makers are operating are low. The costs of transacting out of an unbalanced position would rise sharply, and with it the bid-ask spread on forex deals, liquidity would disappear and forex volatility would be enhanced. Meanwhile speculators, betting on a significant change in the asset/currency price, would not be much deterred by a small increase in transaction costs.

Many of those who support such a tax neither know, nor care, what effects it might have on market efficiency. Besides a, generally misguided view that its imposition would fall primarily on the financial sector, rather than be passed on to its customers.

“Avoiding distortions and insuring systemic efficiency and effectiveness will be important considerations in evaluating the options,” Lipsky said, “including a potential transactions tax, among other alternatives.”

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