In financial markets, volatility pays and extreme volatility pays extremely well. Here’s how: Some smart suit concocts a financial instrument—an interest rate swap, for example. It essentially allows one party to trade the fixed interest rate on its debt to another party for a variable interest rate. The trouble is that the swap creates both liquidity and volatility. The two parties don’t exchange the debts, just the interest obligations, and the swaps themselves then become financial instruments that can be bought and sold. If market interest rates move a percentage point or two, the prices of swaps move proportionately more.
So, the suit invents a derivative to hedge the volatility—say a “swaption,” which is an option on the interest rate swap. But the price of the swaption could be even more volatile. The big moves up and down will attract more money and more traders in one aspect of what John Maynard Keynes called the “fetish of liquidity.” In short, you can get trading for the sake of trading, with computerized players in New York, London, Tokyo and elsewhere pocketing narrow slices of the transactions millions of times a day.
The result is that the derivatives market always has a tendency to expand, financial crisis or not. At last count, the notional value of credit derivatives in the U.S. banking system—the value of the underlying mortgages, loans or other instruments they are tied to—stood at almost $15 trillion (U.S.). The market values of the derivatives themselves are only a fraction of that, but the massive churn of derivatives trading can have a huge impact on interest rates, stock prices and so on.
In August, Lord Turner, the chairman of Britain’s Financial Services Authority (FSA), called all this trading in exotic instruments “socially useless.” Sure, it’s intriguing, even fun, but so is watching Oprah or listening to your old Scritti Politti collection. Unlike bad TV or worse music, however, exotic financial derivatives helped destabilize the entire global financial system last year.
But Turner didn’t stop there. During a panel talk hosted by Prospect magazine, he said frivolous trading needs to be tamed. Then he uttered the t-word—two of them, actually. “I am happy to consider taxes on financial transactions,” he said. “Tobin taxes.”
Boy, the doo-doo sure hit the fan. The Tobin tax is named after James Tobin, the American Nobel laureate economist who, in the early 1970s, after Richard Nixon removed the U.S. dollar from the gold standard, thought a tiny tax on international currency trades—say 0.25%—would dampen short-term speculation. The goal, Tobin said, was not to stop trading, but to “throw some sand in our excessively efficient international money market.”
The Tobin tax was never adopted in any major country, although some governments considered variations of it. The global anti-poverty movement loved the idea, assuming some of the tax loot would actually trickle down to the poor.
Now, the Tobin tax is gaining political currency again on the European left. Yes, the financial services industry condemned Lord Turner’s idea. A strategist at one London brokerage firm said he was “appalled, disgusted, ashamed and hugely embarrassed.” But anything condemned that vociferously has to be a good thing, because it means the tax would have an impact.
The detractors say the Tobin tax presents three monster problems. First, it would be useless unless it was applied in just about every country. Second, the tax windfall would create an international conga line of beggars. Third, determining its optimal level—0.25%, 0.1% or whatever—would be hugely complicated. Too high and liquidity would disappear, which would whack legitimate derivatives, like the wheat futures used by farmers. Too low and it would be ineffective.
The begging issue aside, I’d argue that implementing the Tobin tax is no big deal. Real estate transfer fees, known as “stamp duties” (because governments used to require stamps on transfer documents), are commonplace in many countries. Ireland charges a yearly stamp duty on credit and debit cards. American securities regulators are financed by a tax on financial transactions, but one so small that most traders forget it exists.
But how can you tax global transactions, such as cross-border stock purchases? It might not be that hard. Clearing and settlement systems are consolidating. The dominant global settlement service for foreign exchange is London’s CLS Bank. Determining the tax’s level would be much harder, though doable.
No one, other than overpaid, risk-mad bankers and traders, would deny the financial services sector has to be cut down to size. Recreating it as it was would be a recipe for disaster—it was drawing too much money and talent into pure speculation.
Politically, the Tobin tax would be on the side of the gods. Governments nearly bankrupted themselves to keep their banking systems afloat; the banks should be polite and give something back. What have they and their traders done to deserve another era of windfall profits?
