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Tobin tax: How to reveal you don’t understand risk
November 11, 2009 | 11 Comments | Sam Wylie
I teach the Futures & Options (financial engineering) course at the Melbourne Business School. The students find it pretty hard going (despite my world class teaching). By way of motivation I tell them that you can always tell whether a person has taken a financial engineering course because they think of risk management in a dynamic way and not a static way.
A great way to reveal that you only understand risk management in static terms is to advocate a Tobin tax on financial transactions. The UK Prime Minister Brown and Treasurer Alistair Darling have done that recently. To his credit, the US Treasury Secretary Timothy Geithner dismissed the idea completely, saying that a global financial transactions tax was “not something that we are prepared to support”.
Here is the problem with a Tobin tax. Risk is created on the real side of the economy: investment in risky projects; living on flood plains and and earthquake zones; changes in prices of production factors, assets, comsumption goods; etc. It is all risk that originates in the real side of the economy. One of the main purposes of the financial system is to manage that risk. This is done in two ways: diversification and allocation.
Diversification takes place on a large scale in the financial intermediaries of the economy: commercial bank loan portfolios; insurance company risk pools; investment management portfolios; etc. Allocation of risk, to where it is born at lowest cost, take place through the capital markets (stocks, bonds, real estate) and especially the risk markets (options, forwards, futures, swaps, credit derivatives, etc).
If the financial system was ideal then all diversifiable risk would be eliminated in portfolios of different kinds, and all not diversifiable risk (systematic risk) would be transferred (allocated) to whoever can bear the risk at the lowest cost. The marginal cost of bearing another unit of any type of risk would be the same across all agents in the economy. The finance system would then efficiently eliminate or allocate all the risk that originates in the real sector of the economy.
Moving risk into portfolios and allocating risk across all the agents in the economy takes a lot of trading of financial instruments. Moreover, risk must be reallocated continuously (dynamically) as the economy evolves. So, the more efficient the diversification and allocation of risk, the more trading of financial instruments we will see in the economy.
People who look at the financial system and see the massive growth in trading volumes of capital market and risk market instruments and conclude that it is all just speculation run amok, just don’t get it. They don’t have a good understanding or intuition about how risk is dynamically managed in the economy. They want a Tobin tax to suppress speculation, not realising that they will damage the allocative efficiency of the financial system.
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11 Responses to “Tobin tax: How to reveal you don’t understand risk”
“the more efficient the diversification and allocation of risk, the more trading of financial instruments we will see in the economy. ” Good argument, diversification is indeed a way to “eliminate” risk, on one hand, we need as many products as possible for asset allocation, on the other hand, however, we have to limit the amount of those too exotic products, which inherit high risk.
OK I understand what you are saying. But other critics of Tobin say that it would not have any appreciable dampening effect on the foreign exchange markets, which is one of the original aims.
But, hey, 0.01% on financial trades? Out here in the real world we pay 12, 20, 40% tax. Surely the financial service industry could afford 1% to boost the fortunes of the poorer countries, and to cushion against the next market failure?
The Tobin tax here is supposed to deal with the risk arising from the financial sector. Which real shock caused the crisis? I think that there is a very strong argument that it arose from the financial sector.
In reply to the last point, the real shock that precipitated the crisis was basically over speculation in the real-estate sectors of the US market (as well as the UK, Spanish, and other markets), particularly among the sub-prime and lower quality borrowers. This was the real cause of the crisis.
The resulting turmoil in financial markets, which reflected a range of market ‘frictions’ (lack of liquidity, insufficient information on the quality of the mortgage-backed securities), exacerbated this initial shock.
Alan, I’d suggest the speculation was taken by the institutions lending to borrowers. Oh wait, no, they just shunted that risk off to other investors by getting rating agencies to lie about the quality of the loans.
The trouble with financial markets is that they often re-allocate too quickly. Its not as though the real risks change that fast.
Financial risk management should be like the ballast in a boat. It helps to stabilize. When the ballast is too liquid it doesn’t really stabilize at all. If the boat tips at all, the liquid all sloshes one way an exacerbates it.
Markets should stop pretending they can price risk to within fractions of a percent.
This analysis begs the question and is not dynamic at all. It assumes that the market is not driven by speculating on its own dynamics but by responding to external shocks and risk. Keynes would eviscerate you for this – there is no evidence to support this proposition, and a great deal against it. If markets in fact do not respond proportionately to risk but constantly overshoot and overcorrect, then any control system engineer would tell you that the system needs to be damped to the point where its response is proportional. A tobin tax, or a one-trade-per-day policy, or mandatory zero-interest term deposits of “hot” speculative foreign capital as Eucador (IIRC) has implemented, or any one of various other propositions is a good way to do this.
Leaving aside the element of risk for the moment (I understand your argument to be that a tax would introduce distortions into a market, and I further understand the neoclassical view to be that all taxes do this), what about the broadening the base argument? I seem to recall that the amount of Australian currency purchased on any given day is measured in billions – a 0.01% tax on purchases of AUD would be a significant source of revenue, and would allow for things like reduction in corporate taxes or other, less useful taxes on production. And, given the value would be much, much smaller than the variation in currency of the AUD against the USD or other currencies, it would be irrelevant as compared to daily fluctuations in price.
Where, exactly, is the down side?
So how’s that handling/managing/low cost of risk working out for you? The financial markets have done a bang up job of that haven’t they?
Funny that a small (in percentage terms) tax would stuff all that up but the costs of the bonuses, the salaries, the rents, the advertising etc of the organisations playing the financial instruments doesn’t.
Okay so IANAE and the arguments of climate change “skeptics” that it doesn’t “feel right” always pisses me off so I’ll shut up now.
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