A Call for Tighter Controls in the Foreign Exchange Market - A Look at the Tobin Tax

Transcription

1 A Call for Tighter Controls in the Foreign Exchange Market - A Look at the Tobin Tax Daniel Kearns James Tobin wrote a paper in 1978 in response to the writings of other economists who had, for 20 years prior, tried to develop reforms to the international monetary system. The reforms offered by these authors addressed their dissatisfaction with the Bretton Woods regime that arose in the 1950 s. Tobin had already proposed the material in the paper during his Princeton lectures in Tobin saw the need to force some segmentation into the inter-currency financial markets, i.e. to throw sand in the wheels of the foreign exchange market. Segmentation is needed because speculators tend to buy and sell currencies and their derivatives over very short periods. This was as true in the 1970 s as it is today, Kenneth Kasa noted that of the $1.5 trillion in foreign exchange trading that occurs everyday, 80% is for speculation and 40% of the total stays in the hands of the buyer for fewer than three days. Many are beginning to believe short-term speculation leads to destabilization and excessive exchange rate volatility which can lessen macroeconomic performance. 0.1 Introduction This paper will begin by describing the Tobin tax and discussing its importance in today s market place. The view of those in favour of the introduction of this tax will be discussed next, followed by the view of those who are against it and all the problems that would have to be overcome. To conclude the moves some nations have made in order to control currency exchange are examined. 1

2 0.2 What is a Tobin Tax? Tobin proposed a double tax on foreign exchange transactions, the tax would be charged when the currency is bought and when it is sold. This tax would have a bias toward long-term investments, and away from short-term speculation. The tax would increase the returns needed for an investment to be worthwhile, the shorter the investment period the greater the annualized gain needed. An example put forth by Kasa to illustrate this set the tax at 0.1% and the domestic interest rate at 5%. If a foreign asset is held for a month it needs the equivalent of a foreign interest rate of at least 7.4% to offset the tax. For a one-day round trip, foreign rates would have to be at least 77%. It is clear that a very small tax could cause a severe reduction in short-term speculation, which Tobin and others, have theorized would lead to more stable currencies. The Tobin tax idea has risen to prominence recently in response to the series of currency crises of the 1990 s. Starting in the summers of 1992 and 1993 when currencies in Europe began to lose value, these were followed a year later by Mexico, and then in 1998 there was the Asian currency crisis, Brazil ended out this decade of devaluation. Argentina s crisis of early 2002 is not included in this list because, with all the financial and economic mismanagement that occurred, it is not possible to blame speculation for the peso s fall. Tobin realizes that there are many benefits of open capital markets the most important of these is that savers get a higher rate of return on their capital, while lowering the cost of capital to borrowers. These benefits are only fully realized if the market is functioning efficiently. The crises just described have led analysts to question the current monetary system, many believe that this system of large and highly liquid transactions is partly to blame for the extent of these devaluations. They believe that the current system has many inefficiencies, and a tax on foreign exchange transactions has many potential benefits. 2

3 0.3 The Positive Viewpoint The critics of the current system believe that it is not running efficiently, citing many inefficiencies which detract from the benefits of exchange markets. There have been many claims that currency traders engage in destabilizing speculation, though this is very difficult to prove. Garber and Taylor point to the fact that some of the attacks in the early 1990 s could not be fully explained by the state of the underlying economic fundamentals. These attacks have led some to the conclusion that the collective actions of short-term speculators, who, at 40% of total volume, dominate the market, and cause excessive volatility in exchange rates. Second, there is a tendency for governments to uphold banks within their countries. Banks, realizing this, tend to take on more risk, included in this is currency speculation. A third inefficiency rises from theorists who believe that foreign exchange markets have multiple equilibria, a given set of monetary and fiscal policies could be coherent with multiple exchange rates. Small events might precipitate into major currency valuation changes. The proponents of the Tobin tax believe, as Kasa points out, that by adding capital controls to the foreign exchange markets, the above inefficiencies will be diminished significantly. The double taxation of transactions would cause a large decline in shortterm investments; this would eliminate the first inefficiency since it would be much riskier for speculators to try and destabilize a currency, because if it did not work out, it would be quite costly. The second inefficiency revolving around the banks would be solved for the same reason i.e. the cost of foreign exchange investments has risen, making it a less appealing place for banks to put there money. Thirdly, the slowing of the exchange market would eliminate the multiple equlibria of currency values, which would further stabilize economies. The Tobin tax would raise billions of dollars, Reisen estimates between $50 billion and $250 billion corresponding to tax rates of between 0.05% and 0.25%. Biddel and Grant suggest that this revenue could help reduce the GST in Canada, thus the Tobin tax would lead to a pareto improvement, since a distortionary tax would be replaced by a tax that helps to remove distortions. Reisen suggests using the revenue for global 3

4 initiatives such as the millennium development goal to halve poverty by The tax, by reducing the volume of transactions, would allow central banks to spend less in order to have a significant effect on exchange rates. Tobin believes this would allow nations to use changes in monetary policy to aid their macroeconomic performance without the fear that small decreases in interest rates would lead to major devaluation in their currency. 0.4 The Negative Viewpoint There are those who oppose the addition of a frictional tax for many different reasons. For one they believe that there is not sufficient evidence that the current system is inefficient. Some who believe that some sort of intervention is needed believe that such a tax would have to be large in order to have the desired effect. They also believe that it would be impossible to implement because it would have to involve the cooperation of the whole world. A third issue revolves around the tendency for investors to avoid taxation. Some believe that such a tax would not be able to reduce short-term speculation since 10% currency devaluations over a single day are not unheard of. Following the earlier example, Kasa notes that this is equivalent to 300% annually. A small tax would be completely ineffectual and a tax that could eliminate such gains would be devastating to financial markets. Reisen notes that observers are more worried about long term misalignment of exchange rates (misalignement is the difference between observed exchange rates and the rate at equilibria; this may occur because investors are ignoring economic indicators), misalignment can become quite severe and may lead to sharp changes in rates as the markets suddenly seek to correct the problem, this can cause major economic damage. The Tobin tax would not be large enough to have any effect on this either. Another problem stems from the amount of cooperation that this world wide policy requires. It would be very difficult to get all the countries of the world to agree to implement a tax on foreign exchange transactions. Reisen points out that if one exchange market holds out there will be a migration of trading toward this market because investors will not have to pay the tax there, which means they will have larger gains. To avoid 4

5 this all the other markets could impose punitive taxes on any trades with these holdouts. This solution should work to deter smaller markets, if it were a large exchange such as Hong Kong traders here could just trade amongst themselves. One solution which Tobin suggested for this problem is to make the acceptance of this tax mandatory for entrance into the International Monetary Fund. One major issue that has not been addressed fully is brought up by Reisen as well as Garber and Taylor. There is a tendency for investors to try and avoid taxes, in this case they would begin using different financial instruments. These would be T- bills, and certain combinations of stock market baskets and index options which are the equivalent of cash. The Tobin tax could increase its scope to envelop some of these, but eventually nations would see it as an inefficiency imposed upon their stock markets, which would leave some currency derivatives untaxed. However, Garber and Taylor note that as investors move away from traditional exchange instruments they end up buying less liquid instruments which are not perfect substitutes for each other, which would have the effect of decreasing speculation, especially in the short-term. A final difficulty is in monitoring transactions, in order to make sure that they would be taxed. The current system is not set up to take on such an all encompassing task. Schmidt suggests that such a system is possible, and could be designed along the same lines as other monitoring systems which are already in place. It would certainly be time consuming, and likely costly to implement this system, but this should not be a stumbling block. 0.5 Conclusion A few countries have already started to implement tighter controls over their currency in order to reduce volatility in their exchange rates, and so reduce the risk of shocks to their economies. Kasa used Malaysia s implemented tight capital controls in 1998 to prevent foreign investors from taking the ringgit out of the country by penalizing them harshly if they did as an example. This move may have helped the Malaysian economy to stay on track while many other countries in South East Asia crashed. Haq et al. points out that Chile has also been active in trying to limit the effects of outside investment. 5

6 During the 1990 s Chile set reserve requirements on capital inflows. They required banks to maintain reserves against foreign liabilities ranging from 20% to 30% and lasted from 90 days to upwards of a year, observers believe that this has helped Chile keep short term investment in their country to a minimal. These countries, along with South Korea and others, have all been actively seeking ways to use monetary policies to reduce the uncertainties of their economies in an open environment. The amount of international cooperation needed to implement a Tobin tax is daunting, but with the U.N. studying it it may not be too far off. The biggest problem might be getting some of the larger freer nations on board. If the US dollar s decline were to turn into a route as some doomsayers like Niall Ferguson and James C. Cooper & Kathleen Madigan believe possible, it is very possible that some major international exchange controls may quickly rise to the top of the international agenda. 0.6 Works Cited 1.Biddel, J.L. and Grant, Jordan, (1994) Revised Proposal for a Financial Transactions Tax from Michalos, Alex C. (1997) Good Taxes, the Case for Taxing Foreign Exchange and Other Financial Transactions, Cooper, James C. and Madigan, Kathleen, The Economy: Five Wild Cards For 2005, magazine/content/04 52/ b htm 3.Garber, P and M.P. Taylor (1995) Sands in the Wheels of Foreign Exchange Markets: A Sceptical Note, The Economic Journal, 105: Ferguson, Niall, A DOLLAR CRASH?, com/ a dollar crash.htm 5.Huq, Mahbub ul, Kaul, Inge and Grunberg, Isabelle (1996) The Tobin Tax, Coping with Financial Volatility 6.Kasa, Kenneth, Time for a Tobin Tax?, econrsrch/wklyltr/ wklyltr99/el99-12.html 7.Michalos, Alex C. (1997) Good Taxes, the Case for Taxing Foreign Exchange and Other Financial Transactions 8.Reisen, Helmut, Tobin tax: could it work? fullstory.php/aid/664/ 9.Schmidt, Rodney, A Feasible Foreign Exchange Transactions Tax, halifaxinitiative.org/ index.php/pub TobinTax Research/ Tobin, J. (1978) A Proposal for International Monetary Reform, Eastern Economic Journal, v.4: