Germany?s Angela Merkel and France?s Nicolas Sarkozy have proposed a Eurozone-wide tax on financial transactions as a way to stabilise the regional economy in the long run. The announcement rocked the markets in Europe amid swift opposition from the financial sector. The proposed levy on stocks, derivatives and currencies to generate funding for budget deficits, regulation, poverty and infrastructure needs may not be limited to the EU. It could also affect the New York Stock Exchange, which was bought by the German Deutsche B?rse earlier this year.
Of late, there is a lot of interest among head of states in the EU to curb activity in financial markets, especially speculation. If we take a look at financial history, legislatures for long have grappled with financial markets because they tend to upset government plans and policies. For example, the IMF deems that speculators, at least in part, caused the East Asian Crisis. Speculation against these economies sparked a chain of events starting with an overnight flight of capital, which eventually brought about a decade of lost growth for some of the East Asian economies. Some Eurozone nations stand to lose a few decades of growth following the current sovereign crisis.
Speculators are disliked by many, not just by EU governments who see their plans disrupted. As a former trader at JPMorgan, I know that outside our immediate family and friends circle, it is a little difficult to find too many people who have a good word to say about traders and investment bankers. Surely, if a not-so-benign activity like speculation could be somehow curbed, fluctuations in financial markets would be much less extreme and economies would suffer fewer shocks.
Angela Merkel and Nicolas Sarkozy are trying to implement an idea in economics that has existed since 1972. The idea of taxing financial transactions was originally proposed by Nobel laureate James Tobin to solve the speculation problem. Levying a small tax on financial transactions, he suggested, could reduce speculative transactions and additionally earn the government some revenues. It is the equivalent of ?one stone, two mangoes??the government accomplishes two goals with one piece of legislation.
The idea is very simple. At each transaction, a small tax would be levied?let?s say 0.5% of the volume of the transaction. This would dissuade speculators, as most speculators put their money on a short-term basis. If this money is suddenly withdrawn like it was done in East Asian countries, it could lead to an economic crisis. Even if it doesn?t lead to a crisis, government may still incur significant costs in trying to stabilise financial markets. The Fed invited a lot of flak and cost in rescuing market participants using taxpayers? money in the aftermath of the subprime crisis. This tax has the potential to convert financial markets from a ?cost-centre? in recent times, to a ?profit-centre? for the government. Moreover, Tobin tax could be used as a tool to oppose the dictate of financial markets and may return some margin of manoeuvre to the government.
The primary aim of the tax seems to be to reduce the amount of speculation in EU markets. There are good reasons to believe that Tobin tax can be effective. Simple economic theory says that if the price of something is increased, the demand for it will usually fall. Tobin tax can be thought of as an increase in the price tag of speculation. So the tax should reduce the ?demand? for speculative dealing.
The problem with Tobin?s ?throwing sand in the wheels? method is not so much with the idea but with its implementation. The plan can fall apart if all countries in Europe do not cooperate because countries like Germany and France which impose transaction tax will find financial institutions shifting their base to other countries with no Tobin tax. For instance, if the UK doesn?t agree to the tax proposed by the EU, banks will start doing transactions from London instead of Frankfurt or Paris.
On March 31, 2010, 350 economists from more than 35 countries, including Nobel laureate Joseph Stiglitz, signed a letter to the leaders of the G20 countries calling on them to impose a tax on financial transactions. The leaders of EU?s two largest economies?Germany and France?are now promoting a financial transaction tax as a way of raising as much as 200 billion euros a year to fulfil commitments to domestic budgets. Tobin tax can help reduce speculation and also earn government precious revenue in these high fiscal deficit times. It would also help reduce speculative activity in financial markets, which with a size of $600 trillion has grown too big vis-?-vis the real economy, and has far too much clout. This tax has the potential to be a ?one stone two mangoes? kind of solution.
The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance