It is symptomatic of the modern economic system that only such a short while after deep and global despair over green shoots, the pressing global concern has switched to strategies of exiting stimulus packages! The propensity of economies to tip from boom to bust and back again is intrinsic to their being populated by agents who magnify slender economic signals by acting in concert (though unwittingly) upon them. It is a delicate balancing act that economic policy administrators need to pull off now, with instruments that are not sufficiently supple.
The financial spasm of the last year has whetted public appetite for a comprehensive overhaul of the global financial system. Yet the suggestion of Adair Turner, of the Financial Services Authority in the UK, that it is worth considering a variation of the Tobin tax has simply not drawn the serious debate that it deserves. The proposal has been represented as intended to cut finance down to size. I am not a macroeconomist, but it is clear to me that the real case for a financial transactions tax is its usefulness as an economic policy instrument.
Traditional policy instruments available for regulating boom and bust cycles are weak. A metaphor for the use of interest rates to govern activity is that it is like trying to move an object with a string. You can cool an over-heating economy, but against a drop in demand, low interest rates may not induce consumers and businesses to increase their borrowing or spending. It is difficult to push an object with a string.
The other available policy lever, the monetary base, is used to inject cash directly into the economy, or to drain cash from the economy through purchase or sale of financial assets to banks. The basis for this is a hundred year old identity which states, tautologically, that the stock of money in the economy (M) times the velocity of circulation (V) is equal to the aggregate price level (P) times the real activity in the economy (Y). The implicit assumption is that the velocity of circulation of money (V) is constant; and so it is to a large extent in the real economy.
But when people have greater desire to buy and sell, driven, for example, by the psychology of speculation, money must change hands more often. Speculation is no stranger to the real economy, but is the moving spirit of the casino economy (Keynes? phrase) which sits atop. When conditions are ?right?, it takes only slender signals for the infectious urge to transact in the casino economy, to propel the flow of money to high velocities till the total volume of speculative transactions dominate the volume of real transactions. When the bubble bursts, the flow of money and credit coagulates not only in the casino economy, but also in the real economy.
A harmonised and comprehensive financial transactions tax, that can be raised or lowered, at regular periodic intervals just like interest rates, based on evidence on the rate of growth of the casino economy, can help regulate inflating bubbles. It is naive to argue off-hand that such a tax would distort price signals. Monetary authorities are in the business sending out signals through interest rates. A variable Tobin tax should similarly be conceived as a lever to regulate the volume of transactions, by making them cheap or expensive, particularly in the casino economy.
The conceptual basis for this tax is in the fact that boom and bust cycles are symptoms of an ?externality?. By definition, speculative transactions, whether in the casino economy or in the real economy, are not based on ?due diligence? by individual investors. It is rational for an investor to free ride on information on others? current or impending choices. Mexican waves that result cause financial instability. An instrument that allows the costs of financial trading to be increased or decreased as necessary to control liquidity, offers the possibility of rebalancing speculation and enterprise. The tax will internalise the externality wherein people free ride on incipient bubbles.
A variable Tobin tax must be used in conjunction with other policy instruments, including capital requirements that address leverage and risk. Its purpose cannot be solely to raise revenue, though there are many welcome uses for any revenue that is raised. It is not beyond the ingenuity of regulators working with newly recruited financial engineers to make such a tax expensive to duck. It will have to be harmonised and global?under the transparent control of the central bank when it comes to domestic financial transactions, and under the control of a credible international financial regulator when it comes to cross border financial transactions. There are innumerable arguments to be resolved and practical difficulties to be overcome. But recall the gut-wrenching financial and economic history of the year past, and it is difficult to deny the worth of grappling with these issues.
The author is reader in economics at Judge Business School, University of Cambridge, and a fellow of Corpus Christi College