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Tobin Tax – Keep the Market, Curb Politicians

by on July 23, 2011

Tax on foreign exchange transactions will mask political incompetence and make developing nations poorer, argue Henry and Lawrence Gruijters. First published on The Graduate Times.

The European Union’s budget is constantly growing in contrast to the nation states, who have been forced to cut their budgets. To fund the EU many advocate raising funds through a “Tobin Tax” but this has many practical problems. Greg Mankiw points out the most obvious one. Imposing a Tobin Tax is simply not feasible as the trade of currencies will move from London and Frankfurt to the Cayman Islands or Zug. More fundamentally, the Tobin Tax may just be a smokescreen to cover political incompetence.

The Tobin Tax was first proposed by economist James Tobin. The main idea is to levy a very small tax (0.1%) on transactions from one currency to another. The reason for this is that it would make currency speculation driven by small differences in interest rates unprofitable. Such a tax would then “throw sand in the wheels” of global finance, slowing down the movements of the financial sector.

All countries are dependent on foreign investment. The United States, as the biggest economy, is naturally seen as a good opportunity for foreign investors. With a growing debt, a lower economic performance and a lack of political conviction, investors may soon demand higher rates to persuade them not to pull their money out of dollars into say, Swiss francs. Large money flows can lead to a high volatility in exchange rates and interest rates. This is often seen as particularly hazardous for small open developing economies. For instance, large capital flows out of Greek debt mean that it needs high rates to attract investors. Many believe that finance moves too quickly and that a Tobin Tax can slow it down and avoid crashes. Throwing sand in the wheels may, however, have a detrimental effect on the performance of the small open developing economies which the Tobin Tax (according to the advocates) is meant to help.

One of the big puzzles in economics is the “Lucas Paradox”. Why did capital flow from rich to poor countries before 1914, yet after 1945 mainly flow from rich to rich countries? Theoretically capital should flow to the poorer countries as one additional dollar can produce more there than it can produce in the richer countries. Robert Lucas presented two main reasons for the lack of capital flow to poor countries. Firstly, high levels of human capital may mean that rich countries are still a better investment than developing nations. Secondly, after decolonisation political risk increased in many developing nations.

Lucas’s first reason suggests human capital (education) was a less important driver for capital flows or less different before 1914 than today. Some evidence suggests that human capital is indeed more unequal today, yet it is not impossible to copy “human capital”.  Evidence from South-East Asia suggest that after developing the correct educational and intellectual institutions it is possible to raise human capital levels sufficiently in developing nations. Institutions and economic incentives are not only important for human capital growth, but affect the level of political risk too. Looking at the World Economic Forum’s interactive report we see that the effectiveness of the legal system, efficiency of government and the government’s credit rating are also vitally important for reducing risk. In colonial times investors could trust the crown to enforce debt contracts in the colonies. Now foreign investors must trust the foreign countries’ own political institutions.

A currency crisis often stems from a political crisis and the lack of trust and proper economic incentives in institutions.  Financial markets discipline governments as they drive up rates where they feel “political risk” is increasing. James Carville, former adviser to Bill Clinton once said: “I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” This intimidating power, which can discipline the political world, will be decreased if a “Tobin Tax” is implemented. Many feel this may be good as it gives politicians the power to have an expansionary domestic monetary policy during crises without risking the wrath of the bond market in the short run. Yet the lack of a threat to enforce discipline is bad. It will slow down the reform and development of credible institutions in developing nations. In the Asian crisis, crony capitalism rather that speculation was to blame. In Greece, political ignorance and fraud, not currency speculation, are at the heart of the problems. One lesson hard learnt in the past few years is that politicians are not always the greatest money managers. It would be less damaging if politicians did what is most important and tackled the economy’s institutional weaknesses instead of tackling the monetary flows which highlight their monetary incompetence.

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