IN LATE 2008 the global financial system suffered a massive coronary. This is hardly surprising. It was born, so to speak, in 1945 and so was at an age where coronaries are common. What is remarkable is the system’s response: it made no substantial changes and kept feasting on doughnuts and french fries.
Internationally, the financial downturn has been the biggest economic crisis since the Great Depression. But in that earlier case, within four years the United States had completely transformed its banking sector and its system of financial regulation. By 1934 US banks were different entities, doing business differently under new regulatory regimes.
Today, two years after 2008, the only reforms are marginal: increasing bank capital here, tweaking a regulation or two there. The only substantial reform on the table is Paul Volcker’s proposal to prevent deposit-taking banks from operating trading desks and thereby speculating with the bank’s own money – and this would not have prevented the GFC.
But there is a growing political momentum abroad for a truly substantial reform. The idea is for a tax that would take from the rich, give to the poor, and help capital markets work better to boot. In Britain it is called the Robin Hood tax, and an Australian campaign in favour of the proposal is being launched by Jubilee Australia next week. The genesis of the tax was described earlier this year in Inside Story by John Langmore.
A financial transactions tax is supported by the chancellor of Germany, the president of France, the prime minister of Britain and the foreign minister of Japan, along with the high-profile investors George Soros and Warren Buffet. It is also supported by some 350 eminent economists.
The proposal is for a tiny tax – and I mean tiny – on all wholesale financial transactions. It would be set at perhaps one-twentieth of 1 per cent (0.05 per cent).
To understand why we might need such a tax, some background information is useful. First, it’s important to recognise that financial transactions have got way out of kilter with “real world” transactions. For instance, the global volume of foreign exchange transactions is seventy times greater than the global trade in goods and services. In Germany, Britain and the United States, trading in stocks exceeds business investment by over a hundred times.
Second, “technical trading” represents a large and constantly increasing proportion of overall trading. A product of the computer and information revolutions, technical trading is implemented by computer programs automatically on the basis of incoming information. As data becomes available ever more frequently the incidence of technical trading keeps rising. These trades can be for durations as short as a few seconds, or even fractions of a second. Technical trading is entirely unrelated to market fundamentals; as their share of trades is increasing, so an ever-increasing proportion of financial transactions are not only unrelated to “price discovery” – the process by which the market sets a price – they actually disturb that process.
Third, technical and other very short-term trading is more of a problem than you might think, because it can lead to momentum trading. Indeed, trading on the basis that “the trend is my friend” is the most popular strategy in contemporary financial markets. If speculative short-term trades push a market’s price in a direction then momentum-trading programs can kick in – and prolong and exacerbate the trend. This moves the price further away from what economic fundamentals would dictate, and so the market sends wrong price signals. By this mechanism, excessive short-term speculation can produce long swings in asset prices and persistent deviations from their long-term values. This is what we see today in exchange rates, interest rates and commodity prices. This persistent mispricing favours speculation over longer-term investment and therefore reduces economic growth and employment.
So given this context, why do we need a financial transactions tax? I can think of five very strong reasons.
Most importantly, this tax will deter technical and other very short-term trading. As the tax is the same proportion of the face value of the transaction whether it is a foreign direct investment for three years or a currency trade for three seconds – in other words, whether it’s paid once in three years or once every three seconds – it will deter the latter and not the former.
The tax will make the entire system more amenable to reform. At the moment the global financial system rewards the banks so generously that they fight all potential reforms tooth and nail. In the language of systems science, we need this tax to reduce the system’s negative resilience, the factors in the system that thwart reform.
A financial transactions tax would also give a broader and fairer tax base. At the moment financial services are generally excluded, for no good policy reasons, from taxation. This is so especially with hedge funds. Naturally, as real-world transactions are taxed far more heavily than financial transactions then the latter predominate to the detriment of us all. Why should most sales in Australia be subject to a 10 per cent GST, and many financial transactions be subject to no tax at all?
The post-GFC stimulus measures and bank bailouts have left most OECD countries heavily indebted. A financial transactions tax would provide a revenue source with which to pay down some of this debt over time. And the tax would also provide a much-needed source of revenue to address development needs and climate-change adaptation costs in poor countries.
So why don’t the countries of the world adopt this tax? Well, many commentators still argue that markets invariably produce the best allocation of resources and that any regulation of a market reduces its efficiency. Don’t ask me how anyone believes this after the financial crisis, though.
Of course we need markets. Their price discovery and asset allocation functions are vital and cannot be replicated otherwise. But regulated markets perform these functions better than unregulated ones. Indeed, the United States enjoyed decades of capital inflows from abroad partly because it had the world’s most tightly regulated financial markets, and foreign investors loved the security this brought. And there is nothing traditional about technical trading and the extreme short-termism that has gripped capitalism. These are new phenomena requiring new responses.
This is a very rare tax – a tax worth having irrespective of the revenue it might raise, and one worth having simply for the benefits it will bring to important markets. The revenue is a pure bonus – and is likely to be massive. Calculations are difficult as no one can know what proportion of transactions will be deterred by such a small tax, but reliable estimates range from US$240 billion to US$700 billion per annum. To put these sums in context, they represent roughly two to six times the total annual aid budgets of donor countries. This much money could do so much good. It could be used to halve global hunger and poverty and help poor countries cope with climate change. And it could be used by rich countries to pay down some of the massive deficits they incurred in bailing out their banking systems and stimulating their economies during the GFC. This is principally a tax on hedge funds and investment banks and so it is entirely appropriate that a portion of it should go to remedying the economic devastation caused by the crisis.
Apart from the ideological objections from the market fundamentalists, there are three other common objections: the tax will be difficult to implement, it won’t work unless all countries impose it, and it will strip out the important price arbitraging function of markets. None have substance.
The objection that the tax will be difficult to implement is decades out of date. The idea of a financial transactions tax grew out of the Tobin tax, and when James Tobin first conceived of a small tax on foreign exchange transactions in the early 1970s its implementation would have been decidedly difficult. But the great majority of trading has migrated to exchanges or is conducted through clearing houses. These institutions offer massive efficiencies and are perfectly adapted to collect the tax.
The tax simply will work if only some countries impose it. Britain imposes a tax ten times higher (0.5 per cent) on share trading without traders fleeing London. New York City is a high-tax environment in which to live and work; Connecticut, next door, has no city or state taxes. Yet every day thousands of bankers commute into New York City from Connecticut, not the other way. If the European Union wishes to run with this tax, it can do so without losing significant market activity to the United States.
A tax of 0.05 per cent won’t make real arbitrage opportunities unprofitable so this important function will still be performed. A substantial arbitrage opportunity will still be worth taking, whether there’s a tiny tax or not.
If you scratch below the surface of the objections to this tax you’ll find someone who has a religious devotion to the sanctity of unfettered markets, or a hedge-fund trader or investment banker not wanting to be forced to trade in their ninety-foot yacht for a fifty-foot one.
For this tax will affect the profits of hedge funds and investment banks far more than those of commercial banks. This is because it doesn’t apply to retail financial transactions, the main focus of the big four banks’ business in Australia. It applies principally to derivatives and other speculative short-term trading, the transactions that are the staples of investment banks and hedge funds. Because hedge funds in particular tend to reside in tax havens this is yet another reason to implement the tax – it is one of the few ways to tax profits that otherwise escape taxation. This matters because, of course, assets migrate to tax-free uses.
Accordingly, this tax will not substantially adversely affect Australia’s big four banks. Macquarie Bank is a different matter, so wait for some wailing and gnashing of teeth from the Millionaires Factory should the Australian government support this idea.
So far our government has shown little interest in this proposal. Unfortunately it is doing what it usually does in matters pertaining to international finance – aping the Americans. This might be fine if our interests were the same as America’s but they are not. Financial services are not the driver of growth here that they are in the United States, and, thankfully, our Treasury is not captured by investment banks in the manner of the US Treasury. Australia’s interests are utterly different from those of the United States, yet we seemingly exercise no independent policy in these matters. It is time for this to change. We owe it to ourselves. The world needs this tax, and so do we. •
Ross Buckley is Professor of International Finance Law at the University of New South Wales. He was recently invited to address a forum of the European Parliament examining the financial transactions tax proposal.