WE SHOULD PUT SAND IN THE WHEELS OF THE MARKET / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

We should put sand in the wheels of the market

By Avinash Persaud

Published: August 27 2009 22:06

There is nothing that will generate the ire of bankers and traders more than mention of the Tobin tax. Cynics would say this was Lord Turner’s real intention when the chairman of the British financial watchdog supported the idea on Thursday, but that would be to miss a critical inflexion point in this emerging debate.

In 1971, as currency speculation tore apart the Bretton Woods system of pegged exchange rates, the Nobel-winning economist James Tobin proposed a small tax on foreign exchange transactions, to put “sand in the wheels” of the market. Since then the stock response of bankers and traders has been to express sympathy for the worthy things the tax could be spent on, but to say that while it is of course a desirable idea, it is utterly impractical. The market, it is argued, would simply move to where the tax was not. Sometimes it is added that the tax would destroy financial market liquidity and this would raise the cost of doing business in the real economy.

The secret that few in the industry would like you to know is that financial transaction taxes are not only commonplace, but have become easier to enforce. The real question today is not their feasibility; but their desirability. It is hard to argue that anything is not feasible today after governments have engaged in whole-scale bank nationalisation and credit guarantees, pushed budget deficits into double figures, become the buyer of last resort of assets they would not normally touch with a barge pole and threatened to legislate against private sector pay. Where there is a will there is a way.

To be fair, the principal purpose of most existing financial transaction taxes is not to put a brake on the market, but to raise revenues. Stamp duty on property or equity transactions is one of the oldest taxes. Where these taxes are large, they create an offsetting incentive to avoid them and their proceeds tend to fall over time. Where they are small, such as the tiny transaction taxes that finance the US securities and futures regulators, traders hardly notice them, and they raise modest but rising sums.

Financial transaction taxes have become easier to enforce as a result of trends in the arcane world of securities settlement and clearing. Even before the credit crunch there was concern over the systemic risks attached to the clearing and settling of securities and derivatives, where the gross value of exposures had grown exponentially higher than the net value. Consequently, there is a trend towards the consolidation of clearing and settlement systems, which has been given added impetus by the credit crunch. A majority of foreign exchange transactions are now settled in one place, the London-based CLS Bank. Central clearing and settling systems provide substantial benefits in netting traders exposures, and as a result, reducing their risks. Lower trading risks means lower regulatory capital requirements and hence cheaper trading. If transaction taxes were levied in these centralised settlement systems, they would be very expensive to avoid.

Tobin taxes are now feasible; but are they desirable? Financial institutions naturally concentrate on developing products that they can make money from. The products they make most money from are those that trade extensively. Consequently, the financial system is biased to excessive trading, churning and volatility. The system is not interested in developing products that are fit for a long-term purpose that do not trade so extensively – like hedging life-cycle risks of individuals or the economic cycle of countries. These biases can be found in the way the financial sector places great attention on hedge funds involved in high-frequency trading, and less on buy and hold pension funds; or in the way the size and profitability of the financial sector is out of kilter with its goal of facilitating growth in the real economy.

The size and profitability of the financial sector affords it great political influence. Before the credit crunch it was the only industry more powerful than the defence industry. Like the defence industry it has been able to frame the intellectual and regulatory debate in its favour. The classic economists’ solution to all this is a tax. Setting the right level of this tax so as not to damage liquidity will be hard, but probably not as hard as being one of the first regulators to openly discuss it.

The author is chairman of Intelligent Capital, chairman of the Warwick Commission and a former banker

Copyright The Financial Times Limited 2009