A Tobin tax would destroy London without making the world safer

Matthew Sinclair
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It is imperative that Gordon Brown&rsquo;s proposals to levy a Tobin tax on financial transactions be defeated. Such a tax would be a disaster: it would endanger Britain&rsquo;s economic interests and do nothing for ordinary taxpayers or the stability of the financial system. <br /><br />Championing such a scheme reflects a failure to engage with the real causes of the crisis and an obsession with grabbing cheap, easy headlines. Instead of this kind of posturing, we need politicians to start looking seriously at how bad policy drove the bubble and bust and what changes can be made to return the financial system to long-term stability.<br /><br />The original Tobin tax was designed to cushion exchange rate fluctuations.&nbsp; Economist James Tobin initially proposed a one per cent tax on short term currency trades. Since then, the proposed rate has fallen, most proposals now suggest about 0.1-0.2 per cent, but the scope has been expanded to include other transactions; because otherwise the tax can easily be avoided by trading via other cash-equivalent derivatives. Until recently, proposals for a Tobin tax had never seriously been taken up by anyone but anti-capitalist protestors and campaigns like War on Want. Some governments in Europe and Latin America had toyed with the idea, but none of the authorities responsible for major financial centres had ever accepted the argument for such a tax. Adair Turner, chairman of the Financial Services Authority, was swimming against the tide when he first floated the idea via Prospect magazine this year.&nbsp; <br /><br /><strong>FLOATING EXCHANGE RATES<br /></strong>One reason why few have supported a Tobin tax is that worries about foreign exchange speculation have slowly subsided as more countries have moved towards floating exchange rates, which do more to limit the potential for exchange rate speculation than a Tobin tax possibly could. Attempts to fix rates such as &ndash; in the 1980s and 1990s &ndash; the European Exchange Rate Mechanism (ERM) meant that we got large and sudden movements in exchange rates when speculators sensed that a peg could not be maintained, rather than the more fluid shifts of today. The pound has collapsed recently, but that isn&rsquo;t the fault of speculators: rather, massive public sector deficits are primarily to blame, as is uncertainty about the UK&rsquo;s relative performance in the years ahead.<br /><br />The whole idea of a Tobin tax is based on the flawed view that trading &ndash; or speculation &ndash; is a bad thing. The truth is that it isn&rsquo;t: it helps the process of price discovery, makes markets work better, enhances liquidity, ensures that resources are priced correctly and generally helps oil the cogs of the global economy. <br /><br />This pro-trading argument also applies to high-frequency trading, one of the practices that a Tobin tax would make much, much harder to sustain. Things only really go wrong when there is a bubble &ndash; and bubbles always require excessively loose monetary policy to form. <br /><br />And trading helps sustain tens of thousands of jobs in London. It is astonishing that Brown seems to want to destroy one of our key industries without making any proper argument against it. <br /><br />Many at the G20 seemed to think&nbsp; that a Tobin tax would provide compensation for the billions spent on bailouts. Some go as far as to claim that a Tobin tax of &pound;5 on every &pound;10,000 of transactions could raise &pound;415bn a year. This, needless to say, is nonsense; there is no way such sums would be raised in this way. Markets would simply collapse, liquidity would go down and prices would become less accurate or take much longer to adjust. There would be lots of other problems.<br /><br />It is understandable that people want to see banks make some restitution to taxpayers who were forced to provide billions for bailouts. But putting in place a Tobin tax won&rsquo;t make that happen. Professor Charles Goodhart has suggested banks will generally pass the cost of a Tobin tax on by widening their bid/ask spreads.&nbsp; The biggest price would ultimately be paid by ordinary borrowers and savers.<br /><br />Things would be even worse if a tax was put in place with any significant financial centre, perhaps Hong Kong, not included. Traders would quickly shift to the tax-free market and that would mean thousands of lost jobs in the City and lost revenues for the British exchequer, which would have to be made up by ordinary taxpayers. Such a risk to the British economy and the public finances would be an unacceptable price to pay .<br /><br /><strong>TAX DOESN&rsquo;T ADDRESS CAUSES<br /></strong>Instead of looking for new ways of paying for bailouts, we should be looking at how we can avoid the need for them in the first place. The last serious deposit bank failures in Britain were in 1878, when the City of Glasgow Bank and the West of England &amp; South Wales District Bank failed. The idea that we should give up on the stability of the British banking system, when it was maintained through an entire century of wars and depressions, is absurdly defeatist.<br /><br />A Tobin tax doesn&rsquo;t address the causes of the financial and economic crisis. Its root cause was simply that too many big banks were too exposed to unreliable mortgage loans. When a housing bubble in the United States burst, those banks got into huge trouble and taxpayers&rsquo; money was used on a huge scale to keep many of them afloat. Reducing the number of financial transactions at any point wouldn&rsquo;t have changed anything (and many mortgage CDOs were held for long periods, not constantly traded).<br /><br />If Brown were serious about protecting ordinary people, he would start asking serious questions about whether there were any policies that drove the previously quite stable British banking system to need a bailout from the taxpayer. There are a number of ways in which government action made matters worse.<br /><br />In the build-up to the crisis policy often encouraged banks to take more risks. Low interest rates, in particular, encouraged both more borrowing and riskier lending. Regulation and activism in the United States promoted subprime lending. Even the housing bubble itself cannot be separated from policy decisions, as strict planning regulations make the supply of housing more inelastic and mean changes in demand are almost entirely reflected in prices.<br /><br />Once the crisis got underway, regulators performed poorly and made matters worse once again. The Bank of England complained that it was unable to support Northern Rock covertly thanks to EU rules. There were clearly problems at the Financial Services Authority and the Bank of England has been described as &ldquo;flying blind&rdquo; with the tripartite system leaving it bereft of the detailed information on individual banks needed to maintain financial stability.<br /><br />Finally, regulations exacerbated the crisis. As far back as 2004, a study for the Board of Governors of the US Federal Reserve System had warned that Basel II&rsquo;s capital requirements would be procyclical. And, during the crisis, mark to market accounting regulations became deeply counter-productive: every one of the United States&rsquo; ten largest banks would have become insolvent in the 1980s had mark to market been in place at the time.&nbsp; Restrictions on short selling hurt hedge funds and prevented them from playing a part in limiting the crisis.<br /><br />Politicians should be looking at these issues, and trying to reform policy to reduce systemic risk. Working out how to pay for financial busts is a poor substitute for avoiding them.<br /><br />Fortunately, the Tobin tax proposal was shot down almost as soon as Brown had finished speaking. The Americans dismissed it immediately and the OECD said the scheme wouldn&rsquo;t work in practice as transactions are difficult to measure and a transaction tax is therefore easy to avoid. This proposal may just be one more embarrassment for Brown, and his laughable attempts to pretend he is leading the global response to the economic crisis.&nbsp; But it is yet another distraction from dealing with the real issues that we can ill afford. A Tobin tax is a bad idea. Politicians should move on to the real policy changes that are needed to make the global economy a safer place.<br /><br />Matthew Sinclair is research director at the TaxPayers&rsquo; Alliance.<br />