This article is based on a speech delivered in 1995 at a CCPA conference in Ottawa by U.S. economist James Tobin, who died in 2002 at the age of 84. A prominent supporter of Keynesian economics and winner of the Nobel Prize in Economics in 1981, Prof. Tobin is now widely known for his suggested imposition of a tax on foreign exchange transactions. Such a tax, he argued, would reduce speculation in the international currency markets, which he saw as dangerous and unproductive.
Unfortunately, the proposed “Tobin Tax” was never implemented. Had it been in effect over the past decade, it would probably have prevented (or at least minimized) the greed-driven speculation in international financial trading that caused the disastrous economic crash in 2008. As a result of the recent meltdown, interest in the Tobin Tax has been re-ignited, and the case its creator made for it to CCPA members 16 years ago remains just as strong and persuasive today.
* * *
Some people have reacted to my proposal for an international tax on currency exchange transactions as if it were some kind of quack medicine – particularly the people who might have to pay the tax. So let me explain, in as close to lay language as possible, what it’s all about.
Economists, bankers, central bankers, exporters and importers have been dissatisfied with the international monetary system for a long time, particularly since the collapse of the Bretton Woods system in 1971-73, and the shift to flexible, floating exchange rates among the major currencies.
The Bretton Woods institutions that had been established in 1945 worked fairly well. We had a remarkable period of prosperity and economic growth, and in the allocation of capital from the developed to the less developed nations. Under this post-war system we had a fixed exchange rate system where currencies were tied to the dollar, the dollar to gold, and the various currencies kept at their parities by the central banks. They had to do that by using their reserves or by borrowing from the International Monetary Fund (IMF) or elsewhere.
Since the conversion to a floating exchange rate system in the early 1970s, nostalgia for the old fixed-exchange-rate system has persisted and flourished. Most advocates of “reform” favour a return to some form of the earlier system. Many would go beyond the restoration of Bretton Woods to the adoption of a single international currency, as contemplated for Europe in the Treaty of Maastricht. Some would even return to the pre-1914 gold standard, with irreversible definitions of national currencies in ounces of gold.
These proposals gain currency from the fact that economic developments since 1973 have been disappointing. The rate of economic growth has slowed and unemployment has increased. Real wages have been stagnant or declining. Stagflation, trade imbalance, and debt burdens have dominated the economic news.
I didn’t think in 1976-78, and I don’t think now, that these economic maladies were the fault of the floating exchange rate system. I think that the shocks that hit the world economy in the last 25 years would have had more severe consequences, not less, had the Bretton Woods system continued. So far as specific international monetary difficulties were concerned, I called attention to a development which maybe people wouldn’t think of so quickly: the facilities for transferring funds across currencies were rapidly improving. They were improving technologically, improving by new institutions and new markets being set up, and improving by regulation.
Until recent years, most countries had exchange controls or capital controls for inter-currency transactions, even developed countries such as France and Italy. All the time, since 1945, even with a vast increase in trade and in the movement of capital all over the world, most countries had some kind of exchange controls regulating the transfer of currencies.
What the IMF had insisted upon in its charter was that currencies should be exchangeable for financing current account transactions. The creators of the IMF – Keynes and others – were very suspicious of “hot” money floating around. They didn’t want that to be encouraged by the IMF. Bretton Woods did not require freedom of capital movements in and out of currencies.
Those controls didn’t interfere with the vast expansion of trade and the vast freeing of trade, reductions of tariffs and non-tariff barriers, and so on, that took place since 1945, nor did they interfere with long-term capital movements.
I thought that the trend towards more and quicker currency transactions was more important than the shift in the exchange rate regime from fixed rates to floating rates. I believed the resources that were and would be at the beck and call of private agents for transactions across exchange rates would overwhelm the international reserves of central banks. They would no longer be able to work their own will in protecting their Bretton Woods parities, if they still existed, or in obtaining a tolerable market exchange rate in the floating rate system. Unlike many economists who enthusiastically welcomed floating rates, I didn’t think they would solve all problems, because I didn’t believe that governments would see with equanimity their exchange rates go to whatever level the markets might put them.
What was doing this? The trends responsible have now become much more important. They are the technology of electronic communication by computers and video, and the worldwide financial markets that sprang up. The sun now sets on the British empire, but it doesn’t set on the foreign exchange markets. They go all the way around the world, day and night, in every time zone. So MBAs with training in modern finance theory and practice can sit at video screens and cheaply, quickly, easily transact billions of dollars at midnight from their stations in whatever big bank they work.
And it’s certainly true that the exchange rate movements that result are beyond the capacity of central banks, individually or collectively, to stem or control, and even beyond the control of the IMF itself. The IMF has inadequate resources to do anything about them.
Keynes pointed out in the General Theory, Chapter 12, that the kinds of transactions that go on in the organized security markets are often not based on economic fundamentals. Such transactions reflect long-run calculations of value. Speculative transactions are like the famous metaphor (mentioned by Keynes) of a beauty contest in which subscribers to the newspaper are invited to vote on baby pictures – not as to which is the cutest baby, but as the one most respondents will think is the cutest. So you are asked to bet on how your co-respondents will vote. And that’s what speculation in securities markets is like in the short run.
Often I think it’s a focus on particular news items, typically just statistics that are due out on particular days. The objective of a trader in an investment bank is to guess what other traders will think is the proper reaction, the likely movement of the exchange rate in response to the next GDP or trade deficit or inflation report. And of course that does go on in various degrees. You think about what other speculators think and they’re thinking about what you and other speculators think, etc., etc. This psychology prevails, especially for short-term transactions.
A few years ago, a student of mine went to work in a commodity exchange, where he learned the trade from a former professor of economics. After serving his apprenticeship for several weeks, my young friend asked his mentor whether he shouldn’t be thinking about long-term things, like crops and harvests, in making his bets. His mentor replied, “Sonny, my long run is the next ten minutes.” So that’s the kind of speculation that I think can make the markets depart from the fundamentals that so-called efficient markets theory assumes.
In any case, the “Tobin Tax” is designed to penalize short-run-oriented transactions. There are more than a trillion dollars of gross transactions in foreign exchange markets every day in the world. The great majority of those are the beginnings of round trips that take only a week or less. They are essentially short-term round trips from one currency to another.
My proposed exchange transactions tax is the same amount for every transaction. So it automatically, in the simplest possible manner, discriminates between short- and long-run round trips. Suppose the exchange tax is 0.5% for each transaction, half a percent of its total value. If you’re going to move from Toronto to New York in order to exploit an interest rate differential and you come back within the same week, that costs you 1% for the round trip. If the advantage is only a few basis points of difference in the short-run interest rates on an annual basis, the tax will erase the gain.
On the other hand, let’s say you want to make a transaction because you’re going to make a serious real capital investment – building a physical capital facility, plant, or equipment in another country, another currency. When you eventually decide to repatriate the money – let’s say, in ten years from now – such a small tax is not going to make the slightest bit of difference to your calculation of the advantages of making that investment. That’s the kind of real investment that we’d like to have, the kind of transaction across the exchanges that we’d like to have, and it’s not going to be hurt by the tax. Neither is a transaction that involves trade, because, again, the size of the tax is too small to make a difference.
So I don’t have to explain, as people often ask me to, “How do you know whether something is speculative or not?” I don’t know, of course, but I don’t need to know. The nature of the tax in itself makes that kind of discrimination.
Now, admittedly, some people use the liquidity of the market in the other way, in a stabilizing way. They take advantage of an opportunity for making a long-run profit because the market has made a short-run error. Thus they also have to pay the tax. But my judgment is that these fundamentalists are expecting to hold on for a long time, so the tax is not going to hurt or discourage them in the way it’s going to hurt the in-and-out participants in the market.
So that’s my proposal. We can’t expect salvation from the Bretton Woods system of adjustable pegs, because those pegs can’t be held when speculation turns against them, as we well know. So we can’t return to Bretton Woods. Floating rates are going to continue to move around in ways that are sometimes embarrassing to countries. They also accelerate the arbitrage involved, the speculation involved in the foreign exchange market.
Floating rates also interfere with the autonomy and sovereignty of local macro-policy managers. The central bank is afraid to allow its interest rate to deviate too much from interest rates elsewhere, to have it be too much different in Toronto from what it is in New York, or else the money will move out to New York and the Canadian dollar will fall. Whatever embarrassment or problems that creates, the central bank is led to raise interest rates to keep at a closer relationship to American interest rates.
Sometimes the U.S. Federal Reserve thinks the same way, perhaps about interest rates in Germany. Certainly the French central bank is always thinking about its rates relative to those in Germany. Autonomy in running monetary policy is therefore endangered by the ease of these transactions and their sensitivity. But a wedge will be created by the Tobin Tax that allows some freedom for short-term money rates in different countries to diverge.
I’m not one who thinks that the markets are always imposing upon any central bank exactly the discipline it ought to have. I still think there is enough difference between countries, and that we don’t have enough harmony of institutions and objectives and enough synchronization of business cycles so that the same monetary policy or the same level of interest rates is as right for Japan as it is for the United States.
So, pending the time when we have a world-wide single currency, we have the problem that currencies move around. People can be speculating in them. Then the smoother, the cheaper, the easier, the more abundant the funds for speculation, the more the autonomous powers of national central banks are circumscribed.
That is an important function of the Tobin Tax, maybe more important than just discouraging speculation: creating more room for autonomous national monetary policies, on the grounds that they’re still desirable and they’re still more likely to be done better by a national central bank than they are by the actors in the international currency markets.
This tax would have to be a virtually universal tax, uniform all over the world, or else the transactions would move to jurisdictions where there isn’t such a tax. I think it’s an exaggerated worry, but that’s the first objection that practical people and those in ministries of finance and central banks make to this proposal. It’s impractical, they say, because all the transactions will move to the Cayman Islands or Rwanda or Burundi, and they will have a great industry in making all the transactions that used to be made in New York and London and Hong Kong.
I think that’s greatly exaggerated. There may already be reasons why all the financial markets ought to be in Dublin instead of New York and London: English-speaking and educated people, lower wages, and all that. But it doesn’t happen and I don’t think that it’s going to happen because of my proposed tax.
If, for example, the tax were imposed in the U.S., and the Chase Manhattan or Citi-Corp were sending funds to its phony branch in the Cayman Islands to make these tax-free transactions, I don’t think it’s beyond the capacity of the U.S. government to tell them they can’t do that or else those dispatches of money to the tax shelter would be regarded as if they were subject to the tax itself – as if they were a purchase of foreign currency.
Nevertheless, it should certainly be a universal tax, so how do we make it one? Well, one way would be to make it a condition of membership in the IMF and having the privilege of borrowing from the Fund. That would require amending the IMF’s articles to set up this tax, and to get agreement among its members that everybody is going to levy it. The IMF could be its administrator and set up the rules as to how it’s done. It might even be empowered, within limits, to change the rate of tax from time to time. Sometimes it should be higher than at other times, and it might fluctuate depending on how much tax revenue it collects.
This would give the IMF something to do besides imposing its one-size-fits-all prescriptions for underdeveloped countries. They don’t have much else to do since the Bretton Woods exchange rate system fell apart.
So that’s the idea. And then the tax would be collected in each jurisdiction and the proceeds divided between the IMF, the international administering agency (if the IMf were not entrusted with this role), and the jurisdiction itself. Many little countries could keep everything they collected from the tax because they’d only be in this game because we don’t want them to be tax havens.
The big countries – the U.K., the U.S., Germany and Japan – would send most of what they collect to be used for worthwhile international purposes. It is an international tax, so it should be used for international purposes. Some of the tax revenue could go to the United Nations, perhaps to increase the financial resources of its international aid agencies such as UNICEF and the UNDP.
What amount could we expect the Tobin tax to generate? Considering that a trillion dollars a day occurs through all financial transactions, it would be a lot, even though the short-term spot transactions would be the only ones taxed. We hope the tax would have a significant deterrent effect on the spot transactions, so that there would be fewer of them over time to be taxed.
Even so, a reasonable estimate of the amount to be derived from the Tobin Tax would be as much a half trillion dollars a year, give or take a couple hundred billions, so it’s not to be sneezed at. Obviously it could be a large source of revenue to fund worthwhile international programs, such as those aimed at reducing poverty, illiteracy, inequality, and deaths from preventable disease.