The most recent Final Conference to Save the Euro ended in disarray when the UK refused to sign up to a proposed set of EU treaty changes. The UK’s veto was due to the inclusion of an EU-wide Tobin Tax on security transactions in the set of proposals. The justification for an international Tobin Tax is quite strong. Hypercompetitive securities markets with excessively-large trading volumes and hyper-fast price changes are a serious danger to global financial stability. A Tobin Tax would eliminate these dangerous trading excesses without impinging much on underlying market efficiency. On other hand, the UK government’s refusal to sign up to an EU-only Tobin Tax, imposed on the City of London while the US and Asian global financial centres remain outside the tax net, was an obvious and sensible policy decision for the UK.
After the proposed EU treaty changes were restricted to a coalition of the willing, the Irish government fretted that a Tobin Tax might particularly disadvantage the Irish financial services industry, given that the UK will be outside the tax net.
What should be Ireland’s policy stance toward an international Tobin Tax? Should Ireland do the right thing as a global citizen by supporting such a tax within the Eurozone, or should it protect its international financial services industry from UK (and non-EU) predation and therefore veto any such tax proposal? It would be much better for all concerned if the Tobin Tax could be imposed at a global rather than EU level.
Sometime in the future, May 6th 2010 might rank with August 9th 2007 as a “warning date” for a subsequent financial market disaster. Recall that starting on August 9th 2007, quant-trading hedge funds experienced an extremely turbulent, credit-market-related meltdown. Although the quant-trading markets calmed down after about two weeks, many analysts now recognize this as an early warning signal of the subsequent global credit crisis. In an interesting parallel, on May 6th 2010, high-frequency trading systems generated a “flash crash” of US equity markets, causing a 9% fall and 9% rise of the US stock market within a 20 minute period. Some individual stock prices went bananas; completed trades at crazy prices during this short “flash crash” period were annulled that evening by the NYSE board. Since the markets righted themselves within a day or two, many analysts have forgotten about this incident. But could this “flash crash” be an early warning sign of a subsequent “permo-crash”? High frequency trading (HFT), using entirely computerized systems to trade at hyper-second frequency, now constitutes 70% of US equity and equity-related (equity baskets, futures, options) trading volume, and 30% in the UK. If HFT generates a flash-crash at the end of the trading day, rather than mid-day as on May 6th, and something else goes wrong at the same time, it could lead to an enormous disaster.
Tobin originally proposed his tax for the foreign exchange market, which was the first financial market to have hyper-competitive trading costs. He saw that most of the trading volume in forex markets provided very little economic value. A small tax would have a big influence on trading volume, rendering purely speculative and potentially destabilizing trading strategies unprofitable, while having little or no impact on the real economic value of these markets. Tobin called it “throwing sand in the wheels” of securities market trading. Nowadays, Tobin’s “sand in the wheels” metaphor is widely misunderstood. Tobin was a World War Two naval officer and throwing sand in the wheels was an accepted way to improve machine performance in his day. For mid-twentieth century machinery a little sand in the wheels would slow down the mechanism (think of something like a navy ship’s water pumps) and make for more reliable performance with less chance of overheating. With modern precision engineering the notion of “sand in the wheels” as a repair method seems ridiculous, so commentators assume Tobin is advocating sabotage of securities markets. That was not what he meant – “sand in the wheels” is an old-fashioned procedure to slow down machinery so that performance improves, not a means of sabotage. Oddly, the tax is designed to generate minimum revenue – it relies on the elasticity of trading volume to net costs, and tries to drive out destabilizing short-term trading strategies while collecting minimal tax revenue.
Now, after decades of hard-fought liberalization, US and UK equity markets have the same hyper-competitive trading costs as forex markets. HFT has hijacked this and feeds off this market cost improvement (and by earning net profits from “normal” market traders) with trading systems that add little real efficiency improvement for markets. Eliminating their net profits with a small tax would do little harm, and make markets safer. The very bright computer scientists who run these HFT firms could go back to socially useful activities like designing better software.
There is another interesting parallel to the global credit crisis. US housing regulators worked for thirty years to increase access to owner-occupied housing for lower and middle income households and this was a big success. Then, they took that policy too far, and the policy was hijacked by self-interested actors in the US property lending and securities trading sectors. There was too much of a good thing in terms of the too-low-credit-quality US residential property lending market. The same applies now with securities market trading costs and trading access. Regulators have succeeded in driving out bad securities trading practices and greatly lowering trading costs, but this process has gone too far. It has been hijacked by HFT. I call this the Too Much of a Good Thing (TMGT) theory of regulatory capture.
During the credit bubble, Ireland enthusiastically joined the dumb-down contest to impose the minimal possible regulation on the financial services sector. Perhaps now Irish policy leaders could make amends by joining the push for a Tobin Tax.
How would a Tobin tax impact the competitive draw of Dublin for its brand of “off shore” financial services? Perhaps it would be the death knell for the Irish stock exchange since all trading volume might migrate to London. Ireland policymakers should encourage a global solution, bringing the US and UK in particular into the plan. Asian markets (which are not yet competitive for HFT) might be willing to cooperate as well, since there is no great cost for them.