Taming the Casino

Author: 
John Fullerton

Bloomberg View has joined its Wall Street customers in coming out against the Financial Transactions Tax proposed by Germany and France, and recommended by the European Union, declaring it politically unfeasible while undermining economic growth.  

Presuming for a moment that the politically unfeasible can become reality when good ideas are pursued in a real democracy, it is important to clarify the sound purpose and likely impact of a Europe-wide or, ideally, universal Financial Transactions Tax. 

FTT advocates have positioned it as a “tax on Wall Street,” a response to the profound injustice of the Wall-Street-induced economic collapse that has left Main Street in tatters. This response also comes at a time when bankers’ arrogance and, let us be clear, unchecked power has grown to previously unimaginable heights.  This is a tactical mistake.  A FTT will not provide justice, nor will it address the unchecked power of mega-banks.  Only dramatic structural reform of the kind Teddy Roosevelt understood will achieve these ends.

A FTT should rather be understood as a laser-sharp policy intervention that will combat (not fix) one of the most corrosive realities undermining capitalism itself: short-term speculation has displaced real investment, transforming our economy into a bankrupt financial system that lacks morals and purpose.

We know that speculation is not bad per se.  In moderation, it enhances market efficiency.  John Maynard Keynes, a speculator himself, said it well: “Speculators may do no harm as bubbles on a steady stream of enterprise.  But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation.  When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done.” 

“Ill-done” is certainly an understatement.  No doubt James Tobin had this in mind when he introduced the idea of a Tobin Tax to “throw some sand into the gears” of our overly “efficient” financial markets, as did Larry Summers and Victoria Summers when they published “When Financial Markets Work Too Well:  A Cautious Case for a Securities Transactions Tax” (1989).  The paper nicely affirms the expected gains to economic efficiency (emphasis added) through redirecting human and financial capital to more productive purposes, outstripping any losses in liquidity and impact on the cost of capital.  The paper concludes:

“The examples of Japan and the United Kingdom suggest that a STET is administratively feasible and can be implemented without crippling the competitiveness of U.S. financial markets. A STET at a 0.5% rate [5 times the EU proposed rate] could raise revenues of at least $10 billion annually.”

Confusion about the impact of a FTT on economic growth, as reflected in the Bloomberg View piece, has been sowed by the same banks that destroyed the economy and millions of lives.  It rests on two misunderstandings:  

First, because the economic system has effectively become a (misguided) financial system, opinion leaders get lulled into confusing financial market efficiency with economic efficiency.  Markets are simply tools designed to facilitate the efficient allocation of capital to productive purpose in the real economy.  As Keynes, Tobin, and the two Summers have made explicit, excess allocation of human and financial capital to speculation harms long-term economic efficiency, thereby harming the quantity and, more importantly, the quality of economic growth. 

Second, systems scientists understand that any system must balance efficiency with resiliency in order to be sustainable.  Modern financial markets represent excessive efficiency, with the resulting diminution of resiliency that manifests in extreme volatility and flash crashes.

In the post “efficient market theory” world of 2011, with high frequency trading accounting for up to 70% of the market’s explosive trading volume, and short-term-momentum-driven and information-driven (legal and illegal) speculation overwhelming long-term investors in the marketplace, and highly leveraged derivative speculation overwhelming the use of derivatives for genuine risk management purposes, the policy case for a well-designed FTT is overwhelming. The fact that it can generate billions of dollars in badly needed tax revenues is a bonus, one that any genuine deficit hawk should favor. 

The mechanical feasibility of collecting the tax in our digital world is now well-documented in a study by the Institute of Development Studies, and can be seen in practice in the UK, Singapore, Hong Kong, and Switzerland to name just a few.  As Bloomberg View points out, the UK’s refusal to endorse the EU proposal appears highly hypocritical in light of the century-old stamp duty in the UK. The tax has hardly shifted equity trading offshore as FTT critics suggest.  How society chooses to allocate the revenues - for example to third-world development as Bill Gates advocates - is a separate question.

To fully assess who would get hurt by an FTT, and how, would require exhaustive research and transparency within firms that is not available.  Here’s my educated guess.

Certain “high frequency” proprietary trading strategies would be negatively impacted, rendering them either less profitable or in some cases uneconomic.  This direct impact would be born by a myriad of sparsely capitalized “high frequency trading” specialists, certain quantitatively-driven hedge funds, most notably firms like Renaissance Capital and D.E. Shaw (who paid Larry Summers a reported $5 million for a year’s worth of part-time work after he wrote his paper on the transactions tax and before he joined the Obama Administration), and Wall Street firms like Goldman Sachs and Morgan Stanley that have large quant trading desks. 

As far as I can determine, the genuine systematic market-making functions of these firms should be unaffected, with the bid/ask spreads adjusted accordingly. The case for technology enhancing the legitimate market-making function is strong.  In this case, the cost of the FTT will be passed on to the customer.  If that customer is a trading-driven hedge fund, either using momentum models or perceived information advantages, or a rapid-turnover mutual fund managing 401ks, then the end investor will realize somewhat lower returns.  This is what the policy aims to accomplish, encouraging end investors to shift at the margin into longer term investment strategies where the tax will be inconsequential, and away from short-term speculation, with resulting efficiency gains for the real economy.  This will in turn reduce the take of the tax, but enhances long-run economic efficiency, which should generate many benefits, culminating in more tax revenue.  It is important to understand impacts holistically.

The indirect effects on Wall Street are also material.  If trading volume shrinks, revenues shrink in two ways.  First, on the direct transaction fees and bid/offer spreads earned, and second, through the profitable Prime Brokerage financing of leveraged speculative trading strategies of numerous hedge funds.  As Summers and Summers nicely explain, the real economy and job creation would be enhanced if FDIC-insured consumer deposits funded productive loans to the real economy instead of leveraged short-term speculation by banks and their hedge fund counterparties, and, if more human capital shifted out of finance and into the productive economy.

It’s easy to see why banks won't like the FTT.  But, it's equally hard to understand how Mr. Geithner can remain so confused about the benefits of an FTT, and its manageable implementation, when the US was and remains ground zero for short-term financial speculation run amok under his watch.  It is equally disappointing Mr. Summers has chosen to remain uncharacteristically silent on the subject he wrote so eloquently about prior to his affiliation with D.E. Shaw. 

I’m not sure it should be the top demand of the “We are the 99” movement occupying Wall Street as Nicholas Kristof suggests, but it’s an important policy tool that is long overdue.