This is not the way to stop markets blowing speculative bubbles
Diane Coyle on the idea of a tax to curb the excesses of currency traders
Thursday 28 May 1998
This is the reasoning. Currency markets are obviously necessary to finance bona fide trade and investment, but all too easily speculative bubbles emerge which drive exchange rates far away from the levels that would be justified by economic fundamentals such as future GDP growth, inflation and export prospects.
A small tax on currency transactions,however, might well discourage enough short-term trading, not related to "real" financial flows, to prevent such divergences of exchange rates from where they ought to be. Its fans also argue that a Tobin tax would raise funds for useful expenditure such as Third World debt relief. What could be more satisfying than taking from the international elite of financial fat cats and giving to the world's poorest people, at the same time as making the financial markets more orderly?
Sadly, there are many possible objections to a Tobin tax. Some are practical. Who would enforce and collect it? Why should a small tax actually discourage speculators when transaction costs in most markets are already much higher than the proposed tax rate - and when the potential gains from speculation are so enormous?
But the main problem with the idea is that it rests on the existence of immutable fundamentals, which sensible investors will reflect in the price at which they are willing to trade but from which the Soroses and suckers can push them too far in one direction. There has to be an underlying truth, reflected in the efficient market price from which self-fulfilling bubbles emerge and ultimately burst. The right policy for market stability in this case is to skim off the bubbles before they grow too big.
A pleasing vision, but a false one. The evidence is that financial markets, and not just their bubbles, can be inherently self-fulfilling. There is no true valuation corresponding to an objective set of economic fundamentals.
To see this, just think about the importance of technology stocks in Wall Street's long bull run. None of the investors in these software and biotech companies has the remotest idea how valuable they ought to be, and the stocks trade at awe-inspiring prices while the companies' earnings remain low or even negative. There is simply too much uncertainty about future demand for different types of high-tech products, not to mention the underlying science. But the same point can be made about the Asian markets. They were valuable as long as they were valuable, and when enough investors changed their mind, they weren't.
As the great master, John Maynard Keynes put it, writing in 1937, a market valuation "... is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation."
In today's high-speed markets, a change in expectations can rapidly create a new future. As soon as the general optimism about the Tiger economies foundered, for whatever reason, their currency and stock markets crashed and, lo, their economic future no longer looks rosy.
This is not to say that fundamentals do not matter at all, for it is also true that the Asian economies were labouring under weak banking systems, corrupt loans and bad government. If this were not the case, they could probably have sailed quite swiftly out of the crash, as the western economies did after the stock market crash of 1987. As it is, recovery is going to take a long haul of political and institutional reform as well as the IMF's economic medicine. In the real economy, the fundamentals do still matter.
But not in the markets, and this gets back to why the Tobin tax is misguided. As Paul Davidson, an economics professor at the University of Tennessee, pointed out in a presentation to the annual conference of the Royal Economic Society last month, the available empirical evidence suggests that a reduction in transactions costs on 1 May 1975, making the US stock market more liquid and bringing in more investors, reduced the volatility of share prices.
This is consistent with the view that the market is entirely self-fulfilling, because in that case the more investors there are, the more likely there are to be different views about where the market is heading. Bubbles still emerge - they do so whenever a critical mass of investors adopts the view that it is heading up and up. Increasing transaction costs via a tax would not only not prevent bubbles but would also increase day-to-day volatility.
Does this have any implications for Wall Street now? One comfort is that if Wall Street does crash, the American economy is in good shape. Inflation is low. So is government borrowing. The US technological edge has widened, and the economy starts from a position of having the lowest unemployment rate for a quarter of a century. Besides, Alan Greenspan proved himself amazingly good at sweeping up after the 1987 crash, and there is every reason to believe the Fed would do as good a job again.
However, even better news is that there exists a wide difference of opinion about where US shares are heading. The believers in a "new economic paradigm" argue that technology is delivering higher prospective growth and low inflation, justifying the current and higher levels of share prices.
Somewhat alarmingly, all of Main Street, USA seems to have joined this group, if the popularity of investment clubs is anything to go by. Still, there are real benefits from a frothy stock market. It does encourage venture capitalists and entrepreneurial investors in high-technology companies no end, helping to create its own fundamentals.
On the other hand, there is also a Barnum camp which reckons the stock market is a dangerously stretched bubble about to burst at the first clear sign of re-emerging inflation and a downturn in the business cycle.
Along with Mr Greenspan's carefully timed reflections that the stock market might be suffering "irrational exuberance" and his steady massaging of expectations in readiness for a rise in interest rates, we have to hope that there might just be enough sceptics in the market already to prevent anything worse than a serious correction on Wall Street.
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