Thursday, November 12, 2009

In Support of the Tobin Tax - Ari Paul

Dear Friends, Colleagues, and Investors,

A "Tobin Tax" was originally designed to be a tax on foreign currency transactions with the goal of reducing short-term speculation. The economist James Tobin suggested that a tax of about 0.25% be levied on all foreign currency transactions; the income earned from the tax would be incidental; the greater effect would be to dampen speculative money flows that wreck havoc on economies. There is now widespread talk of applying a Tobin tax to all financial transactions.

The most obvious effect of the Tobin Tax would be to shrink the financial sector. As a professional trader at a large market-making firm, a Tobin tax would likely be devastating to my career, so my writing this week may surprise you. In this newsletter I'll lay out a vigorous case for why the Tobin tax should be implemented. The objections to the Tobin tax are more obvious than its benefits so I'll present the case in a question and answer format.

1) Will a Tobin Tax Increase Unemployment?

If the financial sector shrinks, won't a lot more financial professionals will be out of work?

By definition, investors as a whole will perform exactly as well as the market (minus transaction costs). If everyone expends a lot of time and energy to beat the market, as a group, they are wasting valuable resources. Now, a little bit of competition is healthy as investors research companies and help push asset prices where they should be. However, many of the smartest engineers and business minds now devote themselves purely to outwitting one another in completely useless ways. There are some twenty hedge funds filled with programmers and engineers trying to figure out how to send orders to stock exchanges a millisecond faster than one another. The fastest will make billions of dollars in profits. Yet reducing latency from 200 milliseconds to 190 milliseconds provides absolutely no value to society, or even to the market as a whole. These hedge funds soak up large amounts of the intellectual capital of the country. For the last few years about 30% of Harvard's MBA graduates have been heading to Wall Street jobs. These are the business leaders who could be entrepreneurs inventing new services or managers finding ways to increase labor productivity. Instead, they're "playing poker" (e.g. pursuing technical analysis, algorithmic trading, and low latency trading) with astrophysicists and electrical engineers who have also been enticed by the higher pay of Wall Street. It's impossible to estimate the cost to society of having these otherwise productive people spend their time siphoning money off the general public.

Depending on the scale of the Tobin Tax, it could well put 30% of all financial professionals out of business. That's a good thing. We want our electrical engineers working on cheaper energy, not trying to send stock orders a millisecond faster than engineers at another hedge fund.

2) Will a Tobin Tax Make the Market Less Efficient?

The "efficient market hypothesis" suggests that the more speculators are involved in a market, the more "efficient" the market will be. These speculators might push the value of stocks and other assets to "fair" value which helps the capital markets run smoothly. For example, by pushing the stock price of a good company higher, speculators let that company raise capital to expand. By lowering the stock price of an insolvent company, speculators signal to the company's creditors and suppliers that the company is in trouble. This is great in theory, except it doesn't actually happen.

When transaction costs are very high, only a handful of market participants can earn significant profits. The less skillful investors/traders go out of business quickly, because not only do they need to beat their competitors, they also need to overcome the higher costs of business. So with high transaction costs, the main market movers are the very best investors/traders. As the transaction costs are lowered, less and less skilled gamblers are enticed to play, and these gamblers do what you'd expect - they push prices in stupid ways. It's these less skilled gamblers that produced the tech bubble in the late nineties and the real estate bubble we're still dealing with. Lower transaction costs act similarly to easy credit - they encourage gambling. Gambling makes the market less efficient as the gamblers are more likely to act as a herd and send prices far from fair. So a Tobin Tax might make the markets more efficient. While this isn't clear, I judge it unlikely that a Tobin tax will make the markets any less efficient.

3) Will a Tobin Tax Drive Up Transaction Costs?

The more speculators are involved in a market, the more liquidity the market will have. The idea is that the speculators reduce the bid/ask spreads and therefore reduce the transaction costs to all involved. For example, today you can buy Microsoft stock for $28.51 and sell it at $28.50. This suggests that the fair value is $28.505, so the theoretical cost to execute the transaction is just half a penny. If there weren't so many speculators constantly willing to bet on Microsoft's stock, you might have to pay $28.61 to buy the stock and you'd only be able to sell it at $28.40. The fair value is still $28.505 but now you're paying more than a dime to execute the trade. Wouldn't the Tobin tax drive up transaction costs and therefore be a burden on all of society?

A Tobin tax would certainly raise transaction costs, but this isn't necessarily a bad thing. For example, we deliberately make cigarettes more expensive with a tax to discourage people from smoking. In this analogy, the effect of speculation on society is similar to that of smoking. It's true that anyone buying or selling Microsoft stock would effectively pay more to do so, but for investors, the cost is negligible. Warren Buffett deliberately kept the bid/ask spread of Berkshire Hathaway wide to discourage speculation. Most people lose money trading stocks. In fact, more than 70% of professional mutual fund managers underperform the indexes they try to track. In other words, the more you play the stock market game, the more you're likely to lose. Yet, many retail investors believe they can consistently beat the stock market and are convinced to gamble and try. They're lured by "low commissions" on stock trades and they're lured by small bid/ask spreads. The low transaction costs make it seem inexpensive to gamble. The low costs make it seem like they have a great chance of wining. With higher transaction costs, many of these hopeless gamblers would be dissuaded from gambling in the first place. Not only does stock market gambling cost the general public great amounts of money, it produces a deadweight loss to society. Where does the lost money go? It goes to professional traders who only exist because the public keeps losing money. If the public stopped gambling on stocks, the traders (who are generally bright and well educated) would find gainful employment producing something of value to society. The higher transaction costs from a Tobin Tax would keep more money in the public's pockets.

4) Isn't a Tobin Tax a "tax", and aren't taxes bad?

Whatever money the Tobin tax raises will be coming out of the already weak financial sector, businesses, and even an individual's 401K. Isn't this bad?

The most obvious "benefit" of the tax - the generation of revenue, is the least important benefit. Taxes aren't inherently a good thing or a bad thing; they redistribute income and depending on how intelligently the government spends the money, that could be productive or destructive. It's also important how the tax is collected. For example, income taxes have been proven to reduce the amount of time people spend working, obviously a destructive side effect. The Tobin Tax is about as productively collected a tax as I can imagine. If managed properly, it would have little impact on the kind of financial transactions that benefit society, but would eliminate a great bulk of the kind of transactions that are harmful. For example, if a company is a great investment, that 0.25% tax wouldn't dissuade any intelligent long-term investor from buying their stock. However, it would completely end stock day trading. The effect on an individual's 401K would be negligible; the vast majority of the tax would initially come from financial speculators, many of whom would quickly leave the industry. The remaining burden of the tax would fall on legitimate hedgers and the remaining profitable speculators.

5) Can We Trust That the Tax Will be Intelligently Applied?

Isn't it likely that big financial firms would find ways to outsmart the regulators and gain legal loopholes or simply escape enforcement? The big firms have ignored other rules like the "uptick rule" for shortselling, or the ban on naked shortselling.

This is a very real and serious criticism. If you believe the federal government is not competent enough to impose meaningful financial regulation, you are justified in opposing a Tobin tax as it could be abused to merely solidify the oligopoly of the major financial players. To implement a uniform Tobin tax, we will probably need the kind of populist anger and political consensus that existed in the great depression and gave rise to the Glass-Steagall Act.

In Summary: A Tobin tax would reallocate smart hardworking people from the "poker game" of trading and wealth management, to more productive enterprises. If applied intelligently, it would reduce speculation, dissuade the public from wasting time and money gambling in the stock market, and have few negative effects. It seems unlikely to gain enough political support to pass, and even if it was passed by all the major financial centers, there would be a real risk that it would not be uniformly applied.

Your Masochistic Trader,
Copyright 2009 Risk Over Reward. All Rights Reserved

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