Is There a Place for a Financial Transaction Tax?

Financial transaction taxes have long been a topic of discussion in econ circles, the most famous of which is the so-called “Tobin tax” designed to help protect against undue currency speculation.  Considerations of their potential utility have risen again since the financial crisis that brought down the world economy in 2008.  Several policymakers in Europe are still arguing for one that would likely be a disaster for their goal of a capital markets union in the eurozone; the proposal has remained too broad and would likely impede liquidity, cross border flows, risk management, etc.  However, evidence has mounted as of late presenting the case for a very nuanced one—particularly in the U.S, which I’ll focus on here.

As interest rates on fixed income assets have remained low since the crisis and continue to fall, investment funds/firms are hard-pressed to find returns that align with what they promised and/or with perception issues surrounding nominal return rates (identical real returns might not be perceived as equal if one is a higher nominal return–the rate an investor typically sees, or cares about due to fixed price liabilities),  funds have reached for new complex, quantitative tactics that can help them profit from volatility or increased leverage.  This brings with it several consequences.

This trend towards desperate measures points to the fact that the U.S. has yet to eliminate the over-financialization of the U.S. economy—8% of GDP—that partially contributed to the financial crisis of 2008 (CDOs were financial “innovations” that ate up GDP with management fees and were essentially a worthless piece of financial engineering).  As opposed to investing in real, risky assets, funds are trying to find new ways to profit off safe, financial assets, increasingly fracturing the connection from the financial world to the real economy.  This represents a huge obstruction to monetary policy’s goals: instead of reaching for yield in real investments which currently have returns hovering around historical highs (see Figure 1), investment houses are simply levering up and each is promising solid returns due to its supposedly brilliant new strategies.  (Of course, without real investment, not everyone can win—meaning very real costs as fees go to countless firms that bet wrong.)

real-returns-on-capital
Figure 1 – Returns on productive capital are well above historical averages. Source: Gomme, Ravikumar, Rupert (2015)

Additionally, as investors continue to send money to these firms promising brilliant strategies, these firms are hiring more and more quantitative folks to develop these strategies.  Financial companies are paying up for graduate degrees in computer science, physics, and the like as these folks can bring their strong quantitative background.  However, that means less folks working on scientific discovery and innovation.  As talent drains from other areas of research, productivity growth (and thus wages and real investment) will continue to lag: productivity-growth-in-nonfarm

Too, by further increasing leverage and complexity in the financial system, monetary policy is limited in its ability to “lift off” as it may cause excess volatility.  A monetary policy shock or other similar economic shock could also increase financial market participants’ information-sensitivity, causing complex positions to fall in value and asset runs to occur, as happened in commercial paper, repurchase agreements (repos), and other markets in 2008.

Certainly, a financial transaction tax would help prevent the negative outcomes described here by preventing the excess financial activity ex ante.  Importantly, significant time would be required to shape what the tax would look like so as to prevent a deterioration in market liquidity, efficiency, risk transfer, etc.  However, due to the ability of some financial strategies/innovations to impose significant output and productivity costs and impede the transmission of monetary policy to the real economy, the Federal Reserve and others would be wise to delve into the task of designing the potential tax sooner rather than later.

POSTSCRIPT (9/26/16):

Due to reader interest and the fact that I didn’t at all mention the active portfolio management industry (another area of finance I am often critical of—as it is a drag on GDP and savers), I wanted to update this post with a couple further readings.

Actively managed funds lag passive funds’ performance, and thus simply eat up fees/savings/GDP/talent.  Via Bloomberg, “Failing to Measure Up Is $422 Billion Stock Pickers’ Crisis”: http://www.bloomberg.com/news/articles/2016-09-15/the-chart-that-explains-stock-pickers-422-billion-in-outflows

The Economist sums up some recent BIS (and other) papers on how excessive financial sectors can damage productivity as talent is redirected toward the finance industry and lending is redirected toward high-collateral (but low-productivity) industries such as real estate: http://www.economist.com/blogs/buttonwood/2015/02/finance-sector-and-growth (Though, the article comes down too harshly on debt in general; debt is welfare-enhancing in its proper forms.)

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