Tim Hartford, the FT’s Undercover Economist, leapt out of the shrubbery to launch a stinging attack on the Robin Hood campaign today.
In my view he was too harsh and should have treated the campaign more as an opening salvo in a debate about financial transaction taxes than the last word. The campaign, run by charities not finance experts, made a tactical blunder in describing the tax in too much detail, too early.
The specifics of how much, on what, how to use the proceeds and whether to target revenue or speculation, need open discussion before people will rally round. In its current form, opponents and vested interests can easily pick it apart and weaken the progress of real reform.
For example, arguing about whether 0.05% or 0.005% is the right amount is pointless in an anonymous chat forum. It depends massively on the security in question; this is FSA territory.
Also, while increasing tax revenue at the moment is good, proposing general taxation to fund charities is a non-starter as it implies we should nationalise charity and turn moral obligations into legal ones. Some may like this idea, but we have a legislature to decide that sort of thing, and charities should know better than to slip it through on the back of bank reform.
Taking Hartford’s criticisms in turn, he was first worried about unintended consequences, saying for example that taxing an underwriter’s hedge on a car insurance policy at 0.05% with a possible £1m pay-out might trigger £500 of tax, which is bound to affect the premium.
Fair enough, there is obviously a lot of work to be done - just as well there are 350 economists supporting the tax! The campaign should limit the tax to one or two instruments until there is enough research to extend it. Tax expert Richard Murphy suggested recently that the old favourite foreign currency is a good place to start as the tax burden would fall mainly on well-paid currency dealers and bank profits, not retail punters. He explains all with a video clip and post on his blog.
What about extending it to other areas? Much of the debate has been about the equity market, which is already subject to 0.5% stamp duty.
It’s complex and emotive; at one end you have high frequency trading where resources are poured into an activity with no obvious economic merit. At the other, one can argue quite easily that all investment is a bet on the future and it’s impossible to tell economically legitimate from illegitimate trades, so don’t waste time trying.
If the aim is to curb volatility, as Hartford says there is little evidence so far to prove transaction taxes will actually achieve this. I expect there’s also little research on the real economic impact of many financial innovations where a transaction tax might seem a solution.
Who really knows whether high frequency trading, distressed debt dealing, and umpteen other arbitrage strategies are overall good or bad for the wider economy? I've got my hunches but let’s get some empirical data and then discuss taxes and remedies. The Robin Hood campaign should be a spur for this long overdue work to be done.
Liquidity not all it's cracked up to be
Back to equity markets for a moment, low volatility and high liquidity have long been prized as ends in themselves among market experts (who are, incidentally, usually market participants and therefore benefit from high trading volumes). But I’ve heard it said that you can have too much liquidity.
I'm not an economist, but I guess that if you were to plot a stock's liquidity against resulting economic gains, where the gains represented the lower trading costs and the increased productivity resulting from the efficient allocation of resources, you would probably find a curve that rises steeply before tailing off and even falling away.
The idea is that most real economic gains come from the investment itself, the long-term allocation of resource, and therefore occur at a relatively low of liquidity – just enough to facilitate the primary and a limited secondary market.
Productivity gains might then improve marginally as secondary market liquidity increases. In some cases, when liquidity is so high that trading is nearly costless, people can trade the stock for market reasons that have nothing at all to do with the performance of the underlying business. At this point, volatility and pricing errors are more likely to appear, making capital allocation less efficient, at which point I imagine the graph starts to turn downwards again. It has diminishing marginal utility, like the economist's tenth beer.
This is relevant to high frequency trading, a phenomenom that seems to defy logic. Exchanges build faster infrastructures and investors co-locate their servers at the exchange to shave micro-seconds off their order processing. News organisations that should know better, like Bloomberg and Thomson Reuters, are designing web-spiders and news scrapers to help clients launch buy and sell orders seconds ahead of rivals, based on machine reading of key words in news and announcements.
Taken to its logical end, market trading will soon bypass humans altogether, surely an own-goal for the thousands of traders employed in the industry.
This type of trading seems from the outside to be completely pointless, unless you accept that ultra-high liquidity has some intrinsic value, in contrast to the idea of the graph above. The problem is that proving the idea that too much liquidity reduces net economic gain, is difficult. Finding the exact point where additional liquidity is more likely to destroy than create value might be difficult or impossible.
The flip side is that if you could, you'd have a cast iron case for an additional transaction tax on equities. Something for the Robin Hood guys to look into?
Another aspect of this is the costs of financial transactions themselves, meaning fees and commissions that run to many hundreds of millions a year. From a system perspective, these costs should be more than justified by the economic benefits of capital allocation and the proper exercise of share ownership rights.
Public companies have to invest and choose dividend policies with their owners in mind, so they must engage with shareholders. The resulting strategy dictates how companies grow and is a huge factor in economic progress. But what about shareholders who merely switch resources between similar securities for arbitrage reasons, instead of holding them for growth or dividends. Do they contribute to this process? They certainly impose dealing costs in line with their trading volume, which is normally high.
At a system level, it is hard to see how the trading costs from such short-term strategies could be justified by the limited economic benefit of those allocations, although they clearly bring trading profits to the individual. If that's a market failure, transaction taxes may be one of a range of solutions.
The problem, again, is one of evidence. How do you show who bears the costs of such short term activity? Is it hedge funds investors, in which case it doesn’t matter as they are sophisticated individuals who always read the small print. Or, are the costs funded by arbitrage profits captured unfairly from other parts of the market?
These and similar questions all need empirical answers if a discussion about transaction taxes is to be meaningful. The Robin Hood campaign could really help financial reform by calling for such research to be done.
Hartford’s top 10 reforms, including capital requirements and living wills, are aimed at the causes of the crisis and deserve to be prioritised. But let's not forget the wider current of reform towards restoring finance to its proper economic role. As someone that’s “no fan of bankers”, Hartford should be helping Robin Hood sharpen his arrows rather than killing him off.
UPDATE 20 April 2010 - The IMF said it considered proposing a financial transactions tax to the G20 but opted instead to recommend a financial activities tax (with the wonderful abbreviation FAT) on the sum of profits and remueration of all financial institutions. It's different from Robin Hood but has the same aim of hitting rent in the financial sector. The Robin Hood campaign must have featured in the IMF thinking, and although the outcome is a different idea, the campaigners should be delighted.