Global Policy Forum

By Thomas I. Palley

Assistant Director of Public Policy, AFL-CIO

The international financial instability of the last several years has prompted calls for a new international financial architecture. Often included in proposals for this new architecture is a tax on international currency transactions, commonly known as the Tobin tax. Proponents argue that a Tobin tax would help reduce financial instability and is feasible. Opponents counter that it is infeasible, and could even worsen instability. This article examines the case for a Tobin tax, and argues that it is both desirable and feasible.

The idea of an international currency transactions tax was first advanced by Nobel laureate economist James Tobin (1978) who proposed a small tax - these days the suggestion is 1/10 percent - on all foreign exchange (FX) dealings. The intention was to reduce disruptive speculation in FX markets by raising the cost of engaging in such activities.

The Tobin tax builds on an earlier proposal made by Keynes (1936) in his magisterial book, The General Theory of Employment, Interest, and Money. In The General Theory Keynes proposed the imposition of a small transactions tax on all stock exchange dealings to diminish instability in domestic stock markets. His proposal was motivated by the disastrous consequences of the stock market crash of 1929, combined with the observation that speculation tended to be more prevalent on Wall Street then on Throgmorton Street (the London stock exchange) in part due to the absence of a tax in the New York market.

"It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges. That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national character, as to the fact that to the average Englishman Throgmorton Street is compared with Wall Street to the average American, inaccessible and very expensive. The jobber's "turn", the high brokerage charges and the heavy transfer tax payable to the exchequer, which attend dealings on the London Stock Exchange, sufficiently diminish the liquidity of the market to rule out a large proportion of the transaction characteristic of Wall Street. The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States (Keynes, 1936, p.159-60)."

More recently, following the U.S. stock market crash of 1987, the idea of using transactions taxes to curb speculation received support from Joseph Stiglitz (1989), the former Chairman of the U.S. Council of Economic Advisers and former Chief Economist of the World Bank. It also received support from Lawrence Summers (1989), the current U.S. Treasury Secretary. The bottom line is that the Tobin tax has a highly respectable intellectual heritage. Though this does not make the Tobin tax necessarily right, it does dispel the notion that it is an outlandish idea.

Why the revival of interest in the Tobin tax

The current revival of interest in the Tobin tax is the result of events of the last few years. In 1994 Mexico was hit by a major financial crisis. Not only did this crisis hurt the Mexican economy, it also hurt all of Latin America which was infected by a process of financial contagion (the "Tequila" effect). In 1997 financial crisis again erupted in East Asia, this time pulling down the economies of South Korea, Thailand, Indonesia, and Malaysia. In 1998 Russia was hit by financial crisis, and this was followed by a financial crisis in Brazil in 1999. The belief is that all of these crises were either triggered or exacerbated by financial speculation, and that measures to reduce speculation, such as the Tobin tax, would have helped avoid the crises or reduced the extent of resulting damage.

It is not only developing countries that have been hurt by currency speculation. Developed countries, including the U.S., have also been injured. In the wake of the Russian financial crisis of summer 1998, Wall Street was rocked by a crisis of its own. The Russian crisis generated a wave of unpredictable movements in interest rates which pulled down the hedge fund Long Term Capital Management (LTCM). The crumbling of LTCM's financial position in turn threatened to pull down the entire market owing to the extent of LTCM's borrowings and the exposed nature of its financial positions, and this necessitated the Federal Reserve intervening to co-ordinate a private sector funded bailout of LTCM.

U.S. manufacturing industry was also badly injured by the east Asian financial crisis. U.S. exports to the region fell as east Asian currency values plummeted relative to the dollar and east Asian economies went into recession, while U.S. imports from the region surged. The result was a massive increase in the U