Davidson's posted paper; Tobin tax and variance issue

[Greg Nowell <GN842@xxxxxxxxxxxxxxxxx>]

I read with interest Davidson's posted critique of the
Tobin tax.  However, although I have nothing which
proves that a Tobin tax WOULD decrease volatility, I do
not think that Davidson's argument about the number of
participants in the pool would be an argument AGAINST
the Tobin tax.

The reason has to do with variance and sample sizes.
It is true that larger sample sizes reduce variance.
If I have a swimming pool filled with black and white
coffee beans, and I sample one shot glass at a time,
then I will get considerable variance with each shot
glass, reducing the confidence level of estimating the
population of black and white beans.

If sample using a bucket, I reduce that variance
tremenodously.

If I sample using a trash can, the variance reduces to
practically nil.

The accuracy of the sampling, assuming a random
distribution, is pretty well known.  Reasonable
confidence levels start at about thirty.  95%
confidence levels start at about 1200, and 99%
confidence levels start at about 3000.  That's why
polls typically show, in small numbers, sample sizes of
1200, as it is usually considered that the marginal
cost of sampling the extra 1800 people is not worth the
increased accuracy.

But 3000 gets us to the 99% level.  That means that the
increased variance improvement effect of moving from
3000 to 1,000,000 or 2,000,000 is all concentrated in
improving the accuracy of the remaining 1%.

To get back to the stock market problem, if we move
from a situation where a small price change moves us,
say, from 100,000,000 to 150,000,000 transactions a
day, a decrease in volatility is not necessarily the
product of the variance effect of having 50,000,000
additional transactions in the total universe.   In
other words, a measured change in volatility between
the pre- and post- transaction fee change is not in and
of itself meaningful.  I would feel better knowing what
year-to-year volatility changes occur "normally," since
I imagine that this is greatly influenced by any number
of trends.

But let's consider: in the real estate markets
transaction fees are huge.  Yet the real estate market
also exeperiences price volatility, but I would be very
skeptical of a claim that real estate market has MORE
price volatility than the stock market because
transaction costs are higher and the number of players
are fewer.   Since the number of players in most
markets is in the tens of thousands or higher, we are
already at a point where variance due to the size of
the  pool of players is already locked into some
fraction of that 1% range.

However, the fact that there IS price volatility in the
real estate market might be an argument to the effect
that even a high Tobin tax does not control
volatility.  Since a substnatial portion of these fees
IS taxes, these fees are in fact Tobin taxes.  Yet the
kinds of  2-5 year trends we get in real estate are,
after all, in many ways comparable to the trends we get
in stocks.

Personally, I think an increase in margin requirements
for futures transactions would put a greater damper on
speculation than a Tobin tax.  If the Tobin tax is set
at some small amount, say, 1/2 of 1% per transaction, I
am fully invested in a $100 stock, the "deterrent" to
getting in or out is only 50 cents.  I might well pay
that if I fear a price slip of $3.00 on the stock.
However, even 1/2 of 1% might be substantial to a large
investor, over the course of a year.   1/2 of 1% per
day on a portfolio that turned over 100% EVERY day
would be 180% per annum.  It woulod have to give pause
to someone.

But the margin effects are even greater.  To someone
who has bought a stock or commodity on margin (at 5%),
a 3% decline in price translates into a 60% hit on the
investment.  Futures markets are thus notoriously
hyperactive as traders jump in and out on very slight
price movements.  A 10% margin requirement would mean
that a 1% decline in the price would be a 10% hit on
the investment, and a 20% margin would halve that.   An
increase in margin requirements would therefore
substnatially raise the transaction cost for a trade in
proportion to the money at risk, and ought to reduce
the hysteria levels of futures transactions to
something approximating the hysteria levels of stock
trades where people are 100% invested.

Let's come back to the real estate for a moment.  In
fact, buying real estate IS a margined purchase.  You
can get into a house now for as little as 3% down, plus
the substantial Tobin fees and the cost of moving.   If
transaction fees were zero or close to zero, you could
move out of a $100,000 house when you sold it for
$103,000 and net out at a $3,000 return on your initial
$3,000,  for a profit of 100% (just like the futures
market).

One of the reasons you DON'T do that is that in fact
the $3,000 down is more like $11,000 (cost of moving
plus fees).   With a house increase of $3k, you would
net out at a loss of $8,000.  If you have put $20,000
down, you stand to profit, at zero transaction costs,
at around 14%, ($3k on $20k), and would have the same
absolute loss, though smaller as a proportion of
investment (40% with $20k down, nearly 300% with $3k
down), with transaction costs.  But without transaction
costs, the 14% can hardly be said to provide the same
incentive as the 100%.

Speakng from personal experience, I would say that
higher costs do discourage transactions.  Since my wife
and I moved into a nice neighborhood we have discovered
a new house for sale that we might well have been
tempted to buy.  The monthly mortgage and down payment
we could handle.  But forget it with the fees.  So we
stay put.

The notion of "staying put" perhaps has much to do with
a Tobin tax.  To the extent that investors are incited
to stay in the same neighborhood, regardless of price
volatility effects, several things may happen: 1) they
may develop greater expertise in the particular kind of
investment and greater ability and concern about seeing
it properly handled; 2) their costs of exit being
higher, their incentive to reach accommodations with
neighbors (about pollution, about wages) may also be
greater.   Thus it is possibly the case that a Tobin
tax is a recognition that excessive liquidity, while a
benefit for paranoid investors, may damage the
neighborhood, in the same way that one gets "better
neighbors" in a neighborhood with high extry and exit
costs (a typical suburb) than in an apartment
complex.

So, to conclude: 1) I'm not sure variance effects in
moving from one large randomly actuated population to
another even larger population are going to be that
great; and 2) "good neighhbor" or "good owner" effects
of a Tobin tax might be the REAL benefit, regardless of
what we think might become of volatility.

I furthermore note that:

1.  Neither a Tobin tax nor an increase in margins is
incompatible with a buffer stock policy;
2.  US buffer stock policies have been criticized as
imperialist attempts to manipulate world commodity
markets (esp in the 50s and 60s).

--
Gregory P. Nowell
Associate Professor
Department of Political Science, Milne 100
State University of New York
135 Western Ave.
Albany, New York 12222

Fax 518-442-5298