Re: Tobin tax

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

The ineffectiveness of the Tobin tax is well discussed in Paul Davison's
paper:
http://econ.bus.utk.edu/davidsonextra/boulders.html.

To response to you post more specifically, let me try the following:

The increased risk associated with a financial environment which profits
from instability characterized by abrupt and unpredictable change and
flux, has created a demand for financial instruments to protect against
that risk.  These financial instruments, generally called financial
derivatives, can be defined simply as aggregated or "bundled"
contractually created rights and obligations, the effect of
which is to create a transfer or exchange of specified cash flows
between counterparties of coupled needs at defined future points in
time.  The quantum of these cash flows are determined by reference to,
or derived from underlying cash or physical markets (e.g. foreign
exchange, currencies, securities, commodities) or from particular
financial indices (e.g. SP500, interest rate bench marks, Libor, etc.)

The variety and number of financial derivative instruments are endless
and the terminology describing them are esoteric and legalistic. Yet
they are constructed from basic financial building blocks, namely
forward contracts, futures contracts, swap contracts and option
contracts.

Forward contracts, said to have begun in the 12th century, are
agreements to buy or sell a given quantity of a particular asset
(currency or commodity) at a specific future date at a pre-agreed
price.  This instrument remains the basic building block for derivatives
and the principles used to price a forward contract are still the
basic principles that drive international capital markets today.  The
distinctive characteristic of the forward contract is that it is an OTC
(over the counter) instrument: it is traded not on organized exchanges
like futures contracts, but by dealers (typically banks) trading
directly with one another or with their counterparties using electronic
means. The uncontrolled growth of OTC instruments in recent years is
both staggering and alarming.
Futures contracts are traded on exchanges which acts a counterparty to
all transactions and which requires market users to post collateral or
"margin" against their outstanding positions.

The ratio of the forward exchange rate to the spot rate is a reflection
of interest rates in the two countries whose currencies are being
compared.  That ratio, mathematically known as interest rate parity, in
theory protects investors from interest rate differentials on comparable
risk-free assets after foreign exchange conversions.  In other words,
forward exchange rates, traded either at premium or at discount, are
mathematically derived rates reflecting an arbitrage condition:
interest rate parity; they are designed to eliminate arbitrage profits.
They are not market predictions.  Rather, they are market implications
based on known data at the time that rates are set.
But exchange rates are directly linked to interest rates which are set
or at least affected by central bank monetary policies and measures
generally designed to counter market trends. Accordingly, interest rate
parity carries inherent risk for forward contract traders.
Forward contracts on interest rates, known as FRA (forward rate
agreements), stipulate forward interest rates derived from an arbitrage
condition.  The one year forward interest rate in any currency must be
such that no arbitrage profit can be derived from investing for one year
and then re-investing for a second year, as opposed to investing for two
years initially.  The relationship of forward interest rates for various
different future periods is known as the forward yield curve.  It is a
concept and expression of fundamental importance in understanding
swaps and in valuing cash flows.
An interest rates swap is merely a series of forward contracts on
fluctuating interest rates. At each settlement date, the fixed rate
payer is obligated to sell a fixed rate cash flow for a price set by the
floating rate cash flow as pre specified by the swap.
Forward contracts are not generally traded as contracts.  If they have
to be unwound, the value of a forward contract prior to maturity is
taken to be the difference between the forward price at which the
contract was agreed initially and the forward price that prevails in the
market at the date of unwinding.
A forward foreign exchange contract involves a settlement only at
maturity, resulting in a net cash outflow to one counterparty and a net
cash inflow to the other.  Thus there is a credit risk, in both
performance and exposure.  The exposure fluctuates with the deviation in
spot prices from the forward price, the greater the volatility of spot
prices, the larger the potential settlement payments.  Another
risk relates to the dormant nature of the contract, the only payment
being required at maturity without periodic monitoring.
Only counterparty with ready credit lines, such as large corporations,
major financial institutions, government agencies, would find the cost
of setting up credit proportionate to the benefits to be derived
from using forward contracts.

In periods of falling interest rates, banks routinely "short" funds,
funding their assets with interest bearing liabilities that have a
shorter maturity than the maturity of the assets being funded, producing
significant funding profits because the longer term assets are earning
at a previous higher interest rate.  In periods of rising rates, banks
seek to protect themselves with FRAs.  Since the number of large
financial institutions are shrinking through mergers and acquisition,
and the dismantling of Glass-Steagle restrictions, the protection of
large numbers is correspondingly reduced.

Financial futures contracts are exchange-traded contracts dating from
1972 when foreign currency futures contracts were first introduced.
Similar to forward contracts, futures contracts involve binding
obligation under which a participant either sells or buys a specific
asset at a specified exercised prove on contract maturity date.   The
specific asset, the contract, is not literally traded, but the
market price of that contract at maturity compared to the initial
contract price will determine whether the holder of the
futures contract has made a profit ot loss.  In contrast to forward
contracts, futures contracts are marked to market at the end of each
trading day when the resulting profits and losses are settled, and daily
margin requirements met. Since the exchanges act as back to back middle
counterparties in futures contracts, the equity base of the clearing
house itself is available to all users as a further performance bond.
Major exchanges are the Chicago Board of Trade (CBOT), the Chicago
Mercantile (CME), the London International Financial Futures Exchange
(LIFFE), the Paris Marche a Terme d'Instrument Financial (MATIF), the
Tokyo, Hong Kong and Singapore exchanges.
Futures contracts have major impacts in several major market crashes,
such as the 1987 US market crash and the HK crash in August of 1998 when
the government had to intervene by purchasing US$18 billion of
securities in one day to counter market manipulation by hedge funds.

Volatility has created a demand for parallel loans between multinational
parents with foreign subsidiaries.  A US parent would lend a US dollar
loan to the US subsidiary of a Norway counterparty, while the Norway
parent would make a parallel NOK loan to the Norway subsidiary of the US
parent.  Both loans would be of identical value with regard to current
exchange when they were entered into and both loans would have matching
interest  and principal repayment schedules.  But parallel loans have
independent default risks and inflated balance sheet impacts because the
loans are not legally offsetting even when they are economically
ofsetting.

To eliminate such problems, swaps are created to exchange cash flows.
An initial sum in US dollars is exchanged for its NOK equivalent and a
reverse exchange takes place at the maturity of the swap.  Regular
exchange payments reduce the one-sided obligation on default and the
inflated accounting impact is avoided because a contractual agreement to
exchange cash flow is treated as an off balance sheet transaction.  The
first public swap transaction was a currency swap between the World Bank
and IBM in 1981.

An interest rate swap is a contractual agreement entered into between
two counterparties under which each agree to make periodic payments to
the other for agreed periods based on a notional amount of principal.
The amount is "notional" because there is no need to exchange actual
amounts of principal in a single currency transaction.
The notional amount of principal is necessary only to compute the actual
cash amounts that will be periodically exchanged.
A fixed-for-floating interest rate swap is the most common.
Money market or Basis swaps are based on different underlying indices,
such as Libor and commercial papers or Treasury bills and Libor.
The fact that the future stream of floating rate payments is unknowable
at the time the swap is priced is overcome by the body of information
about the relationship between interest rates and future time periods in
some deep and liquid markets in interest bearing securities issued by
governments. The markets value of these securities at any given point in
time to yield whatever interest rates are necessary to make the
securities trade at par.  A yield curve will then show the relationship
between future interest rates and time.  A par coupon yield curve shows
securities displaying the same characteristics as government securities,
such as the US Treasury yield curve.  A graph of the internal rate of
return of zero-coupon bonds over a range of maturities is known as the
zero-coupon yield curve.
At any time, the market is prepared to quote an investor forward rates.
If an investor wishes to place two consecutive 6 month, the market will
quote today a rate at which the investor can reinvest in six months
time. That forward rate is not based on crystal ball glazing but is a
mathematically derived rate which reflects an arbitrage relationship
between current (or spot) interest rates and forward interest rates, a
rate that will eliminate ant arbitrage profit, or making it indifferent
whether the investor invest in 2 consecutive 6 month periods or one 12
month period at todays twelve month deposit rate.  The graphical
relationship of forward interest rates is known as the forward yield
curve.
The net present value of the aggregate set of cash flows due under any
swap is zero at inception.
The fixed rate payments when deducted from the floating rate payments
and the net cash flow for each period is discounted at the appropriate
rate given by the zero yield curve, the net present value of the swap
will be zero.
Because of the predominant acceptance of the US dollar (yen and euro to
a less degree) as the reserves and trade currency of choice, all the
world's currencies have their values expressed in exchanges rates to the
main reserve currencies and all local interest rates are linked to US
interest rates and US dollar exchange rates.  These market values are
determined by both central bank policies and market fundamentals which
includes transaction cost. In that respect, the dampening effect
of a Tobin tax may be neutralized by its effect on volatility.  Some
economists, including Davidson, argue that a Tobin Tax actually
increases volatility.
It is difficult to discuss beyond the level of anticipatory claims
without a detailed specific Tobin tax regime for Norway.
Suffice to say that any increase in transactional cost increases market
inefficiency which arbitrage incentive which increases volatility and
ultimately increases systemic risk.
The economic cost/effectiveness of a Tobin tax remains dubious because
it seeks to control the physical flow of funds rather than its virtual
fluctuation.

Henry C.K. Liu



Trond Andresen wrote:

> At 21:39 13.04.99 +0200, Henry C.K. Liu wrote (forwarded to pkt by me)::
>
> >If Norway adopts an unilateral Tobin tax, or even a regional one, with no
> loopholes, its trade will shrink and therefore its economy.
>
> What is meant here by 'trade'? Norway exports oil, gas, fish, metals, maritime
> equipment - and we import cars, wheat, consumer electronics etc.
> Why should real-economic activity be hampered by a Tobin tax? We are talking about
> a tax in the <1% range, which will have a negligible impact.
> Furthermore, this small impact can, if called for, be offset by a slight decrease
> in domestic taxes for export/import businesses.
>
> There is one sort of 'trade' that will obviously shrink, however: Currency
> transactions and trade in securities involving NOK. But that is one of the
> secondary goals of the reform (the primary goal is to stabilize the financial
> system), to channel society's economic resources away form the 'Casino' towards
> real-economic endeavor - in the spirit of Keynes.
>

>
> >A water tight regime is not that easy.
>
> I have seen this type of argument many times, and my answer is: Who has
> proposed a *water-tight* regime? It is sufficient that a regime reduces
> circumvention and speculation to a manageable level. We have speed limits on
> the roads, and they are broken all the time. Should we then abolish them,
> because they are not 'water-tight'? We all know what happens if we remove
> speed limits altogether. In fact, hardly any legislation in society may be
> said to work perfectly, but it is needed and useful all the same.
>
> >In a world of multinationals with
> >worldwide subsidiaries and joint ventures, foreign exchange transactions can be
> >done off the books, with no direct cross border transfer of funds or
> >instruments.
>
> For short-term speculative activity to be worthwile, you have to have
> markets with broad participation and intense activity. Many agents must be
> given the option of interacting with many other agents - so they need banks
> and other types of financial trading firms. And these firms must continually
> be visible and announce their presence, to attract activity. Therefore they
> will neccessarily also be visible to the central bank, and cannot escape
> abiding by its rules and regulations.
>
> I do not say that circumvention-type transactions will not happen. But
> today's destabilizing activities will be drastically reduced, and that is
> sufficient.
>
> The destablilizing character of the international financial system
> (regardless of what sort of esoteric 'instruments' that are traded) may be
> traced back to TWO phenomena: Buying and selling
>
> (1) on a very short-term horizon
>
> (2) based on predictions of and reactions to what OTHER agents (will)do.
>
> This implies a positive feedback system, perpetually on the border of
> instability. It may be explained through first-semester control theory.
>
> If my two points above capture the essence of the problem, I cannot see a
> scenario where large-scale circumvential speculative activity in NOK
> currency or paper can continue if my regime is implemented.
>
> Henry says
>
> >Parallel loans and swaps are designed to achieve exactly that purpose.
>
> Please elaborate on how this will work to enable continued intense
> speculative activity, under my proposed regime.
>
> >Schemes will be created to cause drops in cash flow or profit or asset
> >in foreign parents with subsidiaries in Norway in favor of Norwagean parents
> >with foreign cubsidiaries, and vice vera, in ways that do not involve cross
> >border transfers of funds or instruments.  It will be all virtual.
>
> Please elaborate on this  too. I may be dense, but how can speculative
> financial activity continue on today's scale, when agents have no organized
> public trading places any more where this is profitable - and where
> such deals may only take place *within* a given
> multinational firm, or in secrecy between a couple of firms? I would be
> thankful if you could construct some detailed and pedagogical hypothetical
> cases.
>
> >So we now are back to step one, except with more complexity.
>
> A system where trade in NOK-denominated securities and currency have to
> involve CB-licensed and monitored Norwegian institutions is very simple. It
> is today's state of affairs that is overwhelmingly and unneccessarily complex.
>
> Trond Andresen