The Tobin Tax: The Fix-It Plan Wall Street Hates … But Can't Seem to Kill

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German Chancellor Angela Merkel recently came out in favor of a "Tobin tax" - a small tax on financial transactions, proportionate to the size of the transaction. The Tobin tax idea also has been proposed by Britain's former prime minister, Gordon Brown, and was proposed in Congress by U.S. Rep. Peter DeFazio, D-OR.

Every time a Tobin tax is proposed, it has failed to gain traction - which isn't surprising: Wall Street, with its international affiliates and legion of lobbyists, hates the idea.

Even so, the Tobin tax idea just refuses to die - which is a good thing, since it is probably the best way of curing some of Wall Street's pathologies.

The Lowdown on the Tobin Tax

When the trading tax was proposed by the Nobel Prize-winning economist James Tobin in 1974, it was supposed to be applied to foreign-exchange trading - the arena that boasted the world's largest trading volume at the time.

A resolution to this effect was introduced in Congress in 2000 and a similar resolution passed the French National Assembly but was defeated in that country's Senate. At that time, it was considered a standard leftie gambit, an effort to raise revenue from the unpopular financial industry with which to fund beloved liberal causes. It ranked with ideas such as a levy on excess bank profits, which appeared to increase costs in the financial sector without any obvious benefits.

That changed with the 2008 crash, which revealed the ways Wall Street makes money. Since that time, Tobin tax proponents have relied upon these two rationales to push the levy:

  • A wish to recover some bailout costs from the financial-services sector.
  • And a more intellectually coherent belief that the Tobin tax might address some structural problems in the sector and in the global economy as a whole.
The first argument, to my mind, is still feeble - and even a bit vindictive. But the second argument has become pretty convincing.

In the three decades since Tobin unveiled his tax idea, the trading volumes in markets and on securities of all types have soared, reaching levels that weren't even conceived of back then. Wall Street, its allies, and its minions tell us over and over that we all benefit from this because of greater liquidity.

But we know that's not entirely true.

As a retail investor in the early 1980s, the reality was that I could buy and sell stocks on slightly lower spreads than I can today. Institutional investors have benefited, but this has just caused them to trade in and out like madmen - instead of becoming the steady, long-term shareholders that are needed for corporate governance to work properly.

In any case, around three quarters of stock trading is now characterized as "fast trading," and is carried out by computers located physically in the stock exchange, to get information about trading patterns faster than the rest of us. There are three things wrong with this:

  • First, since the rest of us don't have trading fingers that can move in milliseconds, three quarters of the trading is being done in a kind of private conversation, with outsiders - especially retail investors - not invited.
  • Second, computer-trading makes markets much more volatile. The algorithms used to generate it are faulty, just like the algorithms used by Wall Street on its risk management, so every now and then something happens that the computers don't like and the markets go cuckoo. The 1,000-point drop in the Dow Jones Industrial Average that took place in mere moments back on May 6 was just one example of this: From what I can see, it could just as easily have been a 5,000-point drop. For a computer, a minute is a long time - an eternity, even - and is certainly enough time to do 60,000 trades, or so!
  • Third - and most important - fast trading is "rent-seeking." Indeed, it is trading on "insider information," which in other forms is illegal. For instance, ever since the stock-market reform that took place back in the post- Great-Crash 1930s, it has been illegal to trade on insider information about next quarter's earnings. Well, information about trade flows, if you have it while the rest of the market doesn't, certainly qualifies as rent-seeking, and trading on that information equally qualifies as rent-seeking - since you are scooping value out of the market while giving nothing in return. You can't make it illegal, because if you did the function of market maker/specialist would become impossible, but technology has made that loophole in our laws much larger and more profitable. Profits from "fast trading" in 2008 have been estimated at $21 billion, and the business is expanding rapidly. With around 20% of the market, Goldman Sachs Group Inc. (NYSE: GS) is presumably making about 20% or more of this.

Tobin Tax Advantages

The principal advantage of a Tobin tax is that it would reduce the profitability of "fast trading." That's because the tax - while low on normal trading - would represent a high percentage of the profit on fast trading, where each profit is tiny and the computers make it up on volume. A tax of even a penny or two a share wouldn't affect normal investors - or even traders - very much. But would take a lot of the profit out of high-speed trading, thereby relieving the hidden tax that trading imposes on the rest of us. It would also yield a lot of money to set against budget deficits, while costing the rest of us very little.

Of course, that's why Wall Street hates the Tobin-tax proposal, and fights it every time it is proposed. The Tobin tax won't stop all their games - the margins on credit default swaps (CDS) are so high that a Tobin tax would affect them only modestly - but the benefits to markets would nevertheless be huge.

The impact on those controversial Wall Street bonuses also would be huge - a key reason the tax will be strongly resisted by lobbyists. But with support from countries like Germany and perhaps Japan - victims, rather than leaders, in the financial-services revolution - it may nevertheless pass in the end. Wall Street will threaten to move its trading offshore, but if the major economies agree to a tax, the big institutions will effectively have nowhere to go.

For us as investors, other than cheering on the Tobin-tax movement, there are few direct implications. Still, you may want to sell your shares of Goldman Sachs Group Inc. (NYSE: GS), Morgan Stanley (NYSE: MS), Citigroup (NYSE: C) and Bank of America Corp. (NYSE: BAC), as well as any other trading-oriented financial institutions.

In the long run, one of Wall Street's most lucrative - but damaging - games may be history.

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About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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