Bring On the Tobin Tax - But Only After Making This One Key Fix

The European Commission (EC) on Sept. 28 proposed a Tobin tax for the European Union (EU). It's likely to pass, in one form or another, but it won't stop there.

The United States will be next - and as investors we should be grateful. I just hope policymakers make one key change first.

I'll explain.

I penned a column for Money Morning almost exactly one year ago that said major world economies should adopt a "Tobin tax" - a small tax on financial transactions, named after its inventor, Nobel laureate James Tobin.

It's always nice - albeit unusual - when politicians take my advice. And I'm certainly glad that the EC is doing just that. But the commission still hasn't gotten it quite right.

A Promising Proposal

You see, the Tobin tax I proposed would be at a very low rate, perhaps 0.01%. Apart from raising revenue, its main effect would be to inhibit speculation. By that I specifically mean "high-frequency trading," or HFT, where computers trade bonds, stocks, and derivatives in milliseconds.

High-frequency trading is objectionable for two reasons.

First, its proponents claim it provides liquidity to the market, but that's not really the case. In periods of turbulence, the liquidity that HFT supplies is quickly withdrawn, as the institutions operating the trading systems shut them off for fear of large and destabilizing losses. Indeed, liquidity that switches off when it is most needed is of no use at all. To the contrary, it destabilizes the market rather than stabilizing it.

The second reason high-frequency trading is bad is that it uses machines to get trade information before competitors. Of course, trading based on extra-fast knowledge of the trading flow should qualify as inside information, and thus be illegal.

Unfortunately, it can't be made illegal, because market-makers do it all the time. And what's more is that stock exchanges make huge sums of money by renting space within feet of the exchanges' computers to high-frequency traders.

And that brings us to the tragic flaw of the EC's proposal.The Tobin tax proposed to the European parliament by EC President Jose Manuel Barroso would impose a 0.1% tax on stock and bond transactions and a 0.01% tax on derivatives trades.

It's backwards.

A Tragic Flaw in the Tobin Tax

A tax rate of 0.1% on bonds and stocks is too high. It will prevent high-frequency trading, but it also will prevent legitimate arbitrage and market-making - thus making markets illiquid.

The tax makes even less sense for bonds, where profit margins at the short end are very skinny indeed. A tax of 0.1% is a gigantic problem for investors in one- and two-year government bonds whose yields are well under 1%. Indeed, money market funds would be wiped out entirely if the tax extended to really short-term paper.

And yet, derivatives are favored by a 0.01% tax, which makes no sense.

By definition derivatives do not finance real economic activity, because they are derived from real investments like bonds, stocks and commodities. So to discriminate in their favor makes derivative investments more attractive than bonds or stocks.

Moreover, at least some derivatives - notably credit default swaps (CDS) - are exceedingly damaging to financial stability as a whole. CDS played a big role in the 2008 crash. And even now they continue to wreak havoc by encouraging speculators to bet against Spanish and Italian government bonds, thus worsening the euro crisis.

The EC should look for ways to dampen down the CDS market. It should lower the tax on trading stocks and bonds to no more than 0.01% on bonds and 0.02% on stocks, and raise the tax on trading derivatives, perhaps as high as 0.05%.

It then needs to reach an agreement with the United States - maybe the entire Group 20 (G-20), in fact - to impose parallel taxes. An EU tax alone will simply drive trading activity offshore - although not, interestingly enough, high-frequency trading. In that case, relocating the trading computers to the Cayman Islands would mean a fatal 0.16-millisecond delay in the information flow!

Still, the Tobin tax is coming. And as investors, we should welcome it.

The EU tax - if imposed - is expected raise about $80 billion (57 billion euros) per year. That money will be split between the EU organization and its member states, which could certainly use it.

The United States could use a tax like that, as well. And it just might get one if the EU follows through.

Of course, you should avoid buying shares in the major trading houses like Goldman Sachs Group Inc. (NYSE: GS), Citigroup Inc. (NYSE: C), and Morgan Stanley (NYSE: MS). These banks already are in bad shape, and a Tobin tax could severely hamper their trading revenue.

News and Related Story Links: