Foldvary on Taxing Financial Capital
|November 9, 2002||Posted by Staff under Archive, Progress Report, The Progress Report|
Tax Financial Capital? Bad idea.
by Fred E. Foldvary, Senior Editor
We are now in the midst of a global financial crisis following a global economic boom. In eastern Asia and Russia, the boom was fueled by borrowed money, much of which went to speculative ventures, especially real estate, which turned out to be unproductive and unprofitable. Once investors realized the game was over, they began to take money out of these countries. Many of these countries had fixed the value of their currencies, usually to the US dollar, and did not have enough dollar reserves to convert their currencies to dollars.
So the currencies collapsed. Imports became very expensive, plunging countries such as Indonesia into poverty, while the banking systems were kaput, so enterprises did not have the credit with which to produce and rise again. The IMF came and bailed out some of the loaned funds, money that went to the speculators and investors rather than the home folks, who instead suffered from IMF-imposed tax increases and government spending reductions. Now the crisis has spread to Latin America, as investors and lenders fear a general default on debt.
Economists and financiers have offered various measures to help these economies recover, centered mostly on banking and financial policy. Some economists think that there is a flaw in the international financial system rather than there being something fundamentally wrong with the countries’ domestic policy. These economists think the financial market has failed, and government must intervene to correct the failure.
An example of this is the article “Unregulated capital is at heart of Asian crisis” by Professor Jonathan Kirshner, which appeared in the September 20 West County Times, Contra Costa County, California. Kirshner calls the international flow of financial funds “a form of economic pollution.”
One reason given for why financial capital is harmful is that a large movement of money into or out of a country can alter the exchange rate and change the prices of imports and exports, causing prices to be unstable. But the fundamental reason for this is not the market, but intervention in the form of fiat money not based on any commodity, plus government central banking which cannot respond flexibly to rapid changes in the demand for money.
The ultimate remedy for such instability is to return to a global commodity currency, namely gold, plus free-market banking in which currency convertible into gold is issued by private banks instead of the government. Then all currencies would have a fixed rate with one another, and the private banks would flexibly expand or contract the paper money supply in accord with market demand.
A second reason given as to why the international flows of financial assets is economic pollution is the “herding behavior” of speculation that feeds on itself, carrying booms to extreme peaks and the collapse to an extreme trough. But such speculation rides on top of the already-existing financial and economic instability caused by dysfunctional policy. Treat the fundamentals, and the speculation will no longer be harmful because it won’t be profitable.
With a global gold standard, there will be no more speculation on national currencies. The key investment vehicle that causes the crisis is real estate, so the fundamental remedy is to tax all or most of the rent, eliminating speculative profits. Unlike other taxes, a tax on economic rent is not an intervention, because the land and natural resources are not produced by enterprise, so tapping the benefits manifested in rent does not hurt business.
The third reason given why financial capital pollutes is that countries have diverse economic conditions and thus it is said that they should have different policies, but that the “unregulated” flow of financial capital creates pressure for uniform policy that does not have taxes or inflation much greater than other countries. But this financial penalty is a good influence, since inflation and high income and sales taxes hurt enterprise.
There is indeed one common policy that helps any economy: economic freedom. This is not only sound in theory but was verified by a study of over 100 countries in the book Economic Freedom of the World (see http://www.fraserinstitute.ca/econ.htm). Economic freedom is achieved with three basic policies: true free trade, sound money, and benefit-based public finance. The latter is achieved by taxing land rent rather than income or sales.
Since these economists think the problem is too much mobility in international funds, they propose controlling the global financial capital that sloshes around from country to country seeking to exploit financial troubles. They propose a tax on the financial “pollution,” just as a tax on physical pollution reduces that pollution. This idea was proposed 20 years ago by James Tobin, winner of the Nobel Prize in Economics in 1981, and thus called the “Tobin tax.” The proposed tax rate is around .2 percent or $2 out of every $1000, quite substantial, given the many billions of dollars of funds out there travelling to and fro.
Kirshner says such a tax on financial capital flows would discriminate between “good” and “bad” flows, deterring “bad” quick back-and-forth movements while not affecting “good” long-term flows. But there are no “good” and “bad” financial flows. The “bad” is the policy that causes the “bad” flow in the first place. Each speculation is a judgment on the part of the speculator that some price is out of whack with market fundamentals. Profits are made when prices come back to those warranted by fundamentals. Often governments cause these price distortions by trying vainly to fix the value of a currency. Speculators exploit the problem and may make it worse, but they don’t cause the problem.
Artificially restricting speculation will just encourage governments to manipulate the value of their currency, since the market will not impose as much discipline. And the tax will indeed reduce the “good” long-term flow of funds for investment by making it that much more expensive, since it taxes the whole investment twice (when the money comes in and when it comes out) rather than just taxing the profit, and because if the investment turns out to be a loss, the tax makes it that much worse.
The “Tobin tax” ultimately harms investment and growth. Rather than imposing artificial costs on the flow of funds, sound economic policy would eradicate the cause of economic woes: fiat money, and the implicit subsidy to owners of land by letting them profit from the rent due to public spending.
Speculation in currencies can be eliminated by either freezing the supply of national currency or basing it on a commodity such as gold, and then letting banks issue private bank notes in response to market demand. Speculation in real estate is cured with free-market banking, which eliminates interest-rate distortions, and by taxing all or most of the land rent. Then let investors enjoy the full gains and suffer the full losses on their assets. Let them have a free choice in where to invest. If they know they will not be bailed out by the IMF and by governments, they will be much less likely to lead themselves and others to financial ruin.
What is your opinion on a Tobin tax and currency speculation? Tell The Progress Report!
Copyright 1998 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieveal system, without giving full credit to Fred Foldvary and The Progress Report.