More on the trading tax

Fellow collegiants Jay and the incomparable Cassandra carp in the comments of the previous post about, well, many things, but mainly about Baruch’s distrust of a trading tax. Their key points in favour of the tax are, I think:

  1. the financial sector is too big and needs to be shrunk and simplified, which is also Krugman’s key idea. A trading tax would be a step in the right direction
  2. there is a way to distinguish, mostly to do with timeframe, between “speculation” and “investment”. Generally two legs, sorry, speculation is Bad, leveraged speculation in highly liquid markets even worse and responsible for lots of the financial crisis. However, “informed and active” investment is Good; a trading tax would restrain one and leave the other unrestrained.

 If I’ve misunderstood something or left something out, let me know.

Firstly, I am very interested as to how we can possibly know how big the financial sector should be. Jay and Cassandra might answer “I don’t know exactly, but I just know it’s too big”. They might argue we expect too much of them; the sizing of any particularly important industry should be above anyone’s pay grade, let alone the responsibility of a couple of commenters on an obscure 3rd rate econo-blog.

Yes, well but that’s the point. We’ve largely done away with the type of industrial planning that pulled western economies out of the devastation of WW2, the period of MITI in Italy, the Marshall Plan, the last time we had an economic regime where people actually decided how big certain industrial sectors should be. That type of dirigisme worked in conditions of relative simplicity, where there were fewer moving parts to an economy, trade was restricted to controllable flows between large trading blocs, and exchange rates were stable. For most of the postwar period the financial sector of most economies was small, and mainly boring. In the UK, for example,  it was the preserve of a class of people drawn from the chinless children of an addled aristocracy. They really did wear bowler hats. Their tasks were simple enough for them to perform even after polishing off a litre of claret every lunchtime and leaving the office at 4pm.

I would argue the explosion in financial innovation and the size of the financial sector coincided with the increase in the overall complexity of the global economy from the early1980s on. Bretton Woods had broken down; there were extreme fluctuations in interest rates and costs of capital; the rise of Japan and other emerging markets were destabilising settled industries in Europe and the US; new technologies were creating new working practices and business models.  I am not saying a supersized financial system was the cause of this increase in dynamism and complexity. But what if it was a response?

Looking at where we are since 2000, we have a global economy which has made a step change again in complexity and dynamism.  Things have globalised to the extent that concepts of imports and exports have lost their meaning. Our economic system is optimised, primed to work at an extremely high level of just-in-time delivery. New business models pop into existence overnight, and destroy old ones — they demand and create capital and wealth at an unprecedented rate. And it’s largely great for everyone; most of us are richer. Literally billions of people have seen their living standards improve this decade. It’s been an exciting time to be alive.

This is an unpopular thought, but here goes: what if the current financial system is actually rightsized for our economy? Sized specifically to provide  the greater degree of economic dynamism we have come to expect, and on a much more massive geographic scale? Might there not be a price to pay in shrinking it?

Now let’s try look at the second debating point of my commenters and distinguish between “speculation” and “investment.” I still don’t understand the difference. But I don’t think anyone does; I am not sure there is a qualitative difference. Cassandra introduces the concept of (allocative) “efficiency” in the sense (correct me if I am wrong) that the hardworking “investor” with his longer-term timeframe performs a useful societal function in allocating capital to where it is needed. Short term specs, on this reading, do not.

I think this is wrong; speculative traders probably have as much or more allocative efficiency as the investment-minded ones. They have more money, for one thing, but more importantly even the highest frequency High Frequency Trader is actually tracking the portfolio decisions made by actual investors. Even Raj, at the height of his powers, was effectively allocating capital to companies which were showing better earnings. He just had the earnings release a bit before everyone else. Most short term specs, whether technical, quant or flow-driven, are really piggy-backing on investors; they basically buy the same stocks and amplify their decisions. Qualitatively, as I say, there’s no real difference, except they are either lazier or smarter than fundamentalists like me. Probably both; I bet they get home before 7pm. Is there a difference in holding period? Generally yes. But today I entered and exited a position in a tech stock in the space of 40 minutes. In fact it was a mistake. But I don’t feel bad about it. Do you think I should?

Cassie thinks it was the leveraged specs who blew us up in the crisis. No way. It was the leveraged investors. Those guys buying subprime weren’t in it for the quick buck; they were going to hold them for as long as they could borrow overnight at 5% and earn 7% on the bonds, ie as long as the then-current interest rate regime was going to last. Holding periods were measured in years. In the end were barely able to trade the stuff. That was the problem. As Jay puts it, “in less liquid markets, shareholders act more like owners” — they acted like owners, all right, and look where it got them, and us.

Look, a smallish trading tax may not make all that much of a difference, really. Financial markets will survive, and a tax will likely end up making a good few investment bankers richer than they would have been, when they come up with a way of avoiding it. There’s actually a trading tax in place in the UK already. It’s called Stamp Duty. I don’t know how much it is because I have never paid it on any of my UK trades, we use something called CFDs to avoid it. Everyone does this except low volume retail investors: Stamp Duty has thus merely become another way the little guy gets screwed. I am not sure this was the intention of its inventors.

But if you think discouraging speculation in liquid equity or forex markets is going to somehow prevent another crisis, think again. The root causes of our difficulties lay in a combination of too much easy money feeding a boom in illiquid debt securities, held for investment. A trading tax would do, and would have done, nothing to prevent any of those conditions from prevailing again.


18 thoughts on “More on the trading tax”

  1. Surely from the above the best idea would be not to tax trading, but rather to tax leverage for the purpose of trading? If you owe the bank £1000 its your problem, if you owe them £1bn its their problem.. Obviously this can be obfuscated, but still..

    The increase in reactionary HFT trading/scalping was one of the things that encouraged me to stop investing in US tech stocks and start investing in frontier markets:

    1. Indeed Emad, that is an excellent idea. Any idea how to implement it? I just know about shares and stuff.

  2. – even the highest frequency High Frequency Trader is actually tracking the portfolio decisions made by actual investors –

    Don’t know about that. Admittedly it’s complicated, but the net effect of program trading from 2004 to 2007 seems to have been an actual damping of the effect that ‘investors’ would have had on the market if left alone in the playpen. Hence, low returns and more leverage to generate them, and on and on.

    A nice start would be getting rid of the sludge that allows one to buy and sell the whole market – a tax on ETF trades.

  3. Stamp duty in the UK for equities is 0.5% for share purchases only – does not apply to sales, and as you point out doesn’t apply to derivatives

  4. so it’s a given that speculation is bad and you people know the right “size” the financial industry should be

    Oh, lord

  5. Baruch

    I would like to think my points were more nuanced, though I understand it’s easier to counter the simple version. I also do not pretend to know how big the financial sector should or shouldn’t be, though I will note that the market rarely does either – witness the extreme winnowing in Japan during the Lost Decade, where 8 out of 10 stockbrokers, and perhaps five out of 10 city bankers lost their jobs.

    Here is how I would tersely put my points:

    1. The primary focus of OTHER PEOPLE’s outrage has been the compensation issue rather than active investing.

    2. I am agnostic and tolerant about spec, but Leveraged Spec is of dubious value at best, and systemically dangerous at worst.

    3. I remain suspicious and doubtful about the hyperbolic virtues of HFT. A world with less intermediation has to be economically better than a world with more intermediation.

    4. I am also dubious about faith that Market-Darwinism always leading to best outcomes. Just because something evolved doesn’t make it better.

    First, I’ll grant you that leverage was the poison. And the distinction between spec and investor is not useful in the context. I’ll also violently agree that easy money was the ultimate culprit, itself with root cause in both Asian policy and American thereof. Further unfettered by regulation, it facilitated leveraged investor borrowing short to lend illiquid long – whether levering dedicated bank capital or HFs limited partners’ equity – which is always an accident waiting to happen – even more so when the collateral has vaulted substantially in price. Ditto for carry trades, equity or commodity investments – anything where a contra move in price would cause one to be forced to sell position to make position.

    So we’d probably agree that good policy the world-over (along with World Peace and helping victims of famine and leprosy) would be the best elixir. However this has proven objectively difficult. But just because we can’t cure the disease, doesn’t mean we shouldn’t treat the symptoms. And the curse of too much liquidity spawns many symptoms – many treatable to allow the hypothetical patient to live so that – hopefully – one day we might address the root cause. Tangential to this is technology and globaization vaulting ahead of regulation, market organization, and full comprehension of the consequences.

    One the problems (as you rightly highlight in questioning my distinctions) when trying to treat the symptoms – of both liquidity, and probable malignant market evolution is that it is a slippery slope, which poses difficulties for diagnosing and rectifying. An analogy, might be one I see daily: in France police use radar deemed necessary for the public safety, and as such radar detectors are illegal. But GPS purveyors are permitted to disseminate the location of fixed radars, and radio stations broadcast the location of mobile speed traps, useful work-around to the law-breaker. Where is the line? But the difficulty in drawing it, doesn;t mean the fixed radars are wasted, since they are typically placed in caution zones, and therefore have the desired effect of slowing traffic and preserving public safety. Of course public safety would be enhanced by prudence and complete adherence to laws, but there is clearly a continuum, and the same almost certainly holds for finance and systemic integrity in the Public’s Interest. Sure it would be best if bankers and leverage providers were inherently counter-cyclical, and if participants didn’t attempt to game every loop-hole. But they don’t, so an activist central bank and treasury BEFORE the fact to protect the Public Interest on the line as the lender/maker-maker of last resort, and to as much as possible lay out and enforce the limits has to be better (though by no means perfect) than laissez-faire – an approach that needs a stronger political constitution than the polity possesses in order to be viable.

    To me, most forms of HFT are not benign but a novel approach to gaming a structure not yet evolved enough to cope, to the detriment of major constituents. The slippery slope exists here too, but I remain unconvinced as to any non-parochial virtues their activity represents – including the amplification of the prevailing trend hypothesis.

    1. Forgive me Cassandra, I was lumping yours and Jay’s objections into one monolithic jobby to respond to; as such you may feel I was responding to points which you did not make. Indeed, you are quite right; I was, and likely Jay will feel I was responding to points he didn’t make either. Clearly also, there’s a lot we can agree on.

      But agreement is boring. Cordial antagonism is much more interesting. Let me expound on each of your points in turn:

      1 — you’re probably right. But people use any excuse these days to bash active investing. I’m pretty sensitive to it.
      2 — most spec squeezes out little scalps. Sometimes not even 1% gains. You gotta have leverage or it’s not worth the candle. Tolerance of spec tends to mean turning a blind eye to leverage. But again, leverage by itself is value neutral, not necessarily a Bad Thing. Companies showing operational leverage are the stocks I most look for in upturns like this, the ones I will make most money on. Leverage is bad in comination with illiquidity; when there’s no chance of undoing it if it goes wrong. That’s what blew us up.
      3 — i don’t think there are many virtues to HFT, and I have never heard anyone say there is. But there are loads of people saying its Bad. And I think that’s probably unfair.
      4 — things that have evolved tend to be more stable and lasting, and less harmful to other, coexisting things, than things that have been designed. That’s all. That doesn’t mean evolved situations can’t suddenly lead to disequilibria and extinctions

      1. Agreed, except for your last point:

        The U.S. Government has evolved, and I’d argue its for the worse. Its less stable, and at this point, quite harmful to other coexisting things (itself included).

        In natural evolution, I’d agree, however, evolution of markets, governments, etc isn’t exactly so; there’s far too much intervention for nature to run its course and whiddle-out the weak.

  6. Allocative efficiency is achieved when resources are put to their most productive uses. Ironically enough, it is actually counterproductive to try to discourage short term “speculators” from a allocative efficiency standpoint. The tax structure that exists in the US punishes those who liquidate positions by taxing capital gains at the time of the sale. Short term “speculators” by definition do not let these consequences affect their actions and liquidate their positions whenever they determine that there is a better use of their capital. Longer term “investors”, again almost by definition, are more conscious of the tax consequences associated with the sales of their positions and thus tend to not allocate capital as efficiently as those who are indifferent to these consequences. They will only move their capital from one company to another if the difference in return to capital is greater than the tax consequences associated with the change. Although you could argue that everyone would behave this way because the tax structure applies to everyone, to me it seems that the longer holding period gives you more time to consider the full impact of a potential change whereas shorter holding periods seem to be less focused on this. In sum, the old adage about speculators providing liquidity (and thus ensuring allocative efficiency) seems to be mostly true.

  7. In early 2008 the City of London claimed it was creating $600bn of derivatives contracts per day.

    A 0.5% tax (stamp duty) giving $3bn per day to the UK treasury might be an irresistible proposition to any UK Chancellor, let alone politically popular with the majority of voters.

    No wonder Brown, Sarkozy and Merkel are all for it. Note that Sarkozy has 3 of his countrymen in key financial positions now too.

    Maybe they’ll call it temporary – like income tax:-)

    1. Yes, Tim, I think you’re right. You and I will no doubt watch with amusement as better, more devious brains than are to be found the chancelries of Europe find inventive ways around the taxes they come up with.

      (thanks for all the links, BTW)

  8. Although I don’t agree with trading tax, I’m sure the financial sector is bigger than it should be. The reasons for this are direct (cheap) central bank financing and the regular government bailouts. Thanks to these two factors the size and risk taking capacity of the financial industry will be always larger than in a fully free-market environment.

  9. Rather than a general tax on trading, why not lobby for an increase in capital ratios or lower leverage ? It is notable that the investment banks which have gone under i.e. Bear and Lehman were operating with leverage ratios far greater than any hedge fund would have ever been allowed by its prime broker. Reducing the amount of embedded leverage in the system may make it more predictable and safer and yes, smaller too, but less likely to need taxpayer bailouts

    1. Question:

      Why did Prime Brokers place more onerous leverage restrictions on their HF clients than the lending/trading arms of these same institutions place on their counterparties?

      I don’t have an answer, but methinks finding one is important.

  10. Anal yst asked:

    Why did Prime Brokers place more onerous leverage restrictions on their HF clients than the lending/trading arms of these same institutions place on their counterparties?

    Just a thought, but is it not because all PB positions are “on balance-sheet” whereas exposures to counterparties are more often than not “off-balance sheet”, i.e. their effective leverage is lower for “on” than “off”.

    This is odder when one considers that the PB relationship is far more favourable to the PB (who legally can more or less puke any client whenever they want) than external exposure to counterparties say versus one’s swaps desk.

    Isn’t it because

  11. > “speculative traders probably have as much or more allocative efficiency as the investment-minded ones.”

    this is a correct but silly argument: imho today we must strive for stability and not predominantly for efficiency!!

  12. @ wolf – i like the idea of surgery but really the gov needs the money and to be seen to be tackling the growing deficit. A stamp duty on all derivatives might raise 10x the proposed bank tax. Note that I say Stamp Duty so that there are no deductions from other tax credits:-) It’s the cheapest tax to collect as it can be entirely automated via the clearing house computers.

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