Sand in the Gears?

Anybody up for a tax on sales of financial assets – maybe a quarter cent on the dollar? A lot of people are, actually.

One reason is opportunism: finding sources of revenue to fund virtuous causes in ways that don’t anger the voters. British PM Brown and President Sarkozy of France want to use a transactions tax to pay for climate change initiatives in poor countries. Meanwhile, back in the USA, Rep. Peter DeFazio (Dem, OR) proposed a transactions tax to recoup the cost of the much unloved Troubled Assets Relief Program and has picked up some cautious support from House Speaker Nancy Pelosi.

But the most plausible case for a transactions tax rests on efficiency claims. New York Times columnist Paul Krugman and liberal policy wonk Dean Baker of the Center for Economic and Policy Research argue that a tax on trading would temper the irrational exuberance that leads otherwise rational adults to believe that housing (or stock) prices can only go up.

Now, the very idea of increasing efficiency by discouraging trading makes economists, most of whom spent their years in graduate school listening to panegyrics on the virtues of low transaction costs, squirm. But the notion has a better pedigree than you might expect.

No less an eminence than John Maynard Keynes proposed a transactions tax in 1936, arguing that it would make financial bubbles less likely by raising the cost of that earlier era’s version of day-trading. Nobel Prize winning economist James Tobin offered a similar rationale for a tax on currency transactions in 1973. He formally made the case that there is such a thing as too much liquidity – that, because trading had become nearly frictionless, the volatility of currency markets was far greater than the volatility of the real economic variables that ought to be driving expectations about exchange rates. Thus, in Tobin’s words, throwing “sand in the gears” would increase efficiency.

Are these heretics right? It is easy to build plausible models of markets in which a transactions tax decreases efficiency à la Chicago or increases it à la Tobin. In the real world we suspect that much would turn on the tax rate, the segment of the financial markets being taxed and the ease of evasion. But as much as we sympathize with the idea of sticking it to the nice folks who brought us the real estate bubble yet seem no worse for wear today, this does not seem the best moment to try.

For one thing, it’s hard to argue that financial markets are now suffering from excessive liquidity. The mortgage market is almost entirely dependent on government support of one form or another. Meanwhile, the Fed has been forced to carry trillions of dollars in financial assets on its books since the market meltdown, and doesn’t yet know how to shovel all that paper back into the private market.

For another, it’s hard to know whether a global transactions tax could be enforced; trading might well move to countries that choose to look the other way. That would be a problem in the best of times. And these are times in which the financial authorities of the major economies already have their plates full trying to find common ground on issues ranging from fiscal policy to bank reserve requirements.

There’s an irony here. Once financial markets do become liquid again and an experiment with a transactions tax might make sense, Congress’ populist-driven enthusiasm for taking on the financial services industry will surely have waned.

What’s the right time to prevent the next bubble? Maybe never…