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Destabilizing Speculation and the Case for an International Currency Transactions Tax
Challenge, May, 2001 by Thomas Palley
This traditional Chicago school view has been challenged from a number of directions. One challenge comes from the Chicago school's own rational-expectations theory of behavior, which shows how asset price bubbles can be rationally self-fulfilling. All that is needed is that market participants expect the future price to be higher, and they will then buy in anticipation of this higher future price. In this fashion, "market beliefs" become the driving fundamental, and if speculators share and shape these beliefs, they can drive prices away from the level warranted by economic conditions.
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A second challenge comes from the noise trade literature (De Long et al. 1990), which shows that market participants who trade purely on the basis of noise may come to dominate the market. The reason is that noise traders are unconcerned about risk and therefore earn a higher rate of return than ordinary persons who are concerned about risk. Thus, noise traders come to dominate the market, and, though the market remains stable, the market produces socially suboptimal outcomes.
A third challenge comes from the literature on herd behavior (Banerjee 1992; Palley 1995), which posits that market investors may act as a herd. Each individual acts rationally from his or her own standpoint, but collectively they behave as a herd, each following the actions of others for no reason other than the fact that others are doing it. In this case, the "behavior of others" becomes the market fundamental, and the actions of speculators can trigger movements in market prices through random dealings that have no relation to underlying economic conditions.
A fourth strand of work explicitly aimed at justifying a Tobin tax focuses on how speculators may cause damage to other market participants when they cash out of their investments (Palley 1999a). This outcome seems to have been particularly prevalent in East Asia, where the decision to cash out and repatriate investments led to a fall in the exchange rate that then increased the debt burden of those East Asian entrepreneurs who had used foreign currency borrowings to finance their business expansions. In such instances, speculators impose a negative externality on other investors. These other investors (call them fundamentals investors) are in for the long haul, and their investment calculus is thereby compromised. Conventional economic theory advises that policymakers should tax activities having negative externalities, thereby making them more expensive and discouraging them. This is the well-known theory of Pigouvian taxes, named after the English economist A.C. Pigou. Viewed from this vantage, the Tobin tax is a form of Pigouvian tax that is applicable to international financial markets.
The correction of negative externalities provides one economic justification for the Tobin tax. A second justification is that it may reduce exchange rate volatility that has damaged manufacturing employment and also likely reduced economic efficiency by increasing uncertainty surrounding investment decisions. Here, it is worth distinguishing between short- and medium-term volatility The former concerns within-day and day-to-day exchange-rate fluctuations, while the latter concerns exchange rate movements over a longer time horizon of six months to a year.
