Rough Trade - currency traders and the economic crisis in Asia

Washington Monthly, June, 1999 by Nick Thompson

Tax 'em

The most commonly offered solution to the problem of currency runs and instability is the creation of a system that revolves around one, or three, stable major currencies. Proponents of this idea range from President Jacques Chirac of France to assorted South American economists. This system would be modeled after the new European economic union. Countries would fax their currencies to the dollar (or to the dollar, euro, and yen) and in this way be able to avoid currency runs, speculation, and the investor uncertainty that comes with potential currency instability.

This solution, however, like all other solutions that keep the value of a currency fixed, is incompatible with two other goals of international policy: free capital mobility and domestic sovereignty over interest rate policies. Countries like to have control over their interest rates so that, when the economy is in recession, rates can be lowered to stimulate growth (lower interest rates make lending and investment easier). However, unless there are capital controls, a country cannot control interest rates while maintaining a fixed currency. If the values of the dollar and the yen were guaranteed at a fixed rate, and the U.S. Federal Reserve raised interest rates even by a fraction of a percent, every investor would immediately be able to make a fortune by borrowing yen at the low interest rate and then buying dollars and lending them out at the high interest rate.

A better solution is an international tax on currency transactions. This idea was originally pushed forward in the early 1970s by Nobel Prize-winning economist James Tobin. A "Tobin tax" would be a very small levy on all international currency transactions. Traders would have to pay the tax to the regular collecting authority of the country in which the transaction originated and the tax revenues would then be sent to the World Bank, IMF, or a yet to be determined international financial agency that would focus on development. A tax of as little as one-tenth of 1 percent on all foreign currency exchanges would easily raise hundreds of billions of dollars a year with current transaction levels and, with a slightly higher tax, revenues could quickly move into the trillions. Countries that try to circumvent the tax and become havens of tax-free currency trading could be denied World Bank loans and international support.

A tax of this level would hardly deter long-term (or even medium-term) investors. If I want to buy a factory in a developing country to hold onto for 20 years, or even two, a levy of one-tenth or one-half of one percent on my currency transaction is unlikely to stop me. It would, however, slow down short-term speculators who try to pounce on tiny movements caused by perception and minuscule spreads and make trades every day. It would surely have dampened some of the chaos in Thailand's currency markets and it would help eventual market outcomes to be determined more by the fundamentals that drive long-term investment than the perceptions that can dominate the short term.