Wednesday, June 23, 2010

Economics 23/06/2010: On Financial Services Tax

This is an unedited version of my article in the current issue of Business & Finance magazine.


Behind the headlines about the ongoing eurozone fiscal crisis, three significant events have taken place on both sides of the Atlantic in recent weeks.

First, in April, assets under management in hedge funds domiciled in North America reached above $1 trillion mark for the first time in 18 months. Currently, North American funds account for two thirds of the total global assets under management.

Second, both the US and Canadian governments, preparing for the upcoming G20 summit have signalled their unwillingness to join European leaders in their crusade against financial markets. In fact the US has taken a distinctly different approach to dealing with the aftermath of the financial crisis, focusing on banks stability and addressing balance sheet risks in the recent finance reform packages that cleared US Congress.

Third, bloodied and bruised by the bonds markets and the voters, European politicians, led by Angela Merkel, have been gearing up for an all-out fight with so-called financial speculators.

As unconnected as these events might appear today, make no mistake, should the EU continue down the path consistent with its recent rhetoric, Toronto, New York, Chicago and Boston, alongside other major financial services centres around the world will be boom towns courtesy of the investors fleeing populist and politicized EU.


German plans for an EU-wide revision of fiscal and financial architecture range from suspending voting rights of the member states to national bankruptcy proceedings, from regulating hedge funds to introducing a tax on financial transactions.

A global or at the very least an EU-wide financial services transaction tax has been an on-and-off topic of discussion amongst the member states and Brussels for some years. Back in 2006 I was asked to review one of such proposals for a senior European decision maker from one of the continental member states. Having systematically overtaxed and overspend their economies, European sovereigns have been seeking new means of getting their hands on taxpayers cash since at least 2002-2003. Like a junkie in a desperate search of the next hit, the EU states are now searching for a convenient and politically, if not economically, easy target to mug. A Tobin-styled transaction levy on financial instruments is just that.

Transactions tax has been proposed back in 1972 as a theoretical construct to reduce the volumes of high frequency trading in foreign exchange markets. The rationale for it was a naïve belief that currencies should only be traded internationally for the purpose of physical commerce – exporting and importing. Any other trading, such as using foreign exchange as either a hedge or a flight to safety instrument against inflation, low economic growth, excessive state graft on personal income, sovereign insolvency and other fundamentals was viewed as speculative. In reality, modern currency is cash and cash is more than a facilitator of physical transactions. It is an asset.

Fallacious in application to Forex markets, Tobin tax would be even more erroneous were it to be applied to a broader set of financial instruments.

Take Ireland: a gravely sick financial system with plenty of financial services taxes, including a stamp duty on transactions. Has the presence of the Tobin tax here helped to prevent or even moderate the crisis? No. Worse than that, over the last 5 years, Irish markets have shown remarkably high volatility, despite having one of the highest stamp duty rates in the developed world. If anything, our stamp duty can be blamed for artificially reducing liquidity in the Irish stock market and, as a result, for adversely (albeit extremely modestly) contributing to the collapse of Irish shares.

Sweden toyed with transactions tax on financial markets back in 1984, imposing moderate levels of a stamp duty on stocks and derivatives. Within one week of the new law coming into effect, Swedish bond market saw an 85% collapse in volumes traded, futures trades fell 98% and options trading ceased all together. Swedes finally abandoned this self-destructive tax in 1991. Finland faced exactly the same experience. Japan was forced to abandon Tobin-style tax in 1999. Switzerland – a global financial services hub – does charge, in theory, a transaction tax, set at a fraction of the one Germany is rumoured to favour. However, in a typical example of Swiss flexibility, authorities there have power to grant exemption from this tax for specific investors.

OECD has issued the following official position on Tobin-style taxes back in 2002: “A “Tobin tax” penalises high frequency trading without discriminating between trades which may be de-stabilising and those which help to anchor markets by providing liquidity and information. Indirect evidence from other financial markets where a securities transaction tax has been in place suggests a substantial effect on trading volume but either no effect, or a small one of uncertain direction, on price volatility.”

Tobin tax will not work for Europe:

The tax is avoidable by conducting trades and structuring portfolia outside the EU. The end game will be higher cost of capital raising for European companies, selection bias in favour of larger companies in access to the capital market, selection bias in favour of larger financial assets trading platforms, to the detriment of smaller exchanges, and lower after-tax returns to investors. Which part of this equation makes any economic sense?

The tax will not fund sufficient insurance cover for future crises. Given the magnitude of bailouts witnessed in the last two years, the levels of taxation would have to be so high – well in excess of benign rate of 0.1-0.2% currently levied in some countries – that there will be no European financial markets left.

This tax on financial transactions will retard economic development in Europe for decades to come.

One of the reasons why European banks are so sick right now is European companies’ disproportionate, by international standards, over-reliance on debt financing. This contrasts the US corporates, which use more equity financing to raise capital. When the debt financing meets an asset bubble, banks balance sheets swell with bad loans. There is no equity cushion on European corporate balancesheets to underwrite the resulting losses. Instead, taxpayers get thrown to the wolves to rescue banks. Mrs Merkel & Co latest plans for ‘reforms’ will, therefore, mean even greater risks of bailouts in the future, and less growth and fewer jobs.


Next, of course, in Berlin’s line of fire were the hedge funds. Per populist rhetoric in European capitals, they had to be reined in because… well, no one actually knows, why. Hedge funds did not cause the current fiscal crisis (they had no control over the EU governments’ borrowing and spending excesses), nor did they cause the crash of our financial systems (hedgies did not pollute banks balance sheets and account for no more than 5% of the global financial assets). The hedge funds are not responsible for the property bubble or for exuberant stock markets overvaluations achieved in 2007-2008 worldwide.

The sole reason for this ‘reform’ is that for European leadership, ‘Doing right’ means ‘Doing politically easy’. Hedgies have no strong political lobby backing them, unlike banks, property developers, sovereign bondholders and issuers, or civil servants. So the EU prefers to attack a bystander in order to pretend that we are tackling the criminal. While taxpayers are being skinned alive to rescue reckless governments and banks, hedge funds are being presented as villain supremo. Farce? No – it’s politics.

After hedgies, came in even more sci-fi villains. Following Mrs Merkel’s ‘reforms’ talk, Germany banned naked short-selling and the trading of naked credit default swaps in euro zone debt. It turns out that European crisis was, after all, not about absurdly high levels of public debt carried by the PIIGS, nor by fraudulent (yes, fraudulent) deception by some countries of European authorities and investors about the true extent of national deficits. It was not exacerbated by the decade-long recessions turning into bubbles of exuberant lending and borrowing by companies and households, nor by a resultant severe depression that afflicted Euro area since 2008. The cause of these were the investors who were betting on all of these factors adding up to an unsustainable fiscal and economic situation in Europe. Farcical, really!

Worse than that, on top of the ridiculous financial services policies decisions Chancellor Merkel has also been working hard “on far-reaching changes to the treaty underpinning Europe's common currency”. German government would like to increase monitoring of member states' annual budgets, the introduction of stiff sanctions for those in violation of euro-zone debt rules and the suspension of voting rights in the European Council. Furthermore, Germany wants to establish “bankruptcy proceedings for insolvent euro-zone countries.”

The problem with the first part of Mrs Merkel’s fiscal policy proposal is that there are no independent organizations in Europe left that could oversee member states’ budgets. The ECB is a full hostage to Europe’s whims on monetary policy, engaging in the most reckless forms of monetary interventionism known to mankind – direct purchases of risky states’ debt. Outside the ECB ‘Yes, Minister’-styled ‘independent’ states-sponsored institutes populate the realm of European economic policymaking. By-and-large, they have no capability of delivering any independent analysis. Even the likes of the OECD – a very capable organization with some degree of independence – is subject to direct political and bureaucratic interference from its own members.

As far as German proposals for euro zone rules enforcement go, member states that do not conform to deficit reduction rules will be temporarily cut off from receiving structural funds. The galling dis-proportionality and lack of realism in this proposition does not even occur to the EU leaders supporting the idea.

Greece today is recipient of €110 billion bailout. Will suspending a few billion worth of discretionary structural funds commitment be a significant deterrent to a state like that?

This idea is potentially quite dangerous economically. Structural funds go to finance long term infrastructure investment programmes which often rely on co-funding from the Member States and/or private partners. All have private sub-contractors. Withholding EU funds will either destabilise these investments (if the measures to have any punitive powers), thus preventing economic growth necessary for fiscal stabilization or will do nothing. In short, Mrs Merkel’s proposal is a cure that threatens to make the disease incurable.

Earlier in May, German officials also mentioned the possibility of suspending member states' votes should they find themselves in violation of European debt rules. Of course, should this come to pass, Italy, Greece… no wait virtually the entire Eurozone, including Germany will have to be suspended from voting.


In short, in contrast to the US Congressional blueprints for financial sector reforms, European proposals to date can be described as a bizarre amalgamation of the impossible, the improbable, and the outright reckless. Their likeliest outcomes would be a large scale capital flight out of Europe and perpetuation of the status quo of continued sovereign and banks bailouts across the continent. Already struggling under the unsustainable burden of European taxation, the real economy – exportable and non-traded services and manufacturing – will be left holding the bag for these politically driven ‘reforms’. In addition to having an acute solvency problem, the EU will be saddled with a crippling lack of liquidity that only financial markets can provide.
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