Friday, January 16, 2015

Is a Financial Transactions Tax a Good Idea?

Our mission on this blog is to follow news and events that may impact change in the monetary system. One event that surely might disrupt the system is some kind of "flash crash" in the markets like we have already seen happen. There is some evidence that the high frequency trading (hft) that is done on Wall Street may add to the risk of market instability and volatility. The link above is to a CFTC report that talks about this problem.

This article in the New Republic talks about proposed legislation by Congressman Chris Van Hollen to implement a financial transaction tax that would hit high frequency traders more heavily in an effort to discourage this type of trading. The article talks about this proposal on the basis of reducing systemic risk as well as being an effort to address income inequality (the bill is said to lower other taxes for those with incomes below $200,000). In theory, the tax on HFT would impact higher income earners in exchange for lowering taxes on those below $200,000 in income.

The latter point (income inequality) is more of a political debate which is not the point we want to emphasize here. Readers of this blog know that we do not try to advance a political agenda here. But the point related to systemic risk directly relates to what we do cover here. Below are some quotes from the article followed by some comments. Please click the link above to read the full article.


"For too long, it appeared that many Democrats were trying to fight economic inequality with policies like the minimum wage while ignoring the 800-pound gorilla, Wall Street. But Rep. Chris Van Hollen on Monday unveiled legislation to cut taxes for those earning less than $200,000, while partially paying for the proposal with a financial transaction tax (FTT), projected to raise $1.2 trillion over the next decade."

"The small FTT in this bill—which also includes provisions to boost stagnant wages and close lucrative tax loopholes—wouldn't burden longer-term investors. The tax is applied to every transaction—the sale and purchase of a stock, bond, or other financial instrument—so as long as the investor holds the investment for a decent period of time, the tax is a tiny percentage of their overall portfolio and won’t drastically alter their trading behavior. It’s the high-frequency traders who have fought this tax tooth and nail, and who will gear up to fight it now, because if you trade multiple times a millisecond then your tax burden will be higher."

"High-frequency trading creates systemic risk.Taxing it would reduce the incentive for the financial sector to chase new bubbles, driving out "noise traders" who make markets more volatile without improving capital intermediation (the purpose of the financial system). This is the argument of economists including John Maynard Keynes, Lawrence Summers, Victoria P. Summers, and Joseph Stiglitz: that reducing the “whirlpools of speculation” is one of the best method for risk reduction. We’ve seen the results of volatility among such traders in the flash crashes, where huge amounts of speculative trading can crash very, very quickly."

. . . . . . . 

"As Nomi Prins has documented ,financial power players have been deeply intertwined with the political process for a long time. However, finance’s political heft has never been greater, to the extent that a recent deregulation amendment was essentially written by financial industry lobbyists. In the wake of Dodd-Frank, bankers were granted 14 times more meetings with the Commodities Futures Trading Commission, the Treasury, and the Federal Reserve Board than pro-reform groups."
My added comments: 

The intent here is to focus on the "systemic risk" part of this article. The tax proposal will of course be debated as a political issue and readers can decide if they think such a tax would be a good thing or not. What caught my attention in this article is the statement "high frequency trading creates systemic risk." Readers here should consider that because one of the events that could lead to another financial crisis would be a stock market crash triggered by a so called "flash crash." This risk is taken seriously not only by those proposing this legislation, but the CFTC report linked above also. That report had this to say about high frequency trading in its concluding remarks:

"The events of May 6, 2010 were extremely traumatic to many market participants. Was the Flash Crash caused by the high frequency traders? What have we learned from this event? How do we make sure that events like that are less likely to happen in the future?"

"In this paper, we show that HFTs did not cause the Flash Crash, but accelerated a price movement due to a large order imbalance caused by an automated execution program to sell E-mini S&P 500 futures contracts. We also show that HFTs contributed to the Flash Crash by engaging in their typical immediacy-absorption practice of aggressively removing the last few contracts at the best bid or ask levels and then establishing new best bids and asks at adjacent price levels."

. . . .

"The Flash Crash has forced regulators and self-regulatory organizations to re-visit the intricacies of market design and to contemplate policies that prevent these events from happening in the future. The proposed responses vary from a tax on all financial transactions to imposing delays on the cancellation or modification of resting orders or restricting directional changes in prices on a security-by-security basis."

The CFTC report does not recommend implementing a transactions tax, but did list it as one alternative to consider. The point here is that HFT is viewed as a real risk that could help start or accelerate a flash crash in the market. An event like that could most certainly open the door to major monetary system changes. 

I reached out by email to a couple of experts we cite here on the blog to see what they think of this proposed bill. Both Jim Rickards and Nomi Prins (mentioned in the article) were kind to reply and grant permission to post their comments on this for readers here.

Here is what Jim Rickards had to say in his reply:

"I agree (with the goal of the bill), it's a good idea. It fits with the idea of descaling a system, i.e. making it less efficient by design (first order cost) to make it less dangerous in operation (second order benefit)."

In a followup he added this comment:

"The only qualification is that I favor the idea in general, but any specific proposal would have to be examined closely in its particulars to make sure it is well designed for the intended purpose."

Here is what Nomi Prins had to say in her email reply:

 . . .  "yes you can definitely include me in supporting this legislation in the name of reducing volatility-contributing speculation."

So there you have it. While this bill will be debated from a political point of view, it shows that the risks that we talk about here on the blog are real. When you combine this risk with all the debt overhang in the system and the unknown derivatives risk hidden out in the system, you see why it is important to stay alert and informed. And why we encourage readers to have a plan in mind in case there is another financial crisis someday. 

Today, things seem pretty stable overall. But we can see that there are risks lurking out there that could change things without much warning. That's kind of what the term "flash crash" suggests isn't it? Note that Jim Rickards and Nomi Prins mention they favor the idea of doing something to make the system "less dangerous" and "reduce volatility-contributing speculation." We should listen to these respected voices.

The time to prepare a plan is before an event. In a "flash crash" I doubt there would be any time left to start planning. A good plan provides peace of mind in case you need it, even as you hope you never have to use it. Kind of like owning insurance on your car or home.

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