Enforceability: Finding a Home for Tobin Taxes

A few months ago, I had a discussion (read argument) with some more left-wing friends (full disclosure: I'd like a 30% smaller, highly localised state, with the rich paying for everything) about the Tobin Tax. A tax to be levied on a small percentage of the value of every foreign exchange transaction. Apparently this will stabilise the FX markets, making incidents like the Asian currency crisis less likely.

I don't believe the Tobin Tax would work, and I don't think it could function as its proponents believe. But speculative contracts do impose a dead weight on society. They tie-up courts with complex cases; they reduce the certainty of company accounts; they distort tax collection. The Tobin Tax is well intentioned in trying to reduce the spill-over effects of speculation, but increasing transaction costs will not necessarily produce any benefit.

We do have an excess of FX speculation today, but that excess is caused by cheap funding (courtesy of the Japanese central bank, and more recently, my UK tax bill) and the growth of the carry trade [borrow in a cheap currency, deposit into a higher yielding one]. The Asian currency crises were banking collapses caused by local cronyism hitting hard dollar peg constraints. Banks over-lent in their local currencies, sucked up cheap dollar funding to cover themselves, then relied on the state to exchange a now debased local currency for dollars at a fixed rate. Imposing small costs on FX transactions would not have stopped this from happening. It would not have altered the behaviour of Indonesian, or Thai, or Korean, bankers. (Or the current behaviour of Western ones.) Asia wasn't attacked by vicious capitalist fiends conspiring in Manhattan boardrooms, they dragged themselves under. Just like Britain on Black Wednesday. Or Iceland last year.

And the Tobin Tax would be ambiguous, both in terms of what actually constitutes a transaction, and more problematically "where" it has occurred. If I go to "the market" for FX today, the following may happen: I buy 14,000RMB for a trip to China, the Post Office sends me Red Maos by recorded post for 1200GBP, they source this cash partly from Chinese bank notes exchanged in the UK, and partly by buying new notes from the PBoC. The Post Office will buy $3m from an FX dealer at the end of the day, which would be held in a US bank on behalf of a British one. $175,000 might then be transfered to a Chinese bank's NYC branch, swapped for RMB under Chinese law that would then be used to pay the People's Bank of China for a delivery of notes. Under all this the banks concerned will then have to settle whatever the net debts are left between them through the CLS [Continuous Linked Settlement] system that operates between all the major international and central banks.

So do I pay Tobin Tax on my end delivery of 14,000RMB? Does it get taken out of the $3m that's settled in America? When the notes arrive at Southampton? When old RMB notes are exchanged for pounds at the Heathrow? For physical goods we have VAT to resolve these issues. Every producer charges VAT to their customers, and reclaims VAT on their own supplies. Eventually the end user, who has no suppliers, pays the accumulated VAT on the item. The chain begins when raw materials enter a juristiction, and ends with a consumer who removes the final good from the economy. With a Tobin VAT, we'd need to arbitarily designate someone as an end consumer, even though currency circulates endlessly.

A Tobin Tax would also have to designate what an FX transaction was. If I trade a 100 times with a broker over the course of a day, then settle the net amount in my home currency, does that count? Do we only count the net final central bank settlement at the CLS system, or the dozen phone calls that lead to it? Because that's how most speculative FX trading works.

(In the 60s, final settlement was often a suitcase of bank notes. And believe me, banks will go back to that if it saves them a few billion on tax.)

None of this is to say that you could not pass a Tobin Tax into law. Or that it would not raise revenue. Tax authorities can just interpret company accounts as they see fit, imposing charges based on their own judgement. It would be a haphazard tax, that struck international firms at random.

Where you can draw absolute boundaries on a business contract's location is in enforcement. When you take a case to court, you have to prove that the contact was binding; that the contract is now enforceable. After which that court can only enforce against the loser's assets within its own jurisdiction. Altering the terms by which speculative contracts can be enforced through national courts is a potential policy avenue for a Tobin Tax substitute. Doing this does not interfer with freedom of contract or action. The state is simply declining to use cohersion to enforce a particular form of private agreement. And it has a good precedent!

Under English law, gambling debts have traditionally been unenforceable. They might be acknowledged by the courts, but cannot be enforced through them. English law does not seek to prevent wagers; it only does not believe that enforcing them is just. If you owed a bookie money, all the bookie could do was blacklist you. This has not stopped the UK from developing a substantial gambling industry. The bookies just make sure to take the money upfront, or that the sums advanced are too small to be worth defaulting on. We British can gamble, but we can't drag ourselves under doing it. (Actually, the Gambling Act of 2005 made gambling debts enforceable in the UK. The government called it reform, so it must be better, right?) Which seems to me to be the sort of arrangement we would want to bring about in the swaps and derivatives markets.

Why not introduce an intermediate state between a commercial contract and a gambling contract? A formal legal category for speculative contracts. All those contracts that concern a transfer of value dictated by a future events in which neither party holds a direct commercial or insurable interest. These contracts can then be made enforceable if a stamp duty is paid. The stamp duty being a fraction of the value that could then be enforced. Only the contract submitted on payment of the tax would be enforced, and the maximum liability that could be sought would be that on which the tax was paid.

The collection of stamp duty would cause these contracts to be registered somewhere. Even if they were not public, potential trading partners could ask for them to be disclosed. Shareholders could pass motions barring their companies from entering those contracts. Anyone selling a hedging program would have to ask themselves very seriously if their contract was genuinely commercial.

With a tightly interpreted definition of a speculative contract, financial intermediaries would have to pre-commit themselves to structures that ensured their ability to meet obligations under derivative contracts. Like commodities exchanges, they would need to point at a physical supply of "stuff" that represents their commercial interest. Waving your arms in the air, and talking about your impeccable credit rating, would not matter. Even if counter-parties accepted it, the law would not give them with an enforceable claim.

None of this would prevent speculation. A hedge fund could deposit collateral upfront to cover their losses (which is normal practice today). It also would not stop structured notes from being created and sold. But these activities do not create contingent liabilities on the firms that indulge in them. The sum that has been risked is the only sum that can be lost. No-one would need to worry that the CFO had bet the firm on 5-year LIBOR [a benchmark interest rate for banks] cubed.

At the very least it would make people think twice, and push speculation by ordinary firms out to the fringes where it belongs.