Date created:12 November 1998

Last modified: 12 November 1998

Maintained by: John Quiggin

The case for a speculation tax

22 October 1998

In the wake of the US Federal Reserve's recent rescue of the hedge fund Long Term Capital Management, much fun has been made of its principals, economists Myron Scholes and Robert Merton, who received the 1997 Nobel prize for their analysis of the pricing of options and other derivatives. In fact, the episode demonstrates that Scholes and Merton understand not only financial markets, but also the political economy of regulation.

The efficient markets hypothesis says that, in the absence of inside information, it is impossible for anyone, even a Nobel prize-winner, to profit by predicting movements in market prices or exploiting arbitrage opportunities. Successful speculation must rely on some form of market inefficiency. LTCM and the banks that backed them exploited just such an ineffiency.

Using rules designed to allow wealthy individuals to gamble with their own money, LTCM was able to speculate without any regulatory restrictions. For every dollar of their own money, they borrowed ten from banks regulated and guaranteed by the Fed. This was multiplied further using derivative contracts, converting a few billion in equity into nearly $US 2 trillton in derivative positions.

Of course, while they were making profits they kept them. The economic insight which made Merton and Scholes worth the fortune LTCM paid them was that, when the bets went wrong, not only LTCM, but also its lenders, would be in trouble. Hence the Fed would be forced to step in and rescue them, as it did. In effect, Merton and Scholes capitalised profits and socialised losses on a trillion dollar scale.

The more fundamental lesson in all of this is that unrestricted capital markets will undermine any form of financial regulation, even prudential regulation. Governments must either take action to restrict flows of speculative capital or they must abandon any attempt to maintain the stability of the financial system. The crucial problem in the LTCM fiasco was that the banks were allowed, through their loans to LTCM, to bankroll speculation they would not have been permitted to undertake directly.

This problem can only be fixed by imposing rigid separation between financial institutions that are regulated and protected and those that are unregulated and unprotected. In this context, it is worth taking another look at the idea of a Tobin tax, that is, a small tax on international financial transactions. The standard objection to such a tax has been that it would simply drive speculators offshore. However, in the context of an internationally supported system of prudential regulation, this would be an advantage. Countries could choose to operate outside the Tobin tax net and the system of prudential regulation in the knowledge that they would not have access to the IMF if things went wrong. Financial institutions could choose to base themselves in these countries but would be unable to borrow from central banks or the institutions operating within their prudential control.

All of this is for the future, however. The immediate economic outlook arising from the financial crisis depends on the United States economy, which has experienced a sustained boom this decade. If this boom collapses, the outlook for the rest of the world is not good.

Many commentators have seen in the US boom evidence of a new 'miracle' economy, in which recessions are a thing of the past. Two kinds of miracle have been proclaimed. One version is that the technological marvels of the Internet have fundamentally changed the nature of economic activity. The other is that the massive increase in flows of capital and goods around the world, commonly called 'globalisation' rewards free market countries like the United States at the expense of the sclerotic welfare states of Europe.

For those of us who don't believe in miracles, howevre, the boom of the 1990s looks depressingly familiar. In every speculative boom, a theory is invented to show that this boom is different and will never end. The more appealing the theory and the longer the boom, the worse the subsequent crash.

The current economic crisis therefore provides something close to a crucial test. If the US economy comes through unscathed, it will be strong evidence in favour of claims of a free-market miracle. A slowdown or recession would add more support to the growing calls for a step back from deregulation.

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