In praise of noise

Lord Turner, the head of the UK FSA has gone on record in support of the Tobin Tax as part of the regulatory response to the global financial crisis. I think this idea is completely mistaken.

Short term “noise” traders played no role in the crisis. On the contrary, one could argue that the lack of noise traders in key asset classes like real estate and some pegged currencies contributed to the crisis. The “great moderation” was characterized by low volatility which lulled everybody into complacency. The excess volatility that noise traders are usually accused of generating would actually have been a good thing during the great moderation. The crisis was caused not by volatility but by tail risk and attempts to reduce volatility usually increase tail risk.

Rather than a Tobin tax, perhaps we should consider a Tobin subsidy in asset classes like real estate where there are too few noise traders. For example, anybody who sells a house within a month of buying it could get a refund of stamp duties and other taxes paid when the house was bought. In other words, the optimal rate for financial stability purposes of the Tobin tax is inversely related to the volatility of the asset class and is probably negative for many of the asset classes that were affected by the global financial crisis.

If we want to use fiscal policy to promote financial stability, I think an MM tax (more precisely, the complete or partial withdrawal of the MM subsidy) on leverage would be a much better idea. The MM (Modigliani-Miller) analysis shows that a key reason for leverage is the tax advantage arising from the tax deductibility of the interest paid on debt. If we impose an MM tax, then debt would be used mainly for its governance advantages (Jensen-Meckling). A huge deleveraging of the financial sector would become regulatorily feasible and that would be a good thing.

Posted at 3:34 pm IST on Tue, 1 Sep 2009         permanent link

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