Should Wall Street Brace for a Tobin Tax?

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Uncertainty about federal economic policy is greater today than any time in the last 40 years. On one hand we have senior policy makers calling for increasing already massive budget deficits, locking in the loosest imaginable monetary policy for the foreseeable future, and boosting taxes on businesses, Wall Street and the rich if inflation rates spike higher. On the other hand we have a President and senior economic officials who are solid members of an alliance among mainstream liberal academic economists and Wall Street executives who have dominated Democratic party economic thinking since the Carter administration.

In the absence of clear, credible pronouncements by top officials, a recent paper co-authored by Treasury Secretary Janet Yellen’s husband, Nobel laureate economist George Akerlof, may be our best insight into the Biden administration’s intentions. While the paper represents no official policy, it’s telling that Yellen is thanked in the acknowledgements, and Akerlof has collaborated with many Democratic-insider economists in the past.  

The paper is particularly valuable because it centers on one issue of dispute between academic liberal economists and Wall Street executives: Tobin taxes. The idea goes back to a 1972 lecture by Nobel laureate economist James Tobin. Tobin suggested that a tax on short-term financial transactions could make markets more stable and efficient. Many liberal economists find the idea appealing. Wall Street hates it.

So while Akerlof might have written about Tobin taxes without thinking of the political reaction, and his wife might have helped only with technical comments, this might be a suggestion that Wall Street input will be excluded from policy making and liberal economists will try to find common ground with progressives.

In arguing for a Tobin tax, the paper considers scheduled release of information about a security, like a corporate earnings announcement. It assumes dealers, market makers and proprietary trading firms will buy if the news is good and sell if it is bad. Despite the oversimplifications, the model correctly predicts that dealers and market makers position their inventories before scheduled announcements to best accommodate expected order flow. This is normally considered a good thing as it smooths the market impact of events. One of the complaints about the Dodd-Frank rules is that they discouraged holding long or short positions, leading to less efficient markets and widening bid/ask spreads.

The paper then introduces some transparent rhetorical tricks to make inventory positioning seem bad. The market makers holding inventory are called “front runners.” Front running is a crime where a broker or other agent transacts for itself before executing a client order. Akerlof stretches the definition to mean any pre-emptive action by a broker. This is no minor lapse, with the phrase used 100 times in the short paper. So the entirely legal and ethical practice of inventory management is labeled with a phrase referring to a criminal act.

Most market makers manage inventory passively. If they wish to accumulate a positive inventory, for example, they get slightly more aggressive in filling sell orders, and slightly less aggressive in filling buy orders. In the Akerlof model, market makers build inventory by seeking out “unsophisticated” investors. It seems to imagine that retail investors are ignorant about the scheduled information release and can be enticed to part with their securities by bids fractionally above the last transaction price. Anyway, whoever these people are, we’re supposed to want them to make more money. When “front runners” reduce their transaction costs by spreading out their orders, the “unsophisticated” investors make less money.

Finally, the paper points out that a tax on short-term transactions would discourage inventory positioning and deliver larger profits to the “unsophisticated” investors. Aside from all the other objections, taxing all financial transactions for the tiny fraction that represent market maker inventory positioning trades with unsophisticated retail investors is wildly out of proportion.

I can’t think of any scheduled information releases of the type the paper considers. Earnings announcements and other big news are usually scheduled when the market is closed, or are done during trading halts. Government statistics released during the trading day affect thousands of securities, and no market maker is adjusting inventory positions in thousands of securities a few minutes before release.

But it is the absurdity of the paper’s policy arguments that lead me to suspect it is a signal. Economists who read the paper will laugh and dismiss it. Non-economists who read second-hand accounts will seize on a paper by a Nobel laureate that supports financial transaction taxes. Liberal economists can shut up, and let the progressives get a win on an issue that many of them think isn’t a bad idea — certainly not as crazy as modern monetary theory or $25 per hour minimum wage. 

Most presidents have clear economic policy positions at the core of their campaigns. They may not adhere to them in office, but at least they give a baseline for prediction. Joe Biden, by contrast, juggled campaign statements that sounded like radical progressive modern monetary theory with conventional Clinton/Obama ideas. Since taking office there hasn’t been much clear talk, although policy proposals and leaked ideas seem to be pointing in the progressive direction.

There are other indications. When Democratic economic club member Larry Summers calls Biden’s fiscal policies “substantially excessive,” that likely means that many long-time party economists are uncomfortable. Further evidence of dissension is Janet Yellen admirer John Cochrane penning an open letter asking, “Why is the Janet Yellen I know and respect giving voice to such nonsense?”

Originally, currency transactions but the idea has been extended to all financial markets.

Progressives love Tobin taxes not because of the claims about stability and efficiency, but in hopes they can raise large amounts of money from rich people and "shady" Wall Street operators.

The paper posits a simple model in which dealers can hold only zero or one share, and points out that some of them will buy before an announcement since — with no ability to short — that’s the only way to make money if the news is bad. If you hold zero shares before an announcement and the news is bad you can’t sell. In the paper’s model, some market markets are long before announcement, some short, and therefore there are always some in a position to profit. The model also implies that total transaction costs will be lower if some of the dealers buy before announcement. In the modelthe reason is the transactions are spread out. In reality the reason is bid/ask spreads are higher and trading more competitive after the announcement.

That is, they are still providing liquidity to the market, only in a slightly biased way. If they are forced to act more quickly and take liquidity, that comes at a cost, which they prefer to avoid. Market makers and dealers make livings selling liquidity, not buying it.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

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