A Reuters article on plans by the European Union to impose a tax on foreign exchange transactions (actually the proposed tax would apply to a wide array of financial transactions, not just foreign exchange) reads like an editorial against such a tax. It tells readers that the tax could cause traders to leave the London market, that it would reduce liquidity and thereby increase volatility and also disrupt efforts to develop algorithms for intraday trading. It describes these as unintended consequences of the tax.

If it had talked to a proponent of the tax, she would have noted the size of the taxes being discussed would just raise transactions costs back to where they were in the 80s or 90s. The cost of trading has plummeted in the last 3 decades due to computers. This tax will simply reverse some of this decline. There was already an extremely well-developed market in foreign exchange in the 80s.

The effect of a tax on volatility is unclear. While it reduces the incentive for arbitrage, it will also make speculation less profitable. This could make large speculative swings of the sort that we have seen in financial markets in recent weeks less likely.

Finally, it is not clear why it views the fact that the tax will make it more difficult to construct trading algorithms as an unintended consequence. These algorithms may provide large profits to the people who develop them, but the benefits to the economy and society are likely to be near zero. If a transactions tax discourages skilled mathematicians and computer programmers from developing complex formulas for financial arbitrage and instead has them work in a productive area of the economy, then the tax will have been a great success.


[Addendum: Reuters does go a small bit of the way back toward saving its soul by running this column from my friend Mark Thoma.]

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