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World Economic Problems For the Summit:
Coordination, Debt, and the Exchange Rate System

Dr. Rudiger Dornbusch

Bissell Paper Number Six
Centre for International Studies, University of Toronto
May, 1988

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Much of the discussion of international monetary reform has focussed on the sustainability of fixed rates and on what arrangements to select to enforce narrower bands. Leading proposals are those of McKinnon (1987a,b,c) and of Williamson and Miller (1987). But there is another perspective on the problem, namely, reduced volatility of capital flows. This is the proposal to put some sand in the wheels of financial engineering. We review the case in light of the recent experience with massive asset market instability to conclude that a financial transactions tax (covering all financial transactions, not only national ones) appears highly desirable.

Financial integration of international money markets has proceeded at an extraordinary scale and is by many considered irreversible. Technology in communications, the volatility of exchange rates and the creation of new products that exploit the latter two have opened up a range of financial opportunities that are not beyond suspicion. With so much integration, the system can only go in one of two directions. One possibility is to move in the direction of closer integration, toward a single money. The other is to keep exchange rates flexible and increase financial segmentation, creating speed limits and barriers for excessive capital mobility. This is the favorite policy of Tobin (1978).

One view of the development of integrated financial markets is that their expansion is quite possibly counterproductive. They seek to create liquidity and mobility for asset holders and in so doing they may create important social costs, Keynes ( 1934. chapter 12) offers a splendid description of the difference between "speculation" which is geared to making capital gains from uncovering the shifting psychological moods versus "enterprise" which seeks to earn income from the long-term holding of an asset. He condemned the market's pursuit of short-term capital gains rather than long-term holding yields when he wrote:

It might have been supposed that competition between expert professionals, possessing judgement and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant investor left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise . . . They are concerned, not with what an investment is really worth to a man who buys it "for keeps", but with what the market will value it at, under the influence of mass psychology, three months or a year hence . . . Of the maxims of orthodox finance, none, surely, is more antisocial than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of "liquid" securities. It forgets that there is no such things as liquidity, of investment for the community as a whole...

The battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not require gulls amongst the public to feed the maws of the professional - it can be played by professionals amongst themselves. For it is, so to speak, a game of Snap or of Old Maid, of Musical Chairs - a pastime in which he is victor who says "snap" neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid that is circulating, or that when the music stops some of the players will find themselves unseated.

Moreover, capital flows may destabilize policies that otherwise might be viable. A simplistic view of this problem is to assert that either policies are or they are not sustainable and that capital mobility merely tests, identifies and calls the bluff for policies that are not really sustainable. Of course, there is no such thing as a policy that is really sustainable, matching any and all tests. The difficulty is that to make a policy more credible, enough to meet a tough challenge from financial markets, one may have to go further in terms of budget or real wage cuts or interest rate increases than is prudent from a vantage point of political stability, economic growth and simply economic fairness. It is worth going back to Nurske's ( 1946) classic discussion of the French stabilization problems of the 1920s to recognize the destabilizing role of private capital. It is true. France did have budget problems and inflation, but how much of this was the result of capital flight? That the capital, by virtue of its mobility, should have a right to sit out safely in a tax haven the economic difficulties a country undergoes a difficult adjustment process needs a thorough challenge. The very mobility of capital aggravates stabilization problems.

Long-term capital should be unrestricted to take world savings to the places with the highest vield. Short-term capital mobility or round-tripping comes up poorly in cost-benefit analysis. Tobin ( 1978) has argued that short-run speculative capital flows do not serve a productive function but do impair the effective operation of policies. His conclusion is the following:

There are two ways to go. One is toward a common currency, common monetary and fiscal policy and economic integration. The other is toward greater financial segmentation between nations or currency areas, permitting their central banks and governments greater autonomy . . .

The particular form of intervention Tobin has recommended is a tax on all foreign exchange transactions. A given tax, says 1/2 percent, would reduce the advantage of a short-term round trip, but would make virtually no dent in the profitability of a long term direct investment project, The Tobin tax might profitably be extended to all sorts of domestic financial transactions, thus reducing the opportunity to create and profit from volatility. Indeed, it is interesting to note that Keynes (op. cit., p. 160) recommended that a government transfer tax on all security transactions would tilt the market toward the long view by penalizing trading for short-term capital gains:

The introduction of a substantial Government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States.

Unfortunately it is unlikely that governments will take on the financial industry by taxing short-term capital flows and financial engineering more generally. The spell of the efficiency of resource allocation by free and unfettered markets, which has full justification outside finance, unfortunately, carries over to this area where externalities abound. But even though governments are reluctant to recognize the problem, the fact remains that much of what goes by the name of capital flow has nothing to do with a socially productive allocation of resources. Significant financial vulnerability, and the increasing recognition that technology has driven markets to near-instantaneous capital gains mentality offers a healthy counterweight to the view that markets know best.

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