Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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