Nobel Prize winner James Tobin has warned that free capital markets with flexible exchange rates encourage short-term speculation that can have a ”devastating impact on specific industries and whole economies”. To avoid this real economic havoc, he advocates a 0.5% tax on all foreign exchange transactions in order to deter speculators, a remedy dubbed the ”Tobin tax”.
But according to Professor Paul Davidson, writing in the latest issue of the Economic Journal, while Tobin”s diagnosis is accurate, the prescription is too timid and would damage international trade far more than it reduced speculative excesses. What is needed, he argues, is a more fundamental reform of the international monetary system, one that puts ”boulders” rather than ”grains of sand” in the wheels of international finance while, at the same time, creating incentives for a return to global full employment.
Davidson proposes an eight-point programme for reforming the world”s payment system, one that will restore to the global economy: a golden age of low unemployment; rapid economic growth; and a stable international competitive structure which allows nations to specialise in the industries where they have comparative advantage.
His key proposals are:
• To fix exchange rates to maintain relative real wage-cost relationships among nations.
• To prevent ”hot money” international portfolio flows from dominating changes in exchange rates.
• To prevent any domestic inflationary tendencies from spilling over to a nation”s trading partners.
• To redistribute much of the onus for resolving the existence of persistent international payment imbalances from deficit nations to surplus nations.
According to Davidson, the redistribution of this burden will be in the interests of both sets of nations: it will prevent the collapse of the surplus nations” export markets while permitting deficit nations to adjust without deliberately deflating their domestic economy. What”s more, the surplus nations have more resources to resolve the problem than the deficit nations. If this proposal were to be adopted, then governments would be able (as they were during the pre-1973 period) to use interest rate policy and government cooperation with private investment initiatives to achieve full employment without stirring up any global inflationary forces.
Davidson notes that the post-war period to 1973 was a Golden Age with annual growth of 4.9% inaverage OECD real GDP per capita. This Golden Age was fostered by the Bretton Woods international monetary system, a system shaped by Keynes” 1940s argument that flexible exchange rates and free international capital mobility are incompatible with the goals of achieving global full employment and rapid economic growth.
Abandonment of the international monetary system that embedded Keynes” principles brought this Golden Age to a close. Davidson believes that it explains why, since 1973, the OECD economies have experienced slower economic growth, rising global unemployment and increasing inequality. Since 1974, Nobel Prize winner James Tobin has been almost the only voice with significant visibility in the economics profession warning that free capital markets with flexible exchange rates encourage short-term speculation, which in turn has a ”devastating impact on specific industries and whole economies”. To avoid this real economic havoc, Tobin advocates that governments impose constraints on speculative international financial flows via a global ”Tobin tax”– a 0.5% ad valorem tax on all foreign exchange transactions.
Davidson argues that Tobin”s diagnosis of why the flexible exchange rate system has such devastating deflationary real effects on the global economy is correct. But he believes that Tobin”s tax remedy is not only too timid a marginal adjustment to achieve what he claims it will, but will also produce a greater hindrance to real international trade flows and (stabilising) arbitrage exchange rate transactions — far more than any the small reduction in speculative excesses that it can achieve. A more fundamental reform of the international monetary system embodying an updated version of the principles that Keynes regarded as essential for the post-war international payments system is required.
”Are Grains of Sand in the Wheels of International Finance Sufficient to Do the Job when Boulders are Often Required?” by Professor Paul Davidson is published in the May 1997 issue of the Economic Journal. Davidson holds the Holly Chair of Excellence in Political Economy in the Economics Department at the University of Tennessee, Knoxville, Tennessee 37996-0550.
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