We are told that 26 out of 27 European leaders agreed to amend the Lisbon treaty, but David Cameron exercised Britain's veto. So the 26 will do as they wanted, but it won't be an EU agreement.
The leaders' statements raise more questions then they answer. Among them:
- Were they really hoping to revise the Lisbon treaty?
A revised treaty would have to be approved by all 27 parliaments, and the Irish would probably have to have a referendum (unless the Supreme Court decided the revision didn't substantially alter the character of the Union). It took two years and two Irish referendums to get the original Lisbon treaty ratified.
Cynics, including me, will have at least a passing suspicion that none of the countries really wanted unanimous agreement. It would suit everyone if the deal could be kept just this side of requiring an new referendum in Ireland. The 26 countries want to be seen to be tough on banks, especially Germany which has spent much more (Figure 1.6) than the UK on bail-outs. Cameron wants to be seen to be tough on the EU. This looks like a separation made in heaven.
- What exactly was it Merkel and Cameron couldn't agree on?
Sarkozy has made the clearest statement about this: he says the sticking point had been Mr Cameron's insistence on a protocol allowing London to opt out of proposed change on financial services. "We were not able to accept because we consider quite the contrary - that a very large and substantial amount of the problems we are facing around the world are a result of lack of regulation of financial services and therefore can't have a waiver for the United Kingdom." The word 'because' is being strained to breaking point there: there's nothing about the substance of the plan that requires new powers to regulate financial services.
This document gives an outline of the plan. The first ten clauses are concerned with the enforcement of budgetary discipline in the member states. The rest is about the new "European Stability Mechanism" (ESM). Clause 15 provides for qualified majority voting when emergency assistance is needed. There's nothing about financial regulation.
The major disagreement between the UK and the others has been on the proposed European Financial Transactions Tax: the rest of the EU wants a tax on business in London to be paid directly to Brussels and the UK doesn't. It's plausible that (unpublished) details of the proposed agreement would remove the UK's veto on this, and Cameron wouldn't agree.
- Why wouldn't Cameron tell us?
He said "We have protected Britain's financial services, and manufacturing companies that need to be able to trade their businesses, their products, into Europe. We've protected all these industries from the development of eurozone integration spilling over and affecting the non-euro members of the European Union". Which seems to be a suggestion joining the other 26 would make it harder for the UK to sell them stuff. Colour me sceptical on that one.
If the real sticking point was that he wanted to retain a veto on a Financial Transactions Tax, why not say so? OK, banks are not popular, but neither is giving money to the EU. Couldn't he have said "they want to impose a tax on business in London that would be paid directly to Brussels. I wouldn't agree to let them do that."? The only explanation that makes sense to me is that the 27 agreed not to be specific about the problem, so that each could spin it in their own way.
- What is Merkel's plan to save the Euro?
No one seriously imagines that austerity alone is going to do it. Cutting government spending never achieves the intended savings, because the government gets some proportion of its spending back in tax revenues. The underlying problem is in the balance of trade: if each country had its own currency then FX rates would have adjusted to prevent the imbalances getting too large. As it is, Italy, Spain, Portugal and Greece are all running large deficits. It would in theory be possible for austerity to reduce imports enough (except perhaps in Greece which has a problem collecting taxes), but that's a theory that requires people not to mind having their living standards crushed.
Last time I wrote about this I guessed that the markets guessed that she was going quietly to allow the ECB to undertake a massive programme of Quantitative Easing, using the money to buy PIGS bonds. There's still no sign of that. The plan as it stands seems to be to calm down the bond markets with more or less believable promises of austerity, with the ESM - a slightly souped up EFSF - to contain any local difficulties: it's hard to see that's going to be sufficient to let Italy refinance its debt at affordable interest rates.
What might work in the medium term would be for Germany to spend (you might prefer to say 'invest') its trade surplus in the PIGS. For example, it likes solar power: how about building solar cell factories in those countries, buying up land there where the sun shines a lot (this is not the hardest part) and covering it in solar power stations? That would help meet any undertakings the EU may make in Durban, and I think it would be a lot easier to persuade German voters to spend money on saving the planet than on supporting pensioners in Greece.
- Whose hand did Nicolas Sarkozy want to shake in Le Snub?
Sarkozy air kisses the hand of Dalia Grybauskaitė, president of Lithuania, then seems to swerve a handshake with Cameron, in favour of Dimitris Christofias, president of Cyprus. According to the Telegraph it was just a trick of the camera angle - "Mr Sarkozy was making eye contact with a man beyond Mr Cameron". According to me, Sarkozy was making a beeline for one man in the room whose hand he could shake without having to look up. (It's interesting that none of the newspapers' European correspondents is able to identify minor European presidents.)
- Has Ed Miliband got a plan?
According to Miliband, Cameron "mishandled these negotiations spectacularly". But how would he know, he wasn't there? Miliband has got a real chance of becoming Prime Minister in three years or so: he needs to start behaving like someone who can be taken seriously in that role. When commenting on international affairs, he should be saying something statesmenlike, along the lines of "it's unfortunate for Great Britain that the Prime Minister was unable to reach an agreement in the best interests of the country. I will be meeting with Mr Cameron to find out why he was unable to do so."
Saturday, 10 December 2011
Friday, 9 December 2011
More on marginal tax rates
In my post on optimum tax rates I mentioned as an afterthought that the 52% marginal direct tax rate in the UK goes through what seems to me to be a psychologically important level of 50%. Comments on a blog that's easier to read than this one have led me to expand on the point.
The analysis of optimum marginal tax rates depends on how much taxable income changes when the tax rate changes. Changes in taxable income can result from two causes: reduction of broad income and tax avoidance which reduces taxable income without the taxpayer actually earning less money.
Tax avoidance, through income timing or taking income in a different way, will involve careful planning, so all avoidable taxes should be considered. But reduction of broad income by trying less hard to earn money, or by moving overseas to a friendly tax regime, will be caused not so much by considered analysis of what's worth it for the money as by one's gut reaction to the marginal tax rate - "Do I really want to do this piece of work just so that Osborne can get 52% of the reward?"
In that context it seems to me that 50% is an important level to breach. It may be that the curve relating taxable income to marginal tax rate has a kink in it at about that level, so that either 42% or 62% might raise more revenue than 52%.
This is just speculation; empirical evidence would be hard to come by. One can't simply experiment with tax rates from year to year: a temporary change will see more elasticity than a permanent change, because some top-rate taxpayers are able to advance or defer their income.
The analysis of optimum marginal tax rates depends on how much taxable income changes when the tax rate changes. Changes in taxable income can result from two causes: reduction of broad income and tax avoidance which reduces taxable income without the taxpayer actually earning less money.
Tax avoidance, through income timing or taking income in a different way, will involve careful planning, so all avoidable taxes should be considered. But reduction of broad income by trying less hard to earn money, or by moving overseas to a friendly tax regime, will be caused not so much by considered analysis of what's worth it for the money as by one's gut reaction to the marginal tax rate - "Do I really want to do this piece of work just so that Osborne can get 52% of the reward?"
In that context it seems to me that 50% is an important level to breach. It may be that the curve relating taxable income to marginal tax rate has a kink in it at about that level, so that either 42% or 62% might raise more revenue than 52%.
This is just speculation; empirical evidence would be hard to come by. One can't simply experiment with tax rates from year to year: a temporary change will see more elasticity than a permanent change, because some top-rate taxpayers are able to advance or defer their income.
Optimum tax rates
Peter Diamond and Emmanuel Saez have published a paper which includes a calculation of the "optimal top marginal tax rate" in the USA, on the assumption that the only criterion is to maximize revenue - there is negligible social utility in letting rich people keep their income. The calculation has attracted considerable interest from on-line commentators. Nobel laureate Paul Krugman writes in the New York Times in defence of the criterion. Brad DeLong observes that Adam Smith disagrees, partly because the rest of us take vicarious pleasure in the rich enjoying their wealth. Richard Green fears that higher taxes on high earners might cause them to pay their servants less. Kevin Drum reports with evident satisfaction that according to one number in the paper the peak of the Laffer Curve is at a (US) Federal income tax of 76%, far above the current top rate of 35%.
In the UK, the "#1 economics blogger" Richard Murphy quotes Drum at length, and concludes that we are comfortably below the peak of the Laffer Curve. Murphy is not one to concern himself with details, but he seems simply to be noting that the top UK tax rate of 50% is a lot less than the 76% he's quoted.
Meanwhile, the UK's leading libertarian scandium oligopolist, Tim Worstall, asked his readers to calculate what tax rate in the UK, including employers' and employees' National Insurance and VAT, would be directly comparable with the tax numbers used by the paper for the USA, which includes the Medicare tax and state income and sales taxes. He used the analyses they (I might say 'we') submitted to declare that Murphy is wrong (that's always Worstall's conclusion) and that the true optimum top UK income tax rate is 40%.
As you might expect, I am going to adjudicate. First, an outline of what Diamond and Saez actually did: They assume, in line with extensive empirical research, that income at the top end follows a Pareto distribution, that is it has a probability density function falling off according to a power law, p(z) = C/z^(1+a). They find empirically that the parameter 'a' in the USA is 1.5 . Then they assume, following various other authors, that taxable income is an elastic function of retained earnings (in the economic sense of 'elastic', i.e. a given change in the logarithm of the fraction of marginal income not taken in tax results in a proportional change in the logarithm of taxable income reported). This is a convenient assumption, in that it means that a change in marginal tax rate leaves the power law shape unchanged, affecting only the value of 'C'. As the tax rate increases the fraction of income retained falls, so that a given change in tax rate has a larger proportional effect on the retained fraction, and hence a larger effect on taxable income reported (e.g. a tax rate change from 0% to 1% takes away one hundredth of your net income, but a change from 90% to 91% takes away a tenth). So with the elasticity assumption there is a critical tax rate at which the reduction in taxable income when the tax rate is increased balances out the extra tax raised by the higher rate - this is the optimum rate, which turns out to be 1/(1+elasticity.a), as the mathematically inclined reader may care to prove. The difficulty now is to determine the elasticity parameter. They report a mid-range estimate from the empirical literature of 0.25, but go on to use figures from another paper, also co-authored by Saez, which finds an elasticity of taxable income for top earners of 0.57, but only 0.17 for 'broad income', which they define as "Total Income less Capital Gains [and] Social Security Benefits". The implication is that most of the elasticity is due to tax avoidance rather than reduced income.
How applicable is this to the UK? The Pareto distribution seems to hold quite generally, but the power law may be different: this paper reports a=1.37 in the USA and a=1.06 in the UK. I would expect the 'broad income' elasticity to be somewhat higher in the UK, because high-earning Britons are more likely than Americans to move overseas, if only because Americans are discouraged by the extraordinary geographical range of American tax laws. But I would expect the taxable income elasticity to be smaller in the UK, because there are fewer deductions available.
What taxes is it appropriate to include in a UK calculation? Income tax obviously, and the 2% top rate employees' national insurance contribution (it's the same for the self-employed). This corresponds to the 1.45% employees' Medicare tax included in the US calculation. Also included in the US calculation are the 1.45% employers' Medicare tax and 40% of average (state) sales taxes, which is 2.32% Analogously, we should include employers' NI of 13.8% and some fraction of the 20% VAT rate. But I'm unconvinced that this is right. The relevant taxes in the USA are quite small, so Diamond and Saez may have included them just to avoid argument. In the UK the issue is more important, and deserves some consideration. It seems to me that tax avoidance schemes are chosen by careful calculation of their benefits, but scaling of effort in response to tax changes is more emotional: I doubt that many people would think of employers' NI as a consideration there. However, the incidence of employers' NI is considered to be largely on the employee, so it may make working abroad relatively attractive financially. Regarding VAT, I doubt that much of the marginal income of high earners goes on goods subject to VAT. For the most part, a person earning well into six figures buys whatever retail goods they feel like already. And psychologically, paying tax when you buy stuff does not affect your attitude to earning money in the same way as having to hand more than half of it over to the government as you get it.
My rough numbers: a=1.25, broad income elasticity = 0.27, taxable income elasticity = 0.4, optimum combined marginal tax rate = 67%. Employer's NI contributing to elasticity effect = 2%, VAT contributing to elasticity effect = 5%, Marginal income tax rate net of 2% employees' NI to give 67% combined rate = 62%
There's a good bit of guesswork in the parameters I've used, so there's no reason why anyone else should get the same answer. But I think it's pretty hard to defend the choice of elasticities of either 0.57 in the UK (Worstall) or 0.17 in the USA (Drum).
In the interests of full disclosure I should say that I've paid tax at the 50% rate ever since it was introduced. I may not do so in the 2012-13 tax year. I can tell you that there's a psychological impact from direct taxes exceeding half one's marginal earnings: it's OK for you not to care.
In the UK, the "#1 economics blogger" Richard Murphy quotes Drum at length, and concludes that we are comfortably below the peak of the Laffer Curve. Murphy is not one to concern himself with details, but he seems simply to be noting that the top UK tax rate of 50% is a lot less than the 76% he's quoted.
Meanwhile, the UK's leading libertarian scandium oligopolist, Tim Worstall, asked his readers to calculate what tax rate in the UK, including employers' and employees' National Insurance and VAT, would be directly comparable with the tax numbers used by the paper for the USA, which includes the Medicare tax and state income and sales taxes. He used the analyses they (I might say 'we') submitted to declare that Murphy is wrong (that's always Worstall's conclusion) and that the true optimum top UK income tax rate is 40%.
As you might expect, I am going to adjudicate. First, an outline of what Diamond and Saez actually did: They assume, in line with extensive empirical research, that income at the top end follows a Pareto distribution, that is it has a probability density function falling off according to a power law, p(z) = C/z^(1+a). They find empirically that the parameter 'a' in the USA is 1.5 . Then they assume, following various other authors, that taxable income is an elastic function of retained earnings (in the economic sense of 'elastic', i.e. a given change in the logarithm of the fraction of marginal income not taken in tax results in a proportional change in the logarithm of taxable income reported). This is a convenient assumption, in that it means that a change in marginal tax rate leaves the power law shape unchanged, affecting only the value of 'C'. As the tax rate increases the fraction of income retained falls, so that a given change in tax rate has a larger proportional effect on the retained fraction, and hence a larger effect on taxable income reported (e.g. a tax rate change from 0% to 1% takes away one hundredth of your net income, but a change from 90% to 91% takes away a tenth). So with the elasticity assumption there is a critical tax rate at which the reduction in taxable income when the tax rate is increased balances out the extra tax raised by the higher rate - this is the optimum rate, which turns out to be 1/(1+elasticity.a), as the mathematically inclined reader may care to prove. The difficulty now is to determine the elasticity parameter. They report a mid-range estimate from the empirical literature of 0.25, but go on to use figures from another paper, also co-authored by Saez, which finds an elasticity of taxable income for top earners of 0.57, but only 0.17 for 'broad income', which they define as "Total Income less Capital Gains [and] Social Security Benefits". The implication is that most of the elasticity is due to tax avoidance rather than reduced income.
How applicable is this to the UK? The Pareto distribution seems to hold quite generally, but the power law may be different: this paper reports a=1.37 in the USA and a=1.06 in the UK. I would expect the 'broad income' elasticity to be somewhat higher in the UK, because high-earning Britons are more likely than Americans to move overseas, if only because Americans are discouraged by the extraordinary geographical range of American tax laws. But I would expect the taxable income elasticity to be smaller in the UK, because there are fewer deductions available.
What taxes is it appropriate to include in a UK calculation? Income tax obviously, and the 2% top rate employees' national insurance contribution (it's the same for the self-employed). This corresponds to the 1.45% employees' Medicare tax included in the US calculation. Also included in the US calculation are the 1.45% employers' Medicare tax and 40% of average (state) sales taxes, which is 2.32% Analogously, we should include employers' NI of 13.8% and some fraction of the 20% VAT rate. But I'm unconvinced that this is right. The relevant taxes in the USA are quite small, so Diamond and Saez may have included them just to avoid argument. In the UK the issue is more important, and deserves some consideration. It seems to me that tax avoidance schemes are chosen by careful calculation of their benefits, but scaling of effort in response to tax changes is more emotional: I doubt that many people would think of employers' NI as a consideration there. However, the incidence of employers' NI is considered to be largely on the employee, so it may make working abroad relatively attractive financially. Regarding VAT, I doubt that much of the marginal income of high earners goes on goods subject to VAT. For the most part, a person earning well into six figures buys whatever retail goods they feel like already. And psychologically, paying tax when you buy stuff does not affect your attitude to earning money in the same way as having to hand more than half of it over to the government as you get it.
My rough numbers: a=1.25, broad income elasticity = 0.27, taxable income elasticity = 0.4, optimum combined marginal tax rate = 67%. Employer's NI contributing to elasticity effect = 2%, VAT contributing to elasticity effect = 5%, Marginal income tax rate net of 2% employees' NI to give 67% combined rate = 62%
There's a good bit of guesswork in the parameters I've used, so there's no reason why anyone else should get the same answer. But I think it's pretty hard to defend the choice of elasticities of either 0.57 in the UK (Worstall) or 0.17 in the USA (Drum).
In the interests of full disclosure I should say that I've paid tax at the 50% rate ever since it was introduced. I may not do so in the 2012-13 tax year. I can tell you that there's a psychological impact from direct taxes exceeding half one's marginal earnings: it's OK for you not to care.
Tuesday, 6 December 2011
And then there were none
There used to be one tolerably sane candidate seeking the Republican nomination for the US presidency. Not any more. Here's John Huntsman revising his position on climate change:
there are questions about the validity of the science — evidence by one university over in Scotland recentlyI think he means the University of East Anglia. It's reassuring to note that he's wrong about the geography as well.
Saturday, 3 December 2011
FTT and stock market crashes
Could a Financial Transactions Tax in Europe avert major falls in equity markets? I'm going to consider this in the light of major equity index falls working backwards from now.
1) The Eurozone debt crisis sell-off starting in July 2011.
Between 7th July and 24th November this year the FTSE fell by 14.6% in reaction to the Eurozone debt crisis. Its hard to see how an FTT on shares could have had much of an effect on that. It's possible that an FTT on bonds (which is also part of the proposal) could have slightly reduced the falls in sovereign bond prices, but the underlying problem is the massive deficit and debt problems of several Euro countries. (I've put an end date to the sell off at the recent market low, but I'm not promising the decline in equity prices is over.)
2) The Flash Crash of 6th May 2010.
Starting at about 2:40pm on the east coast, the S&P and other major indexes fell about 5% over 5 minutes, then recovered their losses over the next 10 minutes. The exact causes are not definitely known, but it's certain that high-frequency trading played an important part. It's probable that the crash wouldn't have happened had there been an FTT in the US.
However, the temporary crash had no effect on European markets, which were closed. Had the crash occurred earlier in the day, there would have been some reaction in Europe, which would have been smaller with an FTT than without. There's no way to quantify this.
3) The Financial Crisis sell-off between October 2007 and March 2009.
Between the end of October 2007 and 3rd March 2009 the FTSE lost 47.7% of its peak value. This was one effect of a global financial crisis caused by the collapse of a credit boom built on the back of rising US house prices. Banks had built up extraordinary levels of exposure to mortgage-backed securities, but an FTT would have affected this not at all.
4) 9/11
The FTSE fell 5.72% on 11th September 2001, in reaction to terrorist attacks in New York. This was the only one of the ten biggest one-day percentage falls not to have happened in either October 1987 or during 2008. The fall was a rational response to the information then available about the attacks (which occurred during the European afternoon). An FTT would have been irrelevant.
5) The collapse of the tech bubble at the beginning of the third millennium
After reaching a new high on the last trading day of the century, the FTSE fell progressively, reaching a low on 12th March 2003, by which time it had lost 52.6% of its peak value. A lot happens in three years, but the simple explanation is that there was a gradual re-evaluation of the true value of the internet market. An FTT would have no bearing on this.
6) The Russian Financial crisis and the collapse of LTCM, July-October 1998
Between 20th July and 8th October 1998 the FTSE fell by 24% as a result of a financial crisis in Russia and in a reaction to the (not unrelated) failure of the hedge fund Long-Term Capital Management on 23rd September. The market recovered the LTCM part of its losses over the following eight days as it became apparent that the damage had been contained.
It would probably have been impossible for LTCM to have executed its strategies in the presence of an FTT in the USA, so its boom and bust never would have happened. An FTT in Europe would have made little difference to it. So an FTT in the USA could have averted the last 6.6% of the fall.
7) Black Monday, October 1987
The FTSE fell 5.4% on Friday 16th October, and 5.7% on Monday 19th. The major action happened in the US market, which fell precipitously after the FTSE had closed: the S&P lost 20.4% on the day. As a result, the FTSE opened on the 20th down another 18.1%.
The causes of this one were complex. The losses on the 19th seem to have been accelerated by program trading and portfolio insurance strategies in the US. It's possible that an FTT would have discouraged the development of these strategies.
***
Of the seven market falls I've looked at, one, which had no effect in Europe, would probably have been prevented by an FTT in the USA, one would probably have been reduced by it by about a quarter, and one might have been reduced by an unknown amount. None would have been significantly affected by an FTT in Europe.
It's not surprising that an FTT would have more effect in the USA. For regulatory reasons, most share trading in the USA is done on (electronic) exchanges, which makes automated trading much more profitable. In Europe, similar exchanges exist but most large share trades are OTC (over-the-counter).
***
While writing this, I came across this BBC analysis which covers many of the same events (without reference to a Financial Transactions Tax).
1) The Eurozone debt crisis sell-off starting in July 2011.
Between 7th July and 24th November this year the FTSE fell by 14.6% in reaction to the Eurozone debt crisis. Its hard to see how an FTT on shares could have had much of an effect on that. It's possible that an FTT on bonds (which is also part of the proposal) could have slightly reduced the falls in sovereign bond prices, but the underlying problem is the massive deficit and debt problems of several Euro countries. (I've put an end date to the sell off at the recent market low, but I'm not promising the decline in equity prices is over.)
2) The Flash Crash of 6th May 2010.
Starting at about 2:40pm on the east coast, the S&P and other major indexes fell about 5% over 5 minutes, then recovered their losses over the next 10 minutes. The exact causes are not definitely known, but it's certain that high-frequency trading played an important part. It's probable that the crash wouldn't have happened had there been an FTT in the US.
However, the temporary crash had no effect on European markets, which were closed. Had the crash occurred earlier in the day, there would have been some reaction in Europe, which would have been smaller with an FTT than without. There's no way to quantify this.
3) The Financial Crisis sell-off between October 2007 and March 2009.
Between the end of October 2007 and 3rd March 2009 the FTSE lost 47.7% of its peak value. This was one effect of a global financial crisis caused by the collapse of a credit boom built on the back of rising US house prices. Banks had built up extraordinary levels of exposure to mortgage-backed securities, but an FTT would have affected this not at all.
4) 9/11
The FTSE fell 5.72% on 11th September 2001, in reaction to terrorist attacks in New York. This was the only one of the ten biggest one-day percentage falls not to have happened in either October 1987 or during 2008. The fall was a rational response to the information then available about the attacks (which occurred during the European afternoon). An FTT would have been irrelevant.
5) The collapse of the tech bubble at the beginning of the third millennium
After reaching a new high on the last trading day of the century, the FTSE fell progressively, reaching a low on 12th March 2003, by which time it had lost 52.6% of its peak value. A lot happens in three years, but the simple explanation is that there was a gradual re-evaluation of the true value of the internet market. An FTT would have no bearing on this.
6) The Russian Financial crisis and the collapse of LTCM, July-October 1998
Between 20th July and 8th October 1998 the FTSE fell by 24% as a result of a financial crisis in Russia and in a reaction to the (not unrelated) failure of the hedge fund Long-Term Capital Management on 23rd September. The market recovered the LTCM part of its losses over the following eight days as it became apparent that the damage had been contained.
It would probably have been impossible for LTCM to have executed its strategies in the presence of an FTT in the USA, so its boom and bust never would have happened. An FTT in Europe would have made little difference to it. So an FTT in the USA could have averted the last 6.6% of the fall.
7) Black Monday, October 1987
The FTSE fell 5.4% on Friday 16th October, and 5.7% on Monday 19th. The major action happened in the US market, which fell precipitously after the FTSE had closed: the S&P lost 20.4% on the day. As a result, the FTSE opened on the 20th down another 18.1%.
The causes of this one were complex. The losses on the 19th seem to have been accelerated by program trading and portfolio insurance strategies in the US. It's possible that an FTT would have discouraged the development of these strategies.
***
Of the seven market falls I've looked at, one, which had no effect in Europe, would probably have been prevented by an FTT in the USA, one would probably have been reduced by it by about a quarter, and one might have been reduced by an unknown amount. None would have been significantly affected by an FTT in Europe.
It's not surprising that an FTT would have more effect in the USA. For regulatory reasons, most share trading in the USA is done on (electronic) exchanges, which makes automated trading much more profitable. In Europe, similar exchanges exist but most large share trades are OTC (over-the-counter).
***
While writing this, I came across this BBC analysis which covers many of the same events (without reference to a Financial Transactions Tax).
Thursday, 1 December 2011
Hypersensitivity
The BBC, in an article about AIDS funding, lists the ten leading causes of death in high, middle, and low-income countries. It seems that about 2% of global mortality is due to "hypersensitive heart disease". I think it's rather tactless of the BBC to say so - mightn't it hurt the poor darling's feelings?
This isn't spelling correction software doing its worst - "turberculosis" is also on the list.
But this is a serious subject, so on a more serious note: why won't the BBC link to its sources? The data come from this WHO report (the WHO gets the names of the diseases right). There's a list of countries by income group on page 170 here: the list is derived from a World Bank spreadsheet.
Update: The BBC has deleted the list. Here's a screenshot:
This isn't spelling correction software doing its worst - "turberculosis" is also on the list.
But this is a serious subject, so on a more serious note: why won't the BBC link to its sources? The data come from this WHO report (the WHO gets the names of the diseases right). There's a list of countries by income group on page 170 here: the list is derived from a World Bank spreadsheet.
Update: The BBC has deleted the list. Here's a screenshot:
The FTT, noise trading, and volatility
I summarized quite a lot of research in my post about the FTT and volatility with an airy "There are other high-frequency noise effects which have been theoretically analysed". I'll say a bit more.
First, except in the special circumstances I discussed previously, speculative trading can increase volatility only if it loses money. As Milton Friedman noted in his seminal 1953 paper The Case For Flexible Exchange Rates
But there is only so much money that unsuccessful speculators are willing to lose, so the capacity for speculators to increase volatility is limited. (Bankers have lost apocalyptic amounts of money in the last few years, but not on speculative trading of the sort that might be discouraged by an FTT.)
Nevertheless, the review paper I discussed previously cited no fewer than twelve papers attempting to predict the effect on volatility of a transaction tax. (The ante-penultimate link doesn't now work, and the paper, which is good, doesn't discuss volatility directly.) Each of them sets up an a model of a securities market, and predicts how it will operate with and without a transaction tax by means of theoretical analysis, or by computer simulation of trading strategies, or by having humans playing a trading game.
An essential component for a transaction tax to be able to reduce volatility in these models is the existence of what Fischer Black (of Black-Scholes) called "noise traders". These are traders who speculate in the market without having any information not already priced in, as distinct from "information traders". In Black's conception, traders often do not know which sort of trader they are, which creates uncertainty essential for the operation of a liquid market. The papers I list do not all follow the definition exactly, but they incorporate the concept in some form. Their results seem to depend on to the extent that the way the market is modelled tends to cause the transactions tax to discourage noise traders more than others.
None of the papers has a set-up which is much like actual equity markets: this is partly because they are analysing something like the Tobin tax proposed for FX markets and partly because it's often easier to analyse something other than reality. But it's the equity market that the proposed European FTT is mainly concerned with (the FX market is excluded). And none of the papers includes the full range of trading strategies that operate in actual markets.
A noise trader whose decisions are indistinguishable from random will add a small amount of volatility, and tend gradually to lose money. I am sceptical that there are many traders of this sort. Most speculative traders follow some sort of strategy, broadly the strategies are either trend-following or contrarian. (One of the papers listed explicitly includes both these strategies; others may do so implicitly by using human traders in their simulations.) It's important to include the trend-followers to give a transactions tax a fair chance to reduce volatility significantly
If I were to attempt something like this I would want to include at least the following:
- large trades being executed gradually. This would feed a series of trades in the same direction, with the broker varying the size and timing in an attempt to disguise what he's doing. These trades are profitable for trend-followers
- trades being done for exogenous reasons. These are not strictly noise trades, and will not be deterred by a small transactions tax, but their size and direction looks random.
- information trades (some authors call them fundamental trades). These are done by traders who have used private aptitude to deduce fundamental valuations from public information.
- hedge trades. These are trades done by option traders who are in aggregate either long or short gamma. If option traders are short gamma their hedging tends to increase volatility, and vice versa.
- insider trades. These are trades done using information that is not yet public, but is made public after some time delay. These trades are profitable for trend-followers.
- trend-following speculative trades.
- contrarian speculative trades.
- speculative trades attempting to profit at the expense of other speculative strategies
- a stochastic process for the fundamental value. All traders will be aware of the direction of large changes in fundamental value (corresponding to obviously important news).
That's a lot of things to put in, and a lot of parameters and relative weightings to vary. However, there are only three sorts of trades which tend to increase volatility - short gamma hedging, unsuccessful trend trades (successful trend trades don't increase volatility, they just bring the price change forward), and trades parasitic on trend trades. If things are set up so that trend trading is profitable despite being unsuccessful quite often then a transactions tax sufficient to make it unprofitable can decrease volatility significantly. Note that trend traders do need to trade quite often, because they need to unwind their position quickly if a trend they've traded on fails to continue.
My guess is that with some care it would be possible to create a set-up where this happens. More tentatively, I guess that the actual market doesn't match it.
First, except in the special circumstances I discussed previously, speculative trading can increase volatility only if it loses money. As Milton Friedman noted in his seminal 1953 paper The Case For Flexible Exchange Rates
People who argue that speculation is generally destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on the average sell when the currency is low in price and buy when it is high.That does not mean that individual speculators cannot profit from activities that increase volatility, but they can do so only at the expense of other speculators. Consider a market in which trend-following speculators are active. An ingenious speculator might create an artificial trend by buying a stock in sufficient volume, causing the trend-followers to start buying into the trend, driving the stock higher. When the clever guy judges the trend-followers have filled their boots, he'll dump the stock at the higher price, locking in a profit. The stock will thereafter gradually revert to whatever it's really worth, and at some point the trend-followers will sell out, realising their losses.
But there is only so much money that unsuccessful speculators are willing to lose, so the capacity for speculators to increase volatility is limited. (Bankers have lost apocalyptic amounts of money in the last few years, but not on speculative trading of the sort that might be discouraged by an FTT.)
Nevertheless, the review paper I discussed previously cited no fewer than twelve papers attempting to predict the effect on volatility of a transaction tax. (The ante-penultimate link doesn't now work, and the paper, which is good, doesn't discuss volatility directly.) Each of them sets up an a model of a securities market, and predicts how it will operate with and without a transaction tax by means of theoretical analysis, or by computer simulation of trading strategies, or by having humans playing a trading game.
An essential component for a transaction tax to be able to reduce volatility in these models is the existence of what Fischer Black (of Black-Scholes) called "noise traders". These are traders who speculate in the market without having any information not already priced in, as distinct from "information traders". In Black's conception, traders often do not know which sort of trader they are, which creates uncertainty essential for the operation of a liquid market. The papers I list do not all follow the definition exactly, but they incorporate the concept in some form. Their results seem to depend on to the extent that the way the market is modelled tends to cause the transactions tax to discourage noise traders more than others.
None of the papers has a set-up which is much like actual equity markets: this is partly because they are analysing something like the Tobin tax proposed for FX markets and partly because it's often easier to analyse something other than reality. But it's the equity market that the proposed European FTT is mainly concerned with (the FX market is excluded). And none of the papers includes the full range of trading strategies that operate in actual markets.
A noise trader whose decisions are indistinguishable from random will add a small amount of volatility, and tend gradually to lose money. I am sceptical that there are many traders of this sort. Most speculative traders follow some sort of strategy, broadly the strategies are either trend-following or contrarian. (One of the papers listed explicitly includes both these strategies; others may do so implicitly by using human traders in their simulations.) It's important to include the trend-followers to give a transactions tax a fair chance to reduce volatility significantly
If I were to attempt something like this I would want to include at least the following:
- large trades being executed gradually. This would feed a series of trades in the same direction, with the broker varying the size and timing in an attempt to disguise what he's doing. These trades are profitable for trend-followers
- trades being done for exogenous reasons. These are not strictly noise trades, and will not be deterred by a small transactions tax, but their size and direction looks random.
- information trades (some authors call them fundamental trades). These are done by traders who have used private aptitude to deduce fundamental valuations from public information.
- hedge trades. These are trades done by option traders who are in aggregate either long or short gamma. If option traders are short gamma their hedging tends to increase volatility, and vice versa.
- insider trades. These are trades done using information that is not yet public, but is made public after some time delay. These trades are profitable for trend-followers.
- trend-following speculative trades.
- contrarian speculative trades.
- speculative trades attempting to profit at the expense of other speculative strategies
- a stochastic process for the fundamental value. All traders will be aware of the direction of large changes in fundamental value (corresponding to obviously important news).
That's a lot of things to put in, and a lot of parameters and relative weightings to vary. However, there are only three sorts of trades which tend to increase volatility - short gamma hedging, unsuccessful trend trades (successful trend trades don't increase volatility, they just bring the price change forward), and trades parasitic on trend trades. If things are set up so that trend trading is profitable despite being unsuccessful quite often then a transactions tax sufficient to make it unprofitable can decrease volatility significantly. Note that trend traders do need to trade quite often, because they need to unwind their position quickly if a trend they've traded on fails to continue.
My guess is that with some care it would be possible to create a set-up where this happens. More tentatively, I guess that the actual market doesn't match it.
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