The Cult of impotence

By Linda McQuaig, Special to The Toronto Star, 22 March 1998

MAKING SURE THE RICH STAY RICH

Second of two excerpts from a new book by economics writer Linda McQuaig

Paul Martin hoped the Tobin tax would help the poor. His officials were horrified.

Rodney Schmidt was about as low as one could be on the finance department totem pole and still have a Ph.D. in economics. After doing his doctorate in international finance at the University of Toronto, Schmidt had joined the department in Ottawa as an entry-level economist and, after two years, he had risen one notch to a slightly more senior but still low-level rank.

It wasn't exactly a meteoric rise, but Schmidt could be said to be doing relatively well for someone his age (36) in the hard-pressed '90s. Married with two young children, he already owned a house in the pleasant, shady-treed neighbourhood of Holland Cross in western Ottawa. In many ways, he had all the characteristics of a young up-and-comer in the finance department: bright, articulate, anglo, white, male. There was only one characteristic that made him seem a little different than the others in the department - a tendency toward independent thinking.

Schmidt was pleased in the spring of '94 to get what promised to be a very interesting assignment. He was to investigate the feasibility of something called the Tobin tax. Schmidt knew vaguely about the Tobin tax; it was an idea that had been proposed by Nobel prize-winning economist James Tobin as an ambitious method of taxing the vast sums of money swirling around the world each day in international currency transactions.

It was an idea that the international financial community hated and it therefore had little chance of ever being implemented. But it was an intriguing concept, nonetheless, because it appeared to offer enormous benefits for those outside the financial community; that is, for most of the world's population.

What made Schmidt's little research project particularly fascinating was the fact that, as he was to discover, it came about because Finance Minister Paul Martin himself had expressed an interest in the tax and the possibility of raising it at an upcoming Group of 7 meeting in Halifax.

As he settled in to work, Schmidt knew there was only one problem: His superiors had made it clear that his task was to come up with reasons to convince the minister that the tax was not a good idea.

Despite the almost ceaseless efforts of deputy minister David Dodge and other senior officials, there remained a small part of Paul Martin's brain that hadn't been fully won over to the finance department's rigid free-market orthodoxy. One indication of Martin's slightly off-beat orientation was the interest he took in the Tobin tax.

In a way, the tax was right up Martin's alley. The notion of such a grand, visionary scheme as taxing affluent speculators in order to feed Third World children, fund the cleanup of Chernobyl-style disasters or assist in Canadian deficit reduction appealed to Martin's innovative, activist side. Perhaps it gave him the feeling of potency.

Cut off from doing anything constructive to strengthen social programs or create jobs in the country where he actually wielded considerable power, Martin could at least cheer himself up by dabbling in remote, impossible schemes to make the whole world a better place.

In fact, Martin was aware there was some high-level support for the tax in other countries.

Lloyd Bentsen, who was at the time secretary of the U.S. treasury, was supportive, as Martin discovered when he began raising the subject informally at the regular meetings of G-7 finance ministers. Furthermore, Lawrence Summers, deputy treasury secretary, had vigorously endorsed the idea of the Tobin tax in his academic writing before joining the Clinton administration.

There was also support from high levels within the French government.

On the other hand, there was opposition from other countries - notably Britain, which at the time had a Conservative government.

Inside Canada, there was also some political support beyond Martin. Even Prime Minister Jean Chretien was initially interested in the tax, and an official of his office was assigned to prepare a memo on the subject.

But if there was some support - or at least willingness to examine the issue further - in political circles, there was a resolute resistance to the tax on the part of senior finance department officials in Ottawa.

"I raised the issue at one of my first meetings of the G-7 finance ministers, and I think it led during the next three meetings to not letting me out of the sight of finance officials," Martin quipped in later comments to the North-South Institute's board of directors.

He went so far that day as to jest: "Almost anybody who has any sense of human understanding and compassion takes views that oppose the views of the department of finance!"

So Martin certainly wasn't surprised when the department's paper on the matter, written by Schmidt, supported the department's case against the tax. Despite his own misgivings, Schmidt had concluded, as instructed, that the tax was not workable. A meeting of senior officials from the finance department and the Prime Minister's Office had no trouble deciding the idea was not worth pursuing at the Halifax summit.

Yet, even as the idea of the Tobin tax was being quietly put to rest at the senior levels of the Canadian government, there was a development at the other end of the continent that provided the perfect illustration of why such a tax could help the world.

For Canadians lying on sun-drenched Mexican beaches during the 1994 Christmas holidays, the biggest worry had likely been whether they had applied enough sun screen to their pale Canadian skin, all too suddenly uncovered after months encased in sweaters and coats.

The most immediate effect of the sudden collapse of the peso was that Canadian dollars could buy a whole lot more than the day before. Canadian tourists thus had even more bargaining power in haggling with underfed Mexicans for beachside trinkets and colourful local blankets.

But for the Mexicans, it was a bleak picture; their struggling lives were about to become even more difficult. Mexicans were experiencing the wild roller-coaster ride of dealing with international financial markets in the 1990s.

Mexico had become a magnet for footloose capital. Under Harvard- trained political leaders, the country had opened up its markets to foreigners, reduced its deficit and raised interest rates relentessly to reduce inflation. The reforms were very popular with foreign investors, who poured some $30 billion (U.S.) into Mexican financial markets in 1993 alone.

But the flood of money caused problems for Mexico, artificially inflating its currency and making its exports uncompetitive. Fearing a devaluation, investors started pulling their money out. The drain of funds quickly turned into a hemorrhage, sparking the peso crisis.

So, is Mexico just a cautionary tale from the trenches of the new global economy, showing us the awesome power wielded by international investors? Was the peso crisis just an inevitable casualty of the new realities, a revelation of the ultimate powerlessness of the nation-state? Or could a different set of rules have produced a different result?

After Schmidt had completed his paper, producing the negative results his superiors wanted, that should have been the end of the matter. The only problem was that he felt ashamed of himself. Unable to shake the feeling, Schmidt set to work on a second paper, and this time, he decided to write what he considered to be an accurate assessment of the Tobin tax.

Tobin had first proposed his tax back in 1972 because he wanted to ensure that governments had the tools they needed to create full employment. He recognized that it was difficult for nations to pursue full employment policies when investors could move large amounts of money effortlessly around the globe in search of big returns.

If interest rates were higher in Mexico, investors would borrow money at lower rates in New York and move the money into higher-rate Mexican bonds to turn a quick profit. It therefore became necessary for countries to maintain high interest rates in order to compete for mobile capital. But maintaining high interest rates was a sure way for a country to choke its domestic economy; it made full employment policies virtually impossible.

All this rapid exchange of money across currencies also had the negative effect of destabilizing national currencies, making it hard for countries to conduct international trade.

The essential idea behind the Tobin tax was to hinder this easy movement of capital across currencies, thereby giving governments more scope to manage their own economies. Tobin was not trying to stop capital from moving, but simply to slow it down, to hamper its mobility, in order to prevent it from wreaking havoc with national currencies and from wielding too much power over national governments.

To do this, Tobin advocated imposing a small tax whenever money was exchanged from one currency to another. This would have the effect of discouraging short-term, in-and-out investments - such as the ones that contributed to the Mexican crisis - while not really affecting more desirable long-term investments.

Like the perfect cancer drug, which leaves healthy tissue alone, the Tobin tax would not impinge on the healthy flow of capital involved in nations trading and investing in one another.

The tax also had the potential to collect vast amounts of money. Even if it were set as low as 0.2 per cent, the revenue potential was dramatic because of the sheer volume of money that is exchanged on world currency markets - some $1.2 trillion (U.S.) a day. Of course, the revenue collected wouldn't amount to 0.2 per cent of $1.2 trillion a day, because the tax would have the effect of discouraging a lot of the short-term, speculative-type transactions - which was exactly what it was supposed to do.

So, either way, the world community would benefit: It would collect a huge amount of tax, which could be put to good purpose, or it would collect a smaller amount of tax, but succeed in discouraging disruptive capital flows.

`By scooping a tiny percentage of the enormous sums traded daily on foreign exchanges, the Tobin tax could help reduce the volatility in world currencies and collect billions of dollars for good causes'

It seemed hard not to like the Tobin tax. By scooping a tiny percentage of the enormous sums traded daily on foreign exchanges, the Tobin tax could help reduce the volatility in world currencies and collect billions of dollars for good causes. And these were just the side benefits!

Then there was the main benefit: giving countries greater freedom to pursue full-employment policies. If only the Tobin tax could do something really useful, like cure the common cold, perhaps the finance department in Ottawa would give it some serious consideration. y Schmidt set all these issues out in his second paper and provided details of the nature of the vast new market in currency speculation. There were lots of complex, new financial instruments - spot trades, currency options, outright forward swaps - all variations in the game of betting on the changing value of currencies. While increasingly exotic, these instruments were also increasingly divorced from the real world of trade in goods and services.

As Schmidt noted, in two-thirds of all the outright forward and swap transactions, the money moved into another currency for fewer than seven days. In only 1 per cent did the money stay for as long as one year.

While the volatile exchange rates caused by all this rapid movement posed problems for national economies, it was the bread and butter of those playing the currency markets. Without constant fluctuations in the currency markets, Schmidt noted, there was little opportunity for profit.

This certainly seemed to suggest the interests of currency traders and the interests of ordinary citizens were operating at cross-purposes.

Schmidt also noted another interesting aspect of the foreign- exchange market: The dominant players were the private banks, which had huge pools of capital and access to information about currency values. Since much of the market involved moving large sums of money (typically in the tens of millions of dollars) for very short periods of time (often less than a day), banks were perfectly positioned to participate. Among swap transactions, which represented a major chunk of the foreign exchange market, 86 per cent of the transactions were actually between banks.

In Canada, the private banks carried out some $30 billion (Cdn.) a day in currency trades. This was, in fact, a growing part of the banks' business.

As Schmidt put the research together, the political nature of the problem became obvious. While volatile currency markets were bad for the national economy, they were advantageous to key elements in the financial community, particularly the banks, which were not generally shy about making their views known to government.

After his re-examination of the issue, Schmidt concluded in his second paper that the Tobin tax was potentially feasible and desirable. He submitted this second paper to his supervisors, in the hopes it would land on Martin's desk, as the first paper had. But the department considered this paper unsuitable, and it was not approved for distribution up the chain of command.

As he prepared for the Halifax summit, Martin was to be spared the confusion of knowing that the finance department expert who had been assigned to investigate the Tobin tax had concluded, after a more independent review, that the tax was indeed worthy of further investigation.

After Schmidt submitted his second paper, it became clear to him that his supervisors were not pleased with him. "In finance, everybody is very tightly controlled by their immediate superior," he said in an interview. "To advance, you have to be a kind of lackey to your superior."

Certainly, Schmidt could see that the finance department was not the place for someone anxious to open up new avenues of discussion on economic policies, particularly controversial ones. So he left the department in the fall of 1997. He has joined an international aid agency and been posted to Hanoi.

At least the department will no longer have to put up with bothersome arguments about the need for a tax to give democratic governments more control over international financial markets.

If the peso crisis failed to push Ottawa to consider new approaches for dealing with the power and fickleness of financial markets, the Chretien government was quick to co-operate with a request from Washington for a $1 billion line of credit as part of a $50 billion bailout package for Mexico. It seemed ironic, on the face of it, that the United States was hustling to hand over $50 billion to help out a country whose citizens were regularly rounded up by U.S. border patrols and treated little better than dogs.

Of course, the irony disappears when we remember that the $50 billion was not actually to help the Mexican people, but rather to make sure investors, mostly from the United States, Japan and Europe, didn't suffer huge losses on their Mexican holdings. Essentially, Western nations were spending their tax dollars - collected from all their citizens - to make sure their wealthiest and most powerful citizens did not suffer significant investment losses.

What is intriguing is how far all this strays from the notion that international capital markets are simply free markets operating on their own. The investors who stood to lose money in the peso crisis were not left to the mercy of a capricious market. On the contrary, a costly international rescue effort was orchestrated by the most powerful nations of the world, almost overnight, to insulate these investors from any potential harshness the market might deal out.

Indeed, contrary to popular lore, international financial markets are already subject to heavy intervention. But this intervention is carried out in the interests of financial investors. Why not carry it out instead in the public interest - as measures like the Tobin tax aim to do?

To even suggest that international financial markets be regulated in the public interest sounds, of course, like pie-in-the-sky dreaming. But in fact it's been done before - for several decades following World War II. And those decades, interestingly, coincided with the most prosperous era in the history of the world.